Foreign Capital Movement-Assignment (Group1) - Ver4

International Business Environment
FOREIGN CAPITAL MOVEMENTS
Submitted to:
Prof. V.K. Bhalla
Submitted on:
20, March, 2010
By:
Amit Chawla (S-8)

Anshul Khanna (S-12)
Ranjit Kumar (S-51)
Sushil Kumar Sharma (S-65)
Manoj Kumar Rana (N-29)
Subhadip Raychaudhuri (N-54)
MBA-PT 2007-2010
Faculty of Management Studies

University of Delhi
International Business Environment: Foreign Capital Movement
TABLE OF CONTENTS
1) LOANS AND BORROWINGS......................................................................................................................30

2) INTERNATIONAL BANKING FLOWS..........................................................................................................43
3) DONATIONS AND CHARITY....................................................................................................................43
4) HAWALA TRANSACTIONS......................................................................................................................44
5) OTHERS..............................................................................................................................................44
6) ROLE OF RESERVE BANK OF INDIA........................................................................................................46
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Executive Summary
Since liberalization and globalization foreign capital has come to assume an important
place in the development of the country. Foreign capital movements have increased
considerably. The resident individuals and companies are now allowed to undertake
various types of foreign exchange transactions, including investment in foreign
countries, establishing foreign subsidiaries, joint ventures, foreign collaboration,
mergers and acquisitions etc., with foreign residents and companies.
Some of the key drivers of the capital movement across international boundaries
include globalization, higher productivity of capital, tax exemptions, higher returns,
developmental needs exceeding the domestic savings, political stability, exchange rate
policies, demographic trends etc.
The key forms through which the capital moves includes investments (in the form of
private investments, FDIs, FIIs, overseas corporate bodies etc.), loans and borrowings,
international banking flows, donations and charity, remittances, hawala transactions
etc.
RBI plays a critical role in the foreign capital movements across India. In the field of
Foreign Exchange, activities of RBI include - maintenance of foreign exchange rate,
provision of sale and purchase of foreign exchange through authorized dealers and
Licensed Money changers, market intervention, sterilization, deployment of foreign
exchange reserves and representing India at various International forums.
Capital inflows play a critical role in the growth of the economy and accumulation of
foreign exchange reserves. FDIs also bring in advantages with regards to employment
and technology. However, excess of capital inflows lead to speculations with regards
to asset price increases, and also leads to an increase in exchange rates and interest
rates. Capital outflows also bear a negative impact for the home economy as it may
lead to unemployment and capital crunch for the residents of the country.
A sound fiscal and monetary policy is required to maximize the benefits of foreign
capital movement and minimize the adverse impacts of foreign capital movement. It is
important that the domestic banking institutions are made stronger. As a general rule,
nonviable institutions should be weeded out and remaining banks put on a sound
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footing before liberalizing or opening the domestic banking system. Also, it is

important that the domestic markets are made stronger. These domestic markets and
financial infrastructure for portfolio investments in equities and debt instruments are
not well developed in many emerging market countries. Finally, the long-term flows
should be liberalized ahead of the short term flows.
As per a report by a working group chaired by Dr. Rakesh Mohan, Deputy Governor,
Reserve Bank of India, the flow of capital between nations, in principle, brings
benefits to both capital-importing and capital-exporting countries. Swings in capital
inflows without offsetting changes in current account balances can lead to large, and
possibly disruptive, changes in real exchange rates. And they are frequently associated
with more volatile or fragile forms of finance. Past experience suggests that large
capital inflows - whether absorbed or not - can drive up the prices of existing assets
and may not lead to the creation of new assets. Asset market bubbles have been
disruptive in some EMEs. Policymakers need to keep these risks in mind.
How well domestic capital markets function has a major bearing on whether capital
inflows enhance growth without exacerbating financial stability. The greater presence
of foreign investors should, in principle, deepen local financial markets, enhance
investor diversity and improve liquidity. But they can also exacerbate the domestic
macroeconomic and liquidity crisis in the times of crisis through massive liquidation
of their investments in the EMEs.
Overall, it is a combination of sound macroeconomic policies, prudent debt

management, exchange rate flexibility, the effective management of the capital
account, the accumulation of appropriate levels of reserves as self-insurance and the
development of resilient domestic financial markets that provides the optimal response
to the large and volatile capital flows to the EMEs.
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I. Introduction
In earlier times the society and countries had limitations of communications and
transportation. Due to these limitations they remained in aloofness. They made efforts
towards progress and development with the help of capital and resources available
with them. With the passage of time science and technology had made significant
progress, new and faster means of communication and transport were invented and
developed, which increased interaction between people and institutions of different
areas and countries significantly. However still there were considerable restrictions on
capital movements between the countries which hindered the global economic
development.
Eminent economists stressed on liberalization of capital movements. International

economies undertook economic and financial reforms to give a boost to the economic
development.
India started economic and financial reforms in late 1980s. It liberalized various
provisions of Foreign Exchange Regulation Act 1973 and renamed the act as Foreign
Exchange Maintenance Act 1999. It made Current Account fully convertible. Capital
Accounts transactions were also liberalized partially. The Reserve Bank of India and
the central Government had decided to take a cautious view to introduce full capital
account convertibility in stages in due course.
The resident individuals and companies were allowed to undertake various types of
foreign exchange transactions liberally viz. investing in foreign countries, establishing
foreign subsidiaries, joint ventures, foreign collaboration, mergers and acquisitions
etc., with foreign residents and companies.
Since liberalization and globalization foreign capital has come to assume an important
place in the development of the country. Foreign capital movements have increased
considerably. However like every earthy thing, foreign capital had also good and bad
impacts on the economy of the recipient country. It all depended on the circumstances
and terms and conditions on which foreign capital was received, the sectors in which
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the same was employed productive or unproductive, how it was being utilized
earnestly or corruptly.
In the next few chapters an effort has been made to discuss various aspects of foreign
capital as enumerated below:
Chapter I gives a brief introduction to the subject matter, purpose of the report and
chapter scheme.
Chapter II elaborates as to what is foreign capital, why it moves what are the drivers
which make the capital to flow.
Chapter III mentions the various forms the foreign capital assumes and discusses
about the various participants and their roles in foreign capital movement.
Chapter IV presents the whole picture with data on foreign capital movement
(inbound and outbound) from India.
Chapter V evaluates impact of foreign capital movement on our national economy.
Chapter VI depicts the global scenario as regards to foreign capital movement.
Chapter VII touches upon global issues in this regard.
Chapter VIII tells about the global economic crisis and subsequent international
economic cooperation to fight the global recession.
Chapter IX considers implication of printing more money by the USA and that of
revaluation of currencies by countries.
Chapter X tries to delineate the steps to be taken to optimize on the foreign capital.
Chapter XI gives a mention of the conclusions derived by the eminent economists and
study groups.
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II. Drivers of Capital Movement
In the start we will discuss as to what capital is, what foreign capital is and why it
moves.
Capital -
In Economics capital is considered as a factor of production which is not wanted for

itself but for its ability to help in producing other goods. It is the most important input
by which other inputs like labour, raw material, building, plant and machinery etc. can
be purchased and put to use for production.
In Finance, capital is any form of wealth capable of being employed in the production
of more wealth. The capital is invested for producing more wealth. This investment of
capital takes two forms e.g. Real investment and financial investment:
Real investment – Real investment refers to money invested in purchase of tangible

and productive assets such as land, building, plant and machinery etc., as opposed to
investment in securities or other financial instruments.
Financial investment – Financial investment is the commitment of money for purchase

of financial assets e.g. shares, debentures, bonds, mutual funds units, insurance units,
fixed deposits etc.
It may be clarified that the investment in the initial public offer (IPO) of a company
provides money directly to the company and the same uses it for production and hence
may be considered as real investment. However, investment in financial assets, in the
secondary market represents financial investment.
Foreign Capital –
Capital invested in a country by the investors from the other countries is called foreign
capital.
When domestic investors of a country, having surplus investible funds which

represent domestic capital, invest in foreign countries, this domestic capital becomes
the foreign capital for the investee countries. This change of form of capital, from
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domestic capital to foreign capital takes place through the mechanism of foreign
exchange.
Why does capital move?
In economic and finance movement of capital is technically referred to as flow of

capital. Flow is a natural phenomenon. Just like -
◦ Water flows from higher to lower level
◦ Heat flows from higher to lower temperature
◦ Air flows from higher to lower pressure
Similarly capital has a tendency to flow
◦ For a given return, from higher risky investment to a lower risky one.
◦ For a given risk level, from an investment giving lower return to an

investment yielding higher return.
Forms of capital flow –
Capital movement means movement of capital between different countries either by

individuals on corporate. Capital movements are of two types:
• Outward capital movement denotes movement of domestically held capital

from one country outwardly to other countries abroad;
• Inward capital movement represents movement of foreign owned capital into a

country.
Drivers of Foreign Capital Movement –
Some of the main drivers i.e factors which causes capital tl move are listed below:
 Globalization
 Productivity
 Taxes
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 Higher return (rate of interest)
 Developmental needs exceeding the domestic savings
 Exchange Rate Policy
 Political stability
 Demographic trends
Now we shall discuss these drivers in some details:
Globalization –
Globalization is taken here to mean the growing integration of national economies and
societies, so that no society is isolated or remote from changes and developments in
other societies.
This is a process which has been going on for thousands of years, yet since the 1950s
the pace of change has increased. This is manifest in the increasing cross-border flow
of goods and services, where consumers in one country buy a substantial number of
goods produced in other countries.
At the same time there are increased capital flows between nations where savers in
one nation may invest in other nations. For example, over the period 1990-1998,
cross-border trade in goods and services has grown at an average annual rate of 6.6%,
twice the rate of growth of world GNP.
Globalization is the culmination of an evolution of markets. Historically, markets have

started as local in nature, with producers and consumers in close physical proximity.
What we then frequently see is an evolution of these local markets to national markets
and then finally international or global markets. It is this evolution that is called
globalization. It should be emphasized that not all markets evolve at the same rate or
at the same time, so that we can see markets today at all stages.
Capital markets are now more integrated. Capital is more mobile and currency
controls have been relaxed in most countries. The movement of capital to those
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investment opportunities and countries where it generates the highest return can be
destabilizing - witness the controls recently placed on capital in Malaysia.
This is due in part to the mobility of financial capital. Physical capital, represented by
physical plant, is not mobile; once built a factory is hard to move. As currency
controls have been relaxed, investment opportunities for individuals have been
increased and they can now buy shares in the US, or any number of other countries.
There has been rapid growth in the value of world trade (goods and services), much
faster than the growth in the total world economy. This reflects increasing
specialization by countries.
Productivity –
Nature has variety. It has endowed its treasure to different regions and different
countries in different proportions. Some countries have pleasant weather and some
faces vagaries of the weather. Some countries are rich in natural resources whereas the
nature has not been so generous on some others. Some countries are abundant in
natural resources and provide cheap raw material for production. Some countries like
China and India have large workforce and they provide cheap labour for productive
activities. Some are rich in oil and their whole economy is flourishing with oil
production.
Standard neoclassical theory suggests that international capital movements should

respond to differences in expected rates of return on capital across countries.
Accordingly, capital “should” flow from high-income countries to developing
countries (where capital/labour ratios are lower and the productivity of capital higher),
boosting growth for some years and allowing developing countries to run current
account deficits. In a world with perfect capital markets, capital flows can be used to
smooth consumption or finance profitable investment opportunities.
One qualification to this perspective is that the expected variance of returns also
matters: potential investors can be deterred from investing in developing countries
because of greater risks. Nevertheless, allocating capital to where risk-adjusted returns
are higher should raise global welfare.
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The neoclassical perspective broadly fits the pattern seen from the late 19th century up
to 1914. Capital flowed to developing areas where the expected return on capital was
high. The associated current account imbalances were larger, measured in relation to
GDP, than in subsequent periods. Four features of this classical period are worth
noting:
• First, flows were almost entirely denominated in gold standard currencies,

mainly sterling – nominal exchange rates were in fact fixed. This arrangement
also served to stabilise inflation expectations.
• Second, the main investment vehicle was bonds, and nominal long-term
interest rates were comparatively stable.
• A third, partly related, feature was that the range of financial assets was
extremely limited. Denomination of contracts in gold standard currencies and
the stability of long-term interest rates eliminated much of the need for
financial diversification and hedging. In any case, the high costs of
communication and of computation impeded the development of such
activities. Hence the forms that capital flows took were much more uniform
than has been the case in recent decades. Nor were there the huge two-way
flows of capital that prevail today.
• The final feature was that, much of the movement of capital was long-term in
nature, going to finance investment in capital-intensive infrastructure and other
real investment. The scope for profitable foreign investment was considerable
at that time because real output was expanding twice as fast in capital-
importing countries outside Europe than in capital-exporting countries in
Europe and because of confidence that bonds would be honoured. Increased
real investment led to deterioration in the current account of recipient countries
so that the transfer of capital could be “requited” without a change in the real
exchange rate.
In the late 1980s and early 1990s, however, there was a revival of capital flows to the
EMEs as growth in the industrial world picked up. After a short-lived tightening in
1994, US policy rates were reduced in 1995 and the decline in European rates
continued: this easing of monetary conditions in major countries increased the supply
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of low-cost finance through banks and the international capital markets.15

International bank lending moved from Latin America to the rapidly growing Asian
developing countries (“Tigers”). The issuance of debt securities, mostly denominated
in dollars, in international capital markets increased. East Asia and Russia benefited
from declining risk premia on sovereign (and even bank) debt. Substantial current
account deficits were financed in ways that created large risk exposures (see below).
This period of expansion in capital flows, punctuated by the Mexican crisis at the end
of 1994, really came to an end only with the Asian and Russian crises in 1997–98.
These crises demonstrated that capital flows into countries with weak banking systems
and underdeveloped capital markets create huge risks.
Thus the flow of capital increased to the countries which had received large capital
inflows in the past and had established better physical and financial infrastructure
leading to higher productivity of capital.
Taxes –
Logically the capital should move to the countries with low tax regimes so that the
prime motive of increasing return on investment could be attained.
Tariff reductions, falling transport costs, and reduced barriers to international capital
flows have created extensive opportunities for multinational firms and investors in
increasingly integrated global markets.
In the midst of this rapid integration, investors and firms still face tax systems and
investor protections that differ across countries, and these differences have the
potential to affect major investment and financing decisions. Governments anxious to
attract FDI often consider the use of tax incentives to lure multinational firms, and
governments of FDI source countries--including the United States--often wonder
whether their tax treatment of foreign income is appropriate. Similarly, investor
protections and the broader institutional environment remain distinctive around the
world and may influence investors' port folio decisions and firms' operational and
financing decisions. Corporate taxes and investor protections also have the potential to
influence FPI by changing the relative attractiveness of FPI and FDI as means of
achieving international diversification. The potential effects of taxation on FPI result
from the interaction between home and host country taxes. In particular, the United
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States taxes multinational firms legally domiciled here on their worldwide income. As
a consequence of this policy, U.S. investors should prefer FPI as a means of accessing
foreign diversification opportunities, particularly in low-tax countries where the
residual tax imposed by the United States will be most burdensome. In effect, FPI
allows investors to avoid any residual tax on investment income earned abroad arising
from the worldwide tax regime.
With an increasing number of governments competing to attract multinational

companies, fiscal incentives have become a global trend that has grown considerably
in the 1990s. Poor African countries rely on tax holidays and import duty exemptions,
while industrial Western European countries allow investment allowances or
accelerated depreciation. Have governments offered unreasonably large incentives to
entice firms to invest in their countries?
More recent evidence has shown that when other factors - such as infrastructure,
transport costs, and political and economic stability - are more or less equal, the taxes
in one location may have a significant effect on investors' choices. This effect is not
straightforward, however. It may depend on the tax instrument used by the authorities,
the characteristics of the multinational company, and the relationships between the tax
systems in the home and recipient countries. For example, tax rebates are more
important for mobile firms, for firms that operate in multiple markets, and for firms
whose home country exempts any profit earned abroad (Canada, France) rather than
using tax credit systems (Japan, the United Kingdom, the United States).
Even if tax incentives were quite effective in increasing investment flows, the costs
might well outweigh the benefits. Tax incentives are not only likely to have a negative
direct effect on fiscal revenues but also frequently create significant opportunities for
illicit behavior by tax administrators and companies. This issue has become crucial in
emerging economies, which face more severe budgetary constraints and corruption
than industrial countries do.
Developmental needs v/s the domestic savings –
All countries are at various different stages of economic development. All are trying
hard to attain higher level of development to raise their standard of living. Any
country in its endeavour of economic development utilises capital available with it in
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the form of domestic savings. In poor countries rate of capital formation is very low
because of high consumption and consequent low rate of savings. In such cases they
welcome foreign capital to give a fill up to their development efforts. They provide
tax holidays, import duty exemptions and other preferential treatment to foreign
investors to boost up their developmental efforts.
On the other hand availability of cheaper factors of production e.g. raw material,
labour etc., accompanied with scarcity of domestic capital in such countries provides
an opportunity to the foreign investors to make investment in these capital deficit
countries to earn a good return on their investments.
Other important aspect relating to foreign investment is repatriation of foreign capital.

The country which allows repatriation of foreign capital and interest or income earned
therefrom liberally, attracts more foreign funds compared to those which restrict such
repatriation.
Higher rate of return (rate of interest) –
Maximising the return is the ultimate goal of any investment. The total return
comprise of the interest and the currency appreciation. Thus the country which gives
more interest on foreign capital attracts more capital funds than those which offer
lower return for the equivalent risk.
Interest rates, inflation and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates, and
changing interest rates impact inflation and currency values. Higher interest rates offer
lenders in an economy a higher return relative to other countries. Therefore, higher
interest rates attract foreign capital and cause the exchange rate to rise. The impact of
higher interest rates is mitigated, however, if inflation in the country is much higher
than in others, or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates - that is, lower interest rates tend to
decrease exchange rates.
Exchange Rate Policy –
According to purchasing power parity, exchange rates are determined by relative price
of goods exchanged between countries. Countries with above-average inflation would,
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until their exchange rate fell, see their exports priced out of world markets and their
home markets flooded with imports. The result would be a balance of payment deficit.
But this scenario may be reversed by currency realignment. Exchange rates would
therefore move to equalise the prices of the traded goods between the rival economies
and help to stabilise the system.
The international money flows from where it is cheap and plentiful to where it is
scarce and expensive. It might be hypothesised that exchange rates move to equalise
expected rates of return in rival financial centres. Money moves to centres where
returns are anticipated to be highest. Bur as well as interest received, returns include
anticipated currency appreciation and depreciation. Hence there is direct feedback.
Currencies attracting funds rise and in rising become more attractive. The country
perceived to offer the highest true return has the strongest currency. Its strong
currency then prices its exports out of world markets and causes its home markets to
be flooded with imports. Whereas traditionally, a trade deficit caused a currency to
weaken, it is possible to say that in the middle eighties the relationship has been
reversed. A strong currency causes trade deficit.
This new order is certainly unstable. Currencies overshoot due to effects of positive
feedback. Exchange rate movements operate to generate, rather than to correct
imbalances in trade and payments, and these imbalances may become both large and
unbelievably long-lived. In this world it is vital, but extremely difficult to identify
whether differing expected rates of return are due to real differences in the returns
from capital investment in one economy rather than other. If they are, large
imbalances can and do persist for longer than might be thought to be the case in
traditional models.
Political stability –
Political stability refers to the stable government and stable rules and regulations
framed by such government regulating the economic activities in the country.
Political risk refers to the risk that, 1) political events and processes within the host
country, 2) changing relationships between the host and the home country, as well as
between the host country and third countries, will influence the economic well-being
of the foreign parent firm . Political risk can be classified as macro political risk and
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micro political risk. Macro political risk is country-specific political risk and will
influence all foreign firms in the host country alike. Macro risks include
expropriations of all foreign firms in a country, non-discriminatory measures such as
changes in tax laws, price controls, environmental regulations, and constraints which
affect foreign firms only, such as limitations on the repatriation of capital, restrictions
on expatriate employment and foreign ownership, and local content regulations. Micro
political risk is specific to a certain industry, firm, or project. Political risk may affect
the ownership of the assets, via full or partial forced divestitures, or the operations of
the firm. While macro risk is more visible, micro risk is of more importance to firms.
Economic well being is defined in terms of cash flows. Political risk is defined as
unexpected changes in future cash flows due to political events in the host country.
Political risk may thus lead to unexpected increases or decreases in future cash flows.
Political risk exists because there is no legal recourse if the foreign government
chooses to expropriate an asset or otherwise increase the cost for foreign firms. The
alternatives for host governments to alter the cash flows from foreign operations range
from reducing cash flow due to higher taxes to completely eliminating any cash flows
in case of full expropriation. Foreign governments will likely choose to do so only if
the expected benefits of the expropriation or other cost to the multinational firm
exceed the expected costs to the foreign government of these actions.
The countries which are politically more stable attract more foreign funds than those
which have more political uncertainties.
Demographic Trends –
The world is in the midst of a major demographic transition. Not only is population
growth slowing, but the age structure of the population is changing, with the share of
the young falling and that of the elderly rising. Different countries and regions,
however, are at varying stages of this demographic transition. In most advanced
countries, the aging process is already well under way, and a number of developing
countries in east and south-east Asia and central and eastern Europe will also
experience significant aging from about 2020.2 In other developing countries,
however, the demographic transition is less advanced, and working-age populations
will increase in the coming decades.
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As expected, the changing population and labour force have important impacts both
on private investment through changes in the expected marginal product of capital as
well as on consumption and saving decisions. The increase in the labour force in
developing countries raises the marginal product of capital and stimulates higher
investment, with the investment to GDP ratio 4 percent higher by 2025.
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III. Forms of Capital Movement
Foreign capital movement generally takes place in the form of –
◦ Investments
◦ Loans and borrowings
◦ International Banking flows
◦ Donations and charity
◦ Remittances
◦ Hawala transactions, etc.
We shall discuss each of the abovementioned forms in detail in next pages.
1) Investments
Foreign Direct Investment in India
In terms of RBI circular, Foreign Direct Investment (FDI) in India is governed by the
FDI Policy announced by the Government of India and the provisions of the Foreign
Exchange Management Act (FEMA), 1999. Reserve Bank has issued Notification No.
FEMA 20 /2000-RB dated May 3, 2000 which contains the Regulations in this regard.
This Notification has been amended from time to time.
Entry routes for investments in India
Foreign Direct Investment is freely permitted in almost all sectors. Under the Foreign
Direct Investments (FDI) Scheme, investments can be made by non-residents in the
shares / convertible debentures / preference shares1 of an Indian company, through
two routes; the Automatic Route and the Government Route.
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1. Under the Automatic Route, the foreign investor or the Indian company does
not require any approval from the Reserve Bank or Government of India for
the investment.
2. Under the Government Route, prior approval of the Government of India,

