TRENDS IN K FLOW TO INDIA

TRENDS IN K FLOW TO INDIA

INTRODUCTION

The recent wave of financial globalization and its aftermath has been marked by a surge in international capital flows among the industrial and developing countries, where the notions of tense capital flows have been associated with high growth rates in some developing countries. Some countries have experienced periodic collapse in growth rates and financial crisis over the same period. It is true that many developing economies with a high degree of financial integration have also experience higher growth rate. Low Developing Countries (LDCs) are eager to welcome any kind of foreign capital inflows to overcome the debt crisis situation. They are facing the challenges from the foreign capital and the invisible resource. From the supply side also there are some strong inducing factors, which led the international investors towards the financial market of the developing countries. The correlation between the movements in developed and developing countries financial market, the deceleration in industrial economy markets and high growth prospects of the less developed market are some of the important reasons, which made them an attractive option for portfolio diversification.

It is fact that international capital flows on financial market can be very volatile.However, different countries experienced different degree of volatility of financial market and this may be systematically related to the quality of macro-economic policies and domestic financial governance. In this context high volatility of capital flows has affected the macro economic variables such as exchange rate, interest rate, money stock (M3) and inflation negatively. Even in countries where a conducive atmosphere is created for the free flow of capital and authorities dont operate with any current account deficit complicates the assessment of integration in financial market. Capital flows have significant potential benefits for economies around the world. Countries with sound macroeconomic policies and well-functioning institutions are their best 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.

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 1990s. 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. 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.

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. 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. Foreign Direct Investment (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. Capital flows expose the potential vulnerability of the economy to sudden withdrawals of foreign 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 (FIIs) andthere is convertibility of the rupee for FIIs 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.

LITERATURE REVIEW

Lensik et al (1999) examine the impact of uncertain capital flows on the growth of 60 developing countries during the 1990s. 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) as we as 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.

Rangrajan (2000) investigates the capital flows and its impact on the capital formation and economic growth taking into the variable as net private capital flows, net direct investment, net official flows, net portfolio investment and other net investments in 22 countries during 1992 to 2000. If capital inflows were volatile or temporary, the country would have to go through an adjustment process in both the real and financial market. Inflows, which take the form of direct foreign investment, are generally considered more permanent in character. 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.

Khanna (2002) examines the macro economic impact on Indian capital market as well as the corporate sector and what are the macro economic effects on inflows of capital to Indian and micro economic effects on the capital market during 1989 to 2002. He took the macro variable as FDI, FPI, NRI deposits, external assistance and GDP/GDS/GNP. He tells that entry of international capital flows helps to provide greater depth to the domestic capital market and reduce the systematic risk of the economy. He argues that advanced for liberalizing capital market for liberalizing capital market and opening them to foreign investor are to increase the availability of capital with domestic industries and commercial firms. On the other hand, the Indian stock market is today largely dominated by a small group of FIIs, are able to move the market by large intervened. He concludes that in case of India, the microanalysis of stock market also fails to provide any evidence that the entry of FII has reduced the cost of Indian corporate sector.

Kohli (2003) examines how capital flows affect a range of economic variables such as exchange rates, interest rates of foreign exchange reserves, domestic monetary condition and financial system in India during the period 1986 to 2001. She has examines how capital inflows induce real exchange rate appreciation, stock market and real estate boom, real accumulation and monetary expansion as well as effects on production and consumption. She investigates the impact on capital flows upon the domestic financial sector in India. Inflows of foreign capital have a significant impact on domestic money supply and stock market growth, liquidity and volatility. At the conclusion, the domestic financial sector that is the banking sector and capital market in the event of a heavy inflow of foreign capital in India. Correlation between domestic and foreign financial market highlights Indias vulnerability to external financial shocks. For India on the relationship between portfolio flows and some stock market indicators suggest that market price are not unaffected by capital inflows. So far the difference between net capital inflows and current account deficit has been positive in India.

Chakraborty (2001) explain the effects of inflows of private foreign capital on some major macroeconomic variables in India using quarterly data for the period 1993-99. She analyses of trends in private foreign capital inflows and some other variables indicate instability. She has taken the net inflows of private foreign capital as well as macro economic variables foreign currency assets, wholesale price index, money supply, real and nominal effective exchange rates and exports. The Co-integration test confirms the presence of long-run equilibrium relationships between a few pairs of variables. But the dependence of each variable on private capital flows invalidates such co-integration except in two cases: cointegration exists between foreign currency assets and money supply and between nominal effective exchange rate and exports, even after controlling for private capital flows. The Granger Causality Test shows unidirectional causality from private capital flows to nominal effective exchange rates- both trade-based and exportbased-which raises concern about the RBI strategy in the foreign exchange market. Finally, instability in the trend of foreign currency assets could be partially explained by the instability in private capital flows with some lagged effect.

