Retail therapy

Indian Express, 20 April 2009

India is globalised today, her capital account defacto open and financial markets tightly coupled with the rest of the world, not as much because of foreign investors, the FIIs or foreign banks, it is integrated with global financial markets owing even more to the two hundred and fifty odd Indian companies who operate abroad. Evidence, especially since September 2008, reveals that the global financial crisis was transmitted rapidly to India primarily through these companies. India's balance of payments, financial markets, the exchange rate and money markets were impacted hugely by the actions of India's multinationals.

The balance of payment data from the RBI provides important insights. In the troubled last quarter of 2008, the months of October to December, India saw not merely a sudden stop in capital inflows but a reversal. Although small in magnitude, at USD 3.6 billion, capital flowed out of India. This was not merely a continuation of the slowdown in capital inflows that had been witnessed since the last quarter of 2007, after difficulties started in the US financial sector, it was a sharp and sudden movement.

However, the most striking fact in the balance of payment data for October-December 2008 is not that capital flowed out, as it did from many emerging economies, it is that the biggest outflow from India took place on account of outbound FDI by Indian companies. Companies actually invested more abroad than they had invested in the previous two quarters. Between October and December 2008, Indian companies invested USD 5.86 billion abroad. In contrast, in the quarter of April-June 2008 they had invested only USD 2.9 billion and in July-Sept 2008 USD 3.2 billion.

To put this in the context of the rest of India's balance of payments in October-December 2008, we see that foreign institutional investors(FIIs) came second, pulling out USD 5.78 billion from India. Much has been written about FIIs who faced pressure from clients to redeem investments and who were pulling money out of emerging markets to help out their headquarters that were in dire straits. Banking capital also changed direction and accounted for another USD 4.95 flowing out of India, as banks, including Indian banks opearting abroad, moved capital around the world to London and New York where they faced shortages. For the rest, the inflows of loan and foreign direct investment coming into India fell by about USD 2 billion each. Considering the condition of financial markets in US and Europe this was hardly surprising. All this put together led to a net outflow of capital from the country.

The large outflow of FDI from India at a time when the financial system was reeling under a huge liquidity crunch demands explanation. In normal times, an outflow of FDI from India would have been explained by Indian companies buying companies around the world. However, the October-December 2008 quarter was one of extreme pain and lack of liquid funds around the world and it was not a time when there was any greenfield investment or any mergers or acquisitons by Indian companies. The explanation appears to lie in the operations of existing Indian multinationals. There are nearly two hundred and fifty Indian multinationals today. These are Indian companies ranging from the Tatas, to IT firms to smaller automobile component firms who produce abroad. These companies use global money markets in normal times wherever they were - in London, New York, Munich or Singapore. Immediately after the death of Lehman when global money markets froze they took money out of India to meet the needs of their businesses in the rest of the world. Indeed, when we look back at what happened in Indian money markets and in the rupee dollar spot and forward markets, we find further support for this story.

The developments in Indian financial markets in September and October following the death of Lehman Brothers in New York on September 15, 2008 were quite unprecedented. One was the sudden change in conditions in the money market. Call money rates shot up immediately after September 15th. Despite swift action by the RBI, the tightness persisted through the month of October. Rates kept going above the RBI's policy rate corridor reflecting the tightness in money market. The call rate consistently breached the ceiling of the repo rate of 9 percent to attain values beyond 15 percent. There was a huge amount of borrowing from the RBI. On some days RBI ended up lending an unprecedented Rs 90,000 crore in repo transactions.

At the same time, there was a huge pressure in the rupee dollar market. The rupee depreciated sharply. RBI attempted to prevent an even bigger depreciation of the rupee by selling dollars. It sold USD 18.6 billion in the foreign exchange market in October alone. This, of course, had the undesirable effect of sucking liquidity out of the economy at a time when the economy was already facing huge liquidity shortages and call money rates were shooting up. Another interesting element of the story is the corroborating evidence provided by the rupee dollar forward market. Firms, or banks lending to them, taking dollars out of India apper to have planned to bring the money back to India. To lock in the price at which they would bring money back after a month, they sold the dollars forward. The one month forward which is usually a premium suddenly fell sharply into negative territory. Similar discounts appeared on the three month and six month forward markets.

In summary, Indian multinationals are now one of the most important channels through which India is integrated with global financial markets. In the days ahead when American companies are available at sizable discounts, enterprising Indian firms are likely to acquire more foreign companies increasing India's engagement with the world. India's defacto capital account convertibility is now a reality and is here to stay.

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