Indian Economy: The Arguments Against Opening the Economy Wider to Free Financial Capital Flows
In one respect, different forms of capital inflows serve the same purpose: to increase the investment resources available to the economy beyond domestic savings. Whether a foreign investor invests a billion dollars in a greenfield project, an existing factory, stocks (shares) or debt securities, the stock adds a billion dollars to the country’s investment resources.
No capital punishment
But beyond this common characteristic, the different forms of capital inflows are quite different and, as such, have been the subject of lively debate among economists. This debate became particularly intense in the 1990s when the International Monetary Fund (IMF) aggressively advised developing member countries to open up to the free flow of foreign capital, and the latter found themselves in the midst of two major currency crises. : the Mexican peso crisis of 1994 and the Asian monetary crisis of 1998.
The most influential dissenting voice came from none other than the world’s foremost free trade advocate, Jagdish Bhagwati. In an influential article titled “The Capital Myth: The Difference Between Trade in Widgets and Dollars” (bit.ly/3JqJfI2), published in 1998 in Foreign Affairs just as the Asian currency crisis was unfolding, Bhagwati questioned the assertion that, like free trade in goods and services, the free movement of capital across borders brought undeniable advantages.
He argued that while there was evidence that FDI and equity investments yielded gains to recipient countries, there was no similar evidence for finance capital. On the contrary, countries like Mexico, Thailand and South Korea that had opened up to the latter had suffered from concomitant currency crises and economic downturns. Bhagwati therefore warned developing countries against hasty adoption of the free movement of capital.
There are good analytical reasons why FDI is the most productive form of foreign capital inflow. By making such an investment, the foreign investor takes the usual risk that the investment will go wrong and therefore strives to make his business a success. She also brings new technologies, management practices and links to the global market, which not only benefit her business, but also other local businesses engaged in similar economic activities through dissemination. Being invested in plants and machinery, the risk of outflow from this form of foreign capital in the face of fluctuations in exchange rates and interest rates is minimal.
In terms of hierarchy, investing in stocks (stocks) comes next. The investors of this capital do not bring new technologies, management practices or links to global markets. But they take the usual risk of investment and, therefore, strive to channel their investments into high-return ventures and thus contribute to economic efficiency. But this capital is more sensitive than FDI to movements in interest and exchange rates. Rising foreign interest rates and fears of host country currency depreciation may cause it to seek a quick exit.
A valid flight risk
Foreign financial capital inflows are the least advantageous form of foreign capital. In a country like India, most of this capital goes into public debt, which offers safe and significantly higher returns than those available on source country debt. Consequently, the only risk taken by the investor is that of the depreciation of the local currency. From the host country’s point of view, the risk of capital outflows is high. Whenever interest rates in the home country, such as the United States, rise, this capital flows out in large volume, putting the local currency at risk of severe depreciation.
Indeed, once a country adopts full free mobility of capital, an even greater risk arises from the outflow of savings from its own residents in response to rising returns from stocks and foreign financial assets. Left to their own devices, large capital outflows can lead to a sharp depreciation of the local currency and destabilize the economy. The only hedge against this threat is the accumulation of foreign exchange reserves by the central bank, which it can use to stabilize the local currency as massive outflows occur. Not surprisingly, as countries like India increasingly open their financial markets to foreign finance capital, their central banks have simultaneously increased their war chest of foreign exchange reserves.
But this war chest comes at a cost. While we pay a high return to foreign investors on our debt securities, our own foreign exchange reserves, which must be held in highly liquid assets such as US Treasury bills in order to be able to intervene in the foreign exchange market at all times, earn a tiny yield. In effect, we borrow foreign capital at high interest rates and lend it to foreigners at low rates.
This fact, and increased exposure to the risk of currency crises, are the reasons why some of us have taken a skeptical view of opening up the economy more widely to free financial capital flows at least until national financial and capital markets are much deeper.