Capital flow in India: facts, features, and analysis

What is it about?

Capital flows have become an integral part of the Indian economy. The last two decades have witnessed an increasing volume of capital inflows. It is in this background that this paper delves into the more fundamental aspect which needs to be understood before evaluating the impact of capital inflows and efficacy of alternative policy instruments. To be specific, the paper makes an attempt to explore several characteristics of capital inflows to India. Here, we have focused on the six alternative dimensions of capital inflow, namely, composition of capital flow, behaviors of net and gross flows, volatility, substitutability across flows, persistence, and cyclical behavior.

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Why is it important?

Capital flows consist of several components which are non homogeneous in nature. Broadly speaking, capital flows to India can be categorized into five major heads, namely, foreign investment, loan, banking capital, rupee debt service, and other capital. Different types of flows have different features as well as differing natures of impact on the domestic macro economy. Thus, it is important to analyze the behavior of capital flows in a dis aggregated manner, and this is attempted in this paper. Second, following the balance of payment accounting, it can be inferred that net flows are the financial counterpart to the current account balance and one of the most important factors which determines exchange rates. On the other hand, gross flows can be the drivers of credit and asset prices, affecting domestic financial stability. Most of the existing studies have focused on ‘‘Net’’ capital inflows. The paper makes an attempt to analyze the net flows vis-a`-vis the gross flows. Third, policymakers of developing countries are often skeptical about the capital inflows due to their high volatility and lower persistence. Hence, they look at the issue of capital mobility with mixed enthusiasm. However, all types of flows are not so volatile and unstable. Thus, it would be important to identify the volatility and persistence of different types of flows. Hence, the policymakers would be able to identify the priority areas, i.e., what are the components of capital flows that can be invited and what are the ones that should be dealt with caution. Fourth, if gross inflows and outflows are found to be complementary, then despite having a large movement in gross flows, net flows will be stable. On the other hand, if there is substitutability between different types of flows, then net inflows could be stable in spite of large fluctuations in different components. Fifth, if gross inflows and outflows are found to be highly pro-cyclical, then there will be mild increases in net capital inflows when the economy is growing. On the other hand, if only gross inflows or outflows are pro cyclical in nature, then it will induce net inflows to be highly pro-cyclical.