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Contemporary Issues and Ideas in Social Sciences 2012

Foreign Portfolio Investment in India and Plausible Exchange Rate and Interest Rate Regimes: Policy Options Open to the RBI
Hiranya Lahiri1 Jadavpur University, Kolkata, India Abstract In order to protect the export and the import-competing sector of the economy, RBI often intervenes in the foreign-exchange market. Also, through daily operation of Liquidity Adjustment Facility (LAF), RBI regulates the interest rate. In this theoretical paper, I access the impact of Foreign-Portfolio Investment on real macro-variables under dierent plausible exchange rate and interest rate regimes. Using the Mundell-Fleming framework, I analyze the impact of FPI under xed and exible exchange rate without and then with interest rate regulation, under imperfect and perfect capital mobility regime. Comparing all these cases, I conclude that the correct package for the country is the one that RBI embarks. However this regime will be unsustainable during massive FPI exodus. This paper then analyzes the essential
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The author wishes to thank Prof. Ambar Nath Ghosh, Dr. R.N. Nag, Ms. Rilina

Basu and an anonymous referee for helpful comments and suggestions. Email: hiranyaeco@gmail.com

parameters that RBI must consider in maintaining an adequate forex reserves to make this system work during any massive capital exodus. JEL Classication Code : F31, F32, F41 Key word : Foreign Portfolio Investment, Output, Investment

Lahiri: Foreign Portfolio Investment in India

Introduction

Since the beginning of the nineties, India has opened up more and more to foreign capital inows. Of this total ow, Foreign Portfolio Investment (FPI) has registered a gradual increase in its share in total inows. The amount of FPI has increased from USD 4 million in 1991 to USD 32375 million in 2009. Since FPI do not add to the productivity of investment, it does not contribute to the growth of the nation. On the other hand, the sudden capital inows and outows that the country has experienced from time to time has resulted in much volatility in interest rate and in the exchange rate. Also, sudden capital inows often tend to appreciate the exchange rate, detrimentally aecting the export sector. Thats why; RBI intervenes in the foreign-exchange market whenever the exchange-rate surpasses the comfortable limits. Similarly, to contain volatility in the interest rate, RBI allows the interest-rate to uctuate within a narrow band, called the LAF corridor. Under the LAF regime, the RBI allowed the interest rate to uctuate within the repo and the reverse-repo rate, where both the rates were independently set. However the RBIs Monetary Policy Statement of 2011-12 has started with a new Marginal Standing Facility (MSF) scheme which has revised the LAF corridor with a xed width of 200 basis points. The policy statement of the RBI (pp 12) quotes that: The reverse repo rate will continue to be operative but it will be pegged at a xed 100 basis point below the repo rate. Hence, it will no longer be an independent rate. The revised corridor will have a xed width of 200 basis points. The repo rate will be in the middle. The reverse repo rate will be 100 basis points below it and the MSF rate 100 basis points above it. The rationale behind LAF is the following: Output responds more to changes in interest-rates than through credit channel (Report on Internal Group on Liquidity Adjustment Facility, 2003). Since, LAF targets the interest rate by

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maintaining it within the LAF corridor, the need to tamper with broad-money supply has been reduced. Thus, the RBI operates more through interest rate rather than through CRR and SLR to aect target variables in the short run. Free capital movement across international borders is advocated on the ground that foreign capital is necessary to supplement domestic savings and contribute to capital formation (especially in LDCs) and greater risk sharing among countries (Fisher, 1998; Summers, 2000) and also on the ground that an open capital account imposes costs on loose monetary policy by posing the risk of capital outow (Guben and Mc. Leod, 2002; Sengupta, 2008), and thus, puts a rein on ination. However these authors neglect the fact that these arguments may not be valid for short-term capital ows which are volatile and cannot be put to use for investment purposes due to its quick reversibility, an aspect which this paper captures. Also, none of these authors carry out the comparative static exercise of the eect of FPI ows on output, investment, trade balance and other macro-variables under dierent regimes of exchange rate and interest rate intervention, which this paper focuses upon. This paper further contends the need for protection required for the export and the import competing sector of the domestic economy; by bringing in the dimension of exchange rate intervention as an essential policy measure. The paper seeks to answer what should be the policy regimes of the RBI to protect the economy from the perils associated with FPI, as unrestricted and huge amount of capital inow leads to upward pressure on the domestic currency and harms the export and import-competing sector, so much so that a country might permanently loose its export market (Dornbusch,(1986); Rajan and Subramanian, 2005; Johnson et. al., 2007; and Prasad et. al., 2007). Further, exchange rate movement can lead to shock on commodity prices which might imply a challenge to an otherwise stable inationary regime. These authors neglect the need for interest rate regulation required to oset the fallout on

