Capital account liberalisation in an emerging economy: private capital flows, exchange rates and stock markets in India.

Author:Khanna, Sushil


The emerging economies of Asia have in 1990s, emerged as the epicentre of private capital flows in the global economy, attracting a significant proportion of FDI and portfolio flows. India too has attracted more than $40 billion, during the second half of 1990s.

External capital inflows were expected to have a positive impact on the emerging market economies. At the macro level, capital account liberalisation is expected to lead to more efficient resource allocation at the global level Flows into capital scarce emerging economies would lead to decrease in interest rates, accelerated investment and higher growth. At the micro-level, integration of the capital markets in such economies with global portfolio flows should lead to risk diversification and lower the cost of capital for individual firms by raising Tobin's q.

This paper examines the experience of India at the macro and micro level, which accompanied by large fluctuations in the quantum of lows. At the macro level, periods of large inflows with low current account deficits, forced the central bank to mop up the excess flows. To sterilise the impact of this reserve accumulation, the Central bank mopped up liquidity, raising interest rates and slowing down the growth. At other times, outflows of capital, specially during 1997 crisis forced central bank to defend the currency by raising short term interest rates. Hence interest rates remained high during periods of inflows as well as outflows, slowing down the economy and aborting corporate restructuring necessary under industrial reforms.

The impact at the micro-level is analysed by studying the impact of portfolio flows on the Indian stock market and the cost of capital for firms that accepted investment from foreign investors. The analysis shows that Tobin's q for such firms actually declined and the stranglehold of foreign pension and mutual funds reduced availability of funds from capital market to the Indian corporate sector.


    The decade of nineties has witnessed a radical change in the external sector in the emerging economies of Asia. From a regime of fixed exchange and regulated interest rates, tight control on foreign direct investment (FDI) and a complete absence of foreign portfolio investment, the region has become the epicentre of private capital flows, attracting more than half of the FDI (Foreign Direct Investment) and portfolio investment.

    Along with the economies of the East and South Asia, almost all the countries of South Asia too embarked on capital account liberalisation. By international standards, India has been a late liberaliser. Even in the 1980s India continued to shelter its economy even when Latin America was opening itself to commercial borrowings and the East Asia economies changed their policies to attract private international portfolio capital. This changed with liberalisation in the 1990s when Indian policy makers embarked on a conscious strategy to integrate the economy with global financial markets. The Asian crisis halted this process briefly, but insulation of the South Asian economies from the turmoil of 1997-98, encouraged the central banks to continue with the opening up of the financial markets for foreign investors.

    The role of volatile private capital flows across borders has been debated widely in other countries (Helleiner, G.K., 1998), but the impact of such flows on the Indian economy is yet to be evaluated. The earlier discussion in India on foreign inflows has tended to revolve around the benefits and costs of Foreign Direct Investments (FDI) and the problem of capital flight rather than those of short term financial inflows (Chandra, N.K., 1988).

    The inflows have qualitatively changed the balance of payments situation in India. Today, private flows have replaced official assistance as the main source of meeting the current account deficit. The increase in FDI and portfolio inflows has had a wide ranging impact on the economy. These flows have begun to dominate the Reserve Bank's monetary policy and protecting the economy from the consequences of these flows has been the hallmark of the nineties. They also account for sharp increase in India's foreign exchange reserves, currently estimated to be above US $ 70 billion. However, these flows have not proved to be an unmixed blessing.

    Some authors have argued (Ahuluwalia, M.S., 2002) that India has gained substantially from the liberalisation of capital account and given the controls on residents and strict limits on debt creating inflows, Indian economy is not vulnerable to shocks from such inflows and outflows. The fact that India has escaped any serious capital flight is often cited as evidence.

    The impact of FDI inflows has been studied in some detail by some authors (Saha, B., 2001 and Subrahmanian, K.K. et al, 1996). This paper looks at the experience of Indian economy to private capital inflows and the costs and constraints imposed on the economy as the central bank struggled to manage the impact. It tries to evaluate the costs and benefits and to assess whether India has derived any of the expected benefits.

    Section-I discusses some theoretical issues associated with cross border capital movements and the way in which economists measure the costs and benefits of capital flows. The objective is to derive the hypothesis (that can be empirically tested) macro economic on effects of these inflows on the economy and the micro economic effects on the capital market. Section-II discusses the change in the policy regime that led to liberalisation of financial and external sector in the economy while section-III provides an overview of the nature of capital inflows to India in 1990s. Sections-IV and V look at the macroeconomic impact and on the Indian capital market as well the corporate sector and the last section draws some conclusions.


    The theoretical argument for financial sector liberalisation and liberalisation of cross border capital flows are now part of the neo-classical literature. Yet the debates on relative merits of domestic and external financial liberalisation has a long history.

    In the earlier literature on the subject, McKinnon and Shaw (McKinnon, R.I. 1973 and Shaw, E.S. 1973) argued that the interest rates in developing countries were artificially suppressed lead to longer savings and investments financial liberalisation would lead to higher levels of investment and output growth. Liberalisation would also channel funds towards financing the more productive projects. According to this familiar view, an increase in real interest rates following liberalisation should encourage savings and expand the supply of credit availability to domestic investors, thereby enabling the economy to grow more quickly. According to them the link between savings and investment should be the tighter, in the presence of capital controls and if a country has limited access to foreign savings.

    A number of liberalisation programmes supported by the international financial institutions over the years have had as their explicit objective to increase interest rates from levels that in some cases were substantially negative in real terms.

    While liberalisation of the domestic financial sectors and an increase in the interest rates have been the outcome of the liberalisation episodes, there is no empirical evidence that it leads to an increase in domestic savings and investment (Reinhart, C.M. and I. Tokathidis, 2001). In several cases, the savings may actually fall.

    This phenomena led Campbell and Mankiw ((Cambell, J. Y & N.G.Mankiw, 1989) to argue that before liberalisation, all households may not have access to credit markets, and hence their consumption are entirely determined by current incomes. Domestic financial liberalisation will be associated with relaxation of credit and liquidity constraints resulting in a consumption boom and a decline in aggregate savings. Hence, it is often seen that the financial liberalisation episode results in a period of rapid growth in bank lending, boom in asset price and increases in consumption that often lead to decline in private savings rates. Many of these episodes also resulted in a full-fledged financial crisis.

    There is little consensus in empirical literature on the impact of interest rates on aggregate savings in an economy. For example, a study on 18 developing countries (Giovannini, G. 1985) concludes that for the majority of cases, the response of consumption growth to real rates of interest is insignificant and one should expect no change in savings rate. The literature is equally ambiguous on effects of financial liberalisation on savings rates, growth and other macroeconomic variables. In some cases, research has found that the relationship is significantly negative (Bandiera, GC., 2000).

    The proponents of the external sector liberalisation argue that the impact of some these factors that present increase in savings & investment can be offset by opening up the domestic financial markets to international capital flows. Capital account liberalisation can make it possible for foreign savings to support domestic investment and growth, subject to acceptable risk and adequate returns.

    Hence, liberalising capital account along with capital markets has become a dogma with international financial institutions. Their case rests on standard neo-classical efficiency argument, ignoring the ways in which financial markets are different from the market for goods and services. The arguments for capital market integration are as follows:

    (a) Given the fact that the returns on investment in different countries are not equal, the capital controls lead to resource misallocation: at the margin, some countries may not undertake highly profitable investment projects for lack of financing, while projects worth lower return are funded elsewhere (World Bank, 1997)...

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