1

Southern Economist, August 1,2012,pp25-30.

Managing Volatility in Foreign Inflows

By R.K.Srivastava*
High volatility in foreign capital inflows into India in the recent years has created havoc
particularly in forex and capital markets. Its heat has been realized into other parts of the
economy too. In fact, at a given point of time, the economy has the capacity to absorb
foreign capital. But, excess capital inflows can create problems and it is also true in the
vice-versa case. A number of policy options have been suggested to manage the situation
prudently.
===============================================================

Foreign capital has significant role for every national economy, regardless of its level of
development. For the developed countries, it is necessary to support sustainable
development. For the developing countries, it is used to increase accumulation and rate of
investments to create conditions for more intensive economic growth (Singh, 2009). The
significance of capital flows have been identified as:
It supplements domestic capital supply
It fills the gap between the required amount of foreign exchange and the amount
available
It fills the gap between modern technology and backward technology
In India foreign capital inflows can be classified by instrument (debt or equity) and
maturity (short or long-term). The main components are foreign investment, loans and
banking capital. Foreign investment represents foreign direct investment (FDI) and
portfolio investment. Debt creating flows include external assistance, external
commercial borrowings (ECBs), trade credit and banking capital (Economic Survey,
2011-12). Currently, India is facing the combination of high fiscal and current account
deficits. Record high gap between exports and imports has pushed up current account
deficit (CAD) likely to reach 3% of GDP in 2011-12. While below expectation revenues
and high expenditure have kept high fiscal deficit likely to reach 5% of GDP. The
implications of twin deficits can be summarized as (The Economic Times, November 9,
2011):
Costs of funds rise for all borrowers as government competes for funds with
private sector
In the worst case, a sell off in government securities by investors for fear of rising
yields depreciating their investments
Inflationary pressures emerge
Foreign inflows can slow down and local currency depreciate sharply
________________________

2
*R.K.Srivastava is Professor of Economics, HNB Garhwal University, Campus
Badshahithaul, Distt. Tehri (Garhwal) Uttarakhand
E mail: prof.sri2009@gmail.com

Very clearly, the high CAD along with the rising fiscal deficit in India has dampened
overseas investment sentiment. On the external side, the sluggish US economy and
fragile economic environment in Europe can also disturb Indias apple cart to attract
foreign liquidity especially through FDI channel in a large scale. High volatility in
foreign liquidity has been experienced by global economy. Emerging economies
including India too has experienced high volatility in capital inflows in recent years. For
example, during 2011-12(up to H1) net portfolio investment in India was significantly
declined to US$1.4 billion as against US$23.8 billion in H1 of 2010-11.The exchange
rate appreciated when there were large capital inflows and depreciated when the capital
inflows ebbed or turned into outflows (RBI Annual report, 2009-10). It impacts the
general price level and competitiveness of the economy via exchange rate fluctuations.
Therefore, it may become cause of concern to the monetary authority. Due to these
dangers associated with volatility in capital flows, some variants to Tobin-type taxes have
been tried to control foreign capital in many countries including Brazil, Chile, Argentina,
Philippines, Malaysia, Israel, etc (Bhatt, 2010). But India has not taken this step so far.
However, a lot of evidences show, which will be discussed in later part of article, that
India has reached that stage, where it has no option but to take some steps to avoid
disruption in capital market. Therefore, the objective of the article is to analysis volatility
in foreign capital inflows into India. And, to suggest policy options what India can take to
manage the situation prudently.

Trend, Magnitude and Composition of Capital inflows

Trend
Economic reform in the early 1990s had changed dramatically Indias economic
landscape. The size of capital inflows into India increased from US$7.1 billion in 199091, US$28 billion in 2004-05 to US$ 62 billion in 2010-11. During H1 of 2011-12 the net
capital flows increased to US$41.1 billion vis--vis US$38.9 billion during the
corresponding period of 2010-11.
India, the worlds 10th biggest economy in 2011, would become the fifth largest
economy by 2020(Table 1). It has now emerged as worlds second fastest economy but it
has failed to attract its share in Global FDI. The US expected to remain the main recipient
of FDI accounting for some 17% of the world total in 2007-11. China is the most
preferred destination in emerging markets of Global FDI. It has attracted US$87 billion
Global FDI in its soil which is estimated to 5.79% of the world total in 2007-11.The main
reasons for FDI inflows into China in a large scale are cited as the early implementation
of economic reforms with bold initiatives, world-class infrastructure, etc (Srivastava,
2008). On the contrary India, which is close rival to China in many fronts including
Global FDI inflows, is far behind to China. It has attracted US$20 billion FDI which is

3
estimated to 1.36% of the world total in 2007-11(Table 2). Political resistance to
privatization, policy indecision, inflexible labor laws and poor infrastructure are
considered for the poor performance on this front.