Ministry of Finance, Foreign Investment Promotion Board (FIPB) is required.
Prohibition on investment in India
1. Foreign investment in any form is prohibited in a company or a partnership

firm or a proprietary concern or any entity, whether incorporated or not (such
as, Trusts) which is engaged or proposes to engage in the following activities:
a. Business of chit fund, or
b. Nidhi company, or
c. Agricultural or plantation activities, or
d. Real estate business, or construction of farm houses, or
e. Trading in Transferable Development Rights (TDRs).
2. It is clarified that “real estate business” does not include development of

townships, construction of residential / commercial premises, roads or bridges
educational institutions, recreational facilities, city and regional level
infrastructure, townships. It is further clarified that partnership firms
/proprietorship concerns having investments as per FEMA regulations are not
allowed to engage in print Media sector.
3. In addition to the above, investment in the form of FDI is also prohibited in

certain sectors such as
a. Retail Trading (except single brand product retailing)
b. Atomic Energy
c. Lottery Business
d. Gambling and Betting
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e. Business of chit fund
f. Nidhi company
g. Trading in Transferable Development Rights(TDRs)
h. Activities / sectors not opened to private sector investment
i. Agriculture (excluding Floriculture, Horticulture, Development of

seeds,
j. Animal Husbandry, Pisciculture and cultivation of vegetables,

mushrooms, etc. under controlled conditions and services related to
agro and allied sectors) and Plantations (other than Tea Plantations)
Participants in Investments
The primary participants in the investment are:
◦ Individuals
◦ Foreign Institutional Investors (FIIs)
◦ Companies (investees & investors)
◦ Mergers and Acquisitions
◦ Overseas Corporate Bodies
◦ Funds like Private Equity funds, Hedge fund, Venture Capital funds, sovereign
wealth funds etc.
Individuals including Non Resident Indians (NRIs) and foreigners are afforded many
alternatives for investing in India. Under the extant provisions NRIs are accorded
special treatment. Various options available to them for investment in India are
depicted below:
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Investments by Non-Resident Indians (NRIs)
NRIs are allowed to invest in shares of listed Indian companies in recognised Stock
Exchanges under the PIS. NRIs can invest through designated ADs, on repatriation
and non-repatriation basis under PIS route up to 5 per cent of the paid- up capital /
paid-up value of each series of debentures of listed Indian companies. The aggregate
paid-up value of shares / convertible debentures purchased by all NRIs cannot exceed
10 per cent of the paid-up capital of the company / paid-up value of each series of
debentures of the company.
The aggregate ceiling of 10 per cent can be raised to 24 per cent, if the General Body
of the Indian company passes a special resolution to that effect.
Payment for purchase of shares and/or convertible debentures on repatriation basis has
to be made by way of inward remittance of foreign exchange through normal banking
channels or out of funds held in NRE/FCNR(B) account maintained in India. If the
shares are purchased on non-repatriation basis, the NRIs can also utilise their funds in
NRO account in addition to the above.
The link office of the designated branch of an AD Category – I bank shall furnish to
the Reserve Bank11, a report on a daily basis on PIS transactions undertaken by it,
such report can be furnished on-line or on a floppy to the Reserve Bank.
Shares purchased by NRIs on the stock exchange under PIS cannot be transferred by
way of sale under private arrangement or by way of gift (except by NRIs to their
relatives as defined in Section 6 of Companies Act, 1956 or to a charitable trust duly
registered under the laws in India) to a person resident in India or outside India
without prior approval of the Reserve Bank.
NRIs are allowed to invest in Exchange Traded Derivative Contracts approved by

SEBI from time to time out of Rupee funds held in India on non-repatriation basis,
subject to the limits prescribed by SEBI.
NRIs, PIOs, outside residents can maintain deposit accounts:
◦ Foreign Currency (Non-Resident) Account (Banks) Scheme (FCNR(B)

Account),
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◦ Non-Resident (External) Rupee Account Scheme (NRE Account),
◦ Non-Resident Ordinary Rupee Account Scheme (NRO Account)
Outside residents can also invest in the shares and convertible debentures of an Indian
company. Individuals invest in shares and debentures of companies situated in foreign
countries through:
◦ American Depositary Receipt (ADR) - represents ownership in the shares of

a non-U.S. company and trades in U.S. financial markets.
◦ Global Depository Receipt (GDR) - certificate issued by international bank,

which can be subject of worldwide circulation on capital markets. GDR's are
emitted by banks, which purchase shares of foreign companies and deposit it
on the accounts.
Foreign Institutional Investors (FIIs)
Foreign institutional investor means an entity established or incorporated outside

India which proposes to make investment in India. Positive tidings about the Indian
economy combined with a fast-growing market have made India an attractive
destination for foreign institutional investors.
Various provisions relating to investment by FIIs as contained in master circular of the

Reserve Bank of India are given below:
Investment by FIIs under PIS
Portfolio Investment Scheme (PIS)
• Foreign Institutional Investors (FIIs) registered with SEBI and Non-resident

Indians (NRIs) are eligible to purchase shares and convertible debentures
issued by Indian companies under the Portfolio Investment Scheme (PIS).
• The FIIs, which have been granted registration by SEBI, should approach their
designated AD Category - I bank (known as Custodian bank), for opening a
foreign currency account and / or a Non Resident Special Rupee Account.
22
• NRIs can approach the designated branch of any AD Category - I bank

authorised by the Reserve Bank to administer the Portfolio Investment Scheme
for permission to open a NRE/NRO account under the Scheme for routing
investments.
Reserve Bank has given general permission to SEBI registered FIIs/sub-accounts to

invest under the PIS.
Shareholding
Total shareholding of each FII/sub-account under this Scheme shall not exceed 10 per
cent of the total paid-up capital or 10 per cent of the paid-up value of each series of
convertible debentures issued by the Indian company.
Total holdings of all FIIs /sub-accounts put together shall not exceed 24 per cent of
the paid-up capital or paid-up value of each series of convertible debentures. This
limit of 24 per cent can be increased to the sectoral cap / statutory limit, as applicable
to the Indian company concerned, by passing a resolution of its Board of Directors
followed by a special resolution to that effect by its General Body.
A domestic asset management company or portfolio manager, who is registered with

SEBI as an FII for managing the fund of a sub-account can make investments under
the Scheme on behalf of;
1. A person resident outside India who is a citizen of a foreign state, or
2. A body corporate registered outside India;
provided, such investment is made out of funds raised or collected or brought from
outside through normal banking channel. Investments by such entities shall not exceed
5 per cent of the total paid-up equity capital or 5 per cent of the paid-up value of each
series of convertible debentures issued by an Indian company, and shall also not
exceed the overall ceiling specified for FIIs.
23
Prohibition on investments
1. FIIs are not permitted to invest in equity shares issued by an Asset

Reconstruction Company.
2. FIIs are also not allowed to invest in any company which is engaged or
proposes to engage in the following activities:
a. Business of chit fund, or
b. Nidhi company, or
c. Agricultural or plantation activities, or
d. Real estate business, or construction of farm houses, or
e. Trading in Transferable Development Rights (TDRs).
"Real estate business" does not include construction of housing / commercial

premises, educational institutions, recreational facilities, city and regional level
infrastructure, townships.
Short Selling by FIIs
Foreign Institutional Investors (FIIs) registered with SEBI and sub-accounts of FIIs
are permitted to short sell, lend and borrow equity shares of Indian companies. Short
selling, lending and borrowing of equity shares of Indian companies shall be subject
to such conditions as may be prescribed by the Reserve Bank and the SEBI / other
regulatory agencies from time to time. The permission is subject to the following
conditions:
a) The FII participation in short selling as well as borrowing / lending of equity shares
will be subject to the current FDI policy and short selling of equity shares by FIIs
shall not be permitted for equity shares of Indian companies which are in the ban list
and / or caution list of the Reserve Bank.
b) Borrowing of equity shares by FIIs shall only be for the purpose of delivery into
short sales.
24
c) The margin / collateral shall be maintained by FIIs only in the form of cash. No
interest shall be paid to the FII on such margin/collateral.
Exchange Traded Derivative Contracts
SEBI registered FIIs are allowed to trade in all exchange traded derivative contracts
approved by RBI/SEBI on recognised Stock Exchanges in India subject to the position
limits and margin requirements as prescribed by RBI / SEBI from time to time as well
as the stipulations regarding collateral securities as directed by the Reserve Bank from
time to time. The SEBI registered FII / sub-account may open a separate account
under their
Special Non-Resident Rupee Account through which all receipts and payments
pertaining to trading / investment in exchange traded derivative contracts will be made
(including initial margin and mark to market settlement, transaction charges,
brokerage, etc.). Further, transfer of funds between the Special Non-Resident Rupee
Account and the separate account maintained for the purpose of trading in exchange
traded derivative contracts can be freely made. However, repatriation of the Rupee
amount will be made only through their Special Non-Resident Rupee Account subject
to payment of relevant taxes. The AD Category – I banks have to keep proper records
of the above mentioned separate account and submit them to the Reserve Bank as and
when required.
FIIs are also allowed to offer foreign sovereign securities with AAA rating as
collateral to the recognised Stock Exchanges in India for their transactions in
derivatives segment. SEBI approved clearing corporations of stock exchanges and
their clearing members are allowed to undertake the following transactions subject to
the guidelines issued from time to time by SEBI in this regard:
• to open and maintain demat accounts with foreign depositories and to acquire,
hold, pledge and transfer the foreign sovereign securities, offered as collateral
by FIIs;
• to remit the proceeds arising from corporate action, if any, on such foreign
sovereign securities; and
• to liquidate such foreign sovereign securities if the need arises.
25
Clearing Corporations have to report, on a monthly basis, the balances of foreign

sovereign securities, held by them as non-cash collaterals of their clearing members to
the Reserve Bank. The report should be submitted by the 10th of the following month
to which it relates.
Accounts with AD Category – I banks
FIIs/sub-accounts can open a Foreign Currency Account and / or a Special Non-

Resident Rupee Account with an AD Category – I bank, for the purpose of
investment.
They can transfer sums from the Foreign Currency Account to the Special Non-
Resident Rupee Account for making genuine investments in securities in terms of the
SEBI (FII) Regulations, 1995.
The sums may be transferred from foreign currency account to Special Non-Resident
Rupee Account at the prevailing market rate and the AD Category - I bank may
transfer repatriable proceeds (after payment of tax) from the Special Non-Resident
Rupee Account to the Foreign Currency account.
The Special Non-Resident Rupee Account may be credited with the sale proceeds of
shares / debentures, dated Government securities, Treasury Bills, etc. Such credits are
allowed, subject to the condition that the AD Category - I bank should obtain
confirmation from the investee company / FII concerned that tax at source, wherever
necessary, has been deducted from the gross amount of dividend / interest payable /
approved income to the share / debenture / Government securities holder at the
applicable rate, in accordance with the Income Tax Act.
The Special Non-Resident Rupee Account may be debited for purchase of shares /
debentures, dated Government securities, Treasury Bills, etc., and for payment of fees
to applicant FIIs’ local Chartered Accountant / Tax Consultant where such fees
constitute an integral part of their investment process.
Private placement with FIIs
SEBI registered FIIs have been permitted to purchase shares / convertible debentures
of an Indian company through offer/private placement, subject to the ceilings
prescribed, i.e. individual FII/sub account -10 per cent and all FIIs/sub-accounts put
26
together - 24 per cent of the paid-up capital of the Indian company or to the sectoral
limits, as applicable. Indian company is permitted to issue such shares provided that:
1. In the case of public offer, the price of shares to be issued is not less than the
price at which shares are issued to residents; and
2. In the case of issue by private placement, the price is not less than the price
arrived at in terms of SEBI guidelines or guidelines issued by the erstwhile
Controller of Capital Issues, as applicable. Purchases can also be made of
compulsorily and mandatorily Convertible Debentures / Right Renunciations /
Units of Domestic Mutual Fund Schemes.
Reporting of FII investments
An FII may invest in a particular share issue of an Indian company either under the
FDI Scheme or the Portfolio Investment Scheme. The AD Category – I banks have to
ensure that the FIIs who are purchasing the shares by debit to the Special Non-
Resident Rupee Account report these details separately in the Form LEC (FII).
The Indian company which has issued shares to FIIs under the FDI Scheme (for which
the payment has been received directly into company’s account) and the Portfolio
Investment Scheme (for which the payment has been received from FIIs' account
maintained with an AD Category – I bank in India) should report these figures
separately under item no. 5 of Form FC-GPR (Annex - 8) (Post-issue pattern of
shareholding) so that the details could be suitably reconciled for statistical /
monitoring purposes.
A daily statement in respect of all transactions (except derivative trade) have to be

submitted by the custodian bank in floppy / soft copy in the prescribed format directly
to Reserve Bank to monitor the overall ceiling / sectoral cap / statutory ceiling.
Companies
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Companies raise funds by inviting investments from the investors. Similarly they can
invest in other companies by acquiring equity therein.
Overseas investments in Joint Ventures (JV) and Wholly Owned Subsidiaries (WOS)
have been recognized as important avenues for promoting global business by Indian
entrepreneurs. Joint ventures are perceived as a medium of economic co-operation
between India and other countries. Transfer of technology and skill, sharing of results
of R&D, access to wider global market, promotion of brand image, generation of
employment and utilization of raw materials available in India and in the host country
are other significant benefits arising out of such overseas investments. They are also
important drivers of foreign trade through increased exports of plant and machinery
and goods and services from India and also a source of foreign exchange earnings by
way of dividend earnings, royalty, technical know-how fee and other entitlements on
such investments.
Prohibitions
Indian parties are prohibited from making investment in a foreign entity engaged in
real estate (as defined in Regulation 2(p) of the Notification) or banking business,
without the prior approval of the Reserve Bank.
Direct Investment outside India can be made under two routes –
1. Automatic route, and
2. Approval route - in which prior approval of Reserve bank of India is required.
Corporates are also allowed to enter into mergers and acquisition activities with other
foreign companies.
Overseas Corporate Bodies
Overseas Corporate Body (OCB) means a company, partnership firm, society and
other corporate body owned directly or indirectly to the extent of at least sixty per cent
by Non-Resident Indians and includes overseas trust in which not less than sixty per
cent beneficial interest is held by Non-Resident Indians, directly or indirectly, but
irrevocably. OCBs have been de-recognised as a class of investors in India with effect
28
from September 16, 2003. Erstwhile OCBs which are incorporated outside India and
are not under adverse notice of Reserve Bank can make fresh investments under the
FDI Scheme as incorporated non-resident entities, with the prior approval of
Government of India if the investment is through Government Route; and with the
prior approval of Reserve Bank if the investment is through Automatic Route.
Funds
Here, we will talk about the different funds which are used for investments.
• Private Equity Funds - Private equity fund is a pooled investment vehicle

used for making investments in various equity (and to a lesser extent debt)
securities according to one of the investment strategies associated with private
equity. Private equity funds are typically limited partnerships with a fixed term
of 10 years (often with annual extensions). Investments in private equity most
often involve either an investment of capital into an operating company or the
acquisition of an operating company. P/E funds generally invest for short
duration because they aim at booking profit by selling the company acquired
as soon as its market value goes up.
• Hedge Funds – Hedge funds are used by wealthy individuals and institutions.
Hedge fund is allowed to use aggressive strategies that are unavailable to
mutual funds, including selling short, leverage, program trading, swaps,
arbitrage, and derivatives.
There are no more than 100 investors per fund, and as a result most hedge
funds set extremely high minimum investment amounts from $250,000 to over
$1 million.
• Venture Capital Funds – Venture Capital Fund is a type of private equity

capital typically provided for early-stage, high-potential, growth companies in
the interest of generating a return through an eventual realization event such as
an IPO or trade sale of the company.
• Sovereign wealth funds (SWFs) – SWFs are government investment vehicles

that are funded by accumulation of foreign currency reserves but managed
separately from official reserves of the monetary authorities. Basically, they
29
are pools of money governments invest for profit. SWFs investments are
generally for long term. They usually have higher risk tolerance and higher
expected returns than traditional official reserves managed by the monetary
authorities. They aim at systematic professional portfolio management to
generate a sustainable future income stream. Their portfolio investment
includes bonds, equities and alternative asset classes.
Both SWFs and P/E funds have become increasingly important players in
global investment activities. However, since SWFs hold more financial
resources than private equity of hedge funds, they could have a significant
influence on financial markets worldwide.
Both SWFs and private equity funds have generated significant benefits
through their investments, but they have also given rise to some important
concerns which largely relate to regulatory issues and need to strengthen
transparency and oversight without undermining the benefits that these
institutions generate.
1) Loans and borrowings
Loans and borrowings are raised in the form of External Commercial Borrowings.
External Commercial Borrowing (ECB) refers to commercial loans in the form of
bank loans, buyers’ credit, suppliers’ credit, securitized instruments (e.g. floating rate
notes and fixed rate bonds) availed of from non-resident lenders with minimum
average maturity of 3 years.
Provisions relating ECB as contained in the RBI circular are reproduced below:
ECB can be accessed under two routes, viz.,
1. Automatic Route, and
2. Approval Route
ECB for investment in real sector-industrial sector, infrastructure sector-in India, and
specific service sectors as indicated under the following section are under Automatic
30
Route, i.e. do not require the Reserve Bank / Government of India approval. In case of
doubt as regards eligibility to access the Automatic Route, applicants may take
recourse to the Approval Route.
AUTOMATIC ROUTE
The following types of proposals for ECBs are covered under the Automatic Route.
1. Eligible Borrowers
a. Corporates including those in hotel, hospital, software sectors

(registered under the Companies Act, 1956 except financial
intermediaries, such as banks, financial institutions (FIs), Housing
Finance Companies (HFCs) and Non-Banking Financial Companies
(NBFCs) are eligible to raise ECB. Individuals, Trusts and Non-Profit
making organizations are not eligible to raise ECB.
b. Units in Special Economic Zones (SEZ) are allowed to raise ECB for
their own requirement. However, they cannot transfer or on-lend ECB
funds to sister concerns or any unit in the Domestic Tariff Area.
c. Non-Government Organizations (NGOs) engaged in micro finance

activities are eligible to avail ECB. Such NGO (i) should have a
satisfactory borrowing relationship for at least 3 years with a scheduled
commercial bank authorized to deal in foreign exchange and (ii) would
require a certificate of due diligence on `fit and proper’ status of the
Board/Committee of management of the borrowing entity from the
designated AD bank.
2. Recognized Lenders
Eligible borrowers can raise ECB from internationally recognized sources such
as
i. international banks,
ii. international capital markets,
iii. multilateral financial institutions (such as IFC, ADB, CDC, etc.,),
31
iv. export credit agencies,
v. suppliers of equipment,
vi. foreign collaborators, and
vii. foreign equity holders (other than erstwhile Overseas Corporate Bodies).
A "foreign equity holder" to be eligible as “recognized lender” under the

automatic route would require minimum holding of paid up equity in the
borrower company as set out below:
i. For ECB up to USD 5 million - minimum paid up equity of 25 per cent held directly
by the lender ; and
ii. For ECB more than USD 5 million - minimum paid up equity of 25 per cent held
directly by the lender and debt-equity ratio not exceeding 4:1 (i.e. the proposed ECB
not exceeding four times the direct foreign equity holding)
Overseas organizations and individuals complying with following safeguards may

provide ECB to Non-Government Organizations (NGOs) engaged in micro
finance activities.
Overseas Organizations proposing to lend ECB would have to furnish to the AD

bank of the borrower a certificate of due diligence from an overseas bank which in
turn is subject to regulation of host-country regulator and adheres to the Financial
Action Task Force (FATF) guidelines. The certificate of due diligence should
comprise the following:
i. that the lender maintains an account with the bank for at least a period of
two years,
ii. that the lending entity is organised as per the local law and held in good
esteem by the business/local community, and
iii. that there is no criminal action pending against it.
Individual Lender has to obtain a certificate of due diligence from an overseas

bank indicating that the lender maintains an account with the bank for at least a
period of two years. Other evidence /documents, such as audited statement of
32
account and income tax return which the overseas lender may furnish need to be
certified and forwarded by the overseas bank. Individual lenders from countries
wherein banks are not required to adhere to Know Your Customer (KYC)
guidelines are not eligible to extend ECB.
3. Amount and Maturity
(a) The maximum amount of ECB which can be raised by a corporate other than
those in the hotel, hospital and software sectors is USD 500 million or its
equivalent during a financial year.
(b) Corporates in the services sector viz. hotels, hospitals and software sector are
allowed to avail of ECB up to USD 100 million or its equivalent in a financial
year for meeting foreign currency and / or Rupee capital expenditure for
permissible end-uses. The proceeds of the ECBs should not be used for
acquisition of land.
(c) NGOs engaged in micro finance activities can raise ECB up to USD 5 million or
its equivalent during a financial year. Designated AD bank has to ensure that at
the time of drawdown the forex exposure of the borrower is fully hedged
(d) ECB up to USD 20 million or its equivalent in a financial year with minimum
average maturity of three years.
(e) ECB above USD 20 million or its equivalent and up to USD 500 million or or its
equivalent with a minimum average maturity of five years.
(f) ECB up to USD 20 million or its equivalent can have call/put option provided the
minimum average maturity of three years is complied with before exercising
call/put option.
4. All-in-cost ceilings
All-in-cost includes rate of interest, other fees and expenses in foreign currency
except commitment fee, pre-payment fee, and fees payable in Indian Rupees.
However, the payment of withholding tax in Indian Rupees is excluded for
calculating the all-in-cost.
33
The all-in-cost ceilings for ECB are reviewed from time to time. The following
ceilings are valid until reviewed:
Average Maturity Period All-in-cost Ceilings over 6

month Libor*
Three years and up to five years 300 basis points
More than five years 500 basis points
* for the respective currency of borrowing or applicable benchmark
5. End-use
1. ECB can be raised only for investment [such as import of capital goods (as
classified by DGFT in the Foreign Trade Policy), new projects,
modernization/expansion of existing production units] in the real sector -
industrial sector including small and medium enterprises (SME), infrastructure
sector and specific service sectors, namely hotel, hospital and software - in
India. Infrastructure sector for the purpose of ECB is defined as (i) power, (ii)
telecommunication, (iii) railways, (iv) road including bridges, (v) sea port and
airport, (vi) industrial parks, (vii) urban infrastructure (water supply, sanitation
and sewage projects) and (viii) mining, refining and exploration.
2. Overseas direct investment in Joint Ventures (JV)/Wholly Owned Subsidiaries

(WOS) subject to the existing guidelines on Indian Direct Investment in
JV/WOS abroad.
3. Utilization of ECB proceeds is permitted for first stage acquisition of shares in

the disinvestment process and also in the mandatory second stage offer to the
public under the Government’s disinvestment programme of PSU shares.
4. Payment for obtaining license/permit for 3G Spectrum.
5. For lending to self-help groups or for micro-credit or for bonafide micro

finance activity including capacity building by NGOs engaged in micro
finance activities.
34
6. Premature buyback of FCCBs (facility is available up to December 31, 2009),

subject to compliance with the terms and conditions detailed in Para A (x) (b)
ibid.
6. End-uses not permitted
1. For on-lending or investment in capital market or acquiring a company (or a

part thereof) in India by a corporate.
2. In real estate sector.
3. For working capital, general corporate purpose and repayment of existing

Rupee loans.
7. Guarantees
Issuance of guarantee, standby letter of credit, letter of undertaking or letter of

comfort by banks, Financial Institutions and Non-Banking Financial Companies
(NBFCs) from India relating to ECB is not permitted.
8. Security
The choice of security to be provided to the lender/supplier is left to the borrower.

