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Effects of Foreign Capital Inflow on the Economy

Recently India’s Finance Minister Mr. P. Chidambaram pointed out that surge in foreign capital inflow can be a cause of the rising inflation rate in the economy. This is true! With opening up of the economy, foreign capital has become one of the important factors affecting our economy. The country’s economic policies have changed. We are now an open economy affected by the economic and political happenings of the world. We therefore need to broaden our handling of domestic economic problems like inflation. Inflation is no more only due to supply constraints caused by domestic supply constraint caused by poor monsoon or floods. It is affected by global demand and supply of goods and capital. Today almost all the countries of the world have opened up their respective economy to free capital movement across borders. Foreign capital inflow has both advantages as well as disadvantages. It depends upon the constructive absorption capacity of the economy.

Advantages to the domestic economy

Supplements domestic savings- Less Developed countries lack sufficient savings, required for investment in development projects like building economic and social infrastructure. Foreign capital bridges this gap.

Growth in rate of investment- Foreign Direct Investment brings in more industries and technology to the country, giving a boost to production, employment and income of the host country.

Covers debt and Current Account Deficit of Balance of Payment- Foreign capital inflow adds to our foreign exchange reserves, which is a cushion for the country’s Balance of Payments. The reserve is used to cover maturing international debts and to cover the current account deficit of the Balance of Payment.

India has certainly reaped these benefits as now the country is recognized as a growing/emerging economy. The country is coming out of the ‘Less Developed Country’ tag. Foreign Capital inflow has given a boost to our industrial and social growth and also provided the savings to undertake essential infrastructure development works. Prior to the nineties decade, the country depended heavily on foreign aid and debt. The huge accumulation of debt from continuous international borrowings put tremendous pressure on the country’s Balance of Payment. We had no other source of repaying debts or covering the growing fiscal and current account deficits, other than more borrowings. The country has done away with that painful situation. Today dependence on aid has vanished. Now FDI (Foreign Direct Investment), FPI (Foreign Portfolio Investment) and NRI (Non Resident Indian) deposits dominate the capital flows in the country.

Drawbacks of Foreign Capital

  • Appreciation of Real Exchange Rate- As more foreign investors invest in the country, the demand for the domestic currency rises. As a result the value of the domestic currency appreciates. Appreciation of domestic currency causes loss of competiveness of exports as they become costlier. Cheaper imports and costly exports further add to the current account deficit in the Balance of Payment.
  • Inflation- Foreign capital inflow adds to the domestic money supply. If it is not absorbed and utilized in profitable projects, it leads to inflation in the domestic economy.
  • Destabilising effects- Foreign investors are always in search of greener pastures. They are attracted to developing, emerging markets where demand, interest rates and hence returns are high. Foreign investors, particularly portfolio investors, are quick to sell and fly away at the slightest hint of economic slowdown or turmoil in the country of investment. They may even leave the country if they find it more profitable investing in some other market/country. Too much foreign investment may make the economy overvalued which will discourage foreign investors. Foreign investments and investors come in and fly out in herds. This herd mentality can be rewarding as well as dangerous to the domestic economy. It can take the economy to great heights and it can also lead to a crash in the stock market and drop in rate of investment and growth in the domestic economy. The recent high inflation, scams and the drop in the index of Industrial Production in India has led many foreign investors to sell their shares and leave the country.

Managing Foreign Capital Inflow

Foreign Capital Inflow is beneficial only till the domestic economy is able to absorb it in profitable uses which lead to enhancement of overall economic growth of the country through rise in rate of investment, production and income of the country. The surge in inflows should be matched with a corresponding growth in the absorption capacity of the country. It should be used for investments that cannot be otherwise undertaken by the country. For handling inflows better, the fiscal deficit has to be kept in control. A strong, deep financial system is required to utilize as well as cope with the highs and lows of foreign capital movements.

The traditional method adopted by Central banks to countering the effects of excess inflow (known as sterilization of capital flows) is to reduce the domestic component of the monetary base. This is done by methods like the open market operations, by selling treasury bills and other instruments or raising the repo rate and CRR etc. But this traditional method has limited effect as instruments can be sold or interest rate can be raised only upto a certain limit. The bank faces a tricky situation here. Excess foreign capital inflow causes inflation; to check inflation Central Bank hikes interest rate; high interest rate attracts more foreign investments. Also, too much tightening of the monetary policy may hamper investment in the country. The government should therefore look into other ways of countering the negative effects of surge in capital inflow.

Some possible economic policies that can help to absorb inflow while maintaining an adequate monetary base in the country are-

  • Ease restrictions on capital outflow.
  • Encourage private overseas investment.
  • Allow foreigners to borrow from the local market.
  • Wider band exchange rate policy which allows some appreciation.
  • Interest equalization taxes on foreign borrowings.
  • Capital controls like variable deposit requirements.
  • Acceleration of import liberalization to absorb the inflows.

For successful, profitable management of foreign capital inflow, there has to be strong economic growth fuelled by domestic demand and strong fundamentals. Only a strong sound financial system can sustain the heights to which an economy can soar on the wings foreign capital inflow.

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2 Responses

  1. sorry to tell this…. you may be correct in economic point of view….. but now p.chidambaram is the home minister …. pranab is only the finance minister…