IE 2 - Unit 1 - Financial Globalization in India - Renu Kohli PDF

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FINANCIAL GLOBALIZATION IN INDIA – OPPORTUNITY AND VOLATILITY

Renu Kohli (Oxford Handbook of the Indian Economy, 2014) INTRODUCTION 1. Financial globalization (hereafter FG) may be broadly described to mean the extent to which countries are linked through cross border financial holdings. 2. It is not a new phenomenon, earlier being observed in the 19 th century wave of globalization (and even earlier) 3. A novel feature of the current round of globalization is the change in the operational environment- technological progress and financial liberalization (FL) has changed the landscape and according to Kohli has made it infinitely riskier. 4. The outcome of FG is mixed. a. Financial crisis and volatility have been increasing while b. the gains remain nebulous. 5. The financial crisis of 2008, in particular, made many question unfettered FG. FINANCIAL GLOBALIZATION AND ECONOMIC THEORY 1. In theory, countries gain from FG in several ways –Foreign capital positively impacts growth through: a. Easing financial constraints b. Lowering costs of funds, and consequently, increasing investments and output growth a. Technology spill over b. Competition c. Learning effects to raise the efficiency and productivity of capital 6. It also enables a. international risk sharing b. consumption smoothening. 7. Indirectly it also a. Promotes development of domestic financial sector b. Disciplines the macroeconomic policies of receiving countries FINANCIAL GLOBALIZATION AND EMPIRICAL EVIDENCE 1. As noted earlier, empirical evidence on the benefits of foreign capital is somewhat mixed. 8. According to some authors (Prasad, Rogoff and Wei, IMF occasional papers, 2003), financial globalization benefits once countries cross a certain threshold.

9. However, in this context too many observed results are counter-intuitive e.g. – a. Non-industrial countries that rely on lesser foreign capital have clocked higher growth rates on average in the long run (Prasad et al. 2007). b. Countries financing more of their investments domestically have, on average, grown much faster (Aizenman et al. 2007) c. Capital seems to flow more to countries that invest and grow less d. Countries with faster productivity growth appear to attract less foreign capital (allocation puzzle) (Gourinchas and Jeanne 2007) e. International risk sharing gains are increasing over time but in the initial stages (emerging markets), it is found to be non-existent or insignificantly low or restricted to industrial countries (Lewis 1996, Kose et. al, 2007). 10. Also, although FG seems to be associated with lower inflation, there is little evidence to support that it disciplines macroeconomic policies. 11. However, institutional quality and governance are observed to improve as counties undertake reforms in response to FL and financial market development is observed after basic institutional structures develop. Empirical Proof on Types of Foreign Capital 1. FDI, or stable long term flows are more positively associated with growth through micro-linkages. 2. Equity market liberalization is found positively linked to higher investments and growth. 3. Debt flows, especially short term, are decisively found to yield no obvious benefits to the recipient and are systematically linked to an increased likelihood of financial crisis. FG, VOLATILITY AND FINANCIAL CRISIS 1. How does FG relate to volatility? a. Most studies indicate a striking rise in GDP and consumption correlations with increased global integration. b. In other words, the more integrated a country, the more synchronized is its business cycle with the global one. 2. The association with macroeconomic volatility also depends on a country’s financial development and the quality of its institutions. a. Higher output volatility is linked to higher financial risk, i.e. the ability of a country to pay or not pay its debts. 3. FG also coincides remarkably with a higher frequency in the occurrence of financial crisis, especially in developing and emerging economies, a. for example Latin American debt crisis in the 1980s and the Japanese recession and banking sector problems since late 1980s, East Asian crisis in 1997, global financial crisis of 2008-09, etc.