Lahiri: Foreign Portfolio Investment in India

the money market due to exchange rate intervention. This paper adds this aspect to the literature by considering LAF and MSF as a means to insulate money-market participants from the volatility in interest rate. Calvo and Reinhart (2000) point out that even though economies move to a exible exchange rate regime, the central banks often intervene indirectly by tampering with the interest rate and other policy instruments to aect the behavior of the exchange rate. This paper supports these claims and shows that despite the limitations of a xed exchange rate regime, this is indeed the correct regime for India to manage FPI ows. However, exchange rate regulation, particularly maintaining a xed exchange rate regime possesses the gauntlet of speculative attack on the currency (Obstfeld and Rogo, 1995; Bhalla, 1998; Fischer, 2001; Kim and Yang, 2008). These authors enumerate evidences from other nations which maintained a xed exchange rate regime and had an attack on their currencies. For example, Obstfeld and Rogo (1995) argue that pegged exchange rate regime has a short life span. According to these authors, one reason for the capital market crisis in countries like Mexico (in 1994), Thailand, Indonesia and Korea (in 1997), Russia and Brazil (in 1998) and Argentina and Turkey (in 2000) has been the xed exchange rate regime pursued in these countries. On the other hand, Mexico, South Africa and Israel did not face any crisis for having a exible exchange rate regime in 1998 (Fischer, 2001). Though the arguments adduced by these authors merit claim, it must also be noted that India did not face any such crisis due to capital controls. Moreover, none of these authors considered the deleterious eect of FPI ows on output under exible-exchange rate, which this paper shows. One way of dealing with capital inow has been monetary expansion to reduce the interest rate (Kim and Yang, 2008). However, this process can be inationary as reduced interest rate associated with expansionary monetary

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policy might lead to an increase in investment demand leading to demandpush ination. Thus, this policy is not workable for an economy like India without an inationary episode. This paper illustrates how the central bank can deal with capital inow without monetary expansion by intervening in the money market and foreign exchange market together, under a regime of imperfect capital mobility. The purpose of this paper is to nd out what can be the correct policy regime for India to manage the FPI ows and insulate the domestic economy from the perils associated with the ow of FPI. At the heart of the analysis, lies the Mundell-Fleming Model. We have developed a version of MundellFleming model (MFM) that suites India. Mundell (1962, 1963) and Fleming (1962) have independently worked out the ecacy of monetary and scal policy under xed and exible exchange rate regime with the assumptions of small-economy, perfect-capital mobility, rigid-prices and static-exchange rate expectations. They both arrived at the same conclusion that monetary policy is impotent under xed-exchange rate and most eective under a exible-exchange rate regime, and vice-versa for scal policy. We extend the Mundell-Fleming Model in the Indian context and then seek to nd out the eect of capital inow on the variables of interest. We note that India is a small country with imperfect capital mobility. The RBI, DIPP, SEBI, Ministry of Commerce imposes dierent types of restrictions on the exit and entry of capital. Hence, the usual assumption of perfect-capital mobility in MFM is not valid in this context. The RBI seeks to stabilize the interest rate through Liquidity Adjustment Facility. We incorporate this in our model through the assumption that the government is willing to borrow and lend as much as the public wants at a xed interest rate which we denote by i . The rest of the paper is arranged as follows; Section 2 extends the MFM in the context of a small open econ-

Lahiri: Foreign Portfolio Investment in India

omy and initially under an imperfect capital mobility regime, and access the impact of capital inow on output, investment and import under exible and xed exchange rate regime; initially without and then with interest rate regulation. Finally it compares the following cases and chooses the best package for the economy. Section 3 tests the predictions of the results derived in section 2 by looking at the data. Section 4 draws a conclusion and possible extensions of this paper.

The Model

We shall now lay down the Mundell-Fleming Model for a small open economy with imperfect-capital mobility, to access the impact of capital-inow/ outow on domestic output and other macro-variables. We assume that prices are rigid and India is a small country with capital-controls.