However, creation of charge over immoveable assets and financial securities, such as
shares, in favour of the overseas lender is subject to Regulation 8 of Notification No.
FEMA 21/RB-2000 dated May 3, 2000 and Regulation 3 of Notification No. FEMA
20/RB-2000 dated May 3, 2000, respectively, as amended from time to time.
9. Parking of ECB proceeds
Borrowers are permitted to either keep ECB proceeds abroad or to remit these funds to
India, pending utilization for permissible end-uses.
ECB proceeds parked overseas can be invested in the following liquid assets (a)
deposits or Certificate of Deposit or other products offered by banks rated not less
than AA (-) by Standard and Poor/Fitch IBCA or Aa3 by Moody’s, (b) Treasury bills
and other monetary instruments of one year maturity having minimum rating as
indicated above, and (c) deposits with overseas branches / subsidiaries of Indian banks
35
abroad. The funds should be invested in such a way that the investments can be
liquidated as and when funds are required by the borrower in India.
ECB funds may also be remitted to India for credit to the borrowers’ Rupee accounts
with AD Category - I banks in India, pending utilization for permissible end-uses.
10. Prepayment
Prepayment of ECB up to USD 500 million may be allowed by AD banks without

prior approval of the Reserve Bank subject to compliance with the stipulated
minimum average maturity period as applicable to the loan.
11. Refinancing of an existing ECB
The existing ECB may be refinanced by raising a fresh ECB subject to the conditions
that the fresh ECB is raised at a lower all-in-cost and the outstanding maturity of the
original ECB is maintained.
12. Debt Servicing
The designated Authorized Dealer banks has the general permission to make
remittances of installments of principal, interest and other charges in conformity with
ECB guidelines, issued by Government / Reserve Bank of India from time to time.
13. Procedure
Borrowers may enter into loan agreement with recognized lender for raising ECB
under Automatic Route complying with the ECB guidelines without prior approval of
the Reserve Bank. The borrower must obtain a Loan Registration Number (LRN)
from the Reserve Bank before drawing down the ECB. The procedure for obtaining
LRN is detailed in the following section.
APPROVAL ROUTE
1. Eligible Borrowers
36
The following types of proposals for ECB are covered under the Approval Route.
a) Financial institutions dealing exclusively with infrastructure or export finance

such as IDFC, IL&FS, Power Finance Corporation, Power Trading
Corporation, IRCON and EXIM Bank are considered, on a case by case basis.
b) Banks and financial institutions which had participated in the textile or steel
sector restructuring package as approved by the Government are also permitted
to the extent of their investment in the package and assessment by Reserve
Bank based on prudential norms. Any ECB availed for this purpose so far will
be deducted from their entitlement.
c) ECB with minimum average maturity of 5 years by Non-Banking Financial

Companies (NBFCs) from multilateral financial institutions, reputable regional
financial institutions, official export credit agencies and international banks to
finance import of infrastructure equipment for leasing to infrastructure
projects.
d) NBFCs, which are exclusively involved in financing of the infrastructure sector,

can avail of ECBs from multilateral / regional financial institutions and
Government owned development financial institutions for on-lending to the
borrowers in the infrastructure sector.
e) Foreign Currency Convertible Bonds (FCCBs) by housing finance companies

satisfying the following minimum criteria: (i) the minimum net worth of the
financial intermediary during the previous three years shall not be less than Rs.
500 crore, (ii) a listing on the BSE or NSE, (iii) minimum size of FCCB is
USD 100 million, (iv) the applicant should submit the purpose / plan of
utilization of funds.
f) Special Purpose Vehicles, or any other entity notified by the Reserve Bank, set
up to finance infrastructure companies / projects exclusively, will be treated as
Financial Institutions and ECB by such entities will be considered under the
Approval Route.
37
g) Multi-State Co-operative Societies engaged in manufacturing activity satisfying

the following criteria (i) the Co-operative Society is financially solvent, and
(ii) the Co-operative Society submits its up-to-date audited balance sheet.
h) SEZ developers can avail of ECBs for providing infrastructure facilities within
SEZ, as defined in the extant ECB policy, viz. (i) power, (ii)
telecommunication, (iii) railways, (iv) road including bridges, (v) sea port and
airport (vi) industrial parks (vii) urban infrastructure (water supply, sanitation
and sewage projects) and (viii) mining, refining and exploration. However,
ECB will not be permissible for development of integrated township and
commercial real estate within SEZ.
i) Corporates which have violated the extant ECB policy and are under
investigation by Reserve Bank and / or Directorate of Enforcement, are
allowed to avail ECB only under the Approval route.
j) Cases falling outside the purview of the automatic route limits and maturity
period indicated above.
2. Recognized Lenders
(a) Borrowers can raise ECB from internationally recognized sources such as (i)
international banks, (ii) international capital markets, (iii) multilateral financial
institutions (such as IFC, ADB, CDC etc.), (iv) export credit agencies, (v)
suppliers' of equipment, (vi) foreign collaborators, and (vii) foreign equity holders
(other than erstwhile OCBs).
(b) From 'foreign equity holder' where the minimum paid up equity held directly by
the foreign equity lender is 25 per cent but ECBs: equity ratio exceeds 4:1 (i.e. the
amount of the proposed ECB exceeds four times the direct foreign equity holding).
3. Amount and Maturity
Corporates can avail of ECB of an additional amount of USD 250 million with
average maturity of more than 10 years under the approval route, over and above the
existing limit of USD 500 million under the automatic route, during a financial year.
Other ECB criteria, such as end-use, recognized lender, etc. need to be complied with.
38
Prepayment and call/put options, however, would not be permissible for such ECB up
to a period of 10 years.
4. All-in-cost ceilings
All-in-cost includes rate of interest, other fees and expenses in foreign currency except
commitment fee, pre-payment fee, and fees payable in Indian Rupees. Moreover, the
payment of withholding tax in Indian Rupees is excluded for calculating the all-in-
cost.
The all-in-cost ceilings for ECB are indicated from time to time. The all –in- cost
ceilings have been dispensed with until December 31, 2009. Accordingly, eligible
borrowers, proposing to avail ECB beyond the permissible all in cost ceiling may
approach RBI under approval route .This relaxation in all in cost ceilings will be
reviewed in December 2009.
5. End-use
(a) ECB can be raised only for investment [such as import of capital goods (as
classified by DGFT in the Foreign Trade Policy), implementation of new
projects, modernization/expansion of existing production units] in real sector -
industrial sector including small and medium enterprises (SME) and
infrastructure sector - in India. Infrastructure sector for the purpose of ECB is
defined as (i) power, (ii) telecommunication, (iii) railways, (iv) road including
bridges, (v) sea port and airport (vi) industrial parks (vii) urban infrastructure
(water supply, sanitation and sewage projects) and (viii) mining, refining and
exploration;
(b) Overseas direct investment in Joint Ventures (JV)/Wholly Owned Subsidiaries

(WOS) subject to the existing guidelines on Indian Direct Investment in
JV/WOS abroad.
(c) The first stage acquisition of shares in the disinvestment process and also in the
mandatory second stage offer to the public under the Government’s
disinvestment programme of PSU shares;
(d) ECB can be raised by corporates engaged in the development of integrated

township as defined by Ministry of Commerce and Industry, DIPP, SIA (FC
39
Division), Press Note 3 (2002 Series) dated January 4, 2002. Integrated township
includes housing, commercial premises, hotels, resorts, city and regional level
urban infrastructure facilities such as roads and bridges, mass rapid transit
systems and manufacture of building materials. Development of land and
providing allied infrastructure forms an integrated part of township’s
development. The minimum area to be developed should be 100 acres for which
norms and standards are to be followed as per local bye-laws/rules. In the
absence of such bye-laws/rules, a minimum of two thousand dwelling units for
about ten thousand population will need to be developed. This permission is
available up to December 31, 2009.
(e) Buyback of FCCB subject to terms and conditions as detailed in the sections
above.
6. End-uses not permitted
a. Utilization of ECB proceeds is not permitted for on-lending or investment in

capital market or acquiring a company (or a part thereof) in India by a
corporate except banks and financial institutions eligible.
b. Utilization of ECB proceeds is not permitted in real estate. However, the term
real estate excludes development of integrated township as defined by Ministry
of Commerce and Industry, DIPP, SIA (FC Division), Press Note 3 (2002
Series) dated January 4, 2002.
c. Utilization of ECB proceeds is not permitted for working capital, general

corporate purpose and repayment of existing Rupee loans.
7. Guarantee
Issuance of guarantee, standby letter of credit, letter of undertaking or letter of

comfort by banks, financial institutions and NBFCs relating to ECB is not normally
permitted. Applications for providing guarantee/standby letter of credit or letter of
comfort by banks, financial institutions relating to ECB in the case of SME will be
considered under the approval route on merit subject to prudential norms.
40
With a view to facilitating capacity expansion and technological up-gradation in

Indian textile industry, issue of guarantees, standby letters of credit, letters of
undertaking and letters of comfort by banks in respect of ECB by textile companies
for modernization or expansion of textile units will be considered under the Approval
Route subject to prudential norms.
8. Security
The choice of security to be provided to the lender / supplier is left to the borrower.
However, creation of charge over immovable assets and financial securities, such as
shares, in favour of the overseas lender is subject to Regulation 8 of Notification No.
FEMA 21/RB-2000 dated May 3, 2000 and Regulation 3 of Notification No. FEMA
20/RB-2000 dated May 3, 2000 as amended from time to time, respectively.
9. Parking of ECB proceeds
Borrowers are permitted to either keep ECB proceeds abroad or to remit these funds to
India, pending utilization for permissible end-uses.
ECB proceeds parked overseas can be invested in the following liquid assets (a)
deposits or Certificate of Deposit or other products offered by banks rated not less
than AA (-) by Standard and Poor/Fitch IBCA or Aa3 by Moody’s; (b) Treasury bills
and other monetary instruments of one year maturity having minimum rating as
indicated above, and (c) deposits with overseas branches / subsidiaries of Indian banks
abroad. The funds should be invested in such a way that the investments can be
liquidated as and when funds are required by the borrower in India.
ECB funds may also be remitted to India for credit to the borrowers’ Rupee accounts
with AD Category I banks in India, pending utilization for permissible end-uses.
10. Prepayment
Prepayment of ECB up to USD 500 million may be allowed by the AD bank without
prior approval of Reserve Bank subject to compliance with the stipulated minimum
average maturity period as applicable to the loan.
Pre-payment of ECB for amounts exceeding USD 500 million would be considered by
the Reserve Bank under the Approval Route.
41
11. Refinancing of an existing ECB
Existing ECB may be refinanced by raising a fresh ECB subject to the condition that
the fresh ECB is raised at a lower all-in-cost and the outstanding maturity of the
original ECB is maintained.
12. Debt Servicing
The designated AD bank has general permission to make remittances of instalments of

principal, interest and other charges in conformity with ECB guidelines issued by
Government / Reserve Bank from time to time.
13. Procedure
Applicants are required to submit an application in form ECB through designated AD

bank to the Chief General Manager-in-Charge, Foreign Exchange Department,
Reserve Bank of India, Central Office, External Commercial Borrowings Division,
Mumbai – 400 001, along with necessary documents.
Borrowers are required to submit ECB-2 Return certified by the designated AD bank
on monthly basis so as to reach DSIM, Reserve Bank within seven working days from
the close of month to which it relates.
For providing greater transparency, information with regard to the name of the
borrower, amount, purpose and maturity of ECB under both Automatic Route and
Approval Route are put on the Reserve Bank's website
http://www.rbi.org.in/scripts/ECBView.aspx on a monthly basis with a lag of one
month to which it relates.
International Financial Institutions
Some of the international financial institutions involved in international loans and

borrowings are listed below:
 World Bank
 International Monetary Fund (IMF)
 Asian Development Bank (ADB)
42
 International Finance Corporation (IFC)
 Organization for Economic Cooperation and Development (OECD)
 International Bank for Reconstruction and Development (IBRD)
 Others
Activities of the abovementioned entities are covered in the later chapter.
2) International Banking Flows
International banking flows comprise of
 Lending and borrowings by banks.
 Treasury operations by the banks.
 Issue of Foreign Letter of Credit.
 Issue of Foreign currency denominated guarantees.
 Usually characterized by excess liquidity.
 More dependence of banks on foreign funding leads to liquidity, forex, credit

etc. risks.
 A heavy presence of foreign banks may also accentuate the risk of monetary or
financial contagion. There is evidence that monetary policy shocks at home
prompt global banks to change flows to their affiliates overseas.
3) Donations and Charity
Governments give grant – in – aid and donations to rehabilitate people affected by

natural calamities, war, riot, civil unrest etc., all over the world.
43
International charity organizations give charity and donations for social cause e.g. to
fight epidemic, for research in medical and social fields, for spread of education, for
cultural and sports activities.
4) Hawala Transactions
Hawala is a system for remitting money, primarily in Islamic societies, in which a

financial obligation between two parties is settled by transferring it to a third party, as
when money owed by a debtor to a creditor is paid by a person who owes the debtor
money. Hawala transactions are usually based on trust and leave no written record.
Customers entrust money to hawala bankers or operators (hawaladars), who facilitate

money movement worldwide through personal connections, sometimes using
legitimate bank accounts, but leaving a minimal paper trail. The few records kept are
encoded. Dubai, India and Pakistan form a "hawala triangle," responsible for the
heaviest traffic in worldwide financial transfers.
5) Others
Undernoted entities/activities also add to foreign capital movement
Smugglers
 Transfer the goods illegally to evade tax.
 Transfer banned goods and commodities
 Subsequently, money also transferred through illegal channels. Gives rise to

black economy.
Terrorist’s financiers
 Transfer huge funds to promote destructive terrorist activities in other

countries to destabilize them.
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Fake currency supply
 Sometimes due to political reasons, funds are also transferred in the form of
fake currency in an economy by rival countries to destabilize it.
International banking network
Domestic banks in a country establish arrangements with their counterpart in foreign

countries to facilitate their foreign exchange related transactions. These arrangements
take the under noted forms:
 Correspondent banks – An informal linkage between banks and different

countries is set up when banks maintain correspondent accounts with other.
The purpose of maintaining foreign correspondents is to facilitate international
payments and collections for customers. The banks maintain NOSTRO and
VOSTRO accounts for the purpose and international foreign exchange
transactions are carried through these accounts. This obviates physical
movement of currencies.
Correspondent banking allows banks to help their customers who are doing
business abroad, without having to maintain any persons or officers overseas.
The relationship between the banks is primarily for settling customer
payments, but it can extend to providing limited credit for each other’s
customers and to setting up contacts between local business people and the
clients of the correspondent banks.
 Resident Representative Offices – Resident Representative Offices are

established by banks in other countries for rendering help to their residents.
These offices do not undertake normal banking activities. These are formed
mainly to provide information about local business practices and conditions
including credit worthiness of potential customers to their residents who wish
to establish commercial relations in those countries. The resident
representatives will keep in contact with local correspondent banks and
provide help when needed.
 Bank Agencies – These act like a full fledged bank, deal in local money
market and forex market, arrange loans, clear bank drafts and cheques and
45
channel foreign funds into financial markets. They are more like investment
arms. Agencies also often arrange long-term loans for customers, but they deal
primarily on behalf of the home office to keep it directly involved in the
important foreign financial markets.
 Foreign branches – Foreign branches operate like local banks except that
their control resides elsewhere. Generally, foreign branches are subjected to
both local banking rules and the rules at home. The foreign branch also offers
bank customers in small countries all the services and safety advantages of a
large bank that the local market might not itself be able to support.
 Foreign subsidiary – These are subsidiaries established by banks in foreign

countries. These act as locally incorporated bank owned completely or
partially by foreign parent. Foreign subsidiaries do all types of bankings and it
may be very difficult to distinguish them from an ordinary locally owned bank
except perhaps by name.
 Consortium banks – They are joint ventures of the large commercial banks.
They are primarily concerned with investment and they arrange large loans
and underwrite stocks and bonds. They are not concerned with taking deposits
and they deal only with large corporations or perhaps governments.
6) Role of Reserve Bank of India
In the field of Foreign Exchange, activities of RBI include – maintenance of foreign

exchange rate, provision of sale and purchase of foreign exchange through authorized
dealers and Licensed Money changers, market intervention, sterilization, deployment
of foreign exchange reserves and representing India at various International forums. In
terms of the preamble of the RBI Act, 1934, RBI maintains country’s foreign
exchange reserves.
Section (3) (a) of the act authorizes to purchase from and sale to scheduled banks the
foreign exchange. RBI does not deal with the public directly. Public is required to
carry out their foreign exchange transactions through entities authorized by RBI to
deal in foreign exchange popularly known as ‘Authorized Dealers’. With the
46
progressive liberalization in foreign exchange related transactions a large segment of

population can now undertake a variety of current account transactions on their
individual accounts, without approaching Reserve Bank. With a view to providing
adequate foreign exchange facilities to common persons, to widen the scope of
activities which the rightful persons are eligible to undertake, to increase the number
of entities that are eligible to sell foreign exchange to the public for day-to-day current
account transactions and to ensure efficient customer service through competition,
Reserve Bank has decided to issue authorization to select entities as given below, for
undertaking release / remittance of foreign exchange for various current account non-
trade related transactions.
With a view to maintain orderly foreign exchange rates RBI time to time intervene in
the foreign exchange market and sale / purchase foreign exchange through Authorised
dealers. In turn it absorbs/ releases rupee funds from/ in the market.
In the aftermath of globalisation Indian economy faced a sudden surge of foreign

capital inflow. RBI was required to release large rupee funds to mop up the foreign
exchange from the market. However, large increase of rupee flow in the economy
started to build up inflationary pressure, which was a matter of concern for RBI and
the government. With a view to keep inflation under control a new scheme of issuing
Market Stabilisation Scheme Bonds was introduced. Under the scheme RBI purchased
the excess foreign exchange from the dealers against issue of MSS bonds( Treasury
Bills) and thus sterilised the rupee funds. Rupee funds so sterilised are used only for
the purpose of redemption of MSS bonds.
Maintenance and Deployment of Foreign Exchange Reserves
Objectives of Holding Reserves
Foreign Exchange reserves are held in support of a range of objectives including to –
• Support and maintain confidence in the policies for monetary and exchange
rate management including the capacity to intervene in support of the national
currency.
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• Limit external vulnerability by maintaining foreign currency liquidity to

absorb shocks during times of crisis or when access to borrowing is curtailed
and in doing so;
• Provide a level of confidence to markets that a country can meet its external
obligations;
• Demonstrate the backing of domestic currency by external assets;
• Assist the government in meeting its foreign exchange needs and external debt
obligations; and
• Maintain a reserve for national disasters and emergencies.
The foreign exchange reserves consist of foreign exchange assets, gold, Special
Drawing Rights (SDRs) and Reserve Tranche Position. Foreign Exchange reserves are
managed keeping in view the factors of a) safety, b) liquidity and c) profitability. With
the prominent objective being the safety of funds, a balance is required to be
established between the liquidity needs of the reserves and the yield thereon. These
functions are attended to by a separate department namely ‘Department of External
Investments and Operations’.
Functions
The main function of this department is management and investment of foreign

exchange reserves of the Reserve Bank of India:
• Management and investment of the foreign currency and gold assets of the
Reserve Bank of India.
• Handling external transactions on behalf of Government of India (GOI)

including transactions relating to IMF.
• All matters incidental to India's membership of the Asian Clearing Union.
• Other matters relating to gold policy, membership of the Bank for

International Settlements (BIS) and matters incidental to international
cooperation/arrangements
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Reserves Management
The principal objectives behind the Reserve Bank's approach to reserves management
continue to be safety and liquidity. Within these parameters, return optimisation
dictates operational strategies. The legal framework for reserves management is
provided in the Reserve Bank of India Act 1934. Specifically, Sections 17 (12),
17(12A), 17(13) and 33(1) of the RBI Act 1934 lay down the scope of investment of
foreign exchange reserves by RBI. Broadly, the following investment categories are
permitted under the RBI Act:
• Deposits with other central banks and Bank for International Settlements
• Deposits with foreign commercial banks
• Investments in securities issued by the Government of any other country or by

any institution incorporated outside India provided such securities are
guaranteed by the Government of the country concerned. The maturity period
of such investments should not exceed more than ten years from the date of
such investment.
• Other instruments/institutions as approved by Central Board of RBI.
Further, in order to ensure safety and liquidity of our reserves, RBI has also framed
internal guidelines/procedures to manage the various risks like credit risk, liquidity
risk, operational risks and market risk incidental to the reserves management.
Prudent maintenance and gainful deployment of foreign exchange reserves by RBI

ultimately build up the international confidence in Indian economy and help it to grow
with increased public welfare.
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Role of banks
 Banks act as
◦ Authorized dealers in Foreign Exchange
◦ Respondent banks for other foreign banks
◦ Have credit and they facilitate foreign exchange transactions by issuing

letters of credit, guarantees, covers for hedging the clients exposures in
foreign exchange
◦ Purchase and sell forex from/to the public.
All entities issued authorization under sub-section (i) of Section 10 of the Foreign
Exchange Maintenance Act, 1999 are categorized as under:
S No. Entities Category Major Activities
1 • Commercial Banks Authorized All current and capital

Dealer account transactions
• State Co-op Banks Category - I according to RBI directions
issued from time-to-time.
• Urban Co-op
Banks
2 • Upgraded Full Authorized 15 specified non-trade

fledged Money Dealer related current account
Category - II transactions as also all the
• Changers (FFMCs) activities permitted to
FFMCs. Any other activity
• Urban Co-op as decided by RBI.
Banks
• Regional Rural
Banks
• Others
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3 Select Financial and other Authorized Transactions incidental to