Table 1: World Economic League

Rank
1
2
3
4
5
6
7
8
9
10

2011

2020( forecast )

US
US
China
China
Japan
Japan
Germany
Russia
France
India
Brazil
Brazil
UK
Germany
Italy
UK
Russia
France
India
Italy
Source: The Centre for Economics and Business Research (CEBR), 2011.

Table 2: Worlds major destination of FDI inflows (2007-11

average)
Countries

US$ billion

Rank

% of world total

US
UK
China
France
Belgium
Germany
Canada
Hong Kong
Spain
Italy
Netherlands
Australia
Russia
Brazil
Singapore
Sweden
Mexico
India

250.9
112.9
86.8
78.2
71.6
66.0
63.2
48.0
44.9
41.6
38.5
37.8
31.4
27.5
27.1
26.1
22.7
20.4

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18

16.75
7.54
5.79
5.22
4.78
4.41
4.22
3.20
2.99
2.77
2.57
2.52
2.10
1.84
1.81
1.74
1.51
1.36

4
Ireland
20.3
Turkey
20.0
Source: Economist intelligence Unit.

19
20

1.35
1.33

Magnitude
Net capital flows to India which increased from 3.9% of GDP in 2004-05 to around 9%
in 2007-08. But it declined to 3.7% in 2010-11. During (up to H1 of 2011-12) net capital
flows decreased to 4.5% of GDP as against 5% of GDP in H1 of 2010-11. Net capital
inflows during 2010-11 stood significantly higher at US$62 billion against US$51.6
billion in 2009-10 (Table 3) mainly due to higher inflows under ECB, external assistance,
short-term trade credit, NRI deposits and bank credit.
A large chunk of foreign capital inflows is needed due to finance CAD which is
continuously flattening. The CAD increased to US$45.9 billion in 2010-11 from US$2.5
billion in 2004-05 mainly on account of higher trade deficit. As a proportion of GDP,
CAD increased to 2.7% in 2010-11 from 0.3% in 2004-05. The CAD increased to
US$32.8 billion in H1 of 2011-12 as compared to US$29.6 billion during the
corresponding period of 2010-11, mainly on account of higher trade deficit. As a
proportion of GDP, it was marginally lower at 3.6% during in H1 of 2011-12 vis--vis
3.8% in H1 of the preceding year (Economic Survey, 2011-12).The prime ministers
economic advisory council has also flagged the rising CAD as a big worry for the
economy, projecting it as 3.6% of GDP in 2011-12. It further opined that there is a need
to take measures to ensure that the CAD is stabilized at a lower level of around 2-2.5% of
GDP. The reasons of increasing CAD are:

India is an energy deficient economy. It imports huge amounts of crude oil to

meet its energy needs.
Gold import has increased substantially.
The economic growth is driven by high domestic demand. When incomes
grow, import of commodities grows much faster.
Export growth is not fast enough.

Composition
The rising trend in capital flows in India has been accompanied by a significant change
in composition. Dependence on aid has vanished and FDI and foreign portfolio
investment, ECB, and Non-resident Indians (NRIs) deposits dominate the capital flows
(Sikdar, 2006). Composition of capital inflows can be classified by instrument (debt or
equity).

Non-debt flows:

Foreign investment, comprising FDI and portfolio investment,

represents non-debt liabilities. Net foreign investment decreased by 21.4% from US$50.4
billion in 2009-10 to US$40 billion in 2010-11. During 2011-12(up to H1) net foreign

5
investment decreased to US$13.7 billion as against US$30.8 billion in H1 of 2010-11. It
was mainly due to euro crisis. Decline in foreign investment was offset by the debt flows
component of loans and banking capital which increased by 130.3% from US$14.5
billion in 2009-10 to US$33.4 billion in 2010-11.