2.1

Eect of FPI Inow without Interest-Rate Targeting

We begin with the case of exible exchange rate regime. The goods market equilibrium condition, which is the equation of the IS curve, is given by: Y = A(Y, i) + T (e, Y ) (1)

In equation (1), A() and T () represent domestic absorption and tradebalance respectively. Interest rate and real exchange rate is denoted by i and e respectively. The cross-partials are given as follows: AY > 0, Ai < 0, Te > 0 and TY < 0.

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We focus now on the money market. To simplify matters we assume that there is only the central bank and no other nancial institutions. The equation of LM curve is given by: D = L(i, Y ) (2)

Where D is the domestic credit issued by the RBI and is therefore the supply of loanable funds. L(i, Y ) denotes the money demand. Here, LY > 0 and Li < 0. Finally, the Balance-of-Payment condition, which is the ow of foreign reserves, is given by: T (e, Y ) + K + C (i i ) = 0 (3)

where Ci < denotes imperfect capital mobility and i denotes foreign interest rate. The L.H.S is composed of two accounts: the current account (i.e. trade balance here) and the capital account. The capital account is in turn decomposed into two parts: an autonomous part which is not-interest sensitive (K ) and an interest-sensitive part [C (i i )]. The former in turn is dependant on investors expectations about the performance and fundamentals of domestic economy, expectation about reforms in the country, changes in political regime, prevailing corruption etc. This has in it the very volatile component of ow of foreign reserves, and is primarily composed of FPI. The specication of our model is now complete. Our model comprises of three equations (1), (2) and (3). There are three endogenous variables Y , i ande. G, D are policy variables. K and i are exogenous to the model. Thus, the model is exactly determined. Regarding the slopes of the IS, LM and BOP schedule, dierentiating the above three equations, we get the slopes of the three curves (see Appendix). In i-Y plane, the former curve is downward sloping while the latter two are positively sloped. The LM curve can be steeper or atter than the BOP curve, depending on the responsiveness

Lahiri: Foreign Portfolio Investment in India of capital ow, due to change in interest-rate dierential.

Let us now assume a sudden capital inow which is not induced by any change in the interest-rate dierential between i and i . In this case of exible exchange rate regime, the entry of foreign capital will put upward pressure on the exchange rate (e). As a result, this will worsen the trade balance of the country by reducing home export and increasing homes import of foreign good. This will manifest in an inward shift of the IS curve from IS0 to IS1 (see gure 1). The LM curve will however not shift as domestic credit remains unchanged. As a result domestic output will decrease. In gure 1, nal equilibrium is marked by point E1. The improving of the trade-balance (due to reduced import) implies BOP is in surplus at E1, and thus, FF curve will shift from F F0 to F F1 . This equilibrium point is compatible with a lower interest rate. The reason is clear. With unchanged domestic credit, there arises an excess supply of loanable funds due to the decline in the transaction demand for money (which in turn is due to the decline is equilibrium output to Y1 ). Thus to clear the money market, interest rate has to fall in order to raise the speculative demand. The decline in interest rate leads to an increase in investment, which osets some of the initial decline in output. However, equilibrium output decreases from the initial level. Mathematically, we can derive the expressions for the change in output, interest rate and exchange rate by dierentiating the above equations w.r.t. K and solve for
Y , i K K

and

e K

. These values are given respectively by:

Y = 0 Li K 1 Ci

0 Ai

Te

(4)

Li Te 1 / = < 0 Te

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i = K

(1 AY TY ) 0 Te LY TY 0

(5)

LY Te 0 / = < 0 1 Te

e = K

(1 AY TY ) Ai LY TY Li Ci

(1 AY TY )(Li ) Ai LY <0 0 / = 1 (6)

Where, = Te [Li (1 AY ) + LY (Ai Ci )] < 0 Therefore, volatile capital inow will make output not only volatile but will come at the expense of the external sector, so much so that it will reduce the output. Thus, exible exchange rate will have deleterious eect on output whenever foreign capital enters the economy. Opposite will hold when FPI ows out of the country. As pointed out in section 1, FPI are highly volatile and can get reversed in a moments notice. Hence what matters is not whether output increases or decreases, but the volatility that will be caused on output, exports and investments. This will leave detrimental eect on employment in the export and the import-competing sector as well as on debtors and creditors in the money market. Let us now consider the eect on FPI inow under the case of xed exchange rate, without interest rate targeting. The product market equilibrium is given by: Y = A(Y, i) + T ( e, Y ) (7)

