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Q+A - How will India manage rising capital inflows?
November 19, 2009 / 11:26 AM / 8 years ago

Q+A - How will India manage rising capital inflows?

File photo of the BSE building May 22, 2006. REUTERS/Punit Paranjpe/Files

NEW DELHI (Reuters) - Foreign funds have been pouring into India this year in hopes of capitalising on the country’s growth outlook.

Offshore investors have bought more than $15 billion of local equities in 2009 after selling $13 billion in 2008, helping send Indian stocks more than 75 percent higher. The influx of foreign funds is also pushing up the rupee .

WHY ARE CAPITAL INFLOWS RISING?

India, Asia’s third-largest economy, has suffered less in the global downturn than developed countries. The economy is likely to grow 6.5 percent in the current fiscal year to end-March 2010, after growing 6.7 percent in the last fiscal year.

Though this growth rate is lower than 9 percent or above seen in the three years to 2007/08, it is far better than in western economies, a trend reflected in other emerging markets.

Interest rate differentials, already favouring emerging markets and so attracting investment flows, are set to expand further.

The United States, the euro zone, Japan, and Britain are showing no inclination to push up their rates anytime soon as recovery proves slow, whereas India, South Korea and China are expected to be the first big emerging markets to raise rates in 2010.

CAN RISING INFLOWS BE A PROBLEM?

Rising inflows have helped drive up stock and property prices in India, prompting the Reserve Bank of India (RBI) to increase provisioning requirements for loans to real estate companies to prevent asset bubbles.

The RBI is already worried about inflation, but has limited monetary tools to tame price rises.

The RBI has said there is a risk that if it raised interest rates ahead of other central banks, it could attract more inflows and complicate policymaking.

The rupee has also appreciated about 12 percent from a low of 52.2 in early March, making exports less competitive. Exports, which make about one fifth of India’s GDP, have been falling since October 2008.

The risk is that just as offshore capital can flow into markets quickly, they can flow out again, disrupting the economy.

WHAT HAS BEEN INDIA‘S RESPONSE SO FAR?

Indian officials have welcomed fund inflows and have said the inflows are not a worry.

However, Finance Minister Pranab Mukherjee on Wednesday said the government was monitoring the situation and had tools to manage inflows if they turn disruptive.

His comments follow capital controls imposed by Brazil and Taiwan as they sought to protect their markets from a foreign investment surge.

WHAT COULD BE OPTIONS TO STEM INFLOWS?

Economists say India is unlikely to follow Brazil and impose a tax on inflows, as that could drive away foreign investors and hurt Indian companies.

In 2007, when India attracted a similar wave of inflows, the stock exchange regulator imposed curbs on participatory notes, which had enabled foreign investors to buy local securities anonymously.

A year later it removed most of these curbs after the stock market was battered by the global crisis.

In 2007, the central bank also temporarily imposed curbs on overseas borrowing by Indian firms.

Economists expect Indian regulators to reimpose some of those measures and tighten funding for real estate if inflows prove disruptive.

The government could also cap overseas borrowings of Indian companies by auctioning quotas for foreign credit, which would raise the cost of raising funds. The government has said it currently has no such plans.

Additionally, India’s central bank can sterilise flows using market intervention bonds and raising the cash reserve ratio (CRR), the proportion of deposits banks need to keep with it.

The CRR currently stands at 5 percent and market expectations are already building that it may be raised soon. Raising it could discourage bank lending, which is already weak.

Sterilising inflows, meanwhile, carries additional interest costs for a government that is already in the midst of a record borrowing programme to fund a fiscal deficit running at a 16-year high. Issuing bonds to sterilise inflows could also crowd out private borrowing.

Editing by Neil Fullick

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