Table 3: Composition of foreign capital inflows into India

2004- 2005- 2006- 2007- 2008- 2009- 2010- 2010-11
2011-12
05
06
07
08
09
10
11
H1(AprilH1(AprilSept2010)* Sept
2011)**
1.Current Account -2.5
Deficit(CAD)(US$
billion)

-9.9

-9.6

-15.7

% of GDP
2. Net Capital
flows(US$ billion)
% of GDP
I.
Non-debt
creating
flows(US$ billion)

-0.3
28.0

-1.2
26

-1.0
45.2

3.9
13

3.0
15.5

(a) FDI (net) (US$ 3.7

billion)
(b)
Foreign 9.3
Portfolio
Investment(US$
billion)

-38.1

-45.9

-29.6

-32.8

-1.3
-2.3
106.6 7.4

-2.8
51.6

-2.7
62

-3.8
38.9

-3.6
41.1

4.7
14.8

8.6
43.3

0.5
8.3

3.8
50.4

3.7
40

5.0
30.8

4.5
13.7

3.0

7.7

16

22.4

18

9.4

12.3

12.5

7.1

27.4

-14.0

32.4

30.3

23.8

1.4

II. Debt creating 14.8

flows
(US$
billion)
(a) ECB (US$ 5.2
billion)

9.3

26.4

52.4

14.5

33.4

16.5

36.6

2.5

16.1

22.6

7.9

12.5

5.7

10.6

(b)
capital
billion)

1.4

1.9

11.8

-3.3

2.1

.8

19.3

Banking 3.9
(US$

-27.9

6
(c)
Short-term 3.8
trade credit (US$
billion)

3.7

6.6

15.9

-2

7.5

11

6.9

*Partially revised ** Preliminary

Source: RBI bulletin and Economic Survey, 2011-12
FDI has emerged as most important component of foreign capital flows. It increased
from US$3.7 billion in 2004-05 to US$22.4 billion in 2009-10 but it is decreased to
US$9.4 billion in 2010-11. It is primarily due to uncertain global economic environment.
Portfolio investment mainly foreign institutional investors(FIIs) investment, issue of
Global Depository Receipts(GDRs), American Depository Receipts(ADRs) and offshore
fundswitnessed large net portfolio inflows into India was US$9.3 billion in 2004-05
which increased to US$32.4 billion in 2009-10 but it declined to US$30.3 billion in 201011. This was due to decline in ADRs/GDRs to US$2 billion in 2010-11 from US$3.3
billion in 2009-10, even though FII inflows showed marginal increase to US$29.4 billion
in 2010-11 from US$29 billion in 2009-10.Other categories of capital flows, namely debt
flows of ECB, banking capital, and short term credit recorded a significant increase in
2010-11. During 2011-12 (Up to H1 ) net FDI was higher at US$ 12.3 billion as against
US$7 billion in 2010-11; net portfolio investment substantially declined from US$23.8
billion to US$1.3 billion during the same period. This was on account of a major decline
in FII flows to US$0.9 billion in 2011-12 (up to H1 ) from US$22.3 billion in H1 of
2010-11. Clearly, stronger recovery in India ahead of the global recovery coupled with
positive sentiments of global investors about Indias growth prospects induced with the
revival of capital inflows since 2009-10.

Debt creating Flows:

It represent loan (external assistance, ECB, and trade credit)

and banking capital including NRI deposits. Its role reflects in more fluctuating-nature.
Over the years, the role of external assistance has been in marginal-nature. For example,
net external assistance was recorded US$1.7 billion in 2006-07 and to US$4.9 billion in
2010-11. ECB remained the largest component of debt creating flows. But wider
fluctuations are recorded in net ECB inflow. For example, net ECB inflow increased from
US$5.2 billion in 2004-05 to US$12.5 billion in 2010-11 but it decreased toUS$2 billion
in 2009-10. Among the components of banking capital, NRI deposits witnessed
fluctuating-nature. Banking capital received by India during 2010-11 is at US$5 billion.
Further, short-term trade credit increased from US$3.8 billion in 2004-05 to US$11
billion in 2010-11. During 2011-12(up to H1) debt creating flows comprising ECB and
banking capital have substantially increased. For example, during 2011-12(up to H1)
ECB increased to US$10.6 billion as against US$5.7 billion in H1 of 2010-11.

Implications
The risk of capital inflows runs both ways. If it suddenly decline because of a global
slowdown or could increase sharply in search of higher returns, and both pose problems.