Lahiri: Foreign Portfolio Investment in India

Where, e denotes xed exchange rate. The meaning and restrictions on the parameters are same as before. The money market equilibrium is given by: D + B = L(i, Y ) (8)

where B denotes the ow of foreign reserves (we assume initial value of B = 0), which in turn is the sum of current and capital account and is given by ,: B = T ( e, Y ) + K + C (i i ) (9)

The specication of the model is complete. There are three equations (equation 7, 8, 9) in three unknowns (Y, i, B ). However, we make one simplifying assumption that at the initial equilibrium, current account balance and capital account balance sum to zero. The slopes of the three curves are the same as before. Let us now consider the case of capital inow. With, exchange rate being xed, the inow of foreign capital will put upward pressure on the exchange rate. However, the RBI will resist any such movement. To make the rupee cheaper and foreign currency dearer, the bank will mop up the ow of foreign reserves and expand the domestic credit. Thus, the LM curve will shift outward from LM0 to LM1 . The IS curve will not shift as none of the parameters of the IS curve changes. Equilibrium will shift from E0 to E1. Thus output will expand from Y0 to Y1 . This is shown in gure 2. With increase in total money supply, equilibrium interest rate will go down, stimulating investment somewhat. Since E1 represents a situation of BOP decit, FF curve will shift down. Mathematically, we can proceed as outlined before.The nal expressions for
Y , i K K

and

B K

are:

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Y = 0 Li K 1 Ci

0 Ai

Ai 1 / = > 0 1

(10)

i = K

(1 AY TY ) 0 0 LY TY

(11)

(1 AY TY ) <0 0 1 / = 1 1

B = K

(1 AY TY ) Ai LY TY Li Ci

(1 AY TY )(Li ) Ai LY >0 0 / = 1 (12)

Where, = (1 AY TY )(Li + Ci ) + (Ai )(LY + TY ) > 0 Thus, in a regime of xed exchange rate without any interest-rate regulation, a sudden inow of FPI will expand output and employment while sudden outow of capital will have the opposite eect. Unlike in the previous case, capital inow increases output in this case, as on one hand the export and the import of the county do not alter due to xed exchange rate, and on the other hand, there is only the positive eect of an increase in investment due to decline in interest rate. In the former case of exible exchange rate and without interest rate targeting, this positive eect of decline in interest rate and increase in investment demand was insucient to overcome the negative eect

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of the deterioration of the trade-balance. As a result, output declined. While capital inow would not cause any problem in an under-employed economy like India under a xed exchange rate regime, it will surely cause a problem in case of capital outow. Foreign Portfolio Investments, which are highly volatile in nature, will thus, cause much volatility in output, investment and even to lenders and debtors without any interest rate regulation. However, it is noteworthy, that in such a framework, if India allows perfect capital mobility, then the eect of capital inow on domestic output under exible and xed exchange rate,be it with or without interest-rate targeting, is that domestic output (and hence investment and trade balance) will be unresponsive to FPI ows. In other words, volatile FPI ows leaves the domestic output and other real variables unaltered. One point that is noteworthy is that, in case of perfect-capital mobility, India cannot choose a rate of interest that is dierent from the world interest-rate, owing to the smallcountry factor. Incase of exible exchange rate and perfect capital mobility, whenever FPI ows in, it appreciates the exchange rate and trade-balance worsens. As a result, the IS curve shifts in to IS1 as shown in Fig.1. However the incipient rate of interest is below that of the world interest rate. As a result, capital ows out from India to abroad. This in turn depreciates the rupee, and the trade-balance begins to improve. The IS curve shifts out now, and this process continues till the IS curve intersects the LM curve at the initial (world) interest rate. As a result there is no change in equilibrium value of output, investment, export and import. In case of xed exchange rate, whenever the entry of FPI puts upward pressure on the exchange rate, the RBI is forced to intervene. The bank now mops up the foreign reserves by buying foreign currency and selling the rupee. This leads to an outward shift of the LM curve to LM1 in Fig.2. There is now an incipient decline in domestic interest rate. As a result capital ows out; this in turn implies

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a reduction in money supply. LM curve shifts back to its original position. Thus, there is no change in the equilibrium output, investment, export and import.

