IMPACT OF INTERNATIONAL CAPITAL FLOWS ON INDIA’S ECONOMIC GROWTH Narayan Sethi* & K. Uma Shankar Patnaik**
Abstract The international capital flow such as direct and portfolio flows has huge contribution to influence the economic behavior of the countries positively. Countries with well developed financial markets gain significantly from Foreign Direct Investment (FDI). Given the huge volume of capital flows and their influence on the domestic financial markets, understanding the behaviour of the flows becomes very important especially at time liberalizing the capital account. The study attempts to examine the impact of international capital flows on India’s financial markets and economic growth. The study also examines trends and composition of capital inflows, changing pattern of financial markets in view of globalization, ascertain the impact of domestic financial policy variables on international capital flows and suggest policy implication thereof. By using monthly time series data, we found that Foreign Direct Investment (FDI) is positively affecting the economic growth direct contribution, while Foreign Institutional Investment (FII) is negatively affecting the growth alb its, in a small way and make a preliminary attempt to test whether the international capital flows has positive impact on financial markets and economic growth. The empirical analysis using the time series data between April 1995 to December 2004 shows that FDI plays unambiguous role in contributing to economic growth. *********
___________________________________ * Research Scholar (Ph.D), Dept. of Economics, University of Hyderabad, P.O – Central University,
[email protected] ** Professor in Economics, Dept. of Economics, University of Hyderabad, P.O-Central University. Acknowledgements: I convey my gratitude to my Research supervisor Prof. J V M Sarma, friends and parents for their timely comments and help in all grounds.
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IMPACT OF INTERNATIONAL CAPITAL FLOWS ON INDIA’S ECONOMIC GROWTH Narayan Sethi* & K. Uma Shankar Patnaik**
1. INTRODUCTION International capital flows have significant potential benefits for economies around the world. Countries with sound macroeconomic policies and well-functioning institutions are in the best position to reap the benefits of capital flows and minimize the risks. Countries that permit free capital flows must choose between the stability provided by fixed exchange rates and the flexibility afforded by an independent monetary policy. International capital flows have increased dramatically since the 1980s. During the 1990s gross capital flows between industrial countries rose by 300 per cent, while trade flows increased by 63 percent. Much of the increase in capital flows is due to trade in equity and debt markets, with the result that the international pattern of asset ownership. The integration of debt and equity markets should have been accompanied by a short period of large capital flows as investors re-allocated their portfolios towards foreign debt and equity. After this adjustment period is over, there seems little reason to suspect that international portfolio flows will be either large or volatile. The prolonged increase in the size and volatility of capital flows observed that the adjustment to greater financial integration is taking a very long time, or that integration has little to do with the recent behavior of capital flows. The nature, volatility and impact of international capital flows are still a debatable issue. The present paper tries to make a preliminary attempt to test whether international 2
capital flows has the positive impact on financial market and economic growth with the help of macro economic variables in the economy? Hence, the financial sector reforms to revive the capital markets help to attract the capital flows due to comparative returns. The international capital flow has positive contribution for the economic growth of developing countries explicitly. In view of the above framework, the paper is organized as follows: section 2 presents the brief literature, section 3 describes the important objective of the paper, section 4 explains the methodology used in the paper and data and period of study, section 5 explains the trends and composition of capital flows and section 6 deals with the empirical analysis of capital flows on economic growth and presents results. Finally, section 7 gives conclusion and some policy implication.
2. REVIEW OF LITERATURE The recent waves of financial globalization since mid 1980’s have been marked by a surge in international capital flows among industrial and developing countries. Such dense capital flows have been associated with high growth rates in some developing countries. However, some countries have experienced periodic collapse in growth rates and significant financial crisis over the same period. It is true that many developing economies with a high degree of financial integration have also experienced higher growth rates (Prasad, et, al. 2003). Some LDC’s are eager to any kind of foreign capital inflows due to the debt crisis. They are facing the shortage both foreign capital and invisible resources. On the supply side, there were some strong inducing factors, leading the international investors towards developing country financial markets. International capital flows is now widely perceived as an important source for expediting the industrial development of developing economies in view of fact that it flows as a bundle of capital, 3
technology, skill and sometimes as the market access (Chitre, 1996). Capital flows can contribute to growth rate of the host economy by augmenting the capital as well as with infusion of technology, given the high growth rates as also lead to a better investment climate by enhancing more capital flows in the country. Therefore, the capital - growth relationship is a subject of causality with a possibility of two-way relationship (Duttaray and Mukhopadhya, 2003). Furthermore, it has been shown that sometimes-capital flows may actually crowd out or substitute domestic investments from the product of financial market with market power. Therefore, it is important to examine the impact of capital flows on domestic investment to evaluate the impact of capital flows on economic growth (Misra, et, al. 2001) Capital flows have particularly become prominent after the advent of globalization that has led to widespread implementation of liberalization programme and financial reforms in various countries across the globe in 1990’s. This resulted in the integration of global financial markets. As a result, capital started flowing freely across national border seeking out the highest return.
