The Big bang announcements announced before Pranab Mukerjee vacated the FM’s seat included increasing foreign institutional investor (FII) limits in Indian government bonds by $5 billion and increasing the overall ECB limits for Indian corporates by $10 billion.
The headlines on Manmohan Singh as FM meeting finmin officials say the idea is to revive animal spirits in the economy, and improve investor sentiment by increasing dollar flows into the country. Unfortunately, the government believes that by letting in more dollar flows into the country and dollarising the balance-sheet of the economy, the economy will get back to an unfettered growth path.
The fact is that as the economy depends more on dollar flows for investments, the accountability of the economy to foreign capital increases. The government has to commit itself to fiscal responsibility, financial sector reforms, reducing current account and trade deficit, tackling inflation and improved governance. If the government is not able to commit itself to improving the macroeconomic fundamentals, foreign capital will create havoc in the economy by large scale withdrawals. The average Indian gets hurt in this process.
India has seen the effect capital flows can have on a non-committal government. The rupee is at record lows of over Rs 57 to the dollar, broad equity indices are in negative territory over a four-year period, inflation is staying sticky at high single-digit levels and interest rates are staying high despite an economic slowdown. FII flows in equity have been volatile over the last four years with two years of negative flows (2008 and 2011) and two years of positive flows (2009-2010) and these inflows and outflows are causing euphoria and depression in the economy – as seen by the rise and fall in GDP growth. Table 1 gives the GDP growth and FII flows data since 2008.
The government is also seeing the trends as shown in Table 1 and is mistakenly assuming that economic prosperity can only be achieved by foreign capital flows. It is true that economic growth is pulled up by strong capital flows but when the flows dry up, the withdrawal symptoms are felt by the average man on the street as most of the benefits of the flows go to a chosen few, including corrupt businessmen, bureaucrats and politicians.
India is now tied closely to how the FIIs view the country. FIIs account for around 14.9 percent of India’s total market capitalisation as per a study by Business Standard. FIIs’ debt investment limit stands at $65 billion, up five-fold over the last few years. FIIs’ view on India depend on two factors: a) domestic economic fundamentals, and b) global economic fundamentals. The government does not have control over the global economic fundamentals but it definitely has control over domestic economic fundamentals.
The eurozone debt crisis or China’s hard landing have an effect on capital flows to India. At the same time India’s fiscal deficit, inflation and political scenario also have a bearing on capital flows. If India cannot manage its economy properly, capital flows will turn negative, leading to a sharp fall in growth. India’s democracy also gives rise to political risk, especially when the government is in a coalition. If political equations change, there is a strong possibility of early polls, hung parliament and other such uncertain scenarios. In such politically turbulent times, it would be a disaster for the country if the FIIs hold back investments or take out money.
It is imperative that instead of focusing on allowing FIIs to play a bigger role in the country, the government should focus on improving the macroeconomic fundamentals. If it can achieve the latter, the former is a breeze.
Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.