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2.2

Eect of FPI Inow with Interest-Rate Targeting

We now focus on interest rate targeting and the eect of FPI inow in case of exible exchange rate and then in case of xed exchange rate (which is the policy stance of RBI). In the former case, the specication of the model is as follows: The product market equilibrium is given by: Y = A(Y, i) + T (e, Y ) (13)

where the bar sign on top of iis used to connote interest-rate regulation. The meanings and restrictions on the other parameters are the same as before. The Money-Market Equilibrium is given by: D = L( i, Y ) (14)

where LY > 0 and Dis the domestic credit. Finally the BOP equilibrium is given by: T (e, Y ) + [K + C ( i i )] = 0 (15)

The endogenous variables are Y , e and D. With three equations in three unknowns, the model is exactly determined. Since the RBI has now pegged the interest rate, there is only one level of money-supply that can clear the money market for a given value of Y . Thus D is no longer independently set, but becomes an endogenous variable in this case. We are now in a position to discern the eects the of FPI inow in this model. Dierentiating (13), (14) and (15) w.r.t. K , we get:

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Y e (1 AY TY ) Te = 0 K K D Y (LY ) + =0 K K Y e (TY ) Te = 1 K K Solving (18) and (16), we get, 1 Y = <0 K (1 AY ) Plugging (19) in (17), we get, D LY = <0 K (1 AY ) Plugging (19) in (18) we get, e (1 AY TY ) = <0 K Te (1 AY )

(16) (17) (18)

(19)

(20)

(21)

Thus here also inow of capital has a deleterious eect on output. The intuition is clear. Inow of FPI appreciates the exchange rate. Therefore, the countrys trade balance worsens. Since interest rate cannot change in this case, investment does not increase to oset any decline in output caused by worsened trade balance. Since equilibrium output decreases, there is an excess-supply of loanable funds in the money market. Thus RBI goes for monetary contraction and D reduces. In terms of IS-LM analysis, the appreciation causes a decline in trade balance and thus IS curve shifts inwards from IS0 to IS1 in gure 3. The LM curve

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also shifts inwards from LM0 to LM1 due to monetary contraction. Final equilibrium occurs at E1. In comparison with Figure 1, the decline in output under interest rate targeting is even larger that without targeting. The reason being investment does not rise in the former case unlike in the latter case to oset some of the initial decline in output. This new equilibrium is characterized by BOP surplus. Thus, the FF curve shifts up (not shown in the diagram). Since the volatility caused in the output in a exible exchange rate regime will be even more pronounced if the RBI regulates the interest-rate, we can conclude that given the nature of the Indian economy, it is prudent on the part of the policy makers to carry on with interest rate regulation, if at all the country is to move to a free oat in the future. Finally we now consider the case of the policy stance taken by the RBI, i.e., interest rate targeting and exchange rate intervention. The goods market equilibrium condition, which is the equation of the IS curve, is given by: Y = A(Y, i) + T ( e, Y ) (22)

where the symbols have their usual meanings and restrictions. The Money market equilibrium is given by: D + B = L( i, Y ) (23)

where D is the domestic money supply and B denotes the ow of foreign reserves. Both together determine the aggregate money supply in the economy. Here, LY > 0. Finally, the Balance-of-Payment condition, which is the ow of foreign re-

16 serves (with initial value of B being zero), is given by:

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B = T ( e, Y ) + [K + C ( i i )]

(24)

Our model comprises of three equations (22), (23) and (24). There are three endogenous variables Y, Dand B.G, e , i are policy variables. K and i are exogenous to the model. Thus, the model is exactly determined. From (22) we can solve for Y and this equilibrium value of Y in (23) to get the value of D. Finally substituting the equilibrium value of Y in (24), we get the equilibrium value of B . We now focus on the comparative static result of capital inow. In terms of IS-LM analysis (see Fig 4), as and when capital enters the country, there is an upward pressure on the currency. The RBI is now forced to intervene. The Bank sells domestic currency and buys the foreign currency. As a result, aggregate money-supply increases. Thus, LM curve shifts rightward from LM0 to LM1 , leading to an incipient decline in rate of interest. But, to keep iunchanged, the RBI has to borrow the excess money at the given interest rate. Its domestic credit therefore, goes down. Thus, LM curve shifts back to its original position. The IS curve however does not shift as neither exchange rate nor interest rate changes. Therefore, output is also unaltered. Given RBIs policy stance, foreign portfolio investment does not produce any impact on real variables. Foreign currency that ows in simply gets accumulated with the RBI. None of the macro-variables is aected. Mathematically, we dierentiate equations (22), (23) and (24) with respect to K. Bringing the similar terms together and arranging this system of equations in matrix form we get:

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Now,

(1 AY TY ) 0 0 LY TY

1 1 0 1

Y K D K B K

0 = 0 1

(25)

= (1 AY TY ) > 0(Follows from the stability of IS curve) Now, we use Cramers Rule to solve for the endogenous variables. The nal Expressions are: Y =0 K Thus, capital inow does not aect output of the economy. (26)

D = 1 (27) K Thus the domestic money supply reduces by the same amount of capital entry. Also, we see that: B =1 (28) K From (27) and (28) it implies that total money supply in the economy remains the same. The intuition is clear. Since interest rate cannot be altered and output remains unaected (due to unchanged interest rate and xed exchange rate), there is only one level of total money supply that can clear the money-market. Since, the ow of foreign reserves increases, the domestic component of money supply has to reduce by the exact amount. Thus, total money supply remains constant.

