Information about Asia and the Pacific Asia y el Pacífico
Chapter

VI Recent Experience with a Surge in Capital Inflows

Author(s):
Richard Hemming, Woosik Chu, Charles Collyns, Karen Parker, Ajai Chopra, and Oliver Fratzscher
Published Date:
June 1995
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Information about Asia and the Pacific Asia y el Pacífico
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Author(s)
Charles Collyns

A striking aspect of India’s recent experience has been a remarkable surge in foreign investment. Historically, private capital flows to India have been low, discouraged by a tight regulatory regime as well as a highly distorted economy. However, with a liberalization of controls on capital inflows as well as the broader impact of reforms on India’s economic prospects, India has attracted substantial foreign investor interest during 1993/94 and 1994/95. Over this period, India accounted for a larger volume of international equity issues than any other emerging market. Share purchases on local exchanges have also been heavy, while foreign direct investment has increased appreciably. Taken together, these inflows were a major contributor to the recent strengthening of India’s external position and added substantially to the resources available for investment. However, as in other countries, the surge in inflows complicated the task of macroeconomic management by making monetary control more difficult and putting upward pressure on inflation.

This section reviews the recent experience with capital inflows and assesses their impact on the Indian economy. It first looks at the pattern of recent flows, contrasts India’s experience with that of other countries that have also recently received large private inflows, and considers the factors underlying the flows. Next, it examines the impact of resource flows on firms, on the macroeconomic environment, and on the financial system. Finally, the sustainability of capital inflows to India is assessed in the wake of the Mexican crisis.

Recent Experience

Overall Trends

Prior to 1991, capital flows to India predominantly consisted of aid flows, commercial borrowing, and nonresident Indian (NRI) deposits (Table 6.1). Direct investment was limited, averaging around $200 million a year over 1985–91. Foreign companies wishing to invest in India were generally restricted to 40 percent equity participation, subjected to requirements on technology transfer, and limited to priority areas. Foreign portfolio investment was channeled almost exclusively into a limited number of public sector bond issues, while foreign equity holdings in Indian companies were not permitted.

Table 6.1.Capital Account(In millions of U.S. dollars)
(Annual Average)

1985/86–1990/91
1991/921992/931993/94Est.

1994/95
Capital account7,3473,4202,7858,5067,767
Direct and portfolio investment12091545855,1044,799
Net aid2,5252,4891,4541,3441,533
Net commercial borrowing1,9451,456-358-155-118
Nonresident deposits1,9172902,0019401,000
Other753-969-8971,273552
Memorandum items:
Current account-7,469-1,638-3,888-685-1,388
(In percent of GDP)-0.7-1.6-0.3-0.5
Overall balance-1221,782-1,1037,8216,379
Change in gross international reserves (increase +)-6063,5211,0418,8155,773
Sources: Ministry of Finance; and IMF staff estimates.

Foreign currency convertible bonds and floating rate notes are included in direct and portfolio investment.

Sources: Ministry of Finance; and IMF staff estimates.

Foreign currency convertible bonds and floating rate notes are included in direct and portfolio investment.

A key component of the economic reform program launched in July 1991 has been the adoption of a much more open approach to foreign investment. At the outset, approval for direct investment participation up to 51 percent in priority areas was made automatic, while the criteria for approval were liberalized more generally. In February 1992, it was announced that Indian firms in good standing would be allowed to raise funds through equity and convertible bond issues in Euromarkets, and in September 1992, registered foreign institutional investors (FIIs) were allowed to purchase both equity and debt securities directly on local markets.1 A single FII may hold up to 5 percent of a company’s issued share capital, while all FIIs together may hold up to 24 percent of a company’s capital. To encourage these flows further, in the March 1993 budget the tax on interest and dividend income on FII holdings was set at 20 percent, while capital gains tax was set at 30 percent on investments held for less than one year and 10 percent thereafter.2 After an initial delay, the response to these liberalization measures was strong. Total foreign direct and portfolio investment rose to $5.1 billion in 1993/94, from $585 million in 1992/93 and $148 million in 1991/92 (Table 6.2). Inflows continued at a high rate through November 1994 and, although there was a slowdown in portfolio inflows in the final months of the year, the total for the year still reached $4.8 billion.

Table 6.2.Foreign Direct and Portfolio Investment(In millions of U.S. dollars)
1990/911991/921992/931993/94Est.

1994/95
Total1651485855,1044,799
Foreign direct investment1651483446201,000
Automatic approval by Reserve Bank4389
SIA/FIPB approvals85240314
NRI schemes6261217
Foreign portfolio investment2424,4843,799
Equity2423,4903,464
FII11,7001,419
GDRs2411,4602,045
NRI10
Offshore funds320
Equity related99435
FCCBs99435
Bonds300
FRNs300
Source: Ministry of Finance.
Source: Ministry of Finance.

