International capital flow structure and its implications on national economies: a qualitative study

Abstract

The 1990's has seen a tremendous increase in the mobility of international capital. Private capital flows are the dominant sources of inflows, whereas official capital flows have decreased tremendously in relative terms. In addition, an increase in portfolio capital has tilted the balance and composition of capital flows towards short-term investments, exposing developing economies to high volatility and withdrawal risks. Such trends in the pattern of capital flows into transition and developing economies have been driven by globalization, in the pursuit of higher returns, portfolio diversification and market-oriented reforms -towards liberalizing and opening up of the economy. The rising incidence of financial crises, in the wake of the above trends, has raised concerns as to whether the costs of increased vulnerability to financial fragility might not outweigh gains from financial integration. In spite of these doubts, developing countries have continued to dismantle financial controls, in order to integrate their financial markets with the rest of the world. However it is essential for policy makers, to understand the nature and economic effects of capital flows, in order to be able to frame appropriate policy responses to safeguard against financial instability that apparently seems to be associated with increased international capital mobility. Capital flows have an impact on a wide range of economic variables such as exchange rates, interest rates, foreign exchange reserves, domestic monetary conditions as well as savings and investments. The impacts of capital flows are significant for India in the wake of liberalization, as it gradually opens up its capital account and provides increased access to its financial markets. Prior to1991, India had a closed capital account, with capital mobility being restricted through administrative controls; with the balance of payments situation and exchange rate movements influencing these controls. In the post 1991 period, India has embarked upon an ambitious economic reform program aimed at transforming a controlled economy into a market-driven economic regime. In the JX)st liberalization period, following changes in the exchange rate regime as well as the trade and investment pol ides' reform, there has been a spurt in capital inflows into the country during the 1992-98 period. It is interesting to note that the pattern and composition of these inflows have generally conformed to trends observed in other emerging market economies. The objective of this project report is to study the nature and composition of capital inflows into India, evaluate the impact of inflows in the wake of liberalization, examine the impact on key macroeconomic variables; assess the policy response; and understand the challenges in regulating and controlling the effects of huge capital inflows.