Kaminsky(2003) examine the characteristics of international capital flows since 1970 and summarizes some of the findings of the research conducted in the 1990s on the effects of globalization. Even if international capital flows do not trigger excess volatility in domestic financial market, it is till true that large capital flows can spark off inflation in the presence of fixed exchange rate. He said globalization allows capital to more to its more attractive destination,

fueling higher growth. He suggests that in the short run, globalization triggers bankruptcy of the financial system and protracted recession. The exploration of capital flows to emerging markets in the early and mid 1990s and the recent reversal following the crisiss around the globe have ignited once again a heated debate on how to manage international capital flows. He indicates capital outflows worry policy makers, but so do capital inflows as they may trigger bubbles in asset market and foster an appreciation of the domestic currency and a loss of competitiveness.

OBJECTIVES1. To study the trends and composition of Capital Flow2. To study the Economic Reforms, Capital Flows and Economic Growth in India3. To analyze the types and Magnitude of Capital Flows4. Changes Of Financial Markets In India After Liberalization, 1991

RESEARCH METHDOLOGYThis data has been collected from different sources like reference books, reports and websites.

SCOPE OF THE STUDY:This project represents the Economic Reforms, Capital Flows and Economic Growth in India, trends and composition of Capital Flow, types and Magnitude of Capital Flows and Changes Of Financial Markets In India After Liberalization, 1991

.LIMITATIONS:

This study contains only the Economic Reforms, Capital Flows and Economic Growth in India, trends and composition of Capital Flow, types and Magnitude of Capital Flows Changes Of Financial Markets In India After Liberalization, 1991.

CHAPTER SCHEME

This project comprises of Chapters mainly as shown below:

Chapter 1:Trends and composition of Capital Flow

Chapter 2:Economic Reforms, Capital Flows and Economic Growth in India2.1 : Capital Flows and Economic Growth in India2.2 : Importance of Foreign Capital Flow2.3 : Economic Reforms in India and Capital Flows

Chapter 3:Types and Magnitude of Capital Flows.1.1 : Indian Approach to Capital Growth1.2 : Inbound FDI1.3 : Portfolios Flow1.4 : Sovereign Debts1.5 : Debts of Firms1.6 : Capital Outflows

Chapter 4:Changes Of Financial Markets In India After Liberalization, 1991

CHAPTER 1

TRENDS AND COMPOSITION OF CAPITAL FLOWS

The trends in net capital inflows (sum of FDI, portfolio, loans and resident Indian deposits) into India between 1985-98. The plot shows a recovery of net capital inflows that had begun to decline in the late eighties and bottomed out in the 1991 crisis. Following liberalisation of restrictions on inward investment in 1991-92, there was a sharp increase in capital inflows between 1992-95 and 1996-97.3 This is similar to the experiences of other emerging economies in Asia and Latin America, all of who typically experienced a rise in inward foreign capital following market- oriented reforms. The magnitude of capital flows into India is much smaller though; the peak level for India is 3.5 per cent of GDP in 1993-94, which is small when compared to other emerging markets. For instance, the peak levels are above 20 per cent for Malaysia, 13 per cent for Thailand, 10 per cent for the Philippines and almost 10 per cent for Singapore between 1990-93.

Second, the swing in the capital account observed in the case of other emerging economies is not visible for India so far. In 1995 estimate a change in the capital account from 2.4 per cent (GDP) on an average between 1984-89 to 1.6 per cent (1990-93) for ten Latin American countries and from 1.6 (1984-88) to 3.2 (1989-93) per cent (GDP) for eight Asian ones. Comparative figures for India are 2.3 (1985-89) and 2.4 (1993-985) per cent of GDP, indicating only a marginal increase. This is probably explained by Indias relatively late start in liberalizing its trade and investment regimes, by which time the competition for international capital had already stiffened.