Most dramatic was the surge in Euroissues. In 1992/93, there were two global depository receipt (GDR) issues totaling $241 million, as the initial interest of foreign investors was dampened by the stock market scam in May 1992, as well as by related concerns about market practices and the collapse in stock prices (Chart 6.1). By contrast, in 1993/94 17 GDR issues raised $1.5 billion, and 10 foreign currency convertible bond (FCCB) issues raised a total of $1 billion (Tables 6.3 and 6.4). The bulk of issues occurred in early 1994 as the stock market recovered. Foreign investor enthusiasm rose to such a height that new GDRs could be issued at a premium to prices on local markets (Chart 6.2).

Chart 6.1.Bombay Stock Exchange Sensitivity Index (Sensex)

Source: Indian authorities.

1Standard deviation of daily changes over a six-month period.

Table 6.3.Indian GDR Issues
Year/

Month
Name of CompanySectorIndustrial GroupingNet Sales Rank1Issue Size (In millions of U.S. dollars)Market Capitalization2 (In billions of rupees)Ratio of Issue Size to Market Capitalization (In percent)GDR Premium over Domestic Price at Issue (In percent)Current GDR Premium Relative to Domestic Price at Issue3 (In percent)Current GDR Premium Relative to Current Domestic Price3 (In percent)
1992/93
MayRILDiversifiedReliance1150.461.67.4-13.7-1.78.4
Nov.GrasimDiversifiedBirla790.132.78.3-17.155.431.3
Total240.5
1993/94
JulyHindalcoAluminumBirla1972.025.68.8-48.59.7
Sept.SPICFertilizers1074.85.642.2-22.3-21.622.9
Oct.Bombay DyeingTextiles4250.010.415.1-2.621.6-6.2
Oct.ITCDiversifiedITC468.961.03.5-9.23.6-3.6
Nov.Mahindra and MahindraAutomobiles974.84.453.0-12.629.09.7
Jan.Great Eastern ShippingShipping79100.013.423.414.3-39.15.7
Jan.Indian RayonDiversifiedBirla25125.09.342.010.8-16.313.6
Jan.Indo-Gulf FertilizersFertilizersBirla58100.09.034.9107.617.512.0
Jan.Videocon InternationalElectricalsVideocon2690.06.742.06.4-52.010.5
Feb.Arvind MillsTextilesLabhai98125.06.956.410.6-50.51.9
Feb.Indian AluminiumAluminum3260.09.619.77.911.76.1
Feb.Jain IrrigationMiscellaneous30.012.5-48.9-0.1
Feb.RILDiversifiedReliance1300.061.615.3-3.9-25.76.4
Feb.Tata ElectricalPowerTata1875.07.630.94.8-34.327.7
Feb.United PhosphorusPesticides20455.04.241.3-3.7-39.55.0
Feb.WockhardtDrugs75.0135.3-28.2-6.0
Mar.Garden Silk MillsTextiles10545.01.780.5-5.1-72.0-22.1
Total1,520.5
1994/95
Apr.Calcutta ElectricityPower23125.04.098.8-1.6-49.3-14.7
MayDCWChemicals19125.02.236.2-15.0-13.710.7
MayTube InvestmentsTransport8045.01.4100.8-12.8-40.27.7
MayGrasimDiversifiedBirla7100.032.39.6-5.413.031.3
JuneCore ParenteralPharmaceuticals70.0-8.1-52.6-9.3
JulyRanbaxy LabsPharmaceuticals45100.08.337.9-11.613.021.5
JulyTelcoAutomobilesTata3100.042.87.3-7.131.125.0
JulyHindalcoAluminumBirla19100.025.612.3-19.94.39.7
JulyFinolex CableCables156100.03.296.4-16.7-36.01.1
JulyEID ParryDiversified8240.01.489.6-15.1-57.0-19.1
JulyDr. Reddy’sPharmaceuticals27548.02.364.0-30.0-31.70.5
Aug.Sanghi PolyesterTextiles27050.02.953.4-25.0-51.0-10.5
Aug.S.I. ViscoseTextiles11145.03.441.4-0.1-23.5-1.1
Aug.JCT Ltd.TextilesThapar7845.05.326.7-29.1-27.8-5.8
Sept.Century TextilesTextiles11100.029.710.6-10.0-39.7-6.3
Oct.E.I. HotelsHotelsOberoi207100.05.722.1-6.7-54.0-12.8
Oct.Gujarat NarmadaFertilizersGujarat public sector undertaking3555.08.620.1-4.915.931.8
Oct.India CementsCement6045.03.936.6-15.8-39.71.5
Oct.Usha BeltronCables35.0-24.8-12.19.9
Oct.J.K. Corp.DiversifiedSinghania55.0-8.0-44.1-2.8
Oct.Shriram Ind. Ent.DiversifiedShriram3640.018.26.9-22.9-42.1-3.4
Oct.Bajaj AutoAutomobilesBajaj12110.012.028.91.916.124.3
Nov.L & TMachinery6150.043.010.7-10.81.510.0
Nov.NEPC MiconDiversified48.0-24.7-46.70.2
Nov.Raymond WoolDiversifiedSinghania3560.09.719.5-18.1-25.4-6.1
Dec.IPCLPetrochemicalsCentral public sector undertaking100.0-10.714.210.1
Mar.Ashok LeylandAutomobiles16137.89.545.9
Total2,028.8
Sources: Ministry of Finance; and press reports.

