In the balance

Financial Express, 8 July 2008

Balance of Payments



(US $ billion)

Capital inflows, net



1. Loans, net inflows



a. Foreign assistance, net



b. External commercial borrowings, net



c. Short term foreign loans, net



2. Banking capital, net



a. Commercial bank assets, net



(i)NRI deposits, net



c. Other banking capital, net



3. Foreign investments, net



a. Foreign direct investments in India, net



b. Foreign direct investments by India, net



c. Portfolio investments in India, net



d. Portfolio investments by India, net



4. Other foreign capital, net



Current account balance



Trade balance



Invisible earnings, net



Private transfers (remittances), net



Net capital flows into India were positive and strong in January-March 2008. In contrast to popular perception, this was not on account of high portfolio flows into India. Indeed, the data shows that this was a time when there were portfolio outflows from India.

Balance of Payments data for January to April 2008, the fourth quarter of 2007-08, released recently by the RBI shows that capital inflows fell when compared to the quarter before that by USD 6 billion. Capital inflows were still large in comparison with previous years. One striking element about BOP data for the first quarter is the data on portfolio investment. The quarter saw an outflow of FII flows. In the previous quarter, as seen in the accompanying table, there was a net capital inflow of USD 14.5 billion on account of portfolio flows into India. Between January to March this number turned negative. There was an outflow of USD 3.76 billion on this account. While the reasons for an outflow of equity flows may be many, and may be caused by global factors and developments in the credit market, it is significant that capital flows continued to be positive and strong in a quarter when there were net portfolio flows out of India. This goes against the common perception that portfolio flows constitute the bulk of capital flows into India. Foreign direct investment into India went up, but then so did outbound FDI by Indian companies. As a result of the developments on direct and portfolio investment, net foreign investment into India fell sharply from USD 18.4 billion to USD 2.6 billion from the third to the fourth quarter. The biggest component of capital flows was on account of loans which remained roughly the same at USD 11.5 to 12 billion in each of the quarters. The government’s policy on External Commercial Borrowings (ECBs), which put restrictions on ECBs meant that there was a slowdown in inflows on account of such loans. But if ECBs came down by about USD 1.5 billion, an equal additional amount came in through the short loan window. This meant that despite the restrictions, total net inflows on account of loans did not fall. One curious element in the capital account is inflows of USD 1.1 billion on account of NRI deposits. With the interest rate on NRI deposits capped at LIBOR minus 75 basis points, it is not clear why people should be depositing money in NRI deposits.

In addition to the flows that came in explicitly on the capital account, we find that USD 13 billion came in as private transfers or remittances. About half of these are local NRI withdrawals. There was a net current account deficit of USD 1 billion, in contrast to USD 5 billion in the previous quarter.

The sentiment about India was strong during the quarter January-March. Interest differentials remained high and even after taking the depreciation into account, there was a positive return to be earned by bringing dollars into India. Inflation numbers coming in were still benign and sentiment about the economy was positive.

However, as inflation numbers showed signs of moving up, instead of letting the rupee appreciate, the RBI purchased dollars in the market and pushed it down. In January it bought USD 13.8 billion, continued buying in February and March, and even bought in April (USD 4.3 billion) despite the bad inflation data. At the same time, it talked about tight monetary policy undermining whatever credibility it might have had with market participants.

In the following quarter, not surprisingly, the sentiment about India appears to have changed. There was a sharp depreciation of the rupee in the first quarter of this financial year – April to June. When the rupee fell sharply in the first three weeks of May, RBI stood by and watched. Last year when the rupee was appreciating and RBI was intervening heavily, there was a lot of talk about controlling the volatility of the rupee. Now when the rupee was falling, there was no talk and no action. Indeed, one of the triggers of the rupee depreciation was RBI Governor Reddy’s statement that the RBI would not use rupee appreciation to control inflation.

While data for capital flows is not available yet, the sharp downward pressure on the rupee, when there was little intervention from the RBI, suggests that there were net outflows on the foreign exchange market. With interest rates rising, inflation rising, IIP growth falling, and the rupee depreciating RBI has solved the capital inflows problem. It no longer needs to pile up dollars, struggle with sterilizing its dollar purchases, work hard at keeping the costs of sterilization low. It appears to have killed the beast of capital inflows successfully. The fact that it meant turning the India growth story upside down is, for those obsessing on the rupee, is perhaps only a side story.

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