Capital flight

The exit of FII investment has driven stock indices down and led to the depreciation of the rupee.

AFTER a long spell of growth, the Indian economy is experiencing a downturn. Industrial growth is faltering; inflation remains at double-digit levels; the current account deficit is widening; foreign exchange reserves are depleting; the rupee is depreciating; and the Sensex has crashed. All of these developments are not unrelated to the financial crisis in the markets of the developed countries, which affects India in many ways.

The most immediate effect has been an outflow of foreign institutional investment from the equity market. Faced with the need to retrench assets in order to cover losses in their home countries and seeking havens of safety in an uncertain environment, foreign institutional investors (FIIs) have been major sellers in Indian markets. Over the financial year 2007-08, net FII investment inflows into India amounted to $20.3 billion. As compared with this, FIIs pulled out $11.1 billion during the first nine and a half months of the calendar year 2008; of this, $8.3 billion was pulled out over the first six and a half months of the financial year 2008-09 (April 1 to October 16). Given the importance of FII investment in driving Indian stock markets and the fact that cumulative investments by FIIs stood at $66.5 billion at the beginning of this calendar year, this pullout has triggered a collapse in Indian stock markets. The Sensex has fallen from its closing peak of 20,873 on August 1, 2008, to around 10,500 by the middle of October 2008. Besides driving stock indices down, the exit of FIIs has led to a sharp depreciation of the rupee.

Going by the Reserve Bank of India (RBI) reference rate, between January 1 and October 16, 2008, the rupee depreciated by nearly 25 per cent with respect to even a weak currency like the dollar (from Rs.39.20 to the dollar to Rs.48.86). This depreciation occurred despite the sale of dollars by the RBI, reflected in a decline of $25.8 billion in its foreign currency assets between the end of March and October 3.

It could be argued that the $275 billion it still has in its kitty should be adequate to stall and reverse this depreciation if needed. But, given the sudden exit of FIIs, the RBI is clearly not keen to deplete its reserves too fast and risk a foreign exchange crisis. The result is the sharp depreciation of the rupee. While this depreciation may be good for Indias exports, which are adversely affected by the slowdown in global markets, it is not good either for those who have accumulated foreign exchange payment commitments or for the governments effort to rein in inflation. A second route through which the global financial crisis could affect India is through the exposure of Indian banks or banks operating in India to the impaired assets resulting from the sub-prime crisis. Unfortunately, there are no clear estimates of the extent of that exposure, giving room for rumour in determining market trends. Thus, ICICI Bank was the victim of a run for a short period because of rumours that sub-prime exposure had badly damaged its balance sheet. Thus far, the RBI has claimed that the exposure of Indian banks to assets impaired by the financial crisis is small.

According to reports, the RBI had estimated that as a result of exposure to collateralised debt obligations and credit default swaps, the combined mark-to-market (MTM) losses of Indian banks at the end of July was around $450 million. Given the aggressive strategies adopted by the private sector banks, the MTM losses incurred by the public sector banks was estimated at $90 million, while private banks incurred around $360 million. As yet these losses are on paper, but the RBI believes that even if they are to be provided for, these banks are well capitalised and can easily take the hit. Such assurances have not reduced the fears of those exposed to these banks or those of investors holding shares in these banks. The fears are compounded by those of the minority in metropolitan areas dealing with foreign banks that have expanded their presence in India and whose global exposure to toxic assets must be substantial. What is disconcerting is the limited information available on the risks to which depositors and investors are subjected. Only time will tell how significant this factor would be in making India vulnerable to the global crisis.

A third indirect fallout of the global crisis and its ripples in India is the losses sustained by non-banking financial institutions (especially mutual funds) and corporates as a result of their exposure to domestic stock and currency markets. That such losses would be large is to be expected and is signalled by the decision of the central bank to allow banks to provide loans to mutual funds against certificates of deposit (CDs) or buy back their own CDs before maturity. These losses are bound to render some institutions fragile, with implications that will become clear only in the coming months.

A fourth effect is that, in this uncertain environment, banks and financial institutions, concerned about their balance sheets, have been cutting back on credit, especially the huge volume of housing, automobile and retail credit provided to individuals. It is known that credit-financed housing investment and credit-financed consumption have been important drivers of growth in recent years and underpin the 9 per cent growth trajectory that India has been experiencing. The reluctance of lenders to increase their exposure in markets to which they are already overexposed and the fears of increasing payment commitments in an uncertain economic environment on the part of potential borrowers are bound to curtail debt-financed consumption and investment. This could slow growth significantly.

Finally, the recession generated by the financial crisis in the advanced economies as a group, and the United States in particular, would adversely affect Indias exports, especially its exports of software and information technology-enabled services, more than 60 per cent of which are directed to the U.S. International banks and financial institutions are important sources of demand and the difficulties they face would result in some curtailment of their demands for services. Further, the nationalisation of many of these banks would increase the pressure to reduce outsourcing in order to keep jobs in the developed countries. And the slowing of growth outside of the financial sector, too, would have implications for both merchandise and services exports.

The net result would be a smaller export stimulus and a widening trade deficit. While these trends are still in process, their effects are already being felt. They are not the only causes for the downturn the economy is experiencing, but they are important contributory factors. Yet, this does not justify the argument that Indias difficulties are all imported. They are induced by domestic policy as well. These imports would have been far less if the government had not increased the countrys vulnerability to external shocks by opening up the real and financial sectors drastically.

It is disconcerting, therefore, that when faced with this crisis the government is not rethinking its own liberalisation strategy, despite the backlash against neoliberalism worldwide. By deciding to relax conditions that apply to FII investments in the vain hope of attracting them back and by focussing on pumping liquidity into the system rather than using public expenditure and investment to stall a recession, it is indicating that it hopes that more of what created the problem would help solve it. This is just to postpone decisions that may prove critical until it is too late.