During 1991 to 1996 there was a
spectacular rise in net capital flows from industrial countries to developing countries and transition economies. This development was associated with greatly increased interest by international asset holders in the emerging market economies to find trend toward the globalization of financial markets (Singh, 1998). The global financial markets can gradually create a virtuous circle in which developing and transitional economies strengthen the market discipline that enhances financial system soundness. At present, however, there are important informational uncertainties in global market as well as major gaps and inefficiencies in financial system of many developing countries. Lensik
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et, al (1999) examine the impact of uncertain capital flows on the growth of 60 developing countries during the 1990’s. They distinguished between total capital flows, official capital flows and private capital flows. For the three types of capital flows, they derived a yearly uncertainty measure. They have used the yearly uncertainty measures in Ordinary Least Square (OLS) and also Generalized Method of Moments (GMM) estimates, to explain the impact of uncertain capital flows on growth. They conclude that both types of estimates suggest that uncertain capital flows have a negative effect on financial market and growth in developing countries. Capital flows can be promoted purely by external factors which may tend to be less sustainable than those induced by domestic factors. Both capital inflows and outflows when they are large and sudden have important implication for economies. When capital inflows are large, they can lead to an appreciation of real exchange rate. He concludes that the capital account liberalization is not a discrete event. Looking at the composition of capital flows, net foreign direct investment represents the largest share of private capital flows in the emerging markets. Net portfolio investment is also an important source of finance in the emerging markets, though these flows were more volatile after 1994 (Rangarajan, 2000). Until 1997 a market shift, in the composition of capital flows to domestic financial market with a significant increase in net private capital inflows to financial markets and a decline in the share of official flows. FDI is the most stable capital. Both net portfolio investment and banking flows were volatile. Portfolio flows are rendering the financial markets more volatile through increased linkage between the domestic and foreign financial markets (Kohli, 2001, 2003). Capital flows expose the potential vulnerability of the economy to sudden withdrawals of foreign
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investor from the financial market, which will affect liquidity and contribute to financial market volatility. One opinion that could be explored in the face of capital inflow surge is absorption by the external sector through capital outflows. Financial markets are thrown open to Foreign Institutional Investors (FII’s) and there is convertibility of the rupee for FII’s both on current and capital account. Over the years, Indian capital market has experienced a significant structural transformation. Financial markets are significantly different from other markets; market failures are likely to be more pervasive in these markets and there exists Government intervention. Government interventions in the financial markets that promoted savings and the efficient allocation of capital are the central factor to the efficiency of financial markets (Agarwal, 1997; Bernan 1997).
3. OBJECTIVES OF STUDY The study broadly examines the impact of international capital flows on economic growth in view of changing India’s financial markets. Specifically, the objectives are: (i)
To examine the trends and composition of capital flows
(ii)
To examine the impact of capital flows on economic growth.
(iii)
To suggest policy implication thereof.
4. MODEL DESIGN Before going to use OLS technique one should test the stationary properties of the variable in case of time series data. As our data is time series in nature, the study first of all test stationarity of the variables using different unit root tests, namely Dicky- Fuller (DF), Augmented- Dicky Fuller (1981) and Phillips-Perron (PP) (1988) test. These tests are shown in table-3. To show the Dicky-Fuller (DF) test, the AR (1) process is shown. 6
Yt = µ+ ρ.Yt-1+εt Where ρ and µ are parameters and εt is a white noise. Y is stationary, if 1