Institutions Dealer the foreign exchange
Category – activities undertaken by
III these institutions
4 • Dept. of Posts FFMCs Purchase of foreign

exchange and sale for
• Urban Co-op banks private and business visits
abroad
• Other FFMCs
Table: Categorization of Authorized Dealers
We have 88, 36 and 8 authorized Dealers in category I, II, and III respectively.
RBI undertakes inspection of Authorise Dealers and FFMCs to ensure the compliance
of various regulations and instructions.
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IV. Impact on National Economy
Capital and human resources are the pivots of development. Short supplies of
domestic capital limit the growth of developing countries. Low GDP keeps savings
and investment rates low which, in turn, limit growth. Low technological base of
production is another factor impinging upon growth of developing countries. Capital
inflows in the form of FDI/FII mitigate these constraints to growth to some extent.
FDI brings capital with foreign technology and modern managerial techniques and
organizational structures. Besides, inflows and growth, like several other variables,
are bi-directionally related. FDI/FII has both in and out flows, since developing
economies like Korea, China and India are also the suppliers of FDI/FII. Foreign
Investment Outflows (FIO) depends basically on supply of capital in the home
country. Developed rather than developing countries may, therefore, be hypothesized
to be the main suppliers of FDI/FII, and hence, FIO. As against this, countries of the
third world could be envisaged to be the net recipients of FDI, howsoever high their
growth rate and development status may be.
With the globalization of the various markets, international financial flows have so far
been in excess for the goods and services among the trading countries of the world. Of
the different types of financial inflows, the foreign direct investment (FDI) and
foreign institutional investment (FII)) has played an important role in the process of
development of many economies. Further many developing countries consider foreign
direct investment (FDI) and foreign institutional investment (FII) as an important
element in their development strategy among the various forms of foreign assistance.
The Foreign direct investment (FDI) and foreign institutional investment (FII) flows
are usually preferred over the other form of external finance, because they are not debt
creating, nonvolatile in nature and their returns depend upon the projects financed by
the investor. The Foreign direct investment (FDI) and foreign institutional investment
(FII) would also facilitate international trade and transfer of knowledge, skills and
technology.
International capital investment can play a useful role in development by adding to the
savings of low and middle- income developing countries in order to increase their
52
pace of investment. However, foreign investment can also prove unproductive to

developing economies by exposing them to disruptions and distortions from abroad,
and by subjecting them to surges of capital inflows or massive outflows of capital
flight. International capital flows can best help economies develop and spread the
benefits of prosperity to all their citizens when those flows are steady and do not
undermine the stability of the financial systems of the developing economies. The idea
is to best help economies develop and spread the benefits of prosperity to all their
citizens. This is accomplished when the magnitudes of flows are steady and the types
of investments are suited to local economic needs and involve an appropriate sharing
of market risks. Although the useful purpose of foreign capital is to augment domestic
savings in order to raise investment, the volatility of these flows sometimes results in
the opposite.
Impacts of Capital Flow
Capital inflows can help domestic economies in various ways: portfolio inflows—or
more generally capital inflows—can help finance domestic investment and contribute
to long-run economic growth. Foreign portfolio inflows can provide a better
opportunity for local capital market development, generally providing increased
liquidity and price recovery mechanisms. And as foreign capital flows into the
market, economic authorities may come under greater peer pressure to adopt more
internationally accepted practices and standards in financial systems.
A surge of capital inflows into a developing country can be triggered by the lifting of
restrictions on the capital account, known as capital account liberalization, and by a
policy to privatize what were formerly publicly owned assets such as the telephone or
railway system. Foreign capital can also be “pushed” from abroad when the rates of
return on capital decline in the advanced capital market economies.
There are many motivations for international capital investment, and generally it is the
pursuit of a higher rate of return. Some particular motivations that raise grave
concerns are the outflanking of labor standards and environmental protections in
the home country. In addition, FDI seeks out special natural resources and
opportunities to acquire newly privatized assets. Foreign lending, through bank loans
53
or bonds, helps developing countries adjust gradually to external shock such as an oil
price hike or natural disaster, and provides the lenders some geographical
diversification of their assets. While these motivations can be identified and accounted
for, the actual behavior of financial markets sometimes appears less rational or
dependable than these economic factors would indicate. The consequences of this
include unstable or undependable international capital flows.
However, the consequences of this rush or excessive capital inflow can be devastating.
It puts upward pressure on the developing country's exchange rate and if it is not
sterilized through central bank intervention then it appreciates the currency and
reduces the competitiveness of the country's traded goods. The capital inflow can also
lead to speculative booms in the price of local assets such as real estate and equity
shares. Thailand experienced a boom and bubble in its real estate and stock markets
before they burst during the financial crisis in 1997, and recently, the US sub-prime
crisis impacting the whole world was also related to the boom and bubble in the real
estate market in US.
It is also seen that rapid capital outflow can often follow periods of rapid inflow,
generating boom-bust cycles. The initial period of capital inflows is often
characterized by real exchange rate appreciation, domestic credit expansion, booming
consumption and/or investment, and asset price bubbles. Over time, the process tends
to reverse itself: real exchange rate appreciation weakens the current account and
reduces the attractiveness of domestic assets to foreign investors. Net capital inflows
turn into net outflows, and boom turns to bust, with adverse consequences for local
asset prices and, often, the real economy.
As already mentioned, massive outflows depress the prices of real estate, equity
shares and other domestic assets, and they cause a loss of bank deposits that leads to
lending constraints and tight credit conditions. The result is a rise in unemployment
and poverty, and the weight of these social dislocations has proven to fall
disproportionally on women and the poor. Women are often the targets for lay-offs
during an economic contraction, and families respond to following incomes by
increasingly sending wives and daughters into the labor force.
Making matters even worse is the tendency for international capital markets to spread
the effects of a financial crisis in one country to others in a process known as
54
contagion. In this way, financial market disruptions in one country inflict severe costs
on other countries that played no role in the cause of the original crisis. This is exactly
what happened in the US subprime crisis, where the crisis started in US, and within a
year, spread to the complete world.
We will discuss these impacts in details now.
Impact on Asset Prices
Capital inflows may result in an increase in asset prices. Capital inflows can affect
asset prices in three ways. First, foreign portfolio inflows can directly affect the
demand for assets. For example, capital inflows to stock markets increase the demand
and, therefore, price of stocks. In addition, portfolio inflows may subsequently affect
other markets. For example, as capital flows into stock markets, prices increase, but
the expected return on stocks may decrease. Investors may then seek higher returns in
other asset markets, such as real estate and bonds, thereby putting upward pressure on
other asset prices.
Second, capital inflows may result in an increase in money supply and liquidity,
which in turn may boost asset prices. Capital inflows tend to cause nominal and real
exchange rates to appreciate. If monetary authorities wish to avoid that they must
intervene in the foreign exchange market to offset excess demand for the local
currency by buying foreign currency. This results in an accumulation of foreign
exchange reserves and, accordingly, domestic money supply. When this leads to an
increase in liquidity flows into asset markets, asset prices may surge. The foreign
exchange intervention may be sterilized by selling government securities through an
open market operation. However, if sterilization is partial, then liquidity and asset
prices may increase.
Third, capital inflows tend to fuel strong economic growth—as past studies have
shown— and lead to an increase in asset prices in several ways. Monetary expansion
following capital inflow may lead to an economic boom. Falling world interest rates
may lead to consumption and investment booms, and also lower domestic interest
rates, which in turn may boost investment. And, for a debtor country, a fall in world
55
interest rates will induce income and substitution effects, which may also lead to a
consumption boom.
Impact on Nominal and Real exchange rates
Capital inflows tend to lead to an appreciation of nominal and real exchange rates.
Under a floating exchange rate regime, foreign portfolio inflows would directly affect
the demand for domestic currency assets, which leads to appreciation in the nominal
exchange rate. Combined with sticky prices, the real exchange rate can also
appreciate. On the other hand, under a managed float, if the monetary authority
intervenes in the foreign exchange market the nominal appreciation may be avoided.
However, the real exchange rate may still appreciate. As discussed, consumption and
investment booms are likely to increase the price of non-traded goods more than the
price of traded goods because the supply of non-traded goods is more limited than the
supply of traded goods.
This situation however puts a great deal of pressure on fixed exchange rate systems in
the developing world. Investors and speculators alike know the consequences of a
general US dollar appreciation on the ability of a smaller, poorer country to maintain
its peg to the rising dollar. This makes parallel appreciation of the pegged currency,
reduces the competitiveness of the developing country exports and harms the trade
balance. If the central bank finds it necessary to raise interest rates in order to maintain
the peg, then it also dampens the developing economy. Alternatively, if the central
bank tries to avoid raising interest rates by intervening in the foreign exchange market
in order to defend the peg, then investors and speculators alike will watch the level of
foreign reserves closely for signs of weakness in the central bank's ability to maintain
the peg.
On a similar note, the capital flows to developing countries that are invested as bank
loans or bonds have been almost entirely denominated in US dollars or other major
currencies such as the euro or yen. When the dollar appreciates, say in response to
tighter monetary by the Federal Reserve, then borrowers in developing countries will
face higher debt payments when measured in either the own local currency or other
major currencies.
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Impact of FDI to home and host country
It is very interesting to see how the FDI impacts the country which is making the
direct investment, and the country in which the investment is made. If country A
makes a direct investment in country B, there is an addition to the physical capital of
country B, and new production capacity is created there. Apart from that, country B
would have also acquired some technological knowledge or expertise, which was
earlier not there in country B, but used in country A. The investing firm in A will have
chosen to use some of its capital in B instead of in A. If the output is tradable, some
production that now takes place in country B may replace production that formerly
took place in country A. The investing firm may have reduced its production in its
home country, A, possibly by shutting down or selling a plant, and opened up a new
plant abroad to serve the same market. In such a scenario, it may have had a positive
impact on country B, but a negative impact on country A. This kind of a scenario is
more often seen in the IT industry, where for instance DELL decided to assemble all
the computers catering to Asian markets in Malaysia.
A different possibility is that a firm in country A makes a direct investment in country

B, but the stock of physical capital and the level of production are unchanged in both
countries. Country A owners and managers in industry X, perhaps using the skills they
have acquired in home production, buy out country B owners with lower skills in that
industry and operate the industry X plants in country B more efficiently than before.
Country B owners use their capital, released by the buyout, in other industries. They
might, for instance, lend it to other owners and managers in country B, skilled in
industry Y, to enable them to buy out less competent owners in that industry in
country A. No net movement of physical or financial capital is necessarily implied,
although it could take place.
Impact of FDI on Domestic investment
FDI from outside also has its share of positive and negative impacts on the
investments happening from within the country, also called domestic investment.
Capital flows can affect domestic investment in several ways.
1. First, FDI contributes directly to new plant and equipment (“greenfield” FDI).
57
2. Second, FDI may produce investment spillovers beyond the direct increase in
capital stock through linkages among firms. For example, multinational
corporations (MNCs) may purchase inputs form domestic suppliers thereby
encouraging new investment by local firms. FDI for mergers and acquisitions
(M&A) does not contribute to capital formation directly unless the new foreign
owners modernize or expand their acquisitions by investing in new
technology.
3. FDI may also “crowd out” domestic investment, if MNCs raise productivity
and force local competitors out of the market. This is usually the case when
MNCs use imported inputs or enter sectors previously dominated by state-
owned firms.
4. Finally, FDI, foreign loans and portfolio investment may reduce interest rates
or increase credit available to finance new domestic investment. On this last
point, a study by Harrison, Love and McMillan finds that FDI in particular
eases the financing constraints of firms in developing countries and that this
effect is stronger for low-income than for high-income regions.
In addition to these direct effects, foreign capital can have indirect impact on
domestic investment. To attract foreign investors governments of developing countries
have to implement sound macroeconomic policies, develop their institutions and
improve governance. Loans and portfolio flows also contribute to the deepening and
broadening of financial markets. In addition to the “collateral benefits”, FDI usually
results in the transfer of managerial skills and new technology and, consequently,
improves productivity. Lastly, even when not applied toward capital formation
directly, foreign loans may be used to raise or smooth consumption, thus increasing
GDP growth during periods of sluggish demand.
Capital Flows and India
India is the second largest country in the world, with a population of over 1 billion
people. As a developing country, India’s economy is characterized by wage rates that
are significantly lower than those in most developed countries. These two traits
combine to make India a natural destination for foreign direct investment (FDI) and
58
foreign institutional investment (FII). Till 1991, India attracted only a small share of
global foreign direct investment (FDI) and foreign institutional investment (FII),
primarily due to government restrictions on foreign involvement in the economy. But
beginning in 1991 and accelerating rapidly since 2000, India has liberalized its
investment regulations and actively encouraged new foreign investment, a sharp
reversal from decades of discouraging economic integration with the global economy.
The government of India(GOI) also recognized the key role of the foreign direct
investment (FDI) and foreign institutional investment (FII) in its process of economic
development, not only as an addition to its own domestic capital but also as an
important source of technology and other global trade practices. In order to attract the
required amount of foreign direct investment (FDI) and foreign institutional
investment (FII), it brought about a number of changes in its economic policies and
put in its practice a liberal and more transparent foreign direct investment (FDI) and
foreign institutional investment (FII) policy with a view to attract more foreign direct
investment (FDI) and foreign institutional investment (FII) inflows into its economy.
These changes have heralded the liberalization era of the foreign direct investment
(FDI) and foreign institutional investment (FII) policy regime into India and have
brought about a structural breakthrough in the volume of foreign direct investment
(FDI) and foreign institutional investment (FII) inflows in the economy.
Foreign institutional investors (FIIs) poured inflows heavily to bet on the India growth
story. Overseas investors have infused US$ 816.69 million into the stock market in the
first trading week of 2010, reflecting a positive start for the year after record inflows
in the last year. Foreign institutional investors (FIIs) were gross buyers of shares
worth US$ 3.03 billion, and sold equities valued worth US$ 2.2 billion, resulting in a
net investment of US$ 823.74 million, according to the capital market regulator,
Securities and Exchange Board of India (SEBI). FIIs were net investors of US$
973.22 million in debt instruments in the first trading week of the year, according to
data released by SEBI
According to SEBI, FIIs transferred a record US$ 17.46 billion in domestic equities
during the calendar year 2009. This FII investment in 2009 proved to be the highest
ever inflow in the country in rupee terms in a single year, breaking the previous high
59
of US$ 14.96 billion parked by foreign fund houses in domestic equities in 2007. FIIs
infused a net US$ 1.05 billion in debt instruments during the mentioned period.
During the October-December period in 2009-10, FIIs made a net buy of shares worth
US$ 5.19 billion, according to data compiled from market regulator, the Securities and
Exchange Board of India (SEBI).
In the quarter, December attracted the highest inflow of US$ 2.2 billion, followed by
October US$ 1.95 billion and November US$ 1.18 billion. FIIs poured a net US$ 1.26
billion in debt instruments during the mentioned period. The trend of strong FII
inflows to the tune of about US$ 6.3 billion witnessed during April-June quarter
gained further during the September quarter of current fiscal with an infusion of US$
7.2 billion.
The number of FIIs who registered themselves with SEBI this year was higher by 7
per cent over 2008. Data sourced from the SEBI shows that number of registered FIIs
stood at 1706 and number of registered sub-accounts rose to 5,331 as of December 31,
2009. A number of market and equity analysts indicate that a large part of FII inflows
have come from long-only funds, signaling that the quality of foreign investment is
good.
India has in fact, emerged the most lucrative markets for short and medium-term
investments. The US is once again at the top of the list of foreign investors in the
Indian stock market, as per data presented in the Lok Sabha by the Finance Ministry.
According to the latest data, till mid-November 2009, US-based foreign institutional
investors (FIIs) had net investments of about US$ 4.46 billion in the Indian markets,
as compared with US$ 702.37 million in 2006. They are followed by the US$ 2.57
billion net investments routed through Luxembourg. These two countries are further
followed by France, Mauritius and the UK.
FIIs appear to be betting big on the primary market rather than the secondary market.
Roughly US$ 9 million-US$ 10 million came in the primary issuance – through
qualified institutional placements (QIPs) or preferential allotment or initial public
offerings (IPOs). Private equity firms invested US$ 1.4 billion over 84 deals in India
during October-December quarter of 2009, taking the annual investment numbers to
US$ 3.82 billion over 232 deals, according to a study by Venture Intelligence, a
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research service focused on private equity (PE) and merger and acquisition (M&A)
transactions.
Investment Scenario
Amid signs of improving liquidity, January 2010 has seen private equity investments
in India double to US$ 386 million, from US$ 191 million in January 2009, according
to the financial research body, VCEdge.
US-based private equity firm, New Silk Route Partners LLC (NSR), has picked up a
little over 30 per cent stake in Chandigarh-based listed pharmaceutical company
Nectar Lifesciences Ltd for US$ 54.5 million. US-based investment management firm
T Rowe Price Group (TRP), has bought a 26 per cent stake in UTI Asset Management
Company (AMC) and UTI Trustee Company for US$ 140.03 million. During 2009,
Kohlberg Kravis & Roberts (KKR) PE firm's investment for increasing its stake in
telecom software firm Aricent to 79 per cent for US$ 255 million was the largest deal.
Another remarkable deal was Goldman Sachs’ US$ 115 million investment in
healthcare firm Max India for a 9.4 per cent stake. Credit Suisse (Singapore) bought
1.12 per cent stake in Bharati Shipyard for US$ 1.48 million.
Stocks that had more than 10 per cent of FII stake (in BSE-500) in March went from
205 to 232 by end September. Indiabulls RealEstate, IVRCL Infrastructure, Educomp
Solutions and United Spirits are a few stocks where FIIs accumulated more shares
despite already big holdings.
Government Initiatives
The Securities and Exchange Board of India (SEBI) has allowed equity investors to
lend and borrow shares for 12 months compared with the current limit of one month.
The new norms will also allow a lender or a borrower to close his position before the
agreed-upon expiry date. No single entity (FII) shall be allocated more than US$
62.78 million of the government debt investment limit for allocation through bidding
process.
An investment limit of US$ 73.25 million in Government debt shall be allocated

among the FIIs/sub-accounts on a first-come first-served basis, subject to a ceiling of
US$ 10.46 million per registered entity. The Government of India reviewed the
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External Commercial Borrowing (ECB) policy and increased the cumulative debt
investment limit by US$ 9 billion (from US$ 6 billion to US$ 15 billion) for FII
investments in corporate debt.
India's foreign investment policies allow foreign direct investment up to 26 per cent
and foreign institutional investments of (an additional) 23 per cent in stock exchanges.
Under the regulation, FIIs have been allowed to acquire shares of unlisted stock
exchanges through transactions outside a recognized stock exchange provided it is not
an initial allotment of shares.
The Reserve Bank of India (RBI) and the Securities and Exchange Board of India
(SEBI) have jointly unveiled norms enabling exchange-traded interest rate futures
(IRF). Foreign portfolio investors have been allowed to trade in IRFs with capped
limits.
FIIs and the non-resident Indians (NRIs) are allowed to invest in Indian Depository
Receipts (IDRs), according to the operational guidelines issued by the RBI on July 22,
2009.
Summary – Impacts of Capital flow
In this section, we will summarize the positive and negative impacts of capital flows
(inflow and outflow).
Benefits of capital inflow may be summarized as follows:
1. External capital can supplement domestic savings and stimulate economic

growth.
2. International borrowing and lending enable countries to neutralize fluctuations

in income and attain smooth consumption streams. This improves welfare.
3. The lenders gain from higher return and better International portfolio
diversification.
4. Accumulation of FER. This also leads to an accumulation of foreign

exchange reserves, which is good if it leads to an additional investment which
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cannot be undertaken through domestic capital of expertise. In such a case, it

leads to a stronger and stable economy (if they are within limit).
5. It improves the employment situation of the country, especially if more FDIs

are coming in.
6. In case of FDI, the home country also gets the advantage of getting a
technological expertise which may not be earlier accessible.
Problems of too much capital inflow are summarized as follows:
1. Appreciation of real exchange. For instance, in most Latin American

countries inflow has been accompanied by marked real appreciation.
2. Accumulation of FER. How much FER should a country hold at any point in
time to counter speculative attack on its currency? There is no unique answer.
However, as discussed earlier, government policies in a demand-deficient
situation should try to ensure that the economy’s expenditure on capital
accumulation is met through domestic, not foreign finance. FDI can be
beneficial if it leads to additional investment which cannot otherwise be
undertaken or if it acts as a vehicle of better technology or other positive
supply-side factors.
3. Financial crisis. Increased openness to international capital flows has been

associated with an increasing frequency of financial crisis. Pure currency
crises have declined as countries have moved towards more flexible exchange
rate systems but banking crisis have loomed larger with the dismantling of
capital controls and regulations. For preventing financial instability,
regulations that limit the exposure of banks to the volatility of equity and real
estate markets, as well as ensuring risk-based capital adequacy are in order;
but the flip side is that these policies may promote disintermediation, which
refers to new institutions that develop to bypass these restrictions. Moreover,
greater control on banks may amount to a reversal of the trend of
financial liberalization currently in progress in developing countries.
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4. Exchange rate appreciation. Under a floating exchange rate regime, foreign

portfolio inflows would directly affect the demand for domestic currency
assets, which leads to appreciation in the nominal exchange rate.
5. Asset price appreciation. Capital inflows may result in an increase in asset

prices. It may directly affect the demand for assets or it may result in an
increase in money supply and liquidity, which in turn may boost asset prices. It
may also tend to fuel strong economic growth, which can lead to an increase in
prices.
6. Wage rate appreciation. With greater inflows, and hence greater growth and
demand of human resources, the wage rates start appreciating which also tend
to increase the prices and costs.
Problems which arise to the home country when there is too much of capital outflows
are:
1. Unemployment. As discussed earlier, when the outflows happen, it is usually

when you move the manufacturing or development of some product from the
home country to an outside, low cost country. This leads to an increasing
unemployment in the home country, and more layoffs.
2. Cash crunch. This is an after effect of the unemployment, and it is essentially

because with more work going outside, the cash in the hands of the normal
people decreases, which leads to a cash crunch.
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V. Global Financial Institutions
The global financial system (GFS) is a financial system consisting of institutions

and regulators that act on the international level, as opposed to those that act on
a national or regional level.
The Global Financial System constitutes of International Institutions,

Government Institutions, Private participants and Legal Framework and
Treaties.
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1) International Monetary Fund (IMF)
The IMF was conceived at a United Nations conference convened in Bretton

Woods, New Hampshire, United States, in July 1944. The 45 governments
represented at that conference sought to build a framework for economic
cooperation that would avoid a repetition of the vicious circle of competitive
devaluations that had contributed to the Great Depression of the 1930s.
IMF's responsibilities
The IMF's primary purpose is to ensure the stability of the international
monetary system-the system of exchange rates and international payments that
enables countries (and their citizens) to buy goods and services from each
other. This is essential for sustainable economic growth, increasing living
standards, and alleviating poverty.
Key IMF activities

