VoxEU Column International Finance

The recent surge in capital inflows and policy options for India

Despite the recent drop in capital inflows to India, this column argues that once global markets recover from the latest setback, the country will need to contain volatility in foreign portfolio investment. This column provides a detailed analysis of capital inflows to India and policy recommendations for how to deal with them.

Once again, many emerging economies are grappling with a surge in net capital inflows, particularly through increased foreign portfolio investment. And again, managing these volatile capital inflows is back on the policy agenda. This time round, the need for a debate on policy options has gained added fervour because of the changes in the views of the IMF on capital controls. A recent IMF staff position note (Ostry et.al. 2010) concludes:

"if the economy is operating near potential, if the level of reserves is adequate, if the exchange rate is not undervalued, and if the flows are likely to be transitory, then use of capital controls – in addition to both prudential and macroeconomic policy – is justified as part of the policy toolkit to manage inflows."

Acknowledging the problems associated with increased capital inflows in emerging markets, the IMF’s Global Financial Stability Report in April 2010 recommended the following policy options:

  • Allowing appreciation of domestic currency through a more flexible exchange rate policy
  • Accumulating reserves (using sterilised or unsterilised intervention as appropriate)
  • Reducing interest rates if the inflation outlook permits
  • Tightening fiscal policy when the overall macroeconomic policy stance is too loose
  • Reinforcing prudential regulation
  • Liberalising capital outflows

With this in mind, our ongoing research focuses on the development of capital flows in India. Our main objective is to find out which policy choices would help India to minimise the costs of volatile capital flows.

Changes in the magnitude and composition of capital inflows to India

Following a peak of $107 billion (8.7% of GDP) in 2007 and 2008, net capital inflows plummeted to $7 billion (0.6% of GDP) the following year. They have since bounced back to $50 billion (3.8% of GDP) for the year ending March 2010. But the net capital inflow in 2009 to 2010 is small when compared with the massive current-account deficit of $36 billion (see Table 1).

Table 1. Trends in India’s external sector (2006-2010)

Net Capital flows ($ billions)
Current-account deficit ($ billions)
Net Capital flows in excess of current-account deficit ($ billions)
Net Capital Flows (% of GDP)
Rupee Appreciation (+) Depreciation(-) (in %)

Source: RBI (2010) and own calculations

During the crisis ridden year of 2008 to 2009, foreign institutional investors pulled out $9.77 billion of portfolio investment from Indian equity markets. Yet they have been quick to return in 2010. In just the first four months of the fiscal year, they have nearly made up for the exit, reinvesting 87% of the amount they pulled out (CLSA Asia-Pacific Markets). But while this might e interpreted as a revival of confidence in the Indian market, this segment of capital inflows, along with short-term foreign currency borrowings of Indian banks, represents the most volatile component of capital inflows into India.

Major macroeconomic indicators influencing policy choices for capital controls

Our review of macroeconomic indicators calls for new policy options to be considered:

  • Recently there have been signs of upward pressure on the exchange value of the rupee. Yet while the competitiveness of Indian exports has been somewhat nudged, exports do not appear to have been seriously hurt by a floating exchange rate policy. Indeed, the rupee’s appreciation should help reduce the import bill for energy and intermediate goods.
  • As of May 2010, India’s foreign exchange reserves stood at $272.9 billion compared with the historical high of $315 billion two years earlier. In an attempt to contain the depreciation of the rupee in the second half of 2008, the Reserve Bank of India sold dollars on the open market, reducing its foreign exchange reserves to $245 billion by November. Yet with reserves at more than 6 times the amount of short-term external debt (passing the Guidotti-Greenspan rule) and an import cover of more than a year, India is comfortably placed on both fronts.
  • By the end of September 2009, India’s external debt was $242 billion, of which 17.5% was short-term debt and the remainder long-term debt. With a debt-service ratio of 4.9, India does not have a huge debt-serving burden and a fresh inflow of short-term debt-creating capital flows is not a cause for concern.
  • With inflation fairly high, there have been various upward pressures on interest rates. The recent increase (including 25 basis points in April 2010) in the cash reserve ratio imposed by the Reserve Bank on commercial banks signals a slow exiting from the previously accommodative monetary policy.

Though fiscal deficit shot up during the crisis, the central government has reduced the deficit considerably in the current fiscal year.