4. The nature of global capital flows has become highly pro-cyclical, herding behaviour and speculative attacks. a. FG amplified the costs of policy and regulatory failures in preventing the crisis and its management thereafter. 5. To conclude then, interestingly many economists, including Bhagwati, who generally support free trade, criticize the unfettered movement of global capital. POLICY IMPLICATION AND THE WAY FORWARD FOR INDIA 6. What does this imply for liberalizing, emerging and developing countries? a. The international opinion is now more favourably inclined towards the management of capital flows, including endorsement of capital controls as an additional tool. b. The way forward for FG is designing global, national and regional policy frameworks to cope with high levels of international financial integration. 7. All these issues have a bearing for India, which has been a gradual but a steady liberalizer of its financial markets for over 2 decades now as it belongs to a group of countries whose financial opening coincided with the trend towards increasing financial globalization. 8. This chapter is an attempt to explore these issues. FINANCIAL GLOBALIZATION OF INDIA; AN OVERVIEW 1. Before 1991, India had a closed capital account. In other words, barring trade, all external transactions between private residents and non-residents were prohibited. 2. Capital movements were mostly official transactions leaving the government as the only effective borrower abroad. 3. The BOP crisis in 1991 prompted the restructuring of economic policies including– a. Opening up of the economy to private foreign capital in 1992-93. b. Re-orienting the country’s external financing pattern from expensive debt towards cheaper equity. c. The crisis reinforced the urgency to reduce foreign currency debt. 4. This typically meant encouraging equity over debt, more specifically - foreign direct investment (FDI) and foreign portfolio equity capital. a. These factors effectively shifted the weight of liberalization towards foreign portfolio equity capital, as even FDI at the time depended critically on other economic reforms including the sustainability and certainty of economic policies to inspire the confidence of long term commitment of foreign investors. b. This was helped by the fact that unlike most developing countries, India had a reasonably well developed equity market when liberalization began in the 1990s.

5. To sum up then,India’s approach towards capital account liberalization has been as follows – a. Preference to equity over debt. This tends to minimize the interest rate and liquidity risks for firms. b. In case of debt - long term borrowings have been favoured over short term ones to enhance the productive capacity of the economy and lessen liquidity and rollover risks from a sudden reversal. c. Inflowsof foreign capital have been liberalized before outflows (however, in times of surpluses, outflows have been liberalized fairly fast) d. (Liberalization of) Non-resident capital flows have taken precedence over residents. This results from a fear of domestic capital flight and the nonreadiness to make the currency convertible. e. Among the residents, preference hierarchy is as follows, i. Corporates ii. Non-bank financial intermediaries (NBFCs) iii. Banks iv. Individuals CAPITAL ACCOUNT LIBERALIZATION POLICY 1. India’s strategy w.r.t. to capital account liberalization (first articulated in Tarapore Committee reports - I (1997) and II(2005)) is to aim at striking a balance between fulfilling the country’s foreign capital needs while striving for BOP sustainability. 2. The two reports clearly linked the dismantling of key capital account restrictions with the achievements of macroeconomic objectives like a. reducing inflation, b. fiscal consolidation, and c. monetary-fiscal separation (i.e. removing the strong dependence of the fisc on the domestic banking system for financing the fiscal deficit through ‘financial repression’). 3. Since liberalization, foreign participation in the debt market has increased incrementally to support public debt issuance needs, while implementing a fiscal responsibility framework. 4. Despite these ‘radical’ changes, and after successive reviews of the liberalization process in India, capital account is still not fully open and debt flows are tightly managed. 5. Rakesh Mohan has given a clear account of the logic behind this approach, the government considers that capital inflows in excess of domestic absorptive capacity can lead to overheating of the economy and create asset price bubbles. 6. In light of the above Indian regulation discriminates against debt flows in two ways: a. Foreign investor’s participation in the domestic government bond market is capped