Pertains to sales in 1992/93.

As of March 31, 1993.

As of April 21, 1995.

Sources: Ministry of Finance; and press reports.

Pertains to sales in 1992/93.

As of March 31, 1993.

As of April 21, 1995.

Table 6.4.Eurobond Issues by Indian Companies
Year/MonthCompany’s NameSectorTypeIndustrial GroupingInterest Rate1Tenor (In years)Currency DenominationAmount (In millions of U.S. dollars)
1993/94
JulyEssar GujaratSponge ironFCCB5.505.00US$75.0
Oct.Jindal StripsSteelFCCBJindal4.255.25US$60.5
Oct.RILDiversifiedFCCBReliance3.506.00US$140.0
Oct.SCICIFinancialFCCB3.5010.50US$100.0
Nov.Gujarat Ambuja CementCementFCCB3.505.50US$80.0
Dec.Sterlite IndustriesCablesFCCBKhaitan3.505.50US$100.0
Jan.Bharat ForgeForgingFCCBSF14.0
Feb.ICICIFinancialFCCB2.506.00US$200.0
Feb.Nippon Denro IspatSteelFCCB3.007.00US$125.0
Feb.TiscoSteelFCCBTata2.256.00US$100.0
Total994.5
1994/95
MayBallarpur IndustriesDiversifiedFCCB4.005.00US$35.0
JulyIDBIFinancialFRNLIBOR + 1105.00US$100.0
Aug.Essar GujaratSponge ironFRNLIBOR + 2655.00US$200.0
Total335.0
Sources: Ministry of Finance; and press reports.

Coupon rates for FCCBs.

Sources: Ministry of Finance; and press reports.

Coupon rates for FCCBs.

Chart 6.2.Portfolio Inflows

(Millions of U.S. dollars)

Source: Indian authorities.

Issuance continued to be heavy for the first eight months of 1994/95. A further 25 GDR issues raised $1.8 billion, while two floating rate note (FRN) issues raised $300 million. However, issues have slowed sharply since December 1994, against the background of generally unsettled conditions in international financial markets. Even before the Mexican crisis in mid-December, demand for Indian GDRs had weakened, and new GDRs were issued at significant discounts relative to prices of the underlying stocks on local exchanges. Moreover, there were signs of market saturation, and a number of issues were delayed or canceled. The pace of issuance was also affected by guidelines established by the Ministry of Finance, which was concerned at the liquidity effects of the capital inflows. From May 1994, issues were subject to restrictions on the end-use of funds, and new approvals for FCCB issues were limited to cases involving a restructuring of existing external debt. The guidelines were further modified in October 1994 to require that funds raised be held overseas until utilized for authorized investments.

Like Euroissues, direct share purchases by FIIs on local exchanges were initially slow but burgeoned in late 1993 to such an extent that existing custodial capacity became saturated and share transfer procedures needed to be streamlined.3 Net inflows through this route amounted to $1.7 billion in 1993/94 as a whole, with a further $320 million of FII funds being deposited in offshore accounts prior to investment in local markets (Table 6.5). Net inflows continued at an average of $175 million a month through October 1994, before tapering off in the last five months of the fiscal year. It is noteworthy that net inflows remained positive throughout the year, although there was some increase in sales by FIIs in the immediate wake of the Mexican crisis. By the end of March 1995, a cumulative total of over $3 billion had been invested in Indian equity by FIIs. By contrast, to date there has been virtually no investment in local debt instruments.