The IMF supports its membership by providing
• Policy advice to governments and central banks based on analysis of

economic trends and cross-country experiences;
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• Research, statistics, forecasts, and analysis based on tracking of global,

regional, and individual economies and markets;
• Loans to help countries overcome economic difficulties;
• Concessional loans to help fight poverty in developing countries; and
• Technical assistance and training to help countries improve the

management of their economies.
• Surveillance of economies: To maintain stability and prevent crises in

the international monetary system, the IMF reviews national, regional,
and global economic and financial developments through a formal
system known as surveillance. The IMF provides advice to its 186
member countries, encouraging them to adopt policies that foster
economic stability, reduce their vulnerability to economic and financial
crises, and raise living standards. It provides regular assessment of
global prospects in its World Economic Outlook and of capital markets
in its Global Financial Stability Report, as well as publishing a series of
regional economic outlooks.
• Financial assistance: IMF financing is available to give member

countries the breathing room they need to correct balance of payments
problems. A policy program supported by IMF financing is designed
by the national authorities in close cooperation with the IMF, and
continued financial support is conditional on effective implementation
of this program. To help support countries during the global economic
crisis, the IMF has strengthened its lending capacity and has approved
a major overhaul of how it lends money. In low-income countries, the
IMF provides financial support through its concessional lending
facilities. The IMF has doubled loan access limits and is boosting its
lending to the world's poorer countries, with interest rates set at zero
until 2011.
• Special Drawing Rights (SDRs): The IMF issues an international

reserve asset known as Special Drawing Rights that can supplement the
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official reserves of member countries. Members can also voluntarily

exchange SDRs for currencies among themselves.
• Technical assistance: The IMF offers technical assistance and training

help member countries strengthen their capacity to design and
implement effective policies. Technical assistance is offered in several
areas, including tax policy and administration, expenditure
management, monetary and exchange rate policies, banking and
financial system supervision and regulation, legislative frameworks,
and statistics.
Resources
At the April 2, 2009 G-20 summit, world leaders pledged to support growth in
emerging market and developing countries by boosting the IMF's lending
resources to $750 billion. The IMF's resources are provided by its member
countries, primarily through payment of quotas, which broadly reflect each
country's economic size. The annual expenses of running the Fund have been
met mainly by the difference between interest receipts (on outstanding loans)
and interest payments (on quotas used to finance the loans' "reserve
positions"), but the membership recently agreed to adopt a model based on a
range of revenue sources more suited to the diverse activities of the Fund.
Governance and organization
The IMF is accountable to the governments of its member countries. At the top
of its organizational structure is the Board of Governors, which consists of one
Governor from each member countries. All Governors meet once each year at
the IMF-World Bank Annual Meetings.
Twenty-four of the Governors sit on the International Monetary and Finance

Committee (IMFC) and meet twice each year. The day-to-day work of the IMF
is conducted by its 24-member Executive Board; this work is guided by the
IMFC and supported by the IMF's professional staff. The Managing Director is
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Head of IMF staff and Chairman of the Executive Board, and is assisted by
three Deputy Managing Directors.
Factual Snapshot of IMF
• Membership: 186 countries
• Headquarters: Washington, DC
• Executive Board: 24 Directors representing countries or groups of

countries
• Staff: approximately 2,478 from 143 countries
• Total quotas: $325 billion (as of 3/31/09)
• Additional pledged or committed resources: $500 billion
• Loans committed (as of 9/1/09): $175.5 billion, of which $124.5 billion

have not been drawn
• Biggest borrowers: Hungary, Mexico, Ukraine
• Technical assistance: Field delivery in FY2009-173 person years

during FY2009
• Surveillance consultations: Concluded in 2008-177 countries in 2008,

of which 155 voluntarily published information on their consultation
(as of 03/31/09)
• Original aims: Article I of the Articles of Agreement sets out the IMF's
main goals:
o promoting international monetary cooperation;
o facilitating the expansion and balanced growth of international

trade;
o promoting exchange stability;
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o assisting in the establishment of a multilateral system of

payments; and
o Making resources available (with adequate safeguards) to

members experiencing balance of payments difficulties.
2) World Bank
Since inception in 1944, the World Bank has expanded from a single
institution to a closely associated group of five development institutions. Its
mission evolved from the International Bank for Reconstruction and
Development (IBRD) as facilitator of post-war reconstruction and
development to the present day mandate of worldwide poverty alleviation in
close coordination with affiliates, the International Development Association,
and other members of the World Bank Group.
Reconstruction remains an important part of World Bank's work. However, the

global challenges in the world compelled it to focus on:
• poverty reduction and the sustainable growth in the poorest countries,

especially in Africa;
• solutions to the special challenges of post-conflict countries and fragile

states;
• development solutions with customized services as well as financing

for middle-income countries;
• regional and global issues that cross national borders--climate change,

infectious diseases, and trade;
• greater development and opportunity in the Arab world;
• Pulling together the best global knowledge to support development.
At today's World Bank, poverty reduction through an inclusive and sustainable

globalization remains the overarching goal of its work.
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The World Bank aims to provide funding, take up credit risk or offer favorable
terms to development projects mostly in developing countries that couldn't be
obtained by the private sector. The other multilateral development banks and
other international financial institutions also play specific regional or
functional roles. The World Bank differs from the World Bank Group, in that
the World Bank comprises only two institutions: International Bank for
Reconstruction and Development (IBRD) and International Development
Association (IDA). Whereas the latter incorporates these two in addition to
three more: International Finance Corporation (IFC), Multilateral Investment
Guarantee Agency (MIGA), and International Centre for Settlement of
Investment Disputes (ICSID).
Operations
The World Bank's two closely affiliated entities-the International Bank for
Reconstruction and Development (IBRD) and the International Development
Association (IDA)-provide low or no interest loans (credits) and grants to
countries that have unfavorable or no access to international credit markets.
World Bank does not operate for profit. The IBRD is market-based.
Fund Generation
IBRD lending to developing countries is primarily financed by selling AAA-

rated bonds in the world's financial markets. While IBRD earns a small margin
on this lending, the greater proportion of its income comes from lending out its
own capital. This capital consists of reserves built up over the years and money
paid in from the Bank's 185 member country shareholders. IBRD's income
also pays for World Bank operating expenses and has contributed to IDA and
debt relief.
IDA is the world's largest source of interest-free loans and grant assistance to
the poorest countries. IDA's funds are replenished every three years by 40
donor countries. Additional funds are regenerated through repayments of loan
principal on 35-to-40-year, no-interest loans, which are then available for re-
lending. IDA accounts for more than 40% of World Bank lending.
Loans
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Through the IBRD and IDA, World Bank offers two basic types of loans and
credits: investment operations and development policy operations.
Countries use investment operations for goods, works and services in support
of economic and social development projects in a broad range of economic and
social sectors. Development policy operations (formerly known as adjustment
loans) provide quick-disbursing financing to support a country's policy and
institutional reforms.
Each borrower's project proposal is assessed to ensure that the project is

economically, financially, socially and environmentally sound. During loan
negotiations, the Bank and borrower agree on the development objectives,
outputs, performance indicators and implementation plan, as well as a loan
disbursement schedule. While the World Bank supervises the implementation
of each loan and evaluates its results, the borrower implements the project or
program according to the agreed terms.
Trust Funds and Grants
Donor governments and a broad array of private and public institutions make
deposits in Trust funds that are housed at the World Bank. These donor
resources are leveraged for a broad range of development initiatives. The
initiatives vary significantly in size and complexity, ranging from multibillion
dollar arrangements-such as Carbon Finance; the Global Environment Facility;
the Heavily Indebted Poor Countries Initiative; and the Global Fund to Fight
AIDS, Tuberculosis, and Malaria, to much smaller and simpler freestanding
ones.
The Bank also mobilizes external resources for IDA concessionary financing
and grants, as well as funds for non-lending technical assistance and advisory
activities to meet the special needs of developing countries, and for co-
financing of projects and programs.
Analytic and Advisory Services
While World Bank is best known as a financier, another of its roles is to

provide analysis, advice and information to our member countries so they can
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deliver the lasting economic and social improvements their people need. It
does this in various ways. One is through economic research and data
collection on broad issues such as the environment, poverty, trade and
globalization Another is through country-specific, non-lending activities such
as economic and sector work, where it evaluate a country's economic prospects
by examining its banking systems and financial markets, as well as trade,
infrastructure, poverty and social safety net issues, for example.
Capacity Building
Another core Bank function is to increase the capabilities of its partners, the
people in developing countries, and its own staff -to help them acquire the
knowledge and skills they need to provide technical assistance, improve
government performance and delivery of services, promote economic growth
and sustain poverty reduction programs.
Structure
The World Bank is like a cooperative, where its 186 member countries are
shareholders. The shareholders are represented by a Board of Governors, who
is the ultimate policy makers at the World Bank. Generally, the governors are
member countries' ministers of finance or ministers of development. They
meet once a year at the Annual Meetings of the Boards of Governors of the
World Bank Group and the International Monetary Fund.
Because the governors only meet annually, they delegate specific duties to 24
Executive Directors, who work on-site at the Bank. The five largest
shareholders, France, Germany, Japan, the United Kingdom and the United
States appoint an executive director, while other member countries are
represented by 19 executive directors.
• The President of the World Bank chairs meetings of the Boards of

Directors and is responsible for overall management of the Bank. By
tradition, the Bank president is a U.S. national and is nominated by the
United States, the Bank's largest shareholder. The President is elected
by the Board of Governors for a five-year, renewable term.
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• The Executive Directors make up the Boards of Directors of the World

Bank. They normally meet at least twice a week to oversee the Bank's
business, including approval of loans and guarantees, new policies, the
administrative budget, country assistance strategies and borrowing and
financial decisions.
The World Bank operates day-to-day under the leadership and direction of the
president, management and senior staff, and the vice presidents in charge of
regions, sectors, networks and functions. Vice Presidents are the principal
managers at the World Bank.
3) World Trade Organization (WTO)
The World Trade Organization (WTO) is an international organization dealing

with the global rules of trade between nations. Its main function is to ensure
that trade flows as smoothly, predictably and freely as possible.
History
The World Trade Organization came into being in 1995. One of the youngest
of the international organizations, the WTO is the successor to the General
Agreement on Tariffs and Trade (GATT) established in the wake of the
Second World War.
The system was developed through a series of trade negotiations, or rounds,

held under GATT. The first rounds dealt mainly with tariff reductions but later
negotiations included other areas such as anti-dumping and non-tariff
measures. The last round - the 1986-94 Uruguay Round - led to the WTO's
creation.
In 2000, new talks started on agriculture and services. These have now been
incorporated into a broader agenda launched at the fourth WTO Ministerial
Conference in Doha, Qatar, in November 2001. The work programme, the
Doha Development Agenda (DDA), adds negotiations and other work on non-
agricultural tariffs, trade and environment, WTO rules such as anti-dumping
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and subsidies, investment, competition policy, trade facilitation, transparency

in government procurement, intellectual property, and a range of issues raised
by developing countries as difficulties they face in implementing the present
WTO agreements.
WTO Agreements
The WTO's rules - the agreements - are the result of negotiations between the
members. The current set were the outcome of the 1986-94 Uruguay Round
negotiations which included a major revision of the original General
Agreement on Tariffs and Trade (GATT). The complete set runs to some
30,000 pages consisting of about 30 agreements and separate commitments
(called schedules) made by individual members in specific areas such as lower
customs duty rates and services market-opening.
Through these agreements, WTO members operate a non-discriminatory

trading system that spells out their rights and their obligations. Each country
receives guarantees that its exports will be treated fairly and consistently in
other countries' markets. Each promises to do the same for imports into its own
market. The system also gives developing countries some flexibility in
implementing their commitments.
Goods
It all began with trade in goods. From 1947 to 1994, GATT was the forum for
negotiating lower customs duty rates and other trade barriers; the text of the
General Agreement spelt out important rules, particularly non-discrimination.
Since 1995, the updated GATT has become the WTO's umbrella agreement for
trade in goods. It has annexes dealing with specific sectors such as agriculture
and textiles, and with specific issues such as state trading, product standards,
subsidies and actions taken against dumping.
Services
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Banks, insurance firms, telecommunications companies, tour operators, hotel

chains and transport companies looking to do business abroad can now enjoy
the same principles of freer and fairer trade that originally only applied to trade
in goods. These principles appear in the new General Agreement on Trade in
Services (GATS). WTO members have also made individual commitments
under GATS stating which of their services sectors they are willing to open to
foreign competition, and how open those markets are.
Intellectual property
The WTO's intellectual property agreement amounts to rules for trade and
investment in ideas and creativity. The rules state how copyrights, patents,
trademarks, geographical names used to identify products, industrial designs,
integrated circuit layout-designs and undisclosed information such as trade
secrets - "intellectual property" - should be protected when trade is involved.
Dispute settlement
The WTO's procedure for resolving trade quarrels under the Dispute
Settlement Understanding is vital for enforcing the rules and therefore for
ensuring that trade flows smoothly. Countries bring disputes to the WTO if
they think their rights under the agreements are being infringed. Judgments by
specially-appointed independent experts are based on interpretations of the
agreements and individual countries' commitments.
The system encourages countries to settle their differences through

consultation. Failing that, they can follow a carefully mapped out, stage-by-
stage procedure that includes the possibility of a ruling by a panel of experts,
and the chance to appeal the ruling on legal grounds. Confidence in the system
is borne out by the number of cases brought to the WTO - around 300 cases in
eight years compared to the 300 disputes dealt with during the entire life of
GATT (1947-94).
Policy review
The Trade Policy Review Mechanism's purpose is to improve transparency, to

create a greater understanding of the policies that countries are adopting, and
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to assess their impact. Many members also see the reviews as constructive
feedback on their policies. All WTO members must undergo periodic scrutiny,
each review containing reports by the country concerned and the WTO
Secretariat.
Organizational Structure
The WTO has nearly 150 members, accounting for over 97% of world trade.
Around 30 others are negotiating membership. Decisions are made by the
entire membership. This is typically by consensus. A majority vote is also
possible but it has never been used in the WTO, and was extremely rare under
the WTO's predecessor, GATT. The WTO's agreements have been ratified in
all members' parliaments. The WTO's top level decision-making body is the
Ministerial Conference which meets at least once every two years. Below this
is the General Council (normally ambassadors and heads of delegation in
Geneva, but sometimes officials sent from members' capitals) which meets
several times a year in the Geneva headquarters. The General Council also
meets as the Trade Policy Review Body and the Dispute Settlement Body. At
the next level, the Goods Council, Services Council and Intellectual Property
(TRIPS) Council report to the General Council. Numerous specialized
committees, working groups and working parties deal with the individual
agreements and other areas such as the environment, development,
membership applications and regional trade agreements.
VI. Global Scenario - Before and after crisis
Over the past four years, the world has witnessed some of the most tumultuous
periods in the financial world due to meltdown of economies and slowly but steadily,
since the latter half of 2009, the markets have risen along with the steadying of
economies globally.
However, the scale and magnitude of the recoveries have varied over socio-economic
status of the countries and geographical spreads, much like the extent of damage to the
economies.
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In this chapter, we shall discuss the impact and extent in 2 parts:
1. Financial crisis of 2007–2009;

2. The turn around and recovery of economies since 2009 and future predictions.
Financial crisis of 2007–2009
The financial crisis of 2007–2009 has been called by leading economists the worst
financial crisis since the Great Depression of the 1930s. It contributed to the failure of
key businesses, declines in consumer wealth estimated in the trillions of U.S. dollars,
substantial financial commitments incurred by governments, and a significant decline
in economic activity. Many causes have been proposed, with varying weight assigned
by experts.
The collapse of a global housing bubble, which peaked in the U.S. in 2006, caused the
values of securities tied to real estate pricing to plummet thereafter, damaging
financial institutions globally. Questions regarding bank solvency, declines in credit
availability, and damaged investor confidence had an impact on global stock markets,
where securities suffered large losses during late 2008 and early 2009.
Economies worldwide slowed during this period as credit tightened and international
trade declined. Critics argued that credit rating agencies and investors failed to
accurately price the risk involved with mortgage-related financial products, and that
governments did not adjust their regulatory practices to address 21st century financial
markets.[8] Governments and central banks responded with unprecedented fiscal
stimulus, monetary policy expansion, and institutional bailouts.
1) Background and causes
The immediate cause or trigger of the crisis was the bursting of the United States
housing bubble which peaked in approximately 2005–2006.
High default rates on "subprime" and adjustable rate mortgages (ARM), began to
increase quickly thereafter. An increase in loan incentives such as easy initial terms
and a long-term trend of rising housing prices had encouraged borrowers to assume
78
difficult mortgages in the belief they would be able to quickly refinance at more
favorable terms. However, once interest rates began to rise and housing prices started
to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more
difficult. Defaults and foreclosure activity increased dramatically as easy initial terms
expired, home prices failed to go up as anticipated, and ARM interest rates reset
higher.
In the years leading up to the start of the crisis in 2007, significant amounts of foreign
money flowed into the U.S. from fast-growing economies in Asia and oil-producing
countries. This inflow of funds made it easier for the Federal Reserve to keep interest
rates in the United States too low from 2002–2006 which contributed to easy credit
conditions, leading to the United States housing bubble. Loans of various types (e.g.,
mortgage, credit card, and auto) were easy to obtain and consumers assumed an
unprecedented debt load. As part of the housing and credit booms, the amount of
financial agreements called mortgage-backed securities (MBS) and collateralized debt
obligations (CDO), which derived their value from mortgage payments and housing
prices, greatly increased. Such financial innovation enabled institutions and investors
around the world to invest in the U.S. housing market. As housing prices declined,
major global financial institutions that had borrowed and invested heavily in subprime
MBS reported significant losses. Falling prices also resulted in homes worth less than
the mortgage loan, providing a financial incentive to enter foreclosure.
While the housing and credit bubbles built, a series of factors caused the financial
system to both expand and become increasingly fragile.
These losses impacted the ability of financial institutions to lend, slowing economic
activity. Concerns regarding the stability of key financial institutions drove central
banks to provide funds to encourage lending and restore faith in the commercial paper
markets, which are integral to funding business operations.
Easy credit conditions
Lower interest rates encourage borrowing. From 2000 to 2003, the Federal Reserve
lowered the federal funds rate target from 6.5% to 1.0%. This was done to soften the
79
effects of the collapse of the dot-com bubble and of the September 2001 terrorist
attacks, and to combat the perceived risk of deflation.
80
U.S. Subprime lending expanded dramatically 2004-2006
The term subprime refers to the credit quality of particular borrowers, who have
weakened credit histories and a greater risk of loan default than prime borrowers. The
value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007,
with over 7.5 million first-lien subprime mortgages outstanding.
In addition to easy credit conditions, there is evidence that both government and
competitive pressures contributed to an increase in the amount of subprime lending
during the years preceding the crisis.
Predatory lending
Predatory lending refers to the practice of unscrupulous lenders, to enter into "unsafe"
or "unsound" secured loans for inappropriate purposes..
Former employees from Ameriquest, described a system in which they were pushed to
falsify mortgage documents and then sell the mortgages to Wall Street banks eager to
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make fast profits. There is growing evidence that such mortgage frauds may be a
cause of the crisis.
Increased debt burden or over-leveraging
U.S. households and financial institutions became increasingly indebted or

overleveraged during the years preceding the crisis. This increased their vulnerability
to the collapse of the housing bubble and worsened the ensuing economic downturn.
Leverage Ratios of Investment Banks Increased Significantly 2003-2007
From 2004-07, the top five U.S. investment banks each significantly increased their
financial leverage (see diagram), which increased their vulnerability to a financial
shock.
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Commodity bubble
A commodity price bubble was created following the collapse in the housing bubble.
The price of oil nearly tripled from $50 to $140 from early 2007 to 2008, before
plunging as the financial crisis began to take hold in late 2008. Experts debate the
causes, which include the flow of money from housing and other investments into
commodities to speculation and monetary policy or the increasing feeling of raw
materials scarcity in a fast growing world economy and thus positions taken on those
markets, such as Chinese increasing presence in Africa. An increase in oil prices tends
to divert a larger share of consumer spending into gasoline, which creates downward
pressure on economic growth in oil importing countries, as wealth flows to oil-
producing states.
Systemic crisis
Another analysis, different from the mainstream explanation, is that the financial crisis
is merely a symptom of another, deeper crisis, which is a systemic crisis of capitalism
itself.
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• "Manager's capitalism" which he argues has replaced "owner's capitalism,"

meaning management runs the firm for its benefit rather than for the
shareholders, a variation on the principal-agent problem;
• Burgeoning executive compensation;
• Managed earnings, mainly a focus on share price rather than the creation of
genuine value; and
• The failure of gatekeepers, including auditors, boards of directors, Wall Street

analysts, and career politicians.
2) Financial markets impacts
Impacts on financial institutions
The International Monetary Fund estimated that large U.S. and European banks lost
more than $1 trillion on toxic assets and from bad loans from January 2007 to
September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S.
banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6
trillion. The IMF estimated that U.S. banks were about 60 percent through their losses,
but British and eurozone banks only 40 percent.
Wealth effects
There is a direct relationship between declines in wealth, and declines in consumption

and business investment, which along with government spending represent the
economic engine. Between June 2007 and November 2008, Americans lost an
estimated average of more than a quarter of their collective net worth. By early
November 2008, a broad U.S. stock index the S&P 500, was down 45 percent from its
2007 high. Housing prices had dropped 20% from their 2006 peak, with futures
markets signaling a 30-35% potential drop.
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Global effect
The crisis rapidly developed and spread into a global economic shock, resulting in a
number of European bank failures, declines in various stock indexes, and large
reductions in the market value of equities and commodities.
Both MBS and CDO were purchased by corporate and institutional investors globally.
Derivatives such as credit default swaps also increased the linkage between large
financial institutions. Moreover, the de-leveraging of financial institutions, as assets
were sold to pay back obligations that could not be refinanced in frozen credit
markets, further accelerated the liquidity crisis and caused a decrease in international
trade.
World political leaders, national ministers of finance and central bank directors
coordinated their efforts to reduce fears, but the crisis continued. At the end of
October 2008 a currency crisis developed, with investors transferring vast capital
resources into stronger currencies such as the yen, the dollar and the Swiss franc,
leading many emergent economies to seek aid from the International Monetary Fund.
3) Effects on the global economy
A number of commentators have suggested that if the liquidity crisis continues, there
could be an extended recession or worse.
The continuing development of the crisis has prompted in some quarters fears of a
global economic collapse although there are now many cautiously optimistic
forecasters in addition to some prominent sources who remain negative.
Three days later UBS economists announced that the "beginning of the end" of the
crisis had begun, with the world starting to make the necessary actions to fix the crisis:
1. Capital injection by governments;
2. Injection made systemically;
3. Interest rate cuts to help borrowers.
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The United Kingdom had started systemic injection, and the world's central banks
were now cutting interest rates.
 UBS emphasized the United States needed to implement systemic injection.
 UBS quantified their expected recession durations on October 16,2009:
 The Eurozone's would last two quarters,
 The United States' would last three quarters, and the United Kingdom's would
last four quarters.
 The economic crisis in Iceland involved all three of the country's major banks.
Relative to the size of its economy, Iceland’s banking collapse is the largest
suffered by any country in economic history.
With a recession in the U.S. and the increased savings rate of U.S. consumers,
declines in growth elsewhere have been dramatic.
For the first quarter of 2009, the annualized rate of decline in GDP was
14.4% in Germany, 15.2% in Japan, 7.4% in the UK, 9.8% in the Euro area and
21.5% for Mexico.
By March 2009, the Arab world had lost $3 trillion due to the crisis.
In April 2009, unemployment in the Arab world is said to be a 'time bomb'
In May 2009, the United Nations reported a drop in foreign investment in Middle-
Eastern economies due to a slower rise in demand for oil
In June 2009, the World Bank predicted a tough year for Arab states.
In September 2009, Arab banks reported losses of nearly $4 billion since the onset of
the global financial crisis.
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4) Responses to financial crisis
Emergency and short-term responses
The U.S. Federal Reserve and central banks around the world have taken steps to
expand money supplies to avoid the risk of a deflationary spiral, in which lower wages
and higher unemployment lead to a self-reinforcing decline in global consumption. In
addition, governments have enacted large fiscal stimulus packages, by borrowing and
spending to offset the reduction in private sector demand caused by the crisis. The
U.S. executed two stimulus packages, totaling nearly $1 trillion during 2008 and
2009.
This credit freeze brought the global financial system to the brink of collapse. The
response of the USA Federal Reserve, the European Central Bank, and other central
banks was immediate and dramatic.
During the last quarter of 2008, these central banks purchased US$2.5 trillion of
government debt and troubled private assets from banks. This was the largest liquidity
injection into the credit market, and the largest monetary policy action, in world
history. The governments of European nations and the USA also raised the capital of
their national banking systems by $1.5 trillion, by purchasing newly issued preferred
stock in their major banks.
Regulatory proposals and long-term responses
United States introduced a series of regulatory proposals in June 2009.
The proposals address consumer protection, executive pay, bank financial cushions or
capital requirements, enhanced authority for the Federal Reserve to safely wind-down
systemically important institutions, among others.
A variety of regulatory changes have been proposed by economists, politicians,