5.9

7
Balance of Payment (BOP) indicates whether the inflows are more than the absorptive
capacity of an economy. In BOP, if there is a CAD i.e., imports are larger than exports, a
country will need foreign money to pay for the extra imports. Here capital inflows could
be used to pay-off the deficit. Capital inflows could be in form of FII, FDI, ECB.
Therefore, if capital inflows are more than the CAD, it can be said that capital inflows are
higher than the absorptive capacity of an economy (STCI, 2010) (Table 3). It shows that
capital inflows have been more than CAD during 2004-05 to 2011-12 except 2008-09.
That is, capital inflows into India have been more than the absorptive capacity of the
economy (Srivastava, 2011). Therefore, the following problems have been confronted by
the Indian economy during this period because of excess capital inflows:
Makes monetary management difficult for RBI
Increases money supply, creating asset bubbles and inflation
Sterilization causes interest rates go up which can affect economic growth
It weakens the competitiveness of Indias exports.
Therefore, an effort is made to see the impact of capital inflows on exchange rates and
BSE Sensex. Real Effective Exchange Rate (REER) indices are used as indicators of
external competitiveness of the country over a period of time. REER is defined as a
weighted average of nominal exchange rates, adjusted for home and foreign country
relative price differentials. REER captures movements in cross-currency exchange rates
as well as inflation differentials between India and its major trading partners. The 36
currency trade based REER (base: 2004-05=100) of the rupee depreciated during 200607, 2008-09 and 2009-10 by 1.69%, 10.8% and 2.49% respectively. It appreciated during
2005-06, 2007-08 and 2010-11 by 2.74%, 7.52% and 7.99% respectively (Table 4). It
shows that REER of the Indian currency appreciated whenever net capital flows were
larger than CAD except during the period 206-07 and 2009-10. It does not mean that
REER has appreciated only because of capital inflows but it is one of the most important
reasons.
Like exchange rate, whenever capital inflows surge, BSE Sensex go up normally. It is
most noticeable that when economic recession occurred in the global economy in 2008,
net capital flows was recorded merely to US$7.4 billion in 2008-09 from US$106.6
billion in 2007-08. And portfolio investment was out flowed to US$14 billion in 2008-09
whereas it was in flowed to US$27.4 billion in 2007-08. Table 5 confirms the Sensex
movement during this period. However, capital inflows surge is one of most important
factor of increasing Sensex not a sole factor.

Table 4: Indices of Real Effective Exchange Rate (REER) of the Indian

currency (36currency bilateral weights)
Year
2005-06
2006-07

Base: 2004-05=100
Real Effective Exchange Appreciation(+)/Depreciation(Rate(REER)
)REER over previous year
102.74
+2.74
101.05
-1.69

8
2007-08
2008-09
2009-10
2010-11
Source: RBI Bulletin

108.57
97.77
95.28
103.27

+7.52
-10.8
-2.49
+7.99

Table 5: Indices of Sensex

Year
2004
2005
2006
2007
2008
2009
2010
2011
2012

Open
5872.48
6626.49
9422.49
13827.77
20325.27
9720.55
17473.45
20621.61
15534.67
Source: BSE

High

Low

Close

6617.15
9442.98
14035.30
20498.11
21206.77
17530.94
21108.64
20664.80
18523.78

4227.50
6069.33
8799.01
12316.10
7697.39
8047.17
15651.99
15135.86
15358.02

6602.69
9397.93
13786.91
20286.99
9647.31
17464.81
20509.09
15454.92
17196.47

Policy Options
The East Asian crisis of 1997-98 and Mexican crisis of 1994 generated much concern
among policy analysts regarding volatility in capital inflows. An IMF study suggested
that prudential policies are keys for control to achieve desired objectives. However, this
failed in Thailand as the implementation of policy was not backed by comprehensive
controls. In contrast, Malaysia implemented a combination of administrative and
regulatory measures that ensured a partially positive outcome. The study also highlights
that such controls lose effectiveness overtime as markets exploits the potential loopholes
in the system (Mishra, 2010). However, large increase or decrease in capital inflows has
generated the need of management of capital inflows. To reduce the volatility in capital
flows, the policy response should be toned up in a comprehensive manner. The options
are:
I. If RBI sees excess liquidity in the system, it issues of bonds to control money
supply and check inflation. This is called sterilization, but it pushes up interest
rates which will increase govt.s borrowing costs. Raising the Cash Reserve
Ratio (CRR), it could also discourage capacity of bank lending. RBI
occasionally through buying and selling of currencies intervenes in the foreign
exchange market for reducing excess volatility. For example, as the rupee has

II.