Table 6.5.Investments by Foreign Institutional Investors(In millions of U.S. dollars)
Year/MonthPurchasesSalesNet
1992/93
Jan.0.20.2
Feb.0.40.4
Mar.5.01.33.7
Total5.61.34.3
1993/94
Apr.1.60.11.5
May.13.40.113.3
June33.70.233.5
July46.30.745.6
Aug.81.04.676.4
Sept.57.41.256.2
Oct.61.02.458.6
Nov.351.43.2348.2
Dec.207.27.8199.4
Jan.411.718.1393.6
Feb.291.946.5245.4
Mar.245.965.6180.3
Total1,802.5150.51,652.0
1994/95
Apr.229.164.1165.0
May335.846.8289.0
June349.688.2261.4
July137.055.082.0
Aug.195.461.5133.9
Sept.293.262.8230.4
Oct.269.086.1182.9
Nov.98.188.010.1
Dec.118.6103.115.5
Jan.155.4106.948.5
Feb.129.765.064.7
Mar.127.272.055.2
Total2,438.1899.51,547.2
Sources: Securities Exchange Board of India; Ministry of Finance; and press reports.
Sources: Securities Exchange Board of India; Ministry of Finance; and press reports.

Direct investment inflows have also built up, albeit more slowly, rising to $344 million in 1992/93, $620 million in 1993/94, and an estimated $1 billion in 1994/95. The bulk of the investment has been in joint ventures; only about 10 percent of approvals have been for 100 percent foreign ownership. About one fourth of this inflow occurred through special share issues to foreign partners seeking to raise their stake in existing ventures. Actual flows are still small relative to approved investments: proposals amounting to about $6 billion were approved from August 1991 to March 1995, 85 percent of which were in priority sectors. Reflecting the more liberal framework, the Foreign Investment Promotion Board’s rejection rate fell from 40–50 percent prior to 1991 to under 10 percent in 1993, while about 30 percent of approvals have been through the automatic route.

Investor Base

To date, the investor base for portfolio flows to India has been relatively narrow. The bulk of funding has come from regional and country funds aimed primarily at individual equity investors. During 1993/94, 11 India-dedicated country funds were launched, raising a total of $2.7 billion. Market participants suggest that these funds were targeted mainly at U.S. and U.K. individual investors, although a portion of the resources—perhaps around one fourth—is believed to have been contributed by nonresident Indians or returning “hawala” money (that is, flight capital). Interest from other Asian investors has been mainly from Hong Kong; Japanese portfolio investment has been limited in part because Indian stock exchanges have not yet been approved by the Japanese Ministry of Finance.4 Some of the FII inflows have come from hedge funds, which take an aggressive approach to portfolio management. Interest to date from pension funds and other institutional investors has apparently been limited.5

About one third of approved direct investment has involved U.S. companies. Other important investors include European Union countries, Japan, Switzerland, and nonresident Indians.

Comparison with Other Countries

India’s recent experience with portfolio inflows has been part of a broader phenomenon of increasing access by developing countries to private capital. Indeed, in comparison with a number of other countries in East Asia and Latin America, if not to its own past, the scale of total flows to India has remained modest (Table 6.6). Nonetheless, foreign investment flows to India have been substantially larger than those to neighbors in South Asia, even taking into account the smaller size of their economies.

Table 6.6.Direct and Portfolio Investment in Selected Developing Countries, 1993–94
Net Direct

Investment
Net Portfolio

Investment
TotalTotal Relative to
GDPExportsInvestmentBroad money
(In billions of U.S. dollars)(In percent)
India1.387.098.471.614.27.93.2
Neighbors
Bangladesh0.540.320.860.21.61.20.4
Pakistan0.720.720.75.23.71.7
Sri Lanka0.320.321.55.45.64.7
Other Asia
China35.116.6841.794.920.711.24.2
Indonesia4.104.101.45.34.02.9
Korea-0.9117.7216.812.49.86.65.6
Philippines2.712.765.472.511.310.07.5
Thailand2.224.947.162.79.07.03.3
Latin America
Argentina8.5721.3029.875.6107.328.932.3
Brazil0.3091.4491.147.9114.639.617.4
Mexico10.4817.7328.203.938.016.96.9
Europe
Hungary3.883.885.320.926.39.8
Turkey1.224.926.142.819.02.97.8
Source: International Monetary Fund, World Economic Outlook database.
Source: International Monetary Fund, World Economic Outlook database.

The concentration in equity portfolio flows rather than in debt or direct investment has been a major difference between the Indian experience and that of other recipient countries. In Latin American countries in particular, international bond issues and investments in local currency debt instruments (including bank deposits, certificates of deposit, and treasury bills) have accounted for a large share of the total. In India, by contrast, the Ministry of Finance has kept a tight check on international debt issues (including convertible bonds) as a means to control overall indebtedness, while foreign use of bank accounts in India has remained restricted to transaction purposes. Another factor discouraging foreign interest in local debt instruments has been that secondary markets for such instruments (such as government securities and bonds issued by public sector undertakings) have tended to be illiquid, particularly since the discovery of trading malpractices in public sector bonds at the time of the stock market scam.

