One wonders how resilient the Indian economy or its financial markets would have been, had the global downturn and the resultant flight of capital lasted for a much longer spell than in 2008-09.
Ever since the trickle of foreign capital flows into the emerging markets has turned into a deluge, economists have carried on a sort of love-hate relationship with foreign portfolio investments.
They grudgingly accept that freely flowing capital does allocate resources to the countries where there is higher growth potential. Yet, there is lurking fear of ‘hot' money zipping in and out at will, wreaking havoc on the fragile and already quite whimsical financial markets. The South-East Asian crisis lent credence to these fears.
This dilemma is particularly acute for India, where the capital brought in by FIIs (foreign institutional investors) is crucial to the nation's infrastructure-building and growth plans.
However, episodes like the one in 2008 show how the sudden withdrawal of liquidity can throw not only the financial markets, but also the real economy, into disarray.
Impact across markets
So how do foreign portfolio flows into the Indian market affect stocks, as well as other macro indicators such as the exchange rate, inter-bank interest rates and government security prices? More important, how resilient is the Indian financial market to sudden blips (or ‘shocks') in these flows?
These are the key questions addressed by Saurabh Ghosh and Snehal Herwadkar of the RBI, in a 2009 paper tilted Foreign portfolio flows and their impact on financial markets in India. Based on monthly data of over a decade, from April 1998 to March 2008, the paper arrives at three conclusions.
The first is the fairly straightforward one that higher net FII inflows (they include both debt and equity here) lead to a higher Sensex, lower interest rates and exert an upward pressure on the rupee. This is simply explained by the fact that foreign portfolio investments create greater demand for stocks or bonds, pushing up their prices. Inbound money also increases demand for the local currency and props up the rupee.
The second is that though FII flows do hold sway over the financial markets, the markets are quite able to take temporary blips in such flows in their stride. The authors use some sophisticated statistical tools to test how ‘shocks' in the FII flows impact the different financial market indicators such as stock prices, the rupee and interest rates. Predictably, ‘shocks' applied to the net FII flow led to a spike in the Sensex and the rupee, but tempered call rates and gilt yields due to an excess of liquidity.
However, significantly, the market reactions to such ‘shocks' did not last very long. This tendency of the Indian financial markets to revert to equilibrium played out not only in the short term but also over the long term, which the authors feel indicates the resilience of the Indian markets to changes in FII flows.
Third, the paper concludes that there is a statistically significant long-term relationship between FII flows and various financial variables such as stock prices, exchange rates and gilt prices. Curiously, it is the central bank's intervention in the forex markets that plays a crucial role here.
Confirming that capital flows into India have generally improved returns from equities, the paper offers an additional insight: ‘One of the major reasons for the surplus liquidity in the Indian money market during 2004:04 to 2008:03 was the large capital inflows and consequent upward pressure on the rupee. The central bank's forex operations had a positive impact on domestic money supply and inter-bank liquidity.'
Simply put, when FII money begins to flood in, the rupee appreciates. When it does, the central bank is usually quick to step in and mop up the excess dollars, thus releasing additional rupee liquidity into the system. That has a salutary effect on liquidity and thus on money market rates — sort of making a virtue out of a necessity!
Mercifully short
Having left out crisis-ridden 2008-09 from the purview of this entire study on the pretext that it was ‘characterised by extreme events and the freezing of the financial markets' and thus would ‘distort' the findings, the paper gets back to this issue in the end, only to gloss over it. It notes that the impact of the recent global crisis was ‘rather muted' for the Indian economy, with ‘some capital outflows' witnessed during September-October 2008. It also gently pats policymakers on the back for ‘pre-emptive' policy measures that helped markets back to normal by December 2008, which also reinforces the findings of this study.
However, the truth is that the global credit crisis of 2008 and the resulting outflow of capital from the Indian markets were both confined to a mercifully brief period. Even that short episode in late-2008 triggered an immediate freeze on credit and liquidity in the Indian market, set off a deceleration in the manufacturing and services sectors and dented consumer confidence.
The policy initiatives which helped reverse this decline — fiscal stimulus (in the form of pay hikes, tax cuts and higher public spending) and monetary action (pruning of interest rates and the injection of liquidity) — may have helped the Indian economy and the markets chart a quick recovery. However, these measures have entailed stiff costs, in the form of a precarious fiscal situation and higher inflation, which the Government is still grappling with.
Seen in this backdrop, one does wonder how resilient the Indian economy or its financial markets would be had the global downturn and the resultant flight of capital lasted for a much longer spell than in 2008-09.
As foreign investment flows into India have remained largely a one-way street (even 2008-09 saw higher debt flows making up for the slowdown in equity flows) in recent years, the resilience or otherwise of the economy has not been tested in practice.