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Thus, we discern that if the RBI intervenes in the money-market by controlling the interest rate, having a exible exchange rate is clearly suicidal. This is because, inow of FPI appreciates the exchange rate, which in turn leads to an inward shift of the IS curve and an incipient decline in rate of

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interest. However, the RBIs stance of interest pegging implies that there is monetary contraction to the extent that we have the same interest rate prevailing. Thus, whatever capital ows out during the incipient decline of interest rate is reversed during the monetary contraction. Since interest rate does not change, there will be ultimately no change in the amount of foreign capital. On the other hand the appreciation of the rupee goes counter to growth and employment. Thus output decreases. It is imperative to note that it really does not matter whether output increases or decrease post capital inow. What matters is the volatility of the macro-variables. Since FPI ows are easily reversible, the objective of insulating domestic economy from the volatility assumes central importance. If protection of the vulnerable export and import-competing sector is the primary concern then having a xed or a exible exchange rate is equally good provided we have perfect-capital mobility. On the other hand, if the interest of the debtors and the creditors are also to be considered, then having a xed interest rate is the only option that is viable. In this case, having perfect/imperfect capital mobility really does not matter as monetary sovereignty (dened as the ability of the money supply to aect output and other real variables) is already lost in both the cases. In the former case, this follows from the impossible trinity: if there is a monetary expansion, then there would be a decline in the rate of interest, which in turn would lead to an innite amount of capital owing out of the country and depreciating the currency. Thus, to resist the downward pressure on the exchange rate, RBI will be compelled to reverse the initial monetary expansion. This implies that the interest rate will be back at its initial level. It is however noteworthy, that India will not be able to regulate the interest rate at a level which is dierent from the world rate of interest (since she is a small country). On the other hand, in the latter case domestic credit supply already becomes

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an endogenous variable. There is only one level of domestic money supply that can equilibrate the money-market for the equilibrium output, given the regulated interest rate. The benet of this latter regime is that, the policy makers can chose any interest rate as per the needs of the economy. For example, during ination, RBI will be able to tamper with the interest-rate to choke out some demand and cool the pressure on price level. Even though perfect/imperfect capital mobility in a xed-exchange rate gives the same result as long as volatility in the macro-variables are considered, the latter is clearly superior to the former as policy makers can choose a convenient interest rate as per the needs of time and fundamentals of the economy.

2.3

Massive Capital Exodus and RBIs Policy Stance

Up until now, we have dealt with only manageable capital inow and outow, and have argued that is has helped the domestic economy survive volatility in the foreign-exchange and money-market. However, it is indeed a matter of concern whether the policy makers will be able to withstand massive capital outow. Let us look at the costs associated with it. Whenever huge amount of capital exits from the country, this would put a downward pressure on the currency. However the policy stance of RBI requires a peg of the INR. Therefore, ordinarily, the bank would like to sell its foreign exchange reserves and buy INR. Naturally, this would entail maintaining massive foreign exchange reserves as well, to match the massive exodus of capital. This brings us therefore to the next problem: holding adequate foreign-exchange reserves, which is fraught with the risks of speculative attack on the currency, if the RBIs holding of foreign exchange is not adequate. Speculators maintain a careful vigil on the reserves held by central bank, and attack the currency whenever they nd that the stock held by the bank is about to become insucient.