Policy recommendations: The need for a combination-therapy

In March 2007, with the surge in capital inflows peaking at $107 billion (exceeding current-account deficit by $92 billion, see Table 1), the Reserve Bank of India was moved to impose limits on the following:

  • Indian companies borrowing in excess of $20 million through external commercial borrowings – a main driver of the rise (June 2007),
  • The use of participatory notes by foreign institutional investors (October 2007) and
  • Loans to mutual funds and foreign institutional investors (December 2007).

The clear intention at that time was to reduce the volume of capital inflows into India to stop the appreciation of the rupee, to change the composition of capital flows, to increase the average maturity of loan inflows, and to dampen volatility on the Mumbai stock exchange. Yet before the effectiveness of the new controls on capital flows to India could be tested, the global financial crisis had gripped the international financial markets. Foreign institutional investors, hit by the financial sector meltdown, started selling their holdings in Indian companies in order to ease liquidity conditions. This reversed the situation. Net capital flows to India in FY 2008-09 fell to $7 billion.

Yet the so-called surge in capital inflows in the 2009 and 2010 is barely $14 billion in excess of the Current-account deficit, and is not alarmingly high. A review of policy options proposed by IMF for India (see Joseph 2010) concluded that none of the policy options are a cure for checking excessive capital flows. Indeed, the situation now is more complex than during earlier episodes of capital inflow surges. With this in mind, we recommend India considers the following combination of policy measures:

  • The Reserve Bank of India should intervene in the forex market if there are clear signs that rupee is undervalued in real terms. The 6-currency real exchange rate is presently 15% above the 2004-05 level while the 36-currency real exchange rate is almost equal to the 2004-05 level.
  • If intervention is an inevitable option in the near future, the increase in liquidity could well be mopped up, as before, with sterilisation bonds.
  • If India has excess foreign exchange reserves, and the return on these are low because these are warehoused in low interest rate bearing government securities of triple-A developed countries (Bhagwati 2010), then:
    • a portion of foreign exchange reserves could be more profitably used either for funding infrastructure projects in India or for lending to the foreign branches of Indian banks for meeting their foreign currency needs.
    • Foreign exchange can be routed to Indian infrastructure companies, through India Infrastructure Finance Company Limited1, for financing their capital expenditure outside India (Economic Survey of India 2009-2010).
  • To reduce the volatility of capital flows, the policy response should be to target individual segments of capital inflows:
    • Foreign institutional investors 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 periods) 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 short-term credit dries out (or becomes more expensive) in times of crisis.
    • The deposits made by non-resident Indians in India are stable sources of capital inflows and, therefore, it is important to develop new policies towards encouraging this source of capital.
  • Another policy should be to encourage “non-Indian” foreigners to deposit their long-term funds in Indian banks’ branches abroad through new incentive schemes. India needs enormous funding for infrastructural and developmental projects.

There was a large equity capital outflow of more than $2 billion in the months leading up to May 2010 and the “Greek-tragedy”, causing the rupee to depreciate slightly. If Europe were to stabilise in the near future, capital inflows to India would resume and the whole debate would return to life once more. At this point, the need to contain volatility in foreign portfolio investment and increase the investment holding period will be an unavoidable move.


Bhagwati, Jaimini (2010), “Why India should Welcome all Capital Inflows”, rediff.com, May 21.

CLSA, Asia Pacific Markets (2010), “FIIs Interest in India on the Rise”, Kotak.

Government of India, (2010), “Economic Survey of India 2009-10”, Ministry of Finance

IMF (2010), “Meeting new Challenges to Stability and Building a Safer System”, Global Financial Stability Report

Joseph, Mathew (2010), “Capital Control: The Way Forward for India”, Macro Perspectives and Updates, ICRIER India

Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S. Qureshi, and Dennis B.S. Reinhardt (2010), “Capital Inflows: The Role of Controls”, IMF Staff Position Notes10/04

Subbrao, Duvvuiri (2010) “India and the Global Financial Crisis: Transcending from Recovery to Growth”, Comments of the RBI Governor at the Peterson Institute for International Economics, April 26, Washington DC.

1 India Infrastructure Finance Company Limited has set up as a wholly owned subsidiary in London in 2008. The subsidiary will borrow up to $5 billion from Reserve Bank of India by issuing US-dollar denominated bonds and lend the resources to Indian infrastructure companies for meeting their capital expenditures outside India (Ministry of Finance, India). Given the volume of foreign exchange reserves, the lending capacity of the subsidiary can be increased manifold in the future.

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