Though the magnitude of capital inflows into India is at variance vis--vis LatinAmerica and other parts of Asia, there is a common pattern in the composition. World capital flows in the nineties have displayed a steep decline in official capital flows and a rise in private investment, particularly portfolio capital. This trend is clearly reflected in that profiles the composition of Indias capital account over the eighties and nineties. The substantial contribution of aid towards the capital account in the eighties dwindles steadily by the nineties (excluding the IMF loan in 1991 and 1992). Official flows are replaced by private flows; a sharp increase in foreign investment, direct and portfolio, can be observed after 1992. Commercial borrowings abroad drop during the crisis years, resuming thereafter. Portfolio investment flows exceed direct investment (FDI) in the early years of liberalization. The latter accelerates later, peaking in 1995 and falling thereafter. This feature contrasts with what is observed for the countries in the APEC region, where foreign capital was dominated by FDI after the opening of markets, with portfolio flows increasing only in the early nineties. In a way, these movements reflect the global trends: global financial markets had changed substantially by the nineties, with portfolio capital flows registering a sharp rise. More likely however, might be the process of liberalization in India. While FDI procedures remained complicated and discretionary, investment via the financial markets route was much faster and simpler. This might have tilted the composition of flows in favor of portfolio. A final feature of the table is the continued dependence upon migrants remittances, after a short decline in 1993-94. The jump in foreign inward capital that India experienced after reform/liberalization, as well as the composition of these inflows conforms to the evidence for other developing countries. Two broad explanations for this phenomenon have been offered in the literature. One viewpoint holds that the fall in US interest rate between 1989-92, combined with cyclical recession in the US, Japan and many parts of Europe, drove world capital to developing countries in search of higher returns. The other view upholds the role of internal or pull factors such as credible economic reforms, improved macroeconomic performance and domestic policies that encouraged investor confidence and attracted foreign investment. One way of probing the external factors hypothesis is to examine comparative returns on domestic and foreign assets, noting that capital mobility will be guided by highest available returns. Due to lack of data availability on comparable assets, we compare interest rate differentials between India and the rest of the world.

The interest rate spread between the prime lending rate in India and Libor between 1993-2000. The interest spread narrows rapidly from 1993, mainly because of a movement towards lower interest rates after deregulation rather than arbitrage. Foreign investors were allowed to invest in debt instruments in 1997 (subject to a 30% ceiling on total investment) and government treasury bills in 1998. Though it is inappropriate to interpret the trends in interest differentials without allowing for expectations regarding exchange rate changes, superficial evidence does suggest that the relatively high differential rate of return on Indian assets might have played a role in attracting foreign capital after the opening of financial markets. The timing of these flows however, suggests that internal or pull factors were equally, if not more, important. Before 1991, Indian financial markets were closed, its trade and investment policies did not exactly encourage foreign direct investment and its credit-rating along with investor confidence had ebbed following the balance of payments crisis in 1991. Post-crisis however, market-oriented reforms were instituted by the government. The macroeconomic performance of the economy improved, as output growth recovered on a higher trajectory, the rate of inflation declined and debt/solvency indicators improved. External debt restructuring resulted in a decline of the short-term to total debt ratio from 10.2 in 1991 to 3.9 in 1994; as a ratio to reserves, short-term debt fell from 382.1 (1991) to 24.1 (1994) and further to 13.5 in 1998.10 Significant institutional, regulatory and policy changes impacting the external environment during this period were the switch to a flexible exchange rate regime, consolidation of external debt, full convertibility of current account transactions, trade reforms, liberalization of investment policies relating to FDI and financial sector reforms. While the overall thrust of the reforms served to improve international investors confidence, there is no doubt that specific measures to attract FDI and portfolio capital into India catalyzed these inflows. These focused upon elimination of entry barriers and market integration. Foreign investment, which was permitted only in cases of technology transfer, was liberalised and the ceiling of 40 per cent on foreign equity participation was relaxed, procedures were greatly simplified. Elements of financial liberalisation that have a direct bearing upon portfolio investments were allowing foreign institutional investors to operate in the Indian capital market; these investments, initially restricted to equity, were subsequently relaxed to include debt, including government bonds.

Simultaneously, raising external resources abroad by domestic corporates wasselectively liberalised. These developments are partly reflected in the growing demand of institutional and private investors abroad, which has facilitated depository issues in the US and Europe and equity purchases by foreign institutional investors on the domestic stock exchanges. Equity investment has been an important channel for portfolio inflows in other emerging markets too. the volume of bond issues has increased after 1991. These changes are consistent with evidence available for other emerging markets in Asia, where bond issues nearly quadrupled between 1989 and 1992 and continued to increase beyond this period. The composition of foreign capital is by now well understood to make a difference in impact. Thus short-term or portfolio capital, which is subject to sudden reversal and is, therefore, more volatile, renders the recipient country extremely vulnerable. Tentative evidence for India supports this hypothesis as portfolio flows are more volatile than FDI, as measured by the standard deviation of the two series. The standard deviation of portfolio investment between 1990-99 is 5163.2 which is substantially larger than 4592.3 for FDI. The difference in volatility increases when measured at higher frequency, quarterly (1900.5 and 1226.9 respectively) as well as monthly (205.3 and 94 respectively).