b. Indian corporates can borrow abroad above a minimum maturity and below a maximum interest cost. These limits vary per economic sector, depending on perceived needs. 7. India’s pace of capita account opening - slow and gradual – has often been commented upon by observers. In passing it may be noted that this is not specific to capital account liberalization alone; much of India’s reform process is characterized by gradualism. a. But compared to OECD countries, India’s pace is not particularly slow. OECD counties began to dismantle the capital controls in 1960s when they adopted the OECD code on capital moments to complete dismantling in the 1980s. On average these countries took anything from 20-25 years to fully liberalize their capital accounts. b. However, there is no gainsaying that financial openness remains limited in India today, particularly when compared with many other emerging market economies. 8. Of course, measuring FG is inherently difficult and there can be many measure de jure and de facto and can often show results contradictory to each other. For example, an oft-quoted index, the Chinn-Ito index of financial openness puts India as the least open with an index value of -1.13 (that is a minus 1.13) in 2007 compared to 0.99 for Brazil, 1.18 for Indonesia, -0.19 for Malaysia and 0.14 for Philippines. 9. Some economists however question this measure as it has hardly changed for India since 1970s. By many other measures India remained at the low end of the distribution but moved up significantly after 1995. THE EXPERIENCE: OPPORTUNITY AND VOLATILITY 1. How has India benefitted from its rising level of FG? 2. There are few studies that have looked at the issue in its entirety, although several examine one or the other aspect. 3. For example, [aspects such as] efficiency gain from stock market integration, greater vulnerability in times of distress from market integration, role of capital controls, macroeconomic effects of financial opening, etc. 4. The current section attempts to provide an overview of the issue. a. It assumes that the measure of FG is gross capital flows, as it measures the underlying exposure of an economy to cross border financial flows and its integration and can accurately capture the stress that emerging economy can face in surges and draught of liquidity. Capital Flows - Data 1. As a share of GDP, gross capital flows more than doubled between 2005 and 2007 to US$ 770 Billion, a 10-fold increase over 2000 levels.

5. The net capital account more than doubled from 4% of GDP in 2004-05 to 9.3% of GDP in 2007-08 reflecting the fast pace of integration with global financial markets. 6. This boom, however, turned to bust when foreign capital reversed following the 2008 crisis; net capital (in)flows collapsed to 0.6% of GDP. 7. Post crisis the net capital account is averaging 3.5% of GDP. 8. Perhaps, more than the quantity it is the quality that we should pay attention to. Figure 8.2 (p. 193) dissects the quality of capital entering India. 9. The various categories of Foreign Capital are: a. Loans b. Portfolio Capital Loans and Portfolio Capital c. Banking Capital are more volatile and dominate more than 40% of d. FDI Stable and Long term flows like net capital inflow in India. e. Other Capital FDI have lagged behind with average 30% share since 2005/06

INDIA AND FINANCIAL GLOBALIZATION 1. How has FG benefitted India, if at all? 10. There is little doubt that high growth rates and low, stable inflation and interest rates accompanied this financial globalization (Table 8.1) Table 8.1 Financial Openness

GDP (in%)

Investment Rate

Inflation (Wholesale Price)

Interest Rate (Repo)

Fiscal Deficit (% of GDP)

Current Account (% of GDP)

2000-02

17.9

4.7

24

4.7

7.7

9.7

0.4

2003-07

38.6

8.9

34

5.5

6.4

6.3

-0.3

2008-09

47.8

7.4

37

6.0

6.5

9.0

-2.6

2010-11

51.8

7.5

32

9.3

6.6

7.8

-3.4

Observations from the Table a. FG almost trebled to 50% of GDP. b. Average GDP rate almost doubled from 4.5% to 8.9%. 11. But this does not necessarily imply an association between the two phenomena as the period is characterised by significant structural changes in many spheres of India’s economic policy. 12. Nonetheless, growth inducing channels of FG that work through an expanded pool of resources and lower cost of capital to a. raise the share of Investment in GDP (24% to 38% in India) and an increase in output can be observed in the Indian case. b. Alongside, corporate financial pattern changed to absorb higher share of external funding - that is now almost 33% of their overall financing.

13. Effective borrowing costs have fallen significantly since 2000 relative to bank lending rates. Easing of financial constraints undoubtedly facilitated growth. The level of external commercial borrowing (ECB) - selectively permitted with caps on quality, interest rate maturity and so on a. rose from a monthly average of US$880 million in 2004 to US$ 2.5 billion by 2007, and b. continued to remain between US$2-2.5 billion even in the post crisis period. 14. FDI has risen 7 fold and is in line with the patterns observed in countries like China. 15. Simultaneously, outward direct investments by Indian firms have risen 5-fold in this period. FG and Macroeconomic Discipline 1. Question:Has FG fostered Macroeconomic discipline? 2. From the table (8.1) above we find that a. Inflation rates tumbled down into a range of 4% until mid-2000s but resurged to high levels thereafter [However, have fallen drastically since 2014]. b. Domestic inflation was closely linked to the global phase of low inflation, but i. As the commodity cycle turned up, domestic inflation surged. ii. This was additionally fuelled by domestic supply constraint in relation to overall demand. iii. Fiscal deficit, another explanatory factor of inflation, had also rebounded since the crisis in 2008 [but has come down since 2014]. c. The current account gap, which widens in India with higher growth rate, had expanded unsustainably in the last decade. i. This gap has led to rising dependency on short term financing from abroad (situation with falling petrol prices in 2015-16 had led to the reduction in the gap once again, though it increased again as the petrol prices shot up in 2017). ii. Prima facie therefore, there is little evidence of disciplining effect of FG in India. Financial Globalization and Volatility 1. Question: Has FG led to higher volatility? 3. The short answer is – yes. 4. The increasing co-movements of output, price and interest rates (figure 8.4) indisputably reflect the synchronization of Indian business cycle with the global one. 5. A Study about India (Ang 2011) finds a. consumption volatility has risen after financial liberalization which is consistent with the experience of other countries. b. The GDP volatility – measured by the coefficient of variation – more than doubled from 0.12 to 0.31 while