journalists, and business leaders to minimize the impact of the current crisis and
prevent recurrence. However, as of November 2009, many of the proposed solutions
have not yet been implemented.
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The turnaround and recovery
The acute phase of the financial crisis has passed and a global economic recovery is
under way.
Moreover, the recovery is fragile and expected to slow in the second half of 2010 as
the growth impact of fiscal and monetary measures wane and the current inventory
cycle runs its course.
Indeed, industrial production growth is already slowing (albeit from very high rates).
As a result, employment growth will remain weak and unemployment is expected to
remain high for many years.
The overall strength of the recovery and its durability will depend on the extent to
which household- and business-sector demand strengthens over the next few quarters.
While the baseline scenario projects that global growth will firm to 2.7 percent in
2010 and 3.2 percent in 2011 after a 2.2 percent decline in 2009, neither a double-dip
scenario, where growth slows appreciably in 2011, or a strengthening recovery can be
ruled out.
Financial markets have stabilized and are recovering, but remain weak. Interbank li-
quidity as measured by the difference between the interest rates commercial banks
charge one another and what they have to pay to central bankers have declined to pre-
crisis range.
Currencies, which fell worldwide against the U.S. dollar in the immediate
aftermath of the crisis, have largely recovered their pre-crisis levels.
And international capital flows to developing countries have recovered—with a

rapid run-up during the last months of 2009. Also, borrowing costs for emerging
market borrowers have stabilized over the last few quarters, but remain elevated.
However, the Dubai World event and ripple effects to credit downgrades for Greece
and Mexico can be expected to raise concerns about sovereign debt sustainability and
will impact risk assessments, capital flows, and financial markets in 2010.
On the positive side, the real economy is recovering as well. Although global
industrial production in October 2009 remained 5 percent below its level a year
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earlier, it is recovering, with output in both high-income and developing countries

expanding at more than a 12 percent annualized rate in the third quarter of 2009.
Trade too is recovering but remains depressed. Quarterly growth rates have moved
into positive territory in recent months, but the U.S. dollar value of trade was still off
17 percent from its September 2009 level.
Nevertheless,
1. International metal prices, measured in U.S. dollars, are 20 percent below their
July 2008 levels,
2. oil prices are 44 percent lower, and
3. food prices 24 percent lower.
Recent developments in financial markets
The unprecedented steps that were taken by policy makers in both developed and
developing countries since September 2008 have gone a long way toward
normalizing financial markets and restoring capital flows to developing countries.
The immediate outflow of international capital from developing countries to safe ha-
vens in the United States and Europe has reversed itself.
As a result, a large number of emerging-market exchange rates have recovered their pre-
crisis levels viz.-a-viz. the U.S. dollar, equity markets have recovered much of their initial
losses, and, capital flows to developing countries have begun to recover. Towards the
end of 2009, gross capital inflows to developing countries began to gain momentum
as uncertainty subsided and risk aversion declined.
Developing countries’ access to international capital markets has also revived.
Both sovereign and corporate borrowers have benefited from rising global liquidity,
improved market conditions, and better long-term fundamentals of emerging
economies vis-à-vis advanced economies.
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The improved bond and equity markets reflect normalization of financial markets and,
to an unknown extent, the opening up of a carry trade precipitated by low real interest
rates in high-income countries.
Some middle-income countries (notably Chile and Brazil) are attracting very large
inflows, which if sustained at current rates, pose real policy challenges and could
generate significant stress.
Global growth
After a deep global recession, economic growth has turned positive, as a wide range of
policy interventions has supported demand and reduced uncertainty and systemic risk
in financial markets. However, the recovery is expected to be slow, as financial
markets remain impaired, stimulus measures will need to be withdrawn in the not too
distant future, and households in countries that suffered asset price busts are forced to
rebuild savings while struggling with high unemployment. Although global growth is
expected to return to positive territory in 2010, the pace of the recovery will be slow
and subject to uncertainty. After falling by an estimated 2.2 percent in 2009, global
output is projected to grow 2.7 and 3.2 percent in 2010 and 2011, respectively.
The main drag on global growth is coming from the high-income countries, whose
economies are expected to have contracted by 3.3 percent in 2009. Japan experienced
the sharpest growth contraction (25.4 percent). Growth rates of 2.5 and 2.9 percent are
expected in 2010 for the United States and for high-income countries that are not
members of the Organization for Economic Co-operation and Development (OECD).
The global economic crisis affected developing countries first and foremost through a
sharp slowdown in global industrial activity due to a sudden cut in investment
programs, consumer durable demand, and a widespread effort to reduce inventories in
the face of uncertain future conditions. Falling export demand, commodity prices, and
capital flows exacerbated and extended the downturn. Overall, growth in developing
countries declined to an estimated 1.2 percent in 2009, down from 5.6 percent in 2008.
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South Asia
South Asia appears to have escaped the worst effects of the crisis, with GDP growth
in the region estimated at 6.0 percent in 2009, down from 6.9 percent in 2008. The
slowdown in GDP growth mainly reflected weaker investment and private sector
demand, which were only partially offset by an increase in public expenditures.
Despite enduring a 5 percent decline in goods and services export volumes, an even
sharper decline in import demand (partly explained by weaker investment demand)
and lower food and oil prices meant that trade and current account balances improved
in 2009 Remittance flows to the region, which equal some 4.7 percent of GDP, fell an
estimated 1.8 percent, representing a significant drop in household incomes and
foreign currency earnings.
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Improved investor sentiment, particularly related to relatively strong growth outturns

in India and ongoing or new IMF stabilization programs. The recovery in the region is
expected to be less marked than elsewhere, partly reflecting the relative shallowness
of the downturn. Growth is expected to rebound to 7.0 and 7.4 percent in 2010 and
2011, respectively, compared with 6.0 percent in 2009.
Speaking of India specifically, the following are the World Bank Predictions dated
20th February, 2010:
2007 2008 2009 2010 2011
A. Real Expenditure Growth
1. GDP at market prices 9.1 6.1 6.0 7.5 8.0
2. Private consumption 7.6 2.9 4.0 6.7 7.5
3. Government consumption 7.6 20.2 10.0 7.0 6.5
4. Fixed investment 14.0 8.3 4.9 10.5 10.9
5. Exports, GNFS 2.8 12.8 -6.8 11.1 13.1
6. Imports, GNFS 7.5 17.9 -8.0 11.6 13.3
B. Contribution to GDP Growth
C. Price Deflators
1. GDP at market prices 17.7 -6.7 4.5 10.8 8.9
2. Private consumption 18.6 -2.5 1.1 11.4 8.3
3. Exports, GNFS 14.8 4.9 -8.4 1.8 1.4
4. Imports, GNFS 15.6 14.5 -16.3 6.7 0.9
D. Share of GDP
4. Change in stocks 0.0 0.0 0.0 0.0 0.0
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5. Total investment 35.5 37.8 36.1 37.2 37.9
6. Exports, GNFS 21.3 25.5 19.7 18.7 18.2
7. Imports, GNFS 25.5 34.8 24.2 24.2 23.5
E. Memo
1,123. 1,111. 1,232. 1,467.

1. Nominal GDP (USD billions) 1,725.1
4 9 1 0
1,169. 1,183. 1,197. 1,210.

2. Population (millions) 1,224.3
0 2 2 9
3. GDP per capita, current 1,029. 1,211.

961.0 939.7 1,409.1
USD 2 6
4. Real per capita GDP growth 7.5 4.8 4.8 6.3 6.8
5. USD Fx rate 40.1 44.6 48.5 47.0 46.0
Global scenario is as show below:
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The major concerns of the coming days:
94
Going through the charts below, it seems a herculean task awaits the economists and
leaders around the developing world on the issues of:
"People in the developing world have had to deal with two major external
shocks:
1. the upward spiral in food and fuel prices followed by the financial crisis,
and
2. banking systems and threatening job losses around the world,“ was stated
by
Justin Lin, World Bank Chief Economist & Sr VP.
More generally speaking, the challenges remain the following:
 Fluctuations in Security Markets
 Deepening of local Financial Crisis due to dependence on FI
 Volatility in local market
 Inflation and political instability
VII. BRIC Countries Position
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What is BRIC?
BRIC or BRICs are the acronym used to refer to the combination of the four biggest
emerging-market countries: Brazil, Russia, India and China.
President: Luiz Inacio Lula da Silva President: Dmitry Medvedev
Brazil Russia
President:Pratibha Patil President: Hu Jintao
India China
BRIC origins
The acronym BRIC was coined in 2001 by an analyst for Goldman Sachs who argued
that, by 2050, the combined economies of the BRIC nations would eclipse the
combined economies of the current richest countries in the world. The investment
bank never posited that BRIC would organize itself into an economic bloc, although
recently there have been signs that the BRIC has come to represent much more than
was originally intended.
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"The economic crisis is what pushed them together,". "The term BRIC wrongly
implies that they are actually a bloc in any concrete way," . "They are more of an
informal group within the international forums who meet sometimes to exchange their
points of view and who, when they reach common agreement, will defend their
position. But while they have many things that unite them, there is also a lot that
divides them."
BRIC, with 40% of the world's population, account for about 20% of its gross
domestic product, a share will rise to equal that of the G7 industrialized countries as
early as 2032.
There was a sign this year (2009) of the shape of things to come as China overtook the
United States as the world's biggest car market. And as incomes of 2.5 billion people
steadily rise, company profits as well as stock markets will feel the effect.
No surprise that cash -- direct investment and portfolio capital -- is increasingly

gravitating to these giants. BRIC-geared equity funds absorbed almost $20 billion in
January to November 2009. This is double 2007 levels and equivalent to 40% of what
was taken by emerging stock funds, some of which also went to the BRICs.
"The trend of BRIC outperformance has been very powerful and should continue as
growth is concentrated in these markets," said Martial Godet, who helps manage €37
billion in emerging stocks at BNP Paribas Asset Management in Paris.
"We are betting on the largest, highest-growth markets with the biggest populations
and good liquidity levels."
To capitalize on BRIC consumer demand, Goldman Sachs suggests investing in a

basket of 50 developed market stocks positioned to benefit from the BRICs theme,
and one of 50 BRICs companies that are likely to emerge as global market winners.
Already, BRICs are outgunning broader emerging stocks -- the MSCI BRIC index is
up 90% in 2009 versus 70% for MSCI EM, with only China lagging.
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An investment in Brazilian stocks in 2000 would have quadrupled by now while cash
put in emerging stocks would merely have doubled. And a buyer of world stocks
would have lost money.
As monetary policies start to tighten next year, investors on average expect BRIC
stocks to rise 20-25% in 2010 after the near triple-digit returns of 2009.
But in future, the BRICs as the most liquid emerging markets will gain most from
higher allocations to emerging markets.
Goldman Sachs economist Jim O'Neill, who first came up with the BRIC concept,
projects the BRICs to comprise almost half global stock markets by 2050 from less
than 10% now. He says it is inevitable more cash will move to the BRIC markets.
"If you think of a GDP-weighted benchmark, it would be considerably higher than the
current MSCI-type ones," O'Neill said, referring to indices that use GDP to weight
countries, rather than the usual practice of weighting by market value.
"For some asset managers, especially the sovereign wealth funds, this is what they are
moving towards."
Fund managers say cash will go where growth is -- or where the value is. With China
and India posting the highest growth in the world, and Russia trading at a 40%
discount to emerging markets, the bloc should remain an investment magnet.
Consumer demand is seen as key to the post-crisis global recovery, and at the heart of
the BRIC story is the consumer.
This is the main driver behind the surging tide of direct investment into the BRICs
which took in 16 percent of global direct investment flows in 2008. This is a third up
from the previous year, a total $265 billion, or over half of what was received by the
16-nation European Union, United Nations agency UNCTAD says.
China's car market made headlines earlier this year. With 10 cars per 1,000 Chinese,
there is a lot more room for sales growth than the US which has one car for two
people.
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What is happening is a rebalancing of global consumption, away from advanced

economies and towards emerging markets, says Goldman Sachs, a process expedited
by the shock caused to household wealth and employment by the financial crisis.
GS predicts Chinese household consumption to rise 10% in 2010, with Brazilian and
Indian demand also up over 5% while spending in the developed world remains flat.
Global corporates have cottoned on. Japanese electronics firm Panasonic for instance
said last month it aims for 15-20 % annual sales growth in the BRICs to compensate
for falling demand from Japan's shrinking population.
No wonder then that firms are rushing to set up production in the BRICs --
UNCTAD's 2009-2011 investment outlook survey found all four countries to be in the
top five most favored investment destinations with China topping the list.
"What investors in BRIC are saying is: we believe in GEM (global emerging markets)
but to a great extent, what's happening in GEM is in these four countries," said Alex
Tarver, who helps manage $1.9 billion in BRIC stocks at HSBC. "It is a microcosm
and one that's large enough to drive regional growth."
The four nations, representing emerging economic powers, demanded that developing
economies have a "greater voice and representation in international financial
institutions, and their heads and senior leadership should be appointed through an
open, transparent and merit-based selection process."
“We also believe there is a strong need for a stable, predictable and more diversified
international monetary system," the statement continued, delivering a warning
against the global domination of the US dollar as the world’s standard reserve
currency.
Russian President Dmitry Medvedev had voiced similar sentiments before the summit,
saying the current reserve policies "have not managed to perform their functions."
Russia’s chief economic aide, Arkady Dvorkovich, suggested that the International
Monetary Fund (IMF) should revise the basket of currencies used to value its financial
products to include the Russian ruble and Chinese yuan. At the moment the currencies
included are the dollar, euro, yen and sterling.
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Increased economic power was underscored when Brazil and Russia joined China in
announcing they would shift some $70 billion (50 billion euros) of reserves into
multicurrency bonds issued by the International Monetary Fund. The move was
interpreted by some as an attempt to topple the dollar; in part because the Russian
president said at the time that his proposal to create a new world currency could be
discussed at the summit.
But fiscal experts say that BRIC will tread carefully where the dollar is concerned, as
triggering a dollar crisis would be akin to shooting themselves in the foot.
"The BRICs are putting the US on notice that there has to be a cutback on spending
and that they need to get their house in order," Mark Mobius, emerging markets expert
at Templeton Asset Management. "Any attack on the dollar will hurt them. But they
want to make sure this kind of mess doesn't happen again."
Clearly though, BRIC is using its new influence to put pressure on the IMF to reshape
its voting structure to better reflect the shift in economic power. Brazil, for example, is
the world's 10th largest economy, but has just 1.38 percent of the IMF board's votes,
compared to 2.09 percent for Belgium, an economy one-third the size.
China as a superpower?
China, too, is well-positioned to become a greater actor on the world stage, despite its
past preference for playing a supporting role.
"China has realized that it might become a global power much faster than it thought,"
says Renard. "And the US is realizing that now, too. It is treated as a de facto global
power by the US, at least with regard to economic matters, with the two countries for
all intents and purposes forming a 'G2'."
But while the thought of China as a superpower is perceived by many in the West as a
threat, Renard says that it's an unfounded fear.
"The world today is characterized by interdependence," he says. "Even for China, it's
not a time to think about individual gains, rather it's about minimizing the damage that
we all suffer."
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The "rise of the rest"
While Renard is certain that the current trend is from a unipolar world to a multipolar
one, he says we're unlikely to witness the emergence of a new superpower to rival the
US anytime soon.
"To be a world power, you need more than money," Renard said. "You need military
power and soft powers, such as cultural power. And in these respects, the US is still
the leader."
Instead, Renard says it's more accurate to talk about bad US policies that have
damaged American influence abroad coinciding with the "rise of the rest."
The "rest" not only includes new emerging powers, such as the BRIC nations, but also
"non-state actors such as transnational organizations like al Qaeda and supranational
institutions like the EU, all of which are increasingly challenging American
predominance."
India Dreaming with BRICs: The Path to 2050
In 2003 Goldman Sachs (a leading global investment management firm) came up with
a research report called “Dreaming with BRICs: The Path to 2050″.
According to that BRIC (Brazil, Russia, India, and China) is a coalition of regional
and superpowers reportedly proposed by Russian President Vladimir Putin.
The BRIC research findings:
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If things go right, the firm’s economists argued that, given sound political decision-
making and good luck, the BRIC economies together could become larger than those
of the world’s six most developed countries in less than 40 years. i.e BRIC economies
of Brazil, Russia, India and China together would be larger than G6 (G7 excluding
Canada) in USD in less than 40 years. Of the current G6, only the US and Japan may
be among the six largest economies in US dollar terms in 2050.
BRIC in future
The following list shows the top 22 countries by nominal GDP from year 2010 to
2050. The bottom chart lists the top 22 countries by nominal GDP per capita (the
rankings for this bottom chart do not reflect the GDP per capita for all the world's
countries). The figures are in ‘000. BRIC countries are highlighted below.
Rank Country 2010 2015 2020 2025 2030 2035 2040 2045 2050
United
1 14,535 16,194 17,978 20,087 22,817 26,097 29,823 33,904 38,514
States
2 Japan 4,604 4,861 5,224 5,570 5,814 5,886 6,042 6,300 6,677
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3 Germany 3,083 3,326 3,519 3,631 3,761 4,048 4,388 4,714 5,024
4 China 4,667 8,133 12,630 18,437 25,610 34,348 45,022 57,310 70,710
United
5 2,546 2,835 3,101 3,333 3,595 3,937 4,344 4,744 5,133
Kingdom
6 France 2,366 2,577 2,815 3,055 3,306 3,567 3,892 4,227 4,592
7 Italy 1,914 2,072 2,224 2,326 2,391 2,444 2,559 2,737 2,950
8 Canada 1,389 1,549 1,700 1,856 2,061 2,302 2,569 2,849 3,149
9 Brazil 1,346 1,720 2,194 2,831 3,720 4,963 6,631 8,740 11,366
10 Russia 1,371 1,900 2,554 3,341 4,265 5,265 6,320 7,420 8,580
11 India 1,256 1,900 2,848 4,316 6,683 10,514 16,510 25,278 37,668
South
12 1,071 1,305 1,508 1,861 2,241 2,644 3,089 3,562 4,083
Korea
13 Mexico 1,009 1,327 1,742 2,303 3,068 4,102 5,471 7,204 9,340
14 Turkey 440 572 740 965 1,279 1,716 2,300 3,033 3,943
15 Indonesia 419 562 752 1,033 1,479 2,192 3,286 4,846 7,010
16 Iran 312 415 544 716 953 1,273 1,673 2,133 2,663
17 Pakistan 161 206 268 359 497 709 1,026 1,472 2,085
18 Nigeria 158 218 306 445 680 1,083 1,765 2,870 4,640
19 Philippines 162 215 289 400 582 882 1,353 2,040 3,010
20 Egypt 129 171 229 318 467 718 1,124 1,728 2,602
21 Bangladesh 81 110 150 210 304 451 676 1,001 1,466
22 Vietnam 88 157 273 458 745 1,169 1,768 2,569 3,607
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BRIC funds: Many mutual fund companies have come up with a type of fund called
The BRIC funds, which invest primarily in the BRIC countries.
BRIC Country Returns for 1 year and 10 year vs. the US
The 4 horsemen of growth (B)razil (R)ussia (I)ndia and (C)hina. At this point China is
China, and basically Brazil is a 2nd derivative to China (i.e. when China runs, it needs
to buy commodities. Who has commodities? Brazil. And Brazil is like Russia without
the political risk) India is a unique case in and of itself.
- A comparison of the BRIC countries stock returns versus the U.S. in both the 1 year
and 10 year time horizons. If you have a 10 year horizon and can ignore the stomach
turning shorter term losses in the stock market - throw money at the next 500 million
people (Chindia) who are going to move from poverty to middle class & check back
in 2019.
1st Year:
104
10th Year:
105
Political Risk Perceptions and the Financial Crisis
 Rapid Growth of FDI outflows from developing countries.
 Share of developing countries in global outflows increased from 1.4 in 2000 to