Portfolio flows also render the stock markets more volatile through increased linkages between the local and foreign financial markets. Preliminary evidence for India shows some support for this hypothesis as the co-movement between the share prices index and other stock prices indicators during the capital surge of 1992-95. The rise in the share prices index presumably contributed to the rise in market capitalization and the price-earnings ratios during this period. Simple correlation measures between portfolio capital flows and the BSE share price index is positively strong, 0.58. The price-earnings ratio is observed to be doubling between 1990-91 and 1992-93 and dipping sharply after 1995, when the flows subsided. A similar trend is observed for the period of inflows boom in South-east Asia; this ratio doubled between 1990-93 for Hong Kong and Thailand. The negative consequences were that it fuelled stock market booms and contributed to market volatility in the case of Mexico and the East Asian economies.

CHAPTER 2

ECONOMIC REFORMS, CAPITAL FLOWS AND ECONOMIC GROWTH IN INDIA

Capital Flows and Economic Growth in India

Capital flows into India have been predominantly influenced by the policy environment. Recognizing the availability constraint and reflecting the emphasis on self-reliance, planned levels of dependence on foreign capital in successive Plans were deliberately held at modest levels. Economy in the recourse to foreign capital was achieved through import substitution industrialization in the initial years of planned development. The possibility of exports replacing foreign capital was generally not explored until the 1980s. It is only in the 1990s that elements of an export-led growth strategy became clearly evident alongside compositional shifts in the capital flows in favour of commercial debt capital in the 1980s and in favour of non-debt flows in the 1990s. The approach to liberalization of restrictions on specific capital account transactions, however, has all along been against any "big-bang". India considers liberalization of capital account as a process and not as a single event. While relaxing capital controls, India makes a clear distinction between inflows and outflows with asymmetrical treatment between inflows (less restricted), outflows associated with inflows (free) and other outflows (more restricted).

Differential restrictions are also applied to residents vis--vis non-residents and to individuals vis--vis corporate and financial institutions. The control regime also aims at ensuring a well-diversified capital account including portfolio investments and at changing the composition of capital flows in favour of non-debt liabilities and a higher share of longterm debt in total debt liabilities. Thus, quantitative annual ceilings on external commercial borrowings (ECB) along with maturity and end use restrictions broadly shape the ECB policy. Foreign direct investment (FDI) is encouraged through a progressively expanding automatic route and a shrinking case-by case route. Portfolio investments are restricted to select players, particularly approved institutional investors and the NRIs. Short-term capital gains are taxed at a higher rate than longer-term capital gains. Indian companies are also permitted to access international markets through GDRs/ADRs, subject to specified guidelines. Capital outflows (FDI) in the form of Indian joint ventures abroad are also permitted through both automatic and case-by-case routes.

The Committee on Capital Account Convertibility (Chairman: Shri S.S. Tarapore,2006) which submitted its Report in 2006 highlighted the benefits of a more open capital account but at the same time cautioned that capital account convertibility (CAC) could cause tremendous pressures on the financial system. To ensure a more stable transition to CAC, the Report recommended certain signposts and preconditions of which the three crucial ones relate to fiscal consolidation, mandated inflation target and strengthened financial system.

Importance of the Foreign Capital FlowsThe purpose of the flow of capital to underdeveloped countries is to accelerate their economic development upto a point where a satisfactory growth of rate can be achieved on a self sustaining basis. Capital flows in the form of private investment, foreign investment; foreign aid and private bank lending are the principle ways by which 6 resources can come from rich to poor countries. The transmission of technology, ideas and knowledge are other special types of resource transfer. When discuss about the constraints of economic growth, one should referred to the saving gap and foreign exchange gap of the country. A net capital inflow contributes to the filling of the both the gaps.

The capital flow of countries increases due to the amount of resources available for capital formation above what can be provided by domestic savings. It also raises the recipient economys capacity to import goods: capital flow provides foreign exchange and eases the problem of making international payments. Countries in early stages of development assumed to have a primary need for technical assistance and institution building and only limited need for capital assistance chiefly for infrastructure projects. As the need for capital assistance increases, the need for technical assistance shifts from general to more specific skills.