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Therefore, speculators are likely to attack the currency. Hence the present policy stance of the RBI will not be able to shield the economy if its holding of foreign exchange reserves is not adequate. Often, countries facing BOP crisis have to devalue the domestic currency (as it happened during the 1991 BOP crisis in the country when the INR had to be devalued by 18 pc). This is the currency risk that is associated with capital outows. But one thing has to borne in mind: even if a currency is devalued (or depreciated) in the wake of a currency crisis, this may not be reected in an improvement in the trade-balance. That is, exports may not pick up. This situation is more likely when the massive capital outow is caused by any global crisis. The reason lies in the income eect. Since domestic export is a function of foreign income and terms-of-trade, a devaluation may not lead to a boost in export of the domestic country if the negative income eect in the foreign country (that is decline in foreign income) is stronger than the positive price eect(which is the reduced price that the foreign country faces). A country like India should have adequate foreign exchange reserves, and the amount of holding of these reserves should be large enough (Rakshit, 2003): a) To have import cover for 4-6 months. b) Whenever the debt-service to export ratio is high. c) When the share of FPI and short-term loans are high. d) When the exchange rate is xed and intervened to maintain it within a narrow band. Current-account transactions are easily estimable not only for a short span of time but also in the medium-run. Thus, how much reserves are required to settle current account transaction can be calculated with a limited amount of error(neglecting sudden oil-price shock). The reason for maintaining a higher amount of foreign excess reserves when the debt-service to export ratio is high is also intuitive. The reason lies in the fact that if exports of goods and

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services, which are the supply of foreign exchange reserves, is high, it is easier for the country to meet its obligation of payment of debt to the world. The receipts in the current account (and this is true for any type of current account and only to the one applying to the external sector) must be sucient to met expenditures of recurrent needs. It is the third point, i.e. the FPI and short-term loans that cause most of the problem. The reason is that investors who invest in nancial assets , and more so in foreign exchange markets, are more interested in short-term gains than long-term gains. Their behavior is likely to reverse in a minutes time. As a result, to deter them from causing capital ight, it is necessary to maintain higher foreign-exchange reserves. Therefore, the best way to insulate the economy from his kind of volatility is to ensure that the entry of volatile capital is restricted, instead of being liberalized, if the policy-makers want to maintain the present stance of interest-rate and exchange-rate intervention.

Empirics

From the above discussion we can infer that under the present policy stance of the RBI, i.e., interest rate and exchange rate intervention, output should be insensitive to FPI ows. Or in other words, the scatter plot of FPI and output should be such that no clear trend between the variables should be seen. Similarly, the scatter plot between domestic credit and FPI must exhibit a negative relation while the scatter plot between FPI and ow of foreign reserves must exhibit a upward trend. Though a scatter plot does not give a comprehensive picture, as it neglects many other variables that inuence our variables of interest, yet it is an initial step to delve into the empirics.

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Since monthly data on output are unavailable, we satisfy ourselves by considering quarterly data on output and FPI. Figure 5a illustrates the relationship between FPI and output. Our data ranges from Q1 2005 to Q2 2011, comprising of 25 observations. Clearly no concrete relation between the two series is deciphered, supporting the result of the paper that the RBIs policy stance of interest rate and exchange rate regulation insulates the output from volatile FPI inows and outows. In fact, if we exclude one single observation corresponding to Q2 2010, which is marked in blue in gure 5a, then the result is even stronger. The scatter plot of this new series is reported in gure 5b. The slope of the trend line is 0.01 ( signicant at 5pc level of signicance), which is very close to zero. The elimination of this outlier is justied since in Q2 2010; entry of FPI was unusually high, amounting to Rs 89221 Cr. The standard deviation of FPI for all the 25 observations is Rs 26847 Cr, which decreases to Rs 22690 Cr when we eliminate the observation for Q2 2010. In fact, during Q2 2010, the country witnessed the maximum amount of FPI inow between Q1 2005 to Q1 2011. The last time the country saw such huge entry was in Q3 2007, when FPI amounted to Rs 50223 Cr. Even if we do not exclude this observation, still the conclusion remains unaltered.

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Coming to the scatter between FPI and domestic component of money supply, the scatter plot should not only exhibit a negative relation, but also show a trend line with slope of minus one. However, it must be mentioned that reserve money must increase with the size of the economy, and thus the two components of reserve money, viz domestic credit supply and net foreign assets should also grow. But, the determinants of reserve money (and hence domestic credit) are not only the amount of FPI ows, but also other parameters. Infact, RBI follows a Multiple-Indicator Approach, whereby the central bank juxtaposes data on ination, trade, capital ows, IIP, growth rate of various sectors of the economy and many more data in formulating its credit policy. Therefore, the exact picture would be the one where we are able to lter out the eect of all other factors that aect domestic component of money supply and reserve money.