Regarding direct investment, actual flows relative to GDP in India remain much smaller than in the successful East Asian countries and a number of Latin American countries, in large part because the reforms were launched much later in India than in these countries. The realization of projects has also been slowed by the need to establish appropriate policy frameworks for sectors—like hydrocarbons, power, and telecommunications—only recently opened for private participation. In addition, a number of institutional concerns remain entrenched that have dampened investor interest, including bureaucratic procedures, inflexible labor policies, and a slow-moving legal system (Bhattacharya (1994)).

The Indian experience has also differed from that of other countries in the degree to which foreign investment has been concentrated in the private rather than the public sector. Again, the contrast is particularly sharp with Latin American countries where the re-entry into capital markets was spearheaded by sovereign bond issues and foreign investments connected with privatization. In India, foreign investment into the public sector has been largely limited to FII purchases of shares disinvested by the government. To date, only two public sector companies have issued GDRs, both at the tail end of the surge in issuance, probably because of their lack of autonomy in decision making, which restricts their flexibility in approaching the market. For instance, a jumbo issue by the state telephone company (Videsh Sanchar Nigam Ltd.) was withdrawn from the market in May 1994 after it became apparent that the issue could not be completed at the originally anticipated price.

Factors Behind the Flows

Both external and internal factors accounted for the global surge in private capital flows to developing countries.6 India was no exception to this pattern. The external factors were both cyclical and structural. On the cyclical side, the slow and uneven recovery in industrial countries in 1992 and 1993 implied a depressed global demand for capital and low anticipated rates of return for most assets. Structural changes in international financial markets that encouraged flows to developing countries include the growing importance of professional investment managers in allocating savings, the increasingly global availability of information, and the introduction of instruments to hedge against different sorts of risks. All of these trends served to promote the diversification of international portfolios. On the internal side, foreign investment was attracted to developing countries that have combined dynamic growth performance and prospects with an “investor friendly” environment. Capital inflows were also encouraged by high domestic interest rates relative to international levels. As far as India is concerned the following factors are noteworthy:

  • The basic characteristics of the economy were favorable: the existence of well-known corporate names with established track records of performance; reasonably developed stock markets; familiar accounting and legal systems; and the potential for growth implied by a large market, cheap labor, and extensive natural resources.7

  • The structural reforms launched in 1991 enhanced the growth prospects of the Indian corporate sector. Particularly relevant were the elimination of industrial licensing restrictions, liberalization of the trade regime, and the opening up to the private sector of a number of activities previously reserved for the public sector.

  • Liberalization of restrictions on foreign portfolio investment set in motion a process of portfolio adjustment. Foreign investors were aware that the Indian stock exchanges represented about 6 percent of emerging equity market capitalization and 0.7 percent of global equity market capitalization (International Finance Corporation (1994a)).8 Similarly, reduced restrictions on foreign ownership allowed a number of companies to raise their stakes in joint ventures.

  • Domestic firms were encouraged to approach external markets by the low cost of foreign financing relative to domestic financing. This situation reflected (1) the combination of a relatively tight monetary policy with a less restrictive fiscal stance and a heavy overhang of public sector debt that kept domestic borrowing costs high and the external value of the rupee stable, and (2) institutional factors—such as minimum bank lending rates, high intermediation costs, and legal requirements for domestic capital issues—that have added to the cost of domestic financing.

Table 6.7.Sectoral Distribution of Foreign Investment, 1991–94(In millions of U.S. dollars)
Net

Purchases

by FIIs1
GDRs2Eurobonds2Foreign Direct Investment3
AmountNumberAmountNumberAmountNumber
Manufacturing1,4472,4653579093,9301,569
Basic5287871165571,611305
Electricity12620027117
Mining57
Capital16413521001288468
Consumer6721,018141,199723
Intermediate8245183173
Diversified4807351
Services59814024003896275
Of which:
Financial308400329645
Health care109614
Hotels4240123241
Shipping4710013118
Telecommunications926027
Diversified435151931401151274
Total2,3963,124401,330134,9772,118
Sources: Ministry of Industry; and press reports.

In local exchanges. Through July 27, 1994.

Through October 31, 1994.

Based on approvals data only. Through June 30, 1994.

Figures for net purchase by FIIs and direct foreign investment include investment in the diversified manufacturing company.

Sources: Ministry of Industry; and press reports.

In local exchanges. Through July 27, 1994.

Through October 31, 1994.

Based on approvals data only. Through June 30, 1994.

Figures for net purchase by FIIs and direct foreign investment include investment in the diversified manufacturing company.

