The Hindu Business Line : Structural transformation in capital flows

As the economy is performing well, the Government may consider a further dose of financial liberalisation. With the trend towards non-debt-creating capital, the Government should encourage inflows through FDI by opening up the retail, transport, power generation and other infrastructure sectors such as warehousing and cold storage facilities.

FOLLOWING the liberalisation of external financial transactions and structural adjustment in the economy, there has been a policy push towards encouraging foreign direct investment (FDI) and portfolio investment. Capital inflows by way of external loans on official account from multilateral institutions and bilateral sources (foreign governments), which were available to India on several conditionalities, now occupy the backseat.

Over the past 14 years, the broad approach has been to focus on attracting FDI and portfolio investment. However, FDI has not grown as desired in spite of the composition of capital inflows showing massive change. While the share of portfolio investment in total capital inflows increased from 21.4 per cent in 2001-02 to 36.7 per cent in 2004-05, that of FDI decreased substantially from 14.3 per cent to 5 per cent. On the other hand, the contribution of external assistance to capital inflows, which used to be 39 per cent and 26.8 per cent, respectively, in 1990-91 and 2001-02, fell to 3.4 per cent by 2004-05.

Commercial borrowings are defined to include bank loans, buyers' credit, suppliers' credit, securitised instruments such as floating rate notes and fixed rate bonds, credit from official export credit agencies and borrowings from the private sector window of multilateral financial institutions. External commercial borrowings are being used as a source of finance by the corporate sector for expansion of production capacities.

In 2004-05, commercial borrowings were 8.7 per cent of the total capital inflows against 6.2 per cent in 2001-02. Banking capital has also become less important, with its share falling to 22 per cent from 32 per cent.

Thus, what emerges is that non-debt-creating capital has increased and the country has been able to accumulate large foreign exchange reserves by attracting foreign investment on competitive terms. But on the FDI front, the performance has not been that encouraging.

A disturbing feature is that outflows account for more than 78 per cent of the total capital coming in from abroad. The banking capital outflows are very high. In 2004-2005, the country could retain only 16 per cent of the banking capital inflows.

Portfolio inflows comprise FII investments in equity, bonds, government securities and units of mutual funds. Though a ready source of foreign funds, only 26 per cent of these could be retained. Ways to raise the retention level of portfolio investments must be found.

As against this trend, FDI outflow was only 46 per cent and the retention ratio was a high 54 per cent. Commercial borrowings also show a high retention ratio of 62 per cent, followed by external assurance with 50 per cent. The policy focus should be on enhancing the retention ratio of FDI, commercial borrowings and other capital even while reducing the dependence on portfolio inflows, loans and banking inflows in phased manner.

However, in this context, it is important that capital importing entities and India Inc. resort to more efficient use of resources, monitor financial performance and risks on a continuous basis, hedge against exchange rate risks, and so on. These will provide the market accurate information and create healthy competition.

As the economy is performing well currently, the Government should consider a further dose of financial liberalisation. Since the trend is that of non-debt-creating flows getting preference, the Government should encourage capital inflows through FDI by opening up the retail, transport (especially, the railways), power generation and other infrastructure sectors such as warehousing and cold storage facilities based on commercial parameters.

FDI does not result in long-term debt servicing burden. Project proposals involving FDI should be cleared on a fast-track basis, eliminating in the process all the bottlenecks likely to be generated domestically.

Coming to foreign portfolio inflows, though these now have become a significant part of overall capital inflows and foreign exchange reserves, the quality aspect should not be overlooked. The RBI's Annual Report (2004-2005) has rightly emphasised the need to enhance the quality of portfolio inflows by strict adherence to what may be described as "know your investor principle".

It is common knowledge that foreign portfolio investments have pushed up stock prices, but the accompanying volatility at times create unease among retail and small investors. Again, investments through participatory notes, where the identity of the investors are not disclosed, have affected the market.

A comparatives analysis shows that China, Hong Kong and Singapore, among others, are far ahead of India in terms of FDI inflows. A GDP growth of 9-10 per cent cannot be achieved without huge inflows of FDI into long-term projects, particularly infrastructure.

Also, the policy on FDI should be such that it helps generate employment as well.

For instance, opening up of the retail sector can transform the sources of supply and bring about price competitiveness.

The transaction costs, involving transport and agency commission, will be lower.

Besides, the quality of goods can be maintained. Farmers, for example, can benefit because large purchases by retailers with modern storage facilities would encourage corporatisation and commercialisation of perishable consumer goods.

It is important that, to begin with, FDI in retail should be allowed only for white goods and thereafter for agricultural produce, including perishables.

The Government should initiate this process; only then will domestic retailers wake up and modernise.

(The author is a former economic adviser to SEBI.)

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