c. The private consumption was 3 times as volatile (0.11 & 0.31 respectively) between 1997-2002 & 2003-2011. d. Inflation volatility was range-bound (0.38-0.44) throughout. e. Real exchange rate variability increased significantly, and nominal exchanged rate more than doubled between 2002 and 2011. 6. Development of financial markets has accompanied FG although it may not be attributed just to it as many other policy efforts also took place simultaneously. a. Stock markets first to be opened to foreign investors grew in size; market capitalization rising from 3 fold between 1991 and 2000 and 7 times thereafter to US$ 1 trillion, in other words, it has acquired depth and liquidity. b. But India’s bond market – mostly closed to foreign investors who hold less than 5% of the public debt stock –is neither very deep nor liquid and has remained underdeveloped. c. The government bond market is well developed – at about 30%of GDP, comparing well with countries like the US and the Singapore (48% and 28% of GDP) – and has a liquid yields curve, high turnout volumes and market liquidity. d. The corporate bond market remains small – at about 3% of the GDP. 7. Macro-financial Stability: Financial volatility and hence macro-financial stability risks have risen due to increased transmission of external financial shocks from abroad. a. It is not just the aggregate exposure of the economy that is relevant here; the composition of the flow matters too. b. Figure 8.5 presents the inflow of capital into India in 3 time periods that roughly correspond to i. tranquil, ii. turbulent, and iii. crisis time c. By all measures and at all times FDI is far more stable than non FDI flows. d. Within the non-FDI flows, it is the portfolio capital that is most volatile. e. Non resident deposits and foreign loans are relatively more stable. f. Volatility has increased over time too, going up significantly during the crisis. 8. The Indian stock market is highly correlated and impacted by global events, especially the USA and Europe and the stock markets – the most open segment of the financial system - are (all over the world) increasingly the conduit for the transmission of external shocks. 9. In turn stock market volatility also explains a larger part of bond yield volatility in recent times, although real activity still remains relatively insulated. 10. The question is how to manage these risks – we turn towards it in the next section. MANAGING THE CHALLENGE

1. India’s macroeconomic conditions have shaped the pattern of its FG and according to Kohli this provides a framework for managing it too. 1. Both design and fortune allow India a structure that supports an intermediate exchange rate regime in which we have a. A partially-closed capital account b. A reasonable absorptive capacity (i.e. ability of absorb foreign resources that exceed the outflow of resources 2. The two factors together mean that a current account deficit enabled resolution of the trilemma (impossible trinity), i.e. inability to realize the three goals of a. Free capital mobility (or Full Capital Control) -Vertex A of triangle b. A fixed exchange rate (or Pure Float) - Vertex B of triangle c. Sovereign Monetary policy i.e. policy devoted to domestic objectives e.g. controlling inflation (or Monetary Union) – Vertex C of triangle Free Capital Mobility

Capital Mobility Monetary Independence Exchange rate stability

Sovereign Monetary Policy

Fixed Exchange Rate

Full Financial Integration

3. In other words, a central bank has three policy combination options – a. Option (a): A stable exchange rate and free capital flows (but not an independent monetary policy because setting a domestic interest rate that is different from the world interest rate would undermine a stable exchange rate due to appreciation or depreciation pressure on the domestic currency), e.g. Euro Zone b. Option (b): An ...