III.

IV.

V.
VI.
VII.

VIII.

been under pressure since July 2011, efforts have been made by the RBI to
augment supply of foreign exchange market to stem rupee decline.
.CAD is being managed through foreign capital inflows. Policy of trade
liberalization has increased the absorption capacity of the economy. But it is
risky one. It can increase consumption led-imports. Recently large scale imports
of gold has compelled to the Govt. of India to modify its import policy of gold
through levy of more taxes.
The Government should have improved of liquidity arising on account of large
capital inflows. It should increase infrastructure sector investments either
through increasing budgetary allocation and /or encouraging the private sector
to accelerate investments in this area by improving the regulatory environment.
FIIs should either have incentives for extending their investment-holding period
in the Indian equity market or have penalties (some kind of a progressive
transaction tax which is higher for shorter holding period) for selling their stock
within a particular holding period.
The domestic institutional structure for trade financing should be streamlined so
that Indian exporters are not negatively affected if the external supply of shortterm credit dries out(or become more expensive) in times of crisis.
The deposits made by NRIs are stable sources of capital inflows and, therefore,
it is important to develop new policies towards encouraging this source of
capital (Arora, 2010).
It is advocated that some sort of Tobin tax on foreign capital flows is desirable.
James Tobin, Nobel Prize wining economist, had proposed this tax on forex
flows in 1971. During 1997 Asian crisis, it had been successfully experimented
by Malaysia it. In 2009, Brazil imposed a 2% tax on foreign investments
flowing into its equity and bond markets. Taiwan followed Brazil in 2009 by
banning foreigners from investing in time deposits. The crisis has led to a sea
change in thinking with respect to capital control. Prior to this crisis, capital
controls have been criticized, by IMF and most economists, as inefficient tools.
Continuing with its rethink on capital controls, the IMF has now formally
suggested that there may be situations when developing countries can gain from
placing regulations on the inward flow of foreign capital (Gallagher, 2011). But
in India in some quarters, it is considered as retrograde and impractical steps.
India should take steps cautiously on road map towards full capital account
convertibility. Ultimately, it would give strength to the Indian economy to bear
turbulence in the global economy.

Conclusion
The free flow of foreign capital is the life-blood of sustainable economic growth and
expanding prosperity. It is an attractive device to globalize the domestic economy. But its
pitfalls are well known, any time foreign liquidity especially portfolio money can fly into
another destination to search greener pastures. India has experienced high volatility in
capital flows in recent year. Its impact through exchange rate fluctuations has become
cause of concern. Though India has experienced a secular trend of increasing foreign
flows from US$28 billion in 2004-05 to US$62 billion in 2010-11, it experienced

10
occasionally volatility in foreign inflows. For instance, world economic crisis in 2008
and euro crisis in 2011 have decreased the tempo of capital inflows. Indias growth story
is the main driver for flooding foreign inflows. But at the same time any major crisis in
the global economy has caused to decrease inflows into India.
FDI and portfolio investment are two major components of foreign capital. But India
has failed to attract its share in global FDI which is merely to 1.36% of the world total
FDI in 2007-11. This is mainly because of poor infrastructure and lack of political will to
take strong and bold policy decision. As far as portfolio investment is concerned it is
called hot /risky instrument. Its fluctuating movements are also witnessed in the Indian
capital market too. During 2004-05 to 2011-12, it is found that capital inflows into India
have been more than the absorptive capacity of the economy. Therefore, a number of
problems including inflation, appreciation in exchange rate, bubbles in real asset and
stock market, etc have been experienced in the Indian economy. To avoid the
repercussion volatility in foreign inflows into India, a number of policy options/measures
have been suggested to cut the ice.
References
1. Arora, Dayanand et al, 2010 The Recent Surge in Capital Inflows and Policy
Options for India [On line]. Available at: http://Vox.EU.org (accessed 19/3/2012).
2. Bhatt, U.R., 2010, Managing the Surge in Foreign Inflows The Economic
Times, New Delhi, 11.10.2010.
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2010[on line]. Available at: http://stcipd (Accessed 16 March 2012).
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November 9, 2011.
5. Economic Survey, 2011-12.
6. Gallagher, Kevin P, 2011 The IMF, Capital Controls and Developing Countries
EPW, May 7, 2011, pp12-13.
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New Delhi, October 18, 2010.
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