Impact on the Economy

Impact on Firms

The recent surge of foreign investment substantially increased the availability of funding to the Indian private sector. Total foreign investment amounted to $5 billion in 1993/94, compared with domestic capital market issues by nongovernment public limited companies of $6.2 billion and disbursements by financial institutions of $8.4 billion (Table 6.7).9 To a degree, this increased funding was focused on the leading blue-chip companies: about half of GDR and FCCB issues to date have come from firms in the top 20 (ranked by sales), in industries such as automobiles, chemicals and fertilizers, metallurgical industries, power, and textiles (see Table 6.3).10 But smaller, fast-growing companies in high-technology areas such as pharmaceuticals have also successfully issued GDRs. FII and foreign direct investment inflows have gone to a much more diverse set of companies across a range of sectors, including the services sector as well as manufacturing (Table 6.8).11 FII money has been invested in over 500 different companies. While initially interest was mainly in the larger, more liquid stocks, over time attention has shifted to smaller but fast-growing companies. About 70 percent of the total amount has been invested in the “cash” segment of the Bombay Stock Exchange, which comprises smaller, less liquid stocks.

Table 6.8.Domestic and External Financing
1991/921992/931993/941991/921992/931993/94
(In millions of U.S. dollars)(In percent of GDP)
Domestic financing
Term loans from Indian financial institutions16,4668,6818,3802.63.23.2
New capital market issues22,3477,5076,2170.92.82.4
Equity and preference shares7063,7793,2340.31.41.3
Debenture issues1,6413,7272,9830.71.41.2
Equity related external financing1485855,1040.10.22.0
Foreign direct investment1483446200.10.10.2
Foreign portfolio investment2424,4840.11.7
FII inflows11,7000.7
GDR issues2411,4600.10.6
FCCB issues9940.4
Other3300.1
Memorandum item:
Private investment35,15239,00536,15414.014.61.40
Sources: Reserve Bank of India; and IMF staff estimates.

Such as the Industrial Development Bank of India and the Industrial Credit and Investment Corporation of India.

Issues by nongovernment public limited companies.

Sources: Reserve Bank of India; and IMF staff estimates.

Such as the Industrial Development Bank of India and the Industrial Credit and Investment Corporation of India.

Issues by nongovernment public limited companies.

A key question is to what extent increased access to foreign funds has been used to finance new investments. In principle, GDR issues are related to new investment projects.12 However, data collected by the Ministry of Finance indicate that through the end of September 1994 only 28 percent of funds raised by companies prior to the imposition of end-use guidelines was used for capital equipment. About 17 percent of the funds had been directed at balance sheet restructuring, in particular, reducing high-cost external and domestic borrowings. The remainder was mainly placed in liquid investments, including unit trusts (which are similar to mutual funds) and government paper. The slow initial response of investment may be attributable to a variety of factors:

First, the timing of fund-raising need not coincide with the timing of use of funds. Firms will tend to raise resources when market conditions are judged to be favorable even if the financing is not required for some time. Moreover, investment spending will be distributed over time as a project proceeds while fund-raising will be concentrated to minimize transactions costs.

Second, with high domestic interest rates, firms have a legitimate desire to reduce high-cost domestic funding from commercial banks and term lending institutions. Strengthening of the balance sheet is typically a precursor to embarking on major capital investments.

Third, since money is fungible and the inflow of foreign resources is only a fraction of a company’s cash flow, end-use restrictions on the deployment of foreign investment may not be very effective. Firms may not have too much difficulty in assigning new foreign investments to capital projects that would be undertaken even in the absence of foreign funding.

There is increasing evidence from production and import data that capital spending grew quite strongly in 1994/95. This would be consistent with strong investment growth stimulated by increased access to foreign financing (and the economic reforms more generally), as capital investment projects move into the implementation phase and as companies complete their balance sheet restructuring.

Macroeconomic Impact

Against the background of a deteriorating fiscal position and slow initial investment response, the immediate impact of the surge in foreign inflows was to generate a rapid increase in domestic liquidity. The counterpart was an accumulation of international reserves as the Reserve Bank intervened to avoid an exchange rate appreciation. To a degree, the increase in liquidity may have made it easier for companies that did not have direct access to international markets to fund their own investment projects through banks or the capital markets. However, the easing of credit conditions is also likely to have contributed to higher consumption (for example, as firms’ resistance to wage pressures was relaxed), rising inflation, and an appreciation of the real exchange rate.

