Foreign Portfolio Investments (FPI) play a crucial role in any country’s economy. India being a developing country draws a huge amount of Foreign Portfolio Investments. However, in the recent past, we have seen high volatility in the segment and an exodus of FPI from India as well. How this is impacting the Indian economy?
The high volatility and exodus of foreign portfolio investments from India have given rise to a significant amount of negative feelings regarding the role of foreign capital in fostering the growth and development of a capital-receiving country. In the associated graph, it is easy to see that for the first 10 years since India opened up to foreign portfolio investments (FPI and FII), the net inflow was more or less balanced. However, since about 2002, the net inflow started becoming strongly negative and since 2006 the more rapid and sharp inflows and outflows daunts the pattern of portfolio investments in India.
The movements are big, in the sense that by 2020 the net inflow stood at (-15.112 billion INR). While the overall foreign direct investments coming to India is still positive and high (India sends outward FDI to some African and East Asian countries), with a large inflow still coming from Mauritius, which reports often claim to be actually illegal outflows from India rerouted back and legitimized as inward FDI from this island country. Nevertheless, the high volatility in the FII could alone be a source of crisis for several financial institutions, for the stock market, and even for daily financial operations in the country at least as far as the financial health of important firms and organizations are concerned.
However, this is not new. A similar crisis has happened in the recent past when the East Asian countries were severely affected by the large outflow of capital invested under foreign ownerships. The last two decades produced considerable changes in the way capital are deployed for productive purposes and this change may be deemed partly responsible for the present instability around the world. Should then, the exposure to foreign capital continue to rock the boat that India is riding? Before we can place a judgment on that, let us quickly review the situations that have historical bearings on how the capital inflows and outflows have shaped themselves over time.
In Thailand, Singapore, Indonesia, South Korea, Taiwan, etc., the miraculous economic growth of the 1980s and 1990s was arguably a positive outcome of huge capital inflows from the North, essentially, American, European, Australian and Japanese foreign direct investments. This also has historical routes, whereby the gap between savings and required investments pushed the real interest rate upwards and attracted capital from outside these countries. Usually, this is part of the standard economic logic.
A country that is a surplus in capital, as the OECD countries have been in the post World War II decades, cannot offer high returns per unit of capital investment, but a country that is deficient in the same offers a large premium on every dollar invested.
A country that is a surplus in capital, as the OECD countries have been in the post World War II decades, cannot offer high returns per unit of capital investment, but a country that is deficient in the same offers a large premium on every dollar invested. This is reminiscent of the infamous Enron power project in Dabhol of Maharashtra. Capital invested in the said project used to get a return of 16% on every dollar compared to the pittance that NTPC is guaranteed, in general.
One is consequently curious as to why foreign capital attracts the premium largely unavailable to the domestic investors?
One popular explanation is that foreign capital is also considered as the carrier of advanced technology that domestic investors do not have access to. Therefore, foreign capital is expected to raise the productivity of other factors of production as well as the total output at a higher rate compared to domestic capital.
This is also the well–known argument, which governs the activities of Multinational Corporations, largely. In many cases, it is statistically observed, local bank and non–bank financial intermediaries willingly offer cheaper credits to MNCs investing in their home country. The main reason perhaps is the reputation factor, which leads local financial institutions to lie up with MNCs rather than fund local businesses and projects. Thus, MNCs both bring capital with them and borrow from the domestic capital market.
Essentially, MNC activities have been there for a considerably long time, but they have not been usually blamed for creating financial imbalances in the country of operation. They have certainly been discredited for various other things, mainly, influencing local policies to their own advantage, evading taxes, transferring environmentally harmful production to the poorer countries, arms-length trade and therefore tariff–jumping practices, poor quality control, etc. However, poorer compliments of MNCs – the venture capitalists have been way more harmful to the local economies than the recipient countries ever imagined.
This transition, in fact, happened with a major policy change in many developing countries where the capital account was liberalized in order to allow free inflow and outflow of investible funds from abroad. One of the major reasons why the financial crisis of 1997 happened in all the East Asian countries was the full convertibility of the capital account. In simpler terms, it means that any amount of dollar could be invested and then withdrawn and taken back to the source country at ease.
