Risk-capital inflows, inflation, and macroeconomic policy in India, 1993-95.

I. INTRODUCTION

Since the early 1990s, private risk-capital flows(1) have taken on increased quantitative significance for developing economies. Table 1 provides indicators for some larger developing economies. Estimates by the Bank for International Settlements (BIS)(2) suggest that total net private flows to "emerging-market" economies in 1996 alone exceeded the total flows for the entire 1980s, while flows from official sources have been levelling off. For many developing economies, private-investment flows were an order of magnitude higher as a percentage of GDP and capital formation in the early 1990s than they had been during the 1980s. For example, private-investment flows to Argentina averaged 3.9% of GDP and 22% of fixed capital formation between 1991 and 1994, compared with 0.2 and 0.7% for the years 1981 through 1990. Private-investment flows to Brazil averaged 6.5% of GDP and 33.7% of fixed capital formation between 1991 and 1994, compared with 0.1 and 0.4% for the years 1981 through 1990. Comparable flows to Indonesia averaged 2.0% of GDP and 7.3% of fixed capital formation between 1991 and 1994, compared with 0.6 and 2.2% for the years 1981 through 1990; flows to Pakistan averaged 1.1% of GDP and 6.0% of fixed capital formation between 1991 and 1994, compared with 0.1 and 0.9% for the years 1981 through 1990.

Some of the risk-capital flows to developing economies were related to privatization of public enterprises, and these flows can be expected to decline as this activity runs its course. Nevertheless, while varying world economic conditions will inevitably induce fluctuations, over the longer term placements in "emerging" equity markets, as well as borrowing by and direct foreign investment [TABULAR DATA FOR TABLE 1 OMITTED] in developing economies' private enterprises, can be expected to take on increasing importance in the world financial system.

Considered by itself, growing risk-capital flows to developing economies must be regarded as welcome from the global perspective. Since developing economies are (by definition) relatively capital-scarce, capital appropriately invested in them should yield high returns. Capital flows from developed to developing economies should therefore serve both to relieve developing economies' relative capital scarcity and to increase the aggregate return on global capital resources. In addition, the growth of emerging markets broadens the scope for investors throughout the world to diversify their portfolios.

Particularly in the light of the 1980s debt crisis, capital transfers in the form of private risk capital have notable advantages over transfers in the form of debt. Unlike debt finance, risk capital sets no pre-specified servicing schedule and often conveys technology and management skills. The fact that risk capital goes to private rather than public ventures presumably increases the likelihood that the resources will be placed productively and efficiently. In general, reasonably well-managed developing economies offering attractive yields should tend to retain foreign capital and accumulated returns.

All the same, private risk capital has well-known drawbacks for developing economies. Precisely because risk capital sets no specified repayments schedule, repatriation of capital or of accumulated returns may occur at inconvenient moments, a source of vulnerability for any economy that has received substantial mobile capital inflows. The presence of risk capital may also have implications for the safety and soundness of a developing financial system. Furthermore, even today acquisition of key productive assets by foreigners remains politically sensitive in many countries.

Because their magnitude and even directions can vary, liberalized financial flows can induce significant macroeconomic fluctuations, particularly in economies where the financial infrastructure and institutional framework are still developing. Such fluctuations can severely strain macro-monetary management and subject policy-makers to troubling dilemmas. Large capital flows can affect such macroeconomic variables as the money supply, credit availability, interest rates, equity values, and exchange rates with unprecedented force. Monetary authorities that have learned to strike delicate balances among the objectives of price stability, credit adequacy, financial-system soundness, and exchange-rate stability may find that capital flows greatly complicate their "game."

These drawbacks largely explain why developing economies came to view private risk capital with misgivings in the 1960s and 1970s. In the 1970s many governments took the view that they could direct financial capital inflows to more appropriate - if perhaps less efficient - uses than the private sector, and so preferred to borrow themselves rather than encourage private risk flows. It is largely because of the problems debt finance engendered in the 1980s, together with the deepening perception that public management of investment resources tends to be sub-optimal, that the view gained ground that risk capital is the better, or less bad, form for developing economies to absorb external finance capital.

This essay characterizes and describes some of the macroeconomic policy dilemmas arising from capital inflows, and illustrates them from India's experience during 1993-95, when the flows to the country began to surge. Section II reviews the types of policy dilemma that risk-capital inflows characteristically engender. Section Ill reviews the liberalizing measures taken by India in the early 1990s, and Section IV describes India's experience with capital inflows and their macroeconomic impact. Section V discusses the causal link between the capital inflows and persisting inflation during the period. The concluding Section VI summarizes lessons and policy advice that can be drawn from India's experience.

Those who have followed Latin America's recent experience with capital flows will find much that is familiar in India's experience with macroeconomic management during 1993, 1994, and 1995. Many Latin American economies attracted voluminous risk-capital flows at the same time. The inflows fell off somewhat in the wake of the Mexico crisis toward the end of 1994, but then resumed their growth during 1996 and 1997: at this writing, the late- 1994 Mexico crisis and the months following are coming to seem a relatively brief hiatus in the decade's overall trend of rising capital inflows to developing economies. One distinction among capital recipients is the way in which the capital flows were allocated between higher current-account deficits and reserve accumulation. Broadly speaking, in some economies the flows were applied in significant degree to finance larger current-account deficits, while in other economies the bulk of the flows went into reserve accumulation. Such Latin American economies as Argentina and Mexico tended to run higher current-account deficits (in Mexico's case, it would seem, above the level world financial markets considered acceptable), while Chile and Colombia - like most East Asian economies and India - tended to accumulate reserves. Current-account deficits rose in the larger Latin American economies mainly because capital formation and GDP growth increased, but also due to exchange-rate appreciation as the authorities generally avoided intervening in the foreign-exchange markets. As described below, India took a contrasting approach: by intervening in the foreign-exchange markets, at the cost of a somewhat higher inflation rate, the authorities were able to prevent nominal exchange-rate appreciation. This helped limit India's current-account deficit.

II. MACROECONOMIC CONSEQUENCES OF RISK-CAPITAL INFLOWS

The relevant economic theory is well understood, at least at its basic level. Any capital inflow, considered in itself, generates monetary expansion as foreign exchange is sold to the banking system. The increased foreign-exchange supply simultaneously generates real-effective, if not nominal, currency appreciation. These monetary effects accompany whatever direct and multiplier effects the actual investment expenditure generates for total economic activity, consumption, and external trade. In the short term, by raising the values of government obligations, private equities and private debt instruments, and increasing credit availability, monetary expansion reduces nominal and real interest rates and encourages economic activity, particularly capital formation. By reducing the cost of imported capital goods, the currency appreciation provides impetus for capital formation. To the extent productive capacity comes under strain (i.e., depending on the current state of the business cycle), higher inflation may result. By discouraging exports and encouraging imports, however, currency appreciation reduces export supply and increases import demand, and to this extent offsets the expansionary effect of the monetary expansion.

Simultaneous money-supply expansion and exchange-rate appreciation present a stabilization dilemma for policy-makers. A monetary authority that carries out offsetting "sterilizing" monetary contraction to limit inflationary pressure tends to raise interest rates, which may attract increased capital flows and intensify currency appreciation. According to standard theory, the preferred policy prescription is tightened fiscal rather than monetary policy, since diminished government borrowing should serve to reduce interest rates and so relieve pressure on the exchange rate to …