Table 6.9.Liquidity Impact of Capital Inflows
1991/921992/931993/941994/95
(In millions of U.S. dollars)
Change in net international reserves-2202,5828,2344,895
Direct and portfolio investment1485855,1044,799
(In billions of rupees)
Change in reserve money117.3112.7278.4304.0
Change in net foreign assets108.638.1287.7233.0
(In percent)
Reserve money growth113.411.325.121.9
Contribution of net foreign assets212.43.826.016.8
Memorandum item:
Broad money growth19.315.718.221.4
Source: Reserve Bank of India.

Annual rate.

Change in net foreign assets as percent of beginning-period reserve money; annual rate.

Source: Reserve Bank of India.

Annual rate.

Change in net foreign assets as percent of beginning-period reserve money; annual rate.

The scale of the initial impact on liquidity can be seen from the fact that the $8.2 billion increase in net foreign assets of the Reserve Bank in 1993/94 corresponded to 26 percent of reserve money at the start of the year (Table 6.9). Although not the only factor, foreign investment flows accounted for a substantial part of this increase. Open market operations totaling $2.9 billion mitigated the effects of the large fiscal deficit, but were insufficient to contain the monetary impact of the rapid accumulation of foreign assets. Reserve money increased by 25 percent, inflation rose from 7 percent in March 1993 to about 12 percent in March 1994, and the real effective exchange rate appreciated by about 4 percent.

In 1994/95, with efforts to correct the fiscal slippage and with a growing recovery of investment, capital inflows were absorbed more easily. The moderation in the rate of inflows, together with a widening in the trade deficit as the economic recovery-gathered momentum, contributed to a slowing in the rate of growth of net foreign assets. Steps to tighten monetary policy—including a hike in cash reserve requirements—and the limited expansion of net Reserve Bank credit to the government as the fiscal position improved also helped to dampen money growth. Inflation remained in double digits for most of 1994/95 but came down toward the end of the year as the monetary tightening took effect. The real effective exchange rate also depreciated, as the U.S. dollar weakened against third countries.

Interestingly, so far the capital inflows have not had a marked impact on the current account of the balance of payments. The current account deficit in fact contracted from 2 percent of GDP in 1992/93 to virtual balance in 1993/94. A small deficit (about ½ of 1 percent of GDP) was recorded in 1994/95. To a degree, this moderate response may be attributable to the still relatively closed nature of the Indian economy, particularly the heavily protected consumer goods sector; stronger domestic demand did not immediately lead to higher imports. However, the current account deficit is likely to widen as imports pick up and exports are diverted to the domestic market.

Impact on Financial Markets

To date, the impact of foreign capital flows on Indian financial markets has been more qualitative than quantitative. Total FII investment on Indian stock exchanges is considerably less than 5 percent of market capitalization, and FII transactions have not exceeded 10 percent of market turnover in any single month. The introduction of foreign investment in Indian equity has not added significantly to market liquidity or to the volatility of stock prices.13 Nevertheless, the presence of FIIs in Indian markets has probably contributed to a process that was already under way—the growing role of the wholesale capital market and the evolution of the institutions and financial structures to support it.

Historically, the Indian capital market has been essentially retail based. There are a large number of stocks (over 3,000 companies are listed on the Bombay Stock Exchange), a large number of investors (by one estimate, there are 30 million shareholders), small lot sizes, and a multitude of small intermediaries other than the major publicly owned financial institutions such as the Unit Trust of India. The development of secondary markets has been hampered by limited liquidity and cumbersome transfer and settlement procedures. Elements of a modern financial system have begun to emerge recently, including the growing importance of investment banking activities and the emergence of private mutual funds. The FIIs have added another group of institutional investors with sophisticated needs and concerns. This has given additional momentum to efforts to improve market efficiency and transparency, including to overhaul settlement and transfer systems, introduce screen-based trading, tighten regulatory safeguards, and introduce new financial instruments such as derivatives for better risk management.

A particular question is whether the emergence of an offshore market in Indian equity—the GDR market—has had a significant impact on domestic markets in the underlying shares, as has occurred elsewhere. For example, following the launching of a $3 billion GDR program, shares in the Mexican telephone company—Telmex—are mainly traded on the New York Stock Exchange, and prices on the Mexican Bolsa de Valores follow in step. However, to date links between the offshore market for Indian GDRs and local markets have been limited. Substantial discounts or premiums of GDR prices relative to local prices have tended to persist over time, particularly for the smaller companies (Chart 6.3). Moreover, GDR prices of Indian companies have tended to be more volatile than the prices of those companies on the Bombay Stock Exchange (Chart 6.4). As shown in Chart 6.5, an upward movement of prices on the Bombay Stock Exchange has tended to be associated with an increase in the GDR price relative to the Bombay Stock Exchange price, and vice versa.

Chart 6.3.Discounts or Premiums of GDR Prices Relative to Prices on the Bombay Stock Exchange

(In percent)

Source: Indian authorities.