Onset of capital account convertibility in East Asian countries helped immediate flight of capital from these places.
This was unlike to MNC–led long-run investments in established projects that locked the capital in for a considerable period of time. It is generally argued and was provided with the technical legitimacy in a research article by Sugata Marjit and Saibal Kar in the Economic and Political Weekly (1998), that the onset of capital account convertibility in East Asian countries helped immediate flight of capital from these places. It was also largely defined as the investors’ “herd behaviour”, wherein, all investors behave in the same manner regardless of the true information that exists in the market.
The fundamental economic logic, once again, was put forth in a famous research paper by Abhijit V. Banerjee of the MIT, and published in the Quarterly Journal of Economics. The idea discussed was that a consumer follows the lead of another standing ahead in a queue. So, if a town has only two restaurants, A and B, and it is such that some have prior information that A is better than B. However, when many people (on a Friday night, perhaps) visit these two restaurants located next to each other, the choice made by the visitor standing ahead in a line (suppose she chooses A) influences others standing behind her.
The next in line follow suit despite her own information suggesting the choice of B. The reason for doing that is the problem with not trusting her own information. It seems that the follower believes that the leader has better information worthy of her trust compared to her own sources, which supplied different information. Although this example is overly simple, it appears that the financial sector with investors as its major actors behave exactly in this fashion.
If the market allows it otherwise, then as soon as one investor gets jittery about the prevailing health of an economy, she pulls the investment out and deploys it elsewhere in more profitable activity. Others witnessing this action undermine their own information, which may not necessarily suggest such hasty withdrawal, and replicates the action of the first investor. This gives rise to the well-known herd behaviour (as if moving like a herd of animals) among investors and could cause various economic disruptions including bank runs in the same way the Korean, Taiwanese and Thai banks failed in the wake of the Asian Financial Crisis.
As it has been discussed earlier, it could happen only because the capital account was fully convertible at the time. One would remember that India’s capital account was, however, not convertible at that time and therefore the country was spared from the crisis – The dollar that had come in could not leave the country because the Reserve Bank of India would not convert Rupee back to Dollar allowing the investors to take it back at a short notice.
India had a prolonged period of excess capital reserve and did not have to beg for investments of short-run nature.
The implication of what we discussed thus far should be clear by now. Now, that India has removed all the barriers to full convertibility of Rupee, withdrawals are easy and herd behaviour cannot be ruled out. This is perhaps what was observed two months back and there is no guarantee that it would not recur in the foreseeable future. In particular, after the crisis stalled, FDI’s and FII’s are flowing to India again in huge quantities.
This is where the role of policymaking becomes very important. First, India had a prolonged period of excess capital reserve and did not have to beg for investments of short-run nature. Yet, the country did not consider implementing the policy under which the length of investments would be more than what venture capitalists typically prefer. Second, the production base of India is surprisingly thin for a country of two trillion-dollar GDP.
The overwhelming proliferation of the service sector has bypassed the deep industrialization stage and therefore ignored the main purpose and characteristics of long-run investments. It is indeed replaced by short-run profit-seeking capital deployments, which do not have any regard for standard production facilities and would be just as happy if a one-computer-one- man firm generates the same amount of return for each dollar invested. These are not even close to what entrepreneurship would mean for an economy or society.
The nation has done very little to foster the more long-run activities and has given free hand to the legion of traders and intermediaries who believe only in arbitrage. Local information also reveals that it is not uncommon in, for example, the tea estates of North Bengal and Assam that the owner was previously a money lender in the Burrabazar area of Kolkata who now thinks that the tea estates would give him more returns in one year. Once he is done extracting his rent from tea, he would possibly be investing in the trade of scrap metals!
It is then not hard to imagine what would happen to traditional and established businesses if the owners are equally unstable. How would a country as a whole be any different under these circumstances? The short-run profit-seeking capitalists can bring in large degrees of economic instability that would be beyond the domestic policies to address unless careful choices are made at an early stage.
(Saibal Kar is Professor of Economics, Centre for Studies in Social Sciences, Calcutta & Research Fellow, IZA Bonn.)
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