10.8% in 2008
 BRIC countries account for bulk of FDI outflows from developing countries.
 In 2008: Brazil ($20.5 billion), Russian Federation ($52.6 billion), India ($17.7
billion) and China ($ 53.5 billion)
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Political Risk Survey in the BRICs
 Investors from emerging markets view political risk as a significant constraint

on investment plans.
 Political risk was the leading concern this year for Russian, Brazilian and
Indian investors (jointly with microeconomic instability) and the second most
significant concern for Chinese investors.
107
Top constraints on investments for investors in the BRICs
108
Top political risks of investors from the BRICs
Similarities and differences among the BRICs on the most important political
risk
 Most investors from the BRICs considered breach of contract as the principal
political risk this year and over the next three years (on par with transfer and
convertibility restrictions for the latter).
 This was followed by transfer and convertibility restrictions and non-honoring

of sovereign guarantees.
 Political violence was considered the most significant risk for Chinese
investors over the next three years; it was of least concern for investors from
Brazil and the Russian Federation.
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 11 percent of BRIC respondents said they did not mitigate political risks at all
 Over a third of BRIC respondents said that the level of risk in destination
countries did not warrant mitigating political risk.
 A substantial minority (28%) said they were unaware of specific products and
tools available.
Risk capabilities of investors from the BRICs
 Thought well of own abilities to assess political risk.
 Much less confident in own abilities to anticipate new risks.
Good ability to evaluate risk mitigation strategies.
 Less able to implement new mitigation strategies
How do MNEs from the BRICs mitigate political risk?
 Primarily informal and indirect means (no difference from respondents

of the global survey)
 Most and engaging in joint ventures and popular tools are producing
political risk analysis and assessments, engaging with host country governments
alliances with host country firms
 Political risk insurance ranks low (except for Russian investors)
 The BRIC survey suggests that emerging market investors’ attitude

toward political risk overall is similar to that of industrialized countries’
investors. This challenges the view that investors from emerging markets are
comfortable with political perils
 However, the importance of political risk does not translate into high
usage of political risk insurance
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 BRIC investors manage most risks without resorting to formal risk

mitigation products
Reason of Rapid Growth in FDI in China and India
 Abundance of labour and its low cost
 Rapid expansion of china’s Domestic market
 Role of Overseas Chinese
 Increasing Integration with World Economy
For data of FDIs in India, please refer to the annexures.
FDI LANDSCAPE
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India and China: the Difference
 India could not attract foreign investment in both products and services market,
only seen as a service industry especially in IT.
 To eliminate this difference, three steps can be taken to stimulate domestic

demand
 RBI to keep interest rates regionally competitive
 Implementation of Value Added Tax (VAT) throughout the country
 Government to reduce budget deficit
 China’s Financial Assets – 220% of GDP
 India’s Financial Assets – 160% of GDP
 China’s Financial system shows greater strength in countries saving and

investment
Wasted Capital
112
 Majority of financial capital of both countries going to less-productive areas
 China’s fund going to State Own Enterprises rather than the private sector
 India’s major share taken over by government to finance budget deficit
 Much of what’s left goes to Agriculture, tiny Household etc.
 Reason for this skwed types of lending in both countries is preserving jobs.
ROUND TRIPPING
 Chinese firms illegally transfer domestic (unaccounted) money to other

foreign countries and then invest it in the mainland as FDI inflows in order to
benefit from the preferential treatment given to FDI in terms of taxation, labor
policy, etc.
 Under reporting of FDI by India because of non-conformity of India’s method

of measuring FDI to the international standards.
113
Projected GDP US – 3%, INDIA – 7%, CHINA –

8%
45
40
GDP in Trllion Dollars
35
US
30
25 INDIA
20 CHINA
15
10
5
0
2018
2028
2030
2040
2008
2010
2012
2014
2016
2020
2022
2024
2026
2032
2034
2036
2038
2042
Accounting for Growth: Comparing China and India
114
The emergence of China and India as major forces in the global economy is one of the
most significant economic developments of the past quarter century. Their continued
growth is likely to dominate the course of the world economy for the next several
decades. Up to now, only a small fraction of the world’s population has enjoyed the
fruits of economic well-being, with high-income industrial countries accounting for
less than a fifth of the world’s population. However, China and India together
comprise over a third of the world’s population; and since 1980, they have achieved
remarkable rates of economic growth and poverty reduction.
China’s GDP per capita is now 2.2 times higher than India’s (in USD PPP terms).
Until the early 1990s, GDP per capita in China and India was at comparable levels,
but China adopted wide-ranging economic reform one decade earlier than India.
The Chinese economy is much more integrated with the world economy through
international trade and investment, which helps to explain its stronger rate of GDP
growth during most of the past 3 decades. For its economic development, China has
relied on industry and India on services. China’s ratios of domestic savings and
investment to GDP are roughly double those of India’s.
Both economies currently enjoy strong external positions, with ample foreign
exchange reserves. Higher oil prices are not likely to have a significant adverse impact
on external liquidity. China and India have low external debt as a percentage of GDP,
and the ratio of short-term external debt to foreign reserves is low.
Despite declining fiscal deficits, the level of public sector debt is a cause for
concern, especially in India. In particular, interest payments as a percentage of
general government revenue are very high in India, making the prospect of fiscal
consolidation more remote. Excess domestic liquidity presents a bigger challenge to
China than India. M2 in China is heading toward 200% of GDP with domestic credit
almost 170% of GDP. This explains the rapid rise in CPI inflation during 2004, on
which the Chinese authorities are still keeping a tight rein.
Surveys indicate India has better corporate governance standards and its
companies are more commercially-driven. This explains why, despite China’s
superior economic growth and macroeconomic stability, India’s rate of return on
115
assets has been much higher, non-performing loans in the banking sector lower, and
stock market performance much better.
Social indicators reflect generally improving living conditions for the average
Chinese. China also enjoys superior physical infrastructure, although India’s
availability of skilled workers, especially engineers, is much better regarded.
China’s early steps to liberalize its economy and invest heavily to modernize its
physical infrastructure gave it a substantial edge over India in terms of income per
capita levels. They also made China a more attractive destination to foreign investors.
However, although India started economic reforms only a decade later than China, it
is far more advanced in its institutional infrastructure and corporate governance. This
is reflected in contrasting outcomes: foreign direct investment is considerably lower
than in China, but returns on investment are better on average. The key to unlock
India’s potential to rival China as an FDI destination is a decisive effort by the Indian
authorities to push ahead with reforms.
To summarize:
China and India provide empirical documentation for much of the prior discussion of
their growth performance. In international comparisons, China’s achievements have
truly been extraordinary, but India has also grown at a rate that matches the other
industrializing economies of East Asia. Key differences between the two economies
also stand out, with China’s concentration of growth in industry while India’s growth
has been strongest in various service-producing industries; but China’s growth is
remarkably broad across agriculture, industry and services. Overall, the growth of
services in China actually exceeds that of India. Thus, juxtaposing the experiences of
China and India offers a valuable perspective on each country’s individual
performance.
Our work also extends the growth accounting literature for these economies in a
number of ways. First, it incorporates all of the recent data revisions, some of which
are quite large. Second, the analysis disaggregates by major economic sector. This
116
provides new estimates of the contributions to overall labor productivity growth from
growth within sectors versus from the gains due to reallocation of labor and capital
among sectors. In China, we document the strong contribution to growth that is
provided by both increases in capital per worker and TFP. Surprisingly, we find no
support for some of the recent arguments that China is experiencing a significant
deceleration of growth in TFP due to wasteful and excessive expansions of capital
investment. The comparison of China and India highlights the weak performance of
India’s manufacturing sector as much as the strong growth of services.
Looking forward, supply-side factors suggest that both economies should be able to
sustain their growth. They have plentiful supplies of underutilized labor, though India
faces greater challenges of raising educational attainment. Both have high rates of
private saving, although again China stands out. India currently devotes much of its
saving to finance the large fiscal deficit.
The growth prospects for both depend upon continued integration with global
economy, including trade in goods and services, and investment flows. India in
particular will need to broaden its trade beyond the current emphasis on services. Only
an expansion of goods production and trade can provide employment opportunities for
the current pool of underemployed and undereducated workers. China has done well
in the international dimension and now needs to focus on development of domestic
markets and a more balanced trade position.
 China in a stronger position compared to India
 But INDIA can do better if it opens more sectors for FDI
 Eliminate barriers in foreign investment
 Improve productivity and population control to increase Per Capita income
 More efforts to decouple economy and equity market’s over dependence on

FII
117
VIII. Global Issues
1) Implications for India of more money printing by USA
The money printed by USA will be routed to India to take advantage of

interest rates differentials. In India, the onus to control and take control of the
situation of inflation is upon the Reserve Bank of India (RBI). The Reserve
Bank of India (RBI) follows a multiple indicator approach to arrive at its goals
of growth, price stability and financial stability, rather than targeting inflation
alone.
Steps taken by RBI to tackle inflation
118
The steps generally taken by the RBI to tackle inflation include a rise in repo
rates (the rates at which banks borrow from the RBI), a rise in Cash Reserve
Ratio and a reduction in rate of interest on cash deposited by banks with RBI.
The signals are intended to spur banks to raise lending rates and to reduce the
amount of credit disbursed. The RBI's measures are expected to suck out a
substantial sum from the banks. In effect, while the economy is booming and
the credit needs grow, the central bank is tightening the availability of credit.
The RBI also buys dollars from banks and exporters, partly to prevent the
dollars from flooding the market and depressing the dollar - indirectly raising
the rupee. In other words, the central bank's interactions have a desirable
objective - to keep the rupee devalued - which will make India's exports more
competitive, but they increase liquidity.
To combat this, the RBI does what it calls "sterilization" - it sucks out the
rupees it pays out for dollars through sale of sterilization bonds. It then sells
these bonds to banks. Economists point out that there has not been much
success in such sterilization attempts in India. The central bank's attempt to
offload Government bonds on banks has not been too successful inasmuch as
the banks sell the bonds and get rupees instead.
Economists also contrast this with the successful experience of China, where
the state-owned banks strictly abide by the central bank's dictates and absorb
the sterilization bonds. That discipline is lacking in India. The net effect is that
the RBI has to resort to indirect methods of sterilization, such as raising
interest rates and raising CRR to contract liquidity. This makes India more
attractive for foreign capital flows that seek better returns and a vicious cycle
follows. RBI has to buy more foreign currency and sterilize. The cycle
becomes worse.
Consequences of RBI Policy
The economy was growing at a stupendous 9 per cent, second only to China
worldwide, however the brakes have been firmly pressed by the RBI due to
their anti - inflationary policy. If the CRR and REPO rate are hiked frequently,
119
the economy may take a U - turn, as most commercial banks religiously

increase their lending rates, without actually studying the impact.
The last time that the RBI had imposed its policy, the markets had signaled
their resounding reaction by a sharp fall in the Sensex by nearly 500 points.
The impact on economic growth is also likely to be sharp, judging by effects
of similar therapy applied with disastrous effect in the mid-1990s.
This would reduce the level of investment activity in the economy, particularly
in the infrastructure sector. Big corporate may ask for, and get, access to
external commercial borrowing, but not so favoured are the bulk of small and
medium entrepreneurs (SME). Housing activity will suffer an impact because
most loanees are on floating rates and will face increased equated installments.
These measures generally taken by the RBI do not effectively tackle inflation
but on the other hand effectively stunts the growth pattern of the economy.
The RBI seems to believe that by merely reducing the credit flow and money
flow in the economy, inflation can be curtailed. Inflation is a consequence of
increasing demand vis - a - vis the supply in the economy. The demand must
be effectively curtailed or pushed down, which the present CRR policy is not
managing to do effectively. The RBI, in an ideal world, would have also
looked towards a mechanism to bolster the supply forces to meet the
requirements of the consumers and thereby combat inflation.
Economists admit that while RBI's efforts to contain inflation will reduce
borrowings, prices would continue to rise.
There are two major drawbacks in the CRR - REPO policy adopted by the RBI
to combat inflation. Firstly, monetary tools have proved more effective in
economies with greater financial inclusion. They are less effective in
economies such as India's, where the majority of the population still has no
access to banks, and those with access barely have the resources to open bank
accounts.
The increasing cost of funds and rising interest rates are of little consequence
in the economic life of a financially excluded population. The impact will be
critical on smaller segments and will take a while to yield results for the
120
economy. Much more remains to be achieved on the financial inclusion front.

This contrasts poorly with India, where the ratio of deposit accounts to total
adult population is only 59 per cent. But even this figure is suspect, as the
average urban middle-class income-earner often has more than one bank
account. This is bound to reduce further the percentage of people with bank
accounts. Most account holders are urban-centric, leaving large segments of
the rural population with no access to banks or the means to save or borrow.
Secondly, in spite of its being an indirect weapon of credit control, CRR does
impact the level of money supply in the economy and plays some role in the
fight against inflation. But the impact of the CRR hike will not distinguish as
between productive credit and credit meant for consumption. This will hurt
growth and the creation of assets in the economy.
Farmers today keep several acres of land uncultivated as the financial returns
are not commensurate with the expenses incurred for cultivation. Irrespective
of the increasing cost of funds, large segments of the borrowing public,
especially the small, medium and large farmers, have no option but to
approach the commercial and cooperative banks, or the multitude of
unregulated moneylenders at the beginning of every crop cycle.
As a result, lendable resources of the system will be reduced to that extent and
bank credit will be dearer. This hike will result in increase of the lending rates,
whether for production or consumption. The RBI can address only the demand
side through such an approach. The need of the hour is to curb only
consumption credit and not production.
The monetary measures are meant to increase the cost of funds for banks,
make loans dearer and temper the demand for credit. While there is a greater
possibility of banks passing on the increased costs to the consumer, it is
debatable whether this will choke the demand for funds in some specific
inflation-impacting sectors.
Impact on prospects of growth of economy
121
Today, the prime lending rate (PLR) of the banks varies between 12.75% and
13.25%. That means no SME can get working capital loan at less than 15%.
Compare that with the rest of Asia. China has a negative real interest of 2.64 %
(interest rate on three-month loans at 3.86% minus inflation at 6.5%). South
Korea's real interest rate is 3%. Thailand's is 1.45%. Malaysia's is 1.72%.
Taiwan's is at a negative 0.5%. In fact, it is well understood that real interest
rates in excess of 3.5% universally hurt competitiveness and growth.
Our high interest rates are not only hurting business, but have become a
magnet for foreign portfolio funds. Which, in turn is rapidly appreciating the
domestic currency, and giving foreign institutional investors (FIIs) and their P-
note beneficiaries a double bonus: first through returns on their investment and
then on the appreciating exchange rate.
Figure 1:Summary of impact on India of more money printed by USA
2) Implications for not reevaluating currency (mainly Chinese)

for Long
122
On July 21, 2005, China abandoned the 11-year peg of its currency, Yuan, at
RMB 8.28 to the dollar. From now on, the Yuan will be linked to a basket of
currency (write currency and number of currency), the central parity of Yuan
is decided to set at the end of each day. The Yuan central rate was devalued by
2.1% at RMB 8.11 (far lesser than what the actual value should be). The new
exchange-rate regime might prove taxing to the Chinese firms but would help
to control the over-heated Chinese economy, the burgeoning US trade deficit
and asset pricing bubble.
Brief History
The Yuan has been pegged to US dollar since Jan'1994 when China adopted a
new managed floating rate regime within narrow band. Under this Chinese
Central Bank (the People's Bank of China) unified rate for all authorized
foreign transaction at RMB 8.7 per dollar. The rate was flexible to adjust
within a narrow band of 0.25% of previous day's reference date. The Yuan
began to appreciate in the year '94 and for the first time in May 1995 touched
RMB 8.3 per dollar (5% increase) and remained around the same value for
next two years finally appreciating to RMB 8.21 per dollar and had been
maintained till it was pegged to a basket of currency.
Although the regime was known as market driven managed float, it was de
facto pegged to dollar since '94.
Currency Evaluation
The Goal: Under a "float", which China says it wants someday, a currency
rises and falls on global markets according to supply and demand. This is the
system that applies to many major currencies such as the US Dollar, the Euro
and the British Pound.
The Old System: Under a "peg", which China has had since 1995, the
currency's value is fixed - in China's case, at 8.28 Yuan per US Dollar.
The New System: Under a "managed float", which China adopted in July' 05,
the currency can rise and fall but only within prescribed limits.
123
The Controversy
The hue and cry for revaluation of Yuan was primarily because of following
reasons:
• In PPP terms, Yuan is substantially under-valued. The Big Mac index

assesses Chinese currency as undervalued by 59% in the release of Jun
9, 2005.
• One fourth of the US trade deficit (which was shot up to US$ 600 bn,
5% of US GDP). Given the extravagant life style of Americans, social
security proposal, prospect of continued increasing outlays because of
rising tension with North Korea, Syria and Iran, the US budget deficit
is expected to inflate. Appreciation of Chinese currency is expected to
curb this deficit up to some extent, if not completely.
• Given the healthy Balance of Trade, Balance of Payments, FDI,

Exchange Reserves, GDP growth in last few years, Yuan has become
stronger along with Chinese economy and demand for its currency has
also improved.
Advantages & Disadvantages of Yuan Becoming More Valuable
Advantages for China
1. Cheaper Imports: China imports technologies, petroleum, metals,

machinery and skills from other countries. China is the biggest
consumer of many commodities such as aluminum, steel, coal and
copper and second largest consumer of oil. With the increasing prices
of these commodities, appreciating Yuan will put less pressure.
2. Overseas Investment and Expansion: With huge forex reserve (US

$514 bn in Sept'04), a stronger Yuan and government loosening the
control on capital outflow, it will be economically rewarding to invest
abroad. On the other hand, Chinese firms may desist from investing
abroad if they fear further depreciation may not provide required rate
of return. In short run, they prefer to wait before dollar depreciates
before making investment.
124
3. Control of Inflation: Inflation can act as damper to overheating prices

and excess liquidity. Increased income and more confident mindset of
Chinese has improved the marginal propensity of consumer, fostering
to excess liquidity and made Chinese Central bank's sterilization
strategy of issuing bonds less effective.
4. Reduced Foreign Debt Obligation: The dollar denominated debt

obligation would be reduced (in Yuan terms) once Yuan will be
revalued (because of depreciation of Dollar vis-a-vis Yuan). As per
estimate, the principal of foreign denominated bond will be reduced up
to 15%.
5. Focus on Domestic Economy: Revaluation of Yuan will force

Chinese economy to become more productive, in order to counter the
disadvantage occurring because of revaluation of currency. Chinese
economy is excessive export-oriented which is dangerous (Japan has
faced chronic deflation and three recessions in last decade because of
its export focus and had left internal demand under-developed).
Initially, this step of Yuan revaluation may hurt Chinese economy as
prices may rise and take hit on profit margin. In long term, if efficiency
is achieved and domestic demand is adjusted, enterprise would be able
to generate more wealth.
Disadvantages for China
1. Growth can be stagnated: Purchasing power of US customers will be

affected because of Yuan appreciation; hence China will lose 'cost
advantage' leading to fall in exports. This will show decreases in output
and increased unemployment, which is already a big problem (even
though there is boom in export after lifting the quotas).
2. Impact on FDI: FDI flow may decease drastically as the new

investment will become unviable and existing one will no longer be
economically beneficial as they used to be. Moreover, there will be
increased forex risk associated with it. This could hamper economic
125
growth of China and have considerable impact (as FDI is very high in
China because of less stringent norms).
3. Immature Market: The financial market of China (which is not most

robust market) may not be able to handle revaluation. The Shenzhen
and Shanghai Exchange were formed in late 90's and even then they
were used for funneling the fund in state-owned enterprise. A sudden
appreciation of currency will badly affect many financially
unsophisticated and unhedged firms.
4. Increase in NPAs of Bank: The weak banking system of China has

huge NPAs and it is being mobilized and sold to US investors.
Increased value of Yuan will reduce its appeal to US investors.
5. Hot Money & Increase in Volatility: There has been huge capital
influx into China recently purely through speculation. Once revaluation
is done and investors gain sufficient return, this capital will flow out of
country. If it revaluates too slowly, it might be indicator to investors
that more appreciation is to come, but if it happens too fast, there
would be too many funds at once. Depending upon the rate of
revaluation, it may or may not be a threat of fund outflow. Either way
high volatility is assured. In case of deliberate pull back of economy,
curbing possible gain from non-currency means lead to investors will
to remain invested.
Advantages for USA
1. Control over Deficit: China alone forms one third of US $600 bn

global trade deficit. A revaluation of Yuan would definitely help US
control the deficit.
2. Political Pressure: The political debates in US are heating up over the

rising menace of the Chinese dragon. Outsourcing and steady stream of
job losses in past years have increased the pressure on the policy
makers to act.
126
3. Increased Export: With the increasing Yuan, the US export to China

would become more affordable to Chinese consumer, and hence, will
get a boost.
Disadvantages for USA
1. Rise in Interest Rate: With dollar becoming`g weaker, FDI flows in

China will decrease leading to decrease in Chinese Central bank
investment in US Treasury Bill. The current trend of reverse
diversification, where central banks across the globe are widening their
investing by divesting in dollars investment and investing in other
currencies, as china move towards pegging the RMB to a basket of
currencies, there will be a notable impact on Euro. China is world's
third largest investor in US Treasury Bill. This revaluation will force
Chinese policy maker to sell their holding in US Treasury Bill and buy
in Euro and Yen. This will ultimately decrease the demand for federal
T-Bill and interest rate will rise. The falling dollar and increasing
interest rate will not only hurt US but also impact Asian countries such
as Japan, China, India and to an extent Russia as well. Therefore, these
countries will also try to play diplomatically and diversifying their
investment back stage.
2. Short-term Inflation: In short run, Chinese products will be available

at low price. Given the high spending habits of US consumer, it will
definitely increase the inflation at least in short run.
Advantages for India
1. Improved Export: As compared to before revaluation of RMB, the

Indian products will be cheaper now and India Inc. surely would be
able to capitalize on this opportunity.
2. Outsourcing Advantage: Apart from IT and ITES, India's relatively

cheap labour will be now exploited by the US firms. As the Yuan
127
appreciates, the NPV of investment in China will start decreasing; the

money might be diverted to India as well.
Disadvantages for India
1. Absence of Cheap Chinese Goods: There will be same effect of

revaluation to India as I have previously discussed in case of USA
IX. Steps to be taken
In an earlier section, both benefits of adverse impacts of the foreign capital

movement are listed. A sound fiscal and monetary policy is required to
maximize the benefits of foreign capital movement and minimize the adverse
impacts of foreign capital movement.
1) Making domestic banking institutions strong
It is usually a mistake to liberalize the domestic banking system or to open it

fully to inflows if important parts of the system are insolvent or likely to be
pushed into insolvency by liberalization. As a general rule, nonviable
institutions should be weeded out and remaining banks put on a sound footing
before liberalizing or opening the domestic banking system. Nonviable
institutions should be weeded out and remaining banks put on a sound footing
before liberalizing or opening the domestic banking system.
2) Market Stabilization Scheme (MSS) bonds
128
Inflow of dollars by FIIs (Foreign Institutional Investors) to buy Indian stocks

in 2004 resulted in an oversupply of US dollars in the Indian market. RBI
bought dollars, thus creating an equivalent amount of rupees. This dollar
buying raised forex reserves from $100 bn in January 2004 to about $300 bn
by 2007-08. Thus there was a liquidity overhang that was caused by the inflow
of dollars. This forced the government to mop up the rupees by creating the
MSS bonds.
MSS was introduced by way of an agreement between the government and the
Reserve Bank of India (RBI) in early 2004. Under the scheme, RBI issues
bonds on behalf of the government and the money raised under bonds is
impounded in a separate account with RBI. The money does not go into the
government account. MSS bonds are interest bearing securities meant
primarily for investing banks' surplus deposits. Unlike usual central
government bonds, MSS bonds do not impact inflation as the proceeds of these
bonds are retained by RBI and not passed on to the government for spending.
3) Create strong domestic markets
The domestic markets and financial infrastructure for portfolio investments in

equities and debt instruments are not well developed in many emerging market
countries. Creating the domestic infrastructure is necessary before these
markets can be opened internationally. The economy can also benefit from the
development of domestic financial markets that allow financial flows to be less
heavily dependent on the banking system.
4) Address problems in domestic financial system first
Because banking systems play a central role in the financial affairs of most
emerging market countries, capital flows to and through the domestic banking
system are already significantly liberalized in many of these countries.
Reversing this situation by going back to detailed restrictions on capital flows
through domestic banks hardly seems sensible. But the fact that capital inflows
129
are already a reality only highlights the danger of removing most restrictions
on capital account transactions too quickly, before major problems in the
domestic financial system have been addressed. Inadequate accounting,
auditing, and disclosure practices weaken market discipline. Implicit
government guarantees encourage excessive, unsustainable capital inflows and
inadequate prudential supervision and regulation of domestic financial
institutions and markets can breed corruption, connected lending, and
gambling for redemption. Countries in which these problems are severe should
liberalize the capital account gradually, in conjunction with steps to eliminate
these distortions.
5) Liberalizing long-term flows ahead of short-term flows
Regarding the liberalization of capital outflows, the main concern arises when
the restrictions to be removed are supporting either a significant
macroeconomic imbalance or a distorted financial system. If an overvalued
exchange rate has been maintained with the help of restrictions on capital
outflows, then the government must be prepared to adjust the exchange rate
when the restrictions are removed. Similarly, if policies have kept interest rates
for savers artificially low, market participants must be prepared for a rise in
rates. To avoid such costly accidents, countries should liberalize outflows after
they have reduced macroeconomic imbalances and financial distortions to
manageable proportions.
6) Improved transparency in markets
Critics of open capital markets, point to the inefficiencies resulting from

adverse selection, moral hazard, and herding behavior, all of which are
byproducts of asymmetric information-a situation in which not all parties to a
transaction have equal information. Government policies, however, can lessen
or mitigate the potential damage from asymmetric information problems.
130
X. Conclusion
A working group chaired by Dr. Rakesh Mohan, Deputy Governor, Reserve