Chart 6.4.Share Price Volatility of Companies Issuing GDRs1

Source: DSP Financial.

1Volatility measured as standard deviation of daily price change over a six-month periods.

Chart 6.5.GDR Price Premium and Change in Bombay Stock Exchange

(In percent)

Source: Indian authorities.

The principal reason why arbitrage does not lead to price convergence relates to the high transactions costs involved in moving between the markets: liquidity in both markets is low; there are considerable settlement risks in buying or selling shares on local markets; registration of shares can take three months or more; and the process of converting a GDR into its underlying shares is cumbersome. Arbitrage is further limited by the fact that the investor base for the two markets is segmented. Only approved FIIs are players in both markets, and their willingness to arbitrage is affected by tax laws that favor holding periods of greater than one year.

Sustainability of Capital Flows

It seems unlikely that equity portfolio flows will soon return to the rates experienced in late 1993/94 to early 1994/95 as institutional investors reappraise the risks of investing in emerging markets. Nevertheless, the prospects are still favorable that, with sensible macroeconomic and reform policies that foster strong growth and capital market development, India will continue to attract substantial, even rising, levels of private capital inflows.

The desire to diversify portfolios will continue to encourage foreign portfolio investment into India, both through direct purchases on local exchanges and through GDR issues. Market reforms to improve transparency and efficiency of trading—including the spread of screen-based trading and the setup of a centralized depository system—would also help to sustain these flows by making the Indian market more attractive.

Direct foreign investment will become increasingly important. The rate of such inflows has increased markedly in 1995. Such investment should rise dramatically with increased private involvement in infrastructure projects in the telecommunications and power sectors, once appropriate frameworks have been established in these sectors (see Section VII). External commercial borrowing will also continue, particularly in financing infrastructure projects.

In view of concerns about external indebtedness, FIIs may not hold more than 30 percent of their portfolios in debt instruments. Initially, the 30 percent rule applied to each individual fund administered by an FII. This restriction was relaxed in December 1993 to be applied to each FII’s portfolio as a whole.

Capital gains tax is avoided altogether by investment funds registered in Mauritius, which sets no capital gains tax and has a double taxation treaty with India.

These included the introduction of jumbo transfer certificates and simplification of procedures for application of stamp tax.

Japanese-based securities houses can only undertake transactions on approved exchanges on behalf of their clients. Lack of transparency and problems with trading rules have been cited as reasons for noninclusion of Indian exchanges in the list of approved foreign stock exchanges issued by the Japanese Ministry of Finance.

See Goldstein and Folkerts-Landau (1994) for more general background on the investor base for recent private flows to developing countries.

See, for example, the discussion in International Monetary Fund (1994), Chapter IV, and in Dunaway and others (1995).

Other South Asian countries may have attracted far less portfolio investment than India because of their generally less well-established corporate sectors and stock markets.

Indian stock markets historically have had relatively low degrees of covariances of returns with other markets, given that the Indian economy is large and relatively closed. The correlation between the Bombay Stock Exchange Sensex index and the S&P 500 in the five years ended March 1994 was 28 percent, lower than most other major emerging markets (International Finance Corporation (1994b)). This low correlation means that Indian stocks can be particularly attractive for risk diversification purposes.

Secondary market purchases by FIIs ($0.7 billion) are included as foreign investment in this comparison even though the receipts accrue in the first instance to domestic investors rather than to the companies concerned. The inflow from the FIIs created conditions conducive to domestic equity issues, and thus contributed to increasing the availability of funding to Indian companies.

Data for foreign direct investment in Table 6.7 are based on approvals and needs to be treated with caution. For example, actual foreign direct investment flows into the power and telecommunications sectors to date have been very limited.

Note, however, that foreign investment may be geographically quite concentrated. About 75 percent of foreign direct investment approved in 1993/94 was directed at only five states (Maharashtra, Delhi, Orissa, Tamil Nadu, and Madhya Pradesh). These are states that have established a reputation for a business-friendly environment.

Euroissue prospectuses describe the intended use for the resources. In almost all cases, this has involved new investment projects. GDR issues approved under the new Finance Ministry guidelines are also required to be used predominantly for capital investment.

In a cross-country study of emerging markets, Aziz (1995) reports that Indian stock price volatility has increased since FIIs have been permitted to participate. However, this conclusion is based on a very broad time comparison: the period 1976—May 1992 compared with the period June 1992–February 1994. If one looks at a shorter time span, the opposite seems to be the case: price volatility has declined since mid-1992 compared with the previous two and a half years (see Chart 6.1). A number of factors, however, may account for this decline other than the opening of the market. Thus, firm conclusions should not be drawn from this observation.

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