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One problem that emerges in this analysis is lack of direct availability of data on domestic credit. Thus, we calculate the value of this variable by subtracting the net foreign exchange asset of the RBI from the reserve money. Unlike in the former case, here we do have monthly data available. We consider data from July 2005 to June 2011, a pretty large time span. One noteworthy point is that, from July 2003 onwards, net foreign exchange assets of the RBI have exceeded the amount of reserve money, except for the three months: March 2011 to May 2011. As a result, the dierence between the two has turned out to be negative for the entire period that we have considered, except for the above specied three months. The scatter between FPI and domestic money supply is illustrated in gure 6a. Clearly, the slope of the trend line is negative with the value being -1.5 (insignicant at 5pc level of signicance). The ideal slope should have been near to minus one. In fact, if we consider the scatter between FPI and reserve money, then the scatter should exhibit no upward or downward trend, as the total money supply should remain unchanged in response to FPI entry or exit. The increase in foreign reserves should exactly oset any change in domestic credit. In gure 6b, we illustrate this result. The scatter does not exhibit any upward or downward trend.

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Finally, we now inspect the scatter plot of FPI and changes in Foreign Reserve. Fortunately, monthly data for both the series are directly available. The time span ranges from July 2005 to June 2011. Figure 7a reports this relationship. Needless to say, no clear trend is evasive due to the extreme outliers shown in blue in the same gure. These outliers are those points which have shown either extreme capital inow or outow or huge change in ow of foreign reserves on certain months during the time span that we have considered. A scrutiny of the data on FPI ows corresponding to these data points reveal that the directions of ow have quickly reversed right in the following months for each of these ve observations. Out of the 73 time points, if we exclude these ve observations, the standard deviation of FPI inow reduces from Rs 5160Cr to Rs 2775 Cr. The scatter plot corresponding to these 68 observations is illustrated in gure 7b. The relationship is positive

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with slope of the trend line being equal to 1.17 (which is again signicant at 5pc level of signicance). The ideal slope should be one.

Therefore, the scatter plots shown in this section prove the results derived in equations 26, 27 and 28. Or, in other words, the data are in conformity with our results.

Conclusion

Given the need of the external sector and participants in the money-market, we see that the RBIs policy combination would consist of a xed exchange rate regime under imperfect capital mobility. This paper gives another dimension to the case against full capital account convertibility. While it is true

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that the monetary sovereignty is already lost in pegging the interest rate, yet it is true that interest rate regulation would require control on free movement of capital. Otherwise, India would be able to regulate the interest rate, and thus expose the creditors and debtors to interest-rate volatility. This paper can be extended in many directions. First, expectation about the exchange rate can be brought in using interest-parity condition under exible exchange rate. Secondly, we can assume exible prices and then bring in wage indexation into the model. Debate can be raised regarding the feasibility of this policy stance in the long run.

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Apendix
Derivation of IS, LM and BOP Schedule Product-Market Eqm is given by: Y = A(Y, i) + T (e, Y ) (29)

Money Market Eqm (in case of xed exchange rate) is given by: D + B = L(i, Y ) (30)

where D is the domestic money supply and B is the ow of foreign reserves. On the other hand, Money-Market Eqm in case of exible exchange rate is given by: D = L(i, Y ) BOP Eqm (in case of xed-exchange rate) is given by: B = T (e, Y ) + K + C (i i ) (32) (31)

and in case of exible exchange rate is given by: T (e, Y ) + K + C (i i ) = 0 (33)

where Ci < (Symbols have their usual meanings and cross-partials :Ai < 0, Ay > 0, Te > 0, TY < 0, LY > 0, Li < 0)

30 We trace-out the slopes of these schedules in i-Y plane. Slope of IS Curve Totally dierentiating (29), we get i (1 Ay Ty ) = <0 Y Ai

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(34)

Since Ai < 0, and the numerator is positive, IS curve is negatively sloping. Slope of LM Curve Totally dierentiating (30) and (31) we get, i (Li ) = >0 Y LY Thus, LM curve is positively sloped. Slope of BOP Curve Totally dierentiating (32 and 33), we get: TY i = >0 Y (Ci ) (36) (35)

Thus, BOP Schedule is positively sloped under imperfect capital mobility. In case of perfect capital mobility, the denominator tends to innity, rendering the curve perfectly-elastic. Comparing (35) and (36), we conclude that LM curve can be steeper or atter than the BOP curve. Infact, higher the degree of restriction on capital mobility, steeper will be the slope of BOP curve. In such cases, LM curve is likely to be atter than BOP schedule. Opposite will hold true in case of lower restrictions on capital mobility. Which ever might be the case, both the systems are stable.

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