Bank of India was established by the Committee on Global Financial System to
explore the consequences of capital flows for EMEs: both the macroeconomic
effects and the impact on the domestic financial system.
An outline of the main issues to address was described in their report as follows:
1. The composition of gross capital inflows and their risk characteristics for the
receiving EMEs.
2. The sectoral destination of some components of gross inflows.
3. The size and composition of capital outflows, with particular emphasis on

financial asset investment abroad intermediated by financial institutions.
4. Consequences of inflows for domestic asset markets: equity price

developments, bank balance sheets, land price developments, non-financial
corporate balance sheets and domestic currency interest rates.
5. Implications for the conduct of monetary policy: exchange rate

developments, international reserve accumulation, sterilisation, control over
short-term interest rates, and long-term interest rates.
131
6. Macroeconomic consequences: inflation, current account positions, wealth

effects and government budget balances.
7. Implications for domestic financial infrastructure development: local capital

markets, domestic financial institutions, the activities of foreign financial
institutions and the development of new financial instruments.
8. Challenges posed to regulation of the domestic financial sector.
The working group submitted its report in January 2009. As per the report the
group has concluded as follows:
The flow of capital between nations, in principle, brings benefits to both capital-
importing and capital-exporting countries. But the historical evidence,
reinforced by the current global financial crisis, clearly shows that it can also
create new exposures and bring new risks. The failure to analyse and
understand such risks, excessive haste in liberalising the capital account and
inadequate prudential buffers to cope with the greater volatility in more market-
based forms of capital allocation have at one time or another compromised
financial or monetary stability in many emerging market economies. On the
other hand, rigidities in capital account management can also lead to difficulties
in macroeconomic and monetary management.
The co-existence of large-scale private capital flows to the emerging economies,

taken as a group, with substantial current account surpluses is problematic. In
many ways, the ideal for rapidly growing developing economies is to have
current account deficits financed by stable forms of foreign investment. Swings
in capital inflows without offsetting changes in current account balances can
lead to large, and possibly disruptive, changes in real exchange rates. And they
are frequently associated with more volatile or fragile forms of finance. The
capacity to absorb capital inflows is more limited the less domestic financial
intermediation is able to channel financial flows into real investment. However,
132
given the large volume of net capital inflows experienced by many EMEs in the
recent years - 10% of GDP or even more - it is not apparent that such a large
volume of capital inflows could have been absorbed by the recipient economy,
even in the presence of well-developed domestic financial markets. Past
experience suggests that large capital inflows - whether absorbed or not - can
drive up the prices of existing assets and may not lead to the creation of new
assets. Asset market bubbles have been disruptive in some EMEs. Policymakers
need to keep these risks in mind.
There is no doubt that closer international financial integration creates

challenges for monetary policy. Long-term interest rates are increasingly subject
to global rather than purely local influences. Monetary policy works via changes
in short-term interest rates and short-term capital flows are very sensitive to
domestic short-term rates, which explains why restrictions on short-term flows
have often been the last to be removed.
How well domestic capital markets function has a major bearing on whether
capital inflows enhance growth without exacerbating financial stability. The
Report finds that the links between the resilience of the financial system and
capital inflows go in both directions. The greater presence of foreign investors
should, in principle, deepen local financial markets, enhance investor diversity
and improve liquidity. But they can also exacerbate the domestic
macroeconomic and liquidity crisis in the times of crisis through massive
liquidation of their investments in the EMEs, as has been clearly evident in the
current round of turmoil. A sophisticated and diverse domestic investor base is,
therefore, also essential for enhancing the resilience of the financial system.
In September and October 2008, a further round of de-leveraging by major

international banks, hedge funds and other investors put very heavy downward
pressure on almost all emerging market assets, even as the fundamentals of the
major EMEs are widely believed to be robust. Volatility rose sharply across the
board and policymakers in the EMEs faced very difficult dilemmas.
Although this shock appears to have reversed the focus of much of this report
(which was on the problems of capital inflows), some lessons were reinforced.
Countries with open capital accounts need to prepare for shocks from the
133
financial systems abroad. Flexibility in exchange rates can be an effective buffer

to such shocks and may help deter the build-up in the private sector of
imprudent forex exposures. Countries with substantial forex reserves were better
able to cushion the impact of downward pressure on the exchange rate brought
about by sudden and large capital outflows. Not only could they intervene on a
substantial scale to counter extreme movements in the exchange rate, but they
were also able in the crisis to fund their banks in dollars or other foreign
currencies. Some also bought back foreign currency debt when credit spreads
widened. Similarly, countries that had taken measures to constrain the liquidity
of these banks (eg by increasing reserve requirements) in the phase of heavy
inflows were able to alleviate liquidity pressures by relaxing these restrictions.
Hence countries that had put in place effective "prudential buffers" believe that
they resisted the crisis better than others. It is interesting to note that the large
build-up of forex reserves by most EMEs during 2004-2007 was at that point of
time believed to be excessive. It seems that many EME authorities viewed the
large capital inflows or commodity-related current account surpluses during
2004-2007 as potentially temporary, rather than permanent. Such flows were,
therefore, absorbed into forex reserves. These reserves have turned out to be a
first line of defense in the current episode of reversal of capital flows. This
approach to capital flows, when combined with appropriate exchange rate
flexibility, appears with hindsight to have been prudent. Coordinated action
amongst major central banks, especially the provision of swap facilities, also has
been helpful in containing, to an extent, contagion and volatility in financial
markets.
Overall, it is a combination of sound macroeconomic policies, prudent debt

management, exchange rate flexibility, the effective management of the capital
account, the accumulation of appropriate levels of reserves as self-insurance and
the development of resilient domestic financial markets that provides the
optimal response to the large and volatile capital flows to the EMEs. How these
elements are best combined will depend on the country and on the period: there
is no "one size fits all".
134
XI. Appendix
1) Composition of Capital Flows (NET) of India
APPENDIX TABLE 53 : COMPOSITION OF CAPITAL FLOWS (NET)

2001- 2002- 2003- 2004- 2005- 2006- 2007- 2008-
Item 02 03 04 05 06 07 08PR 09P
1 4 5 6 7 8 9 10 11
Total Capital Flows ( Net) (US $ mn) 8,551 10,840 16,736 28,022 25,470 45,203 107,993 9,146
Percentage share in total net flows
1 Non- Debt Creating Inflows 95.2 55.5 93.7 54.6 84.0 65.8 58.9 231.0
a) Foreign Direct Investment ** 71.6 46.5 25.8 21.4 34.9 50.3 31.7 382.5
b) Portfolio Investment 23.6 9.0 67.9 33.2 49.1 15.5 27.2 -151.5
2 Debt Creating Inflows 12.4 -12.3 -6.0 35.2 41.0 64.2 38.9 87.2
a) External Assistance 14.1 -28.6 -16.5 7.2 6.9 4.0 1.9 28.9
External Commercial
b) Borrowings # -18.6 -15.7 -17.5 19.4 10.8 36.4 21.0 75.9
c) Short term Credits -9.3 8.9 8.5 13.5 14.5 14.6 15.9 -63.4
d) NRI Deposits $ 32.2 27.5 21.8 -3.4 11.0 9.6 0.2 46.9
e) Rupee Debt Service -6.1 -4.4 -2.2 -1.5 -2.2 -0.4 -0.1 -1.1
3 Other Capital @ -7.6 56.8 12.3 10.2 -25.0 -30.0 2.2 -218.2
4 Total (1 To3) 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Memo:
Stable flows + 85.6 82.0 23.7 53.2 36.4 69.9 56.9 314.8
PR : Partially Revised. P : Preliminary.
** Data on FDI have been revised since 2000-01 with expanded coverage to approach international best
practices. FDI data for previous years would not be comparable with those figures.
# Refers to medium and long-term Borrowings
$ Including NR (NR) Rupee Deposits
@ Includes leads and lags in exports (difference between the custom and the Banking channel data), Banking
Capital (assets and liabilities of Banks excluding NRI deposits), and investments and loans by indian residents
abroad. India’s subscription to International Institutions and quota payments to IMF.
135
+ Stable Flows are defined to represent all capital flows excluding portfolio flows and short-term trade credits.
2) International Investment Position of India
COUNTRY NAME: INDIA IFS CODE: 534

INTERNATIONAL INVESTMENT POSITION:EXTERNAL ASSETS AND LIABILITIES AT THE
END OF MARCH 2009
UNIT:Million REPORTING CURRENCY: USD
Mar- Mar-
Period Mar-07(R) 08(PR) 09(PR)
International Investment Position, net -62,463.11 -49,572.30 -62,901.51
A. Assets 247,270.53 386,917.19 345,886.34
1. Direct Investment Abroad 30,946.35 49,781.35 67,276.35
1.1 Equity Capital and Reinvested Earnings 27,623.50 43,128.50 57,779.50
1.1.1 Claims on Affiliated Enterprises 27,623.50 43,128.50 57,779.50
1.1.2 Liabilities to Affiliated Enterprises (-)
1.2 Other Capital 3,322.85 6,652.85 9,496.85
1.2.1 Claims on Affiliated Enterprises 3,322.85 6,652.85 9,496.85
1.2.2 Liabilities to Affiliated Enterprises (-)
2. Portfolio Investment 931.14 1,526.39 828.82
2.1 Equity Securities 523.06 1,442.64 812.36
2.1.1 Monetary Authorities
2.1.2 General Government
2.1.3 Banks 337.24 356.93 306.78
2.1.4 Other Sectors $ 185.82 1,085.71 505.58
2.2 Debt Securities 408.08 83.75 16.46
2.2.1 Bonds and Notes 389.68 73.53 5.81
2.2.1.1 Monetary Authorities
2.2.1.2 General Government
2.2.1.3 Banks 386.70 73.03 4.34
2.2.1.4 Other Sectors $ 2.98 0.50 1.47
2.2.2 Money-market Instruments 18.40 10.22 10.65
2.2.2.2 General Government
2.2.2.3 Banks 18.40 10.22 10.65
2.2.2.4 Other Sectors
3. Financial Derivatives
136
3.1 Monetary Authorities

3.2 General government
3.3 Banks
3.4 Other sectors
4. Other Investment 16,214.04 25,886.45 25,796.17
4.1 Trade Credits 680.00 1,226.00 2,720.00
4.1.1 General Government
4.1.1.1 Long-term
4.1.1.2 Short-term
4.1.2 Other Sectors 680.00 1,226.00 2,720.00
4.1.2.1 Long-term
4.1.2.2 Short-term 680.00 1,226.00 2,720.00
4.2 Loans 3,490.18 11,623.79 6,173.96
4.2.1.1 Long-term
4.2.1.2 Short-term
4.2.2 General Government 864.02 901.79 840.72
4.2.2.1 Long-term 864.02 901.79 840.72
4.2.2.2 Short-term
4.2.3 Banks 1,840.07 9,129.42 4,371.92
4.2.3.1 Long-term 1,840.07 9,129.42 4,371.92
4.2.3.2 Short-term
4.2.4 Other Sectors 786.09 1,592.58 961.32
4.2.4.1 Long-term $ 786.09 1,592.58 961.32
4.2.4.2 Short-term
4.3 Currency and Deposits 7,839.58 7,779.66 10,336.53
4.3.3 Banks 7,039.23 6,879.56 9,642.14
4.3.4 Other Sectors $ 795.34 898.65 692.96
4.4 Other Assets 4,204.28 5,257.00 6,565.68
4.4.1.1 Long-term
4.4.1.2 Short-term
4.4.2.1 Long-term 725.67 740.19 735.07
4.4.2.2 Short-term
4.4.3 Banks 2,550.93 3,480.19 5,026.88
4.4.3.1 Long-term 2,550.93 3,480.19 5,026.88
4.4.3.2 Short-term
4.4.4 Other Sectors 927.68 1,036.61 803.72
4.4.4.1 Long-term $ 927.68 1,036.61 803.72
4.4.4.2 Short-term
5. Reserve Assets 199,179.00 309,723.00 251,985.00
5.1 Monetary Gold 6,784.00 10,039.00 9,577.00
5.2 Special Drawing Rights 2.00 18.00 1.00
5.3 Reserve Position in the Fund 469.00 436.00 981.00
5.4 Foreign Exchange 191,924.00 299,230.00 241,426.00
5.4.1 Currency and Deposits 138,928.00 195,661.00 106,634.00
5.4.1.1 With Monetary Authorities 92,175.00 189,645.00 101,906.00
5.4.1.2 With Banks 46,753.00 6,016.00 4,728.00
5.4.2 Securities 52,996.00 103,569.00 134,792.00
5.4.2.1 Equities
5.4.2.2 Bonds and Notes
137
5.4.2.3 Money-market Instruments

5.4.3 Financial Derivatives (net)
5.5 Other Claims
B. Liabilities 309,733.64 436,489.49 408,787.85

1. Direct Investment in Reporting economy 77,037.08 118,786.79 125,168.26
1.1 Equity Capital and Reinvested Earnings $$ 73,221.15 114,402.80 120,229.19
1.1.1 Claims on Direct Investors (-)
1.1.2 Liabilities to Direct Investors 73,221.15 114,402.80 120,229.19
1.2 Other Capital 3,815.93 4,383.99 4,939.07
1.2.1 Claims on Direct Investors (-)
1.2.2 Liabilities to Direct Investors $$$ 3,815.93 4,383.99 4,939.07
2. Portfolio Investment 79,444.37 117,866.75 83,101.36
2.1 Equity Securities 63,266.89 96,481.18 63,123.76
2.1.1 Banks @@
2.1.2 Other Sectors $$ 63,266.89 96,481.18 63,123.76
2.2 Debt securities 16,177.48 21,385.57 19,977.60
2.2.1 Bonds and notes 15,711.53 20,659.40 17,853.60
2.2.1.2 General Government 108.53 79.40 45.60
2.2.1.3 Banks 534.98 584.69 580.27
2.2.1.4 Other Sectors ## 15,068.02 19,995.31 17,227.73
2.2.2 Money-market Instruments 465.95 726.17 2,124.00
2.2.2.2 General Government 465.95 726.17 2,124.00
2.2.2.3 Banks
2.2.2.4 Other Sectors
3. Financial Derivatives
3.1 Monetary Authorities
3.2 General Government
3.3 Banks
3.4 Other Sectors
4. Other Investment 153,252.19 199,835.95 200,518.23
4.1 Trade Credits 27,727.00 43,975.00 41,961.00
4.1.1 General Government 1,073.00 1,292.00 1,275.00
4.1.1.1 Long-term 1,073.00 1,292.00 1,275.00
4.1.1.2 Short-term
4.1.2 Other Sectors 26,654.00 42,683.00 40,686.00
4.1.2.1 Long-term 675.00 782.00 722.00
4.1.2.2 Short-term* 25,979.00 41,901.00 39,964.00
4.2 Loans 80,794.07 106,845.01 113,915.93
4.2.1.1 Use of Fund Credit & loans from the
fund
4.2.1.2 Other Long-term
4.2.1.3 Short-term
4.2.2.1 Long-term 46,809.00 53,040.00 51,906.00
4.2.2.2 Short-term
4.2.3 Banks 1,543.00 1,650.00 1,990.00
4.2.3.1 Long-term 1,543.00 1,650.00 1,990.00
4.2.3.2 Short-term
4.2.4 Other Sectors 32,442.07 52,155.01 60,019.93
4.2.4.1 Long-term*`* 32,442.07 52,155.01 60,019.93
138
4.2.4.2 Short-term
4.3 Currency and Deposits 41,741.00 44,787.00 42,318.00
4.3.1 Monetary Authorities 501.00 1,115.00 764.00
4.3.2 General government
4.3.3 Banks @ 41,240.00 43,672.00 41,554.00
4.3.4 Other sectors
4.4 Other Liabilities 2,990.12 4,228.94 2,323.30
4.4.1.1 Long-term
4.4.1.2 Short-term
4.4.2.1 Long-term# 1,029.00 1,120.00 1,018.00
4.4.2.2 Short-term
4.4.3 Banks 1,089.00 1,916.00 464.00
4.4.3.1 Long-term
4.4.3.2 Short-term 1,089.00 1,916.00 464.00
4.4.4 Other sectors 872.12 1,192.94 841.30
4.4.4.1 Long-term
4.4.4.2 Short-term $ 872.12 1,192.94 841.30
R : Data are Revised

PR : Data are Partially Revised.
P: Data are Provisional.
$: Based on survey on Foreign Liabilities & Assets
$$ : Foreign Direct Investment (FDI) & Portfolio Investment are not adjusted for price changes.
$$$ : All liabilities (other than equity) between direct investor & direct investment enterprises are
treated as other capital.
@ : Include accrued interest
* : Suppliers Credit upto 180 days are included.
** : Includes Buyers' Credit. Loan transactions between direct investor & direct investment
enterprises are treated as other capital.
## : Include Foreign Currency Convertible Bonds.
@@: Equity Investments in Banks by Non-residents included under FDI.
#:: includes SDRs 3,082.5 million allocated under general allocation and SDRs 214.6 million
allocated under
special allocation by the IMF done on August 28, 2009 and September 9, 2009, respectively.
Note: i) NRO deposits are included under NRI deposits from the quarter ending June 2005.
Supplier's Credits upto 180 days and FII investment in short term
debt instruments are included under short term debt from the quarter ending March 2005.
ii) Vostro credit balance is included in the liabilities of banking system under Other
Liabilities,since September 2006
iii) As per BPM6, SDR allocation is treated as debt liability
139
3) Foreign Exchange Reserves of India
140
XII. Bibliography
• Reserve Bank of India Website, http://www.rbi.org.in

• International Monetary Fund Website, http://www.imf.org
• World Bank Website, http://www.worldbank.org
• World Trade Organization Website, http://www.wto.org
• Wikipedia, http://www.wikipedia.org
• Securities and Exchange Board of India Website, http://www.sebi.gov.in
• Annual Report 2008-2009, Reserve Bank of India.
• Committee on the Global Financial System, “Capital flows and emerging market
economies”. CGFS Papers.
• Burdekin, CK (2005), “China and the Depreciating US dollar, Colombia
International Affairs Online”
• Goldstein, M., “China's Exchange Rate Regime, testimony before the
Subcommittee On Domestic and International Monetary Policy, Trade”. Available
online at www.iie.com/publications/papers/ goldstein1003.htm
• Hilsenrath, J. E., and M. Kissel, “Currency Decision Marks Small Shift toward
Flexibility'', Wall Street Journal, July 22, 2005, p. A1, col. 6.
• Ganbhir, N., Goel, M., “Foreign Exchange Derivatives Markets in India – Status
and Prospects”.
• Sikdar, S., “Foreign Capital Inflow into India, Determinants and Management”.
• Dodd, Randall, (2004), “Managing the Economic Impact from Foreign Capital
Flows”.
141

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International Business Environment

FOREIGN CAPITAL MOVEMENTS

Amit Chawla (S-8)

Faculty of Management Studies

1) LOANS AND BORROWINGS......................................................................................................................30

footing before liberalizing or opening the domestic banking system. Also, it is

Overall, it is a combination of sound macroeconomic policies, prudent debt

Eminent economists stressed on liberalization of capital movements. International

Chapter V evaluates impact of foreign capital movement on our national economy.

Chapter VI depicts the global scenario as regards to foreign capital movement.

Chapter VII touches upon global issues in this regard.

II. Drivers of Capital Movement

In Economics capital is considered as a factor of production which is not wanted for

Real investment – Real investment refers to money invested in purchase of tangible

Financial investment – Financial investment is the commitment of money for purchase

When domestic investors of a country, having surplus investible funds which

Why does capital move?

In economic and finance movement of capital is technically referred to as flow of

◦ Water flows from higher to lower level

◦ Heat flows from higher to lower temperature

◦ Air flows from higher to lower pressure

Similarly capital has a tendency to flow

◦ For a given risk level, from an investment giving lower return to an

Forms of capital flow –

Capital movement means movement of capital between different countries either by

• Outward capital movement denotes movement of domestically held capital

• Inward capital movement represents movement of foreign owned capital into a

Drivers of Foreign Capital Movement –

 Higher return (rate of interest)

 Developmental needs exceeding the domestic savings

 Exchange Rate Policy

Now we shall discuss these drivers in some details:

Globalization is the culmination of an evolution of markets. Historically, markets have

Standard neoclassical theory suggests that international capital movements should

• First, flows were almost entirely denominated in gold standard currencies,

of low-cost finance through banks and the international capital markets.15

With an increasing number of governments competing to attract multinational

Developmental needs v/s the domestic savings –

Other important aspect relating to foreign investment is repatriation of foreign capital.

Higher rate of return (rate of interest) –

Exchange Rate Policy –

III. Forms of Capital Movement

Foreign capital movement generally takes place in the form of –

◦ Loans and borrowings

◦ International Banking flows

◦ Donations and charity

◦ Hawala transactions, etc.

We shall discuss each of the abovementioned forms in detail in next pages.

Foreign Direct Investment in India

Entry routes for investments in India

2. Under the Government Route, prior approval of the Government of India,

Prohibition on investment in India

1. Foreign investment in any form is prohibited in a company or a partnership

a. Business of chit fund, or

c. Agricultural or plantation activities, or

d. Real estate business, or construction of farm houses, or

e. Trading in Transferable Development Rights (TDRs).

2. It is clarified that “real estate business” does not include development of

3. In addition to the above, investment in the form of FDI is also prohibited in

a. Retail Trading (except single brand product retailing)

d. Gambling and Betting

e. Business of chit fund

g. Trading in Transferable Development Rights(TDRs)