The gradual increase in domestic savings and a growing capacity to attract private and other conventional foreign capital on non-concession ally term will progressively reduce the need for foreign aid. The assumption that need for foreign capital is temporary and limited is underlined several recipients in Latin America else where and expected attain rapid development in ten to fifteen years but it is recognized that in Asia and Africa, the need for capital flows ill remain for a much longer time. Theoretical and empirical research on the role of foreign capital in the growth process has generally yielded conflicting results. Conventionally, the two-gap approach justifies the role of foreign capital for relaxing the two major constraints to growth. In the neo-classical framework, however, capital neither explains differences in the levels and rates of growth across countries nor can large capital flows make any significant difference to the growth rate that a country could achieve. In the subsequent resurrection of the two-gap approach, the emphasis has generally laid on the preconditions that could make foreign capital more productive in developing countries. The important preconditions comprised presence of surplus labor and excess productive demand for foreign exchange.

With the growing influence of the new growth theories in the second half of the 1980s that recognized the effects of positive externalities associated with capital accumulation on growth, the role of foreign capital in the growth process assumed renewed importance. In the endogenous growth framework, the sources of growth attributed to capital flows comprise the spillovers associated with foreign capital in the form of technology, skills, and introduction of new products as well as the positive externalities in terms of higher efficiency of domestic financial markets, improved resource allocation and efficient financial intermediation by domestic financial institutions. Since the spillovers and externalities associated with different forms of foreign capital could vary, a pecking order approach to the composition of capital flows is often pursued which helps in prioritizing the capital flows based on the growth enhancing role of each form of capital. The dominant view on what drives cross-border capital flows is that marginal productivity of capital is higher in a country where capital is scarce.

Economic Reforms in India and Capital Flows

After independence, India has a comparatively unrestricted financial system until the 1960s when the government began to impose controls for the purpose of directing credit towards development programmes. Over the decade of the 1960s, interest rate restrictions and liquidity requirement were adopted and progressively tightened. Government established the state banks and nationalized commercial banks by the end of the decade. Through the 1970s and into the 1980s directed credit to rising share of domestic lending and interest rate. Subsidies became common for targeted industries, with the start of economic reforms in 1985, the government began to reduce financial controls, which were reinstated, and it began to realm ceiling on lending rates of interest.

Until reforms began in the late 1980s, international capital inflows and outflowswere restricted by administrative controls, which had outright prohibition on the purchase of foreign asset by residents, direct investment by foreigners and private external borrowing. After the balance of payment difficulties in 1991, authorities began a gradual relax restriction in inward capital flows and currency convertible for current account transaction. Over the last several years, restrictions on direct foreign investment, portfolio borrowing and foreign equity ownership have been relaxed. This was significant turn around reform banning foreign investment. Restrictions on the share of foreign enterprise for most sectors have been removed, and the upper bounds for automatic approval of direct and portfolio investment have been progressively raised. Foreign investment income is fully convertible to foreign currency for repatriation.

External commercial borrowing has been relaxed but as regulated with respect of maturities and interest rate spreads. Effective restrictions continued on the acquisition of foreign financial assets by residents and on currency convertibility for capital account transaction. Recently these restrictions have been slightly eased to allow domestic resident to investment in foreign equities. The experience of capital account liberalization elsewhere suggests that opening domestic financial markets to international capital flows exacerbates imprudent practice under weak regulation or regulatory forbearance. The large accumulation of reserves by RBI provides insurance against rapid capital outflows but at the loss of foreign interest earnings.

The rapid liberalization of financially repressed economy often leads to large capital and rapid expansion of domestic financial market followed by a capital account crisis and economic contraction. The elimination of capital controls exposes domestic capital markets and macro economic policies to discipline of international capital market, starting a race between financial reforms and crash. Indian policy is following a determined gradual path towards economic liberalization and international integration. Following the liberalization of transaction on the current account, restrictions on capital inflows have been relaxed steadily with an emphasis on encouraging long-term investment and saving.

The pattern of liberalization capital inflows in India has been the gradual raising of quantitative restriction on inflows and the size of flows that automatically approved. The gradual relaxation on restriction on capital outflows would logically follow, while restriction that discourages short-term inflow, which are the parts of current policy. Capital control means that the Government borrows on captive domestic financial market regardless of financial reforms on date. International financial integration typically leads to both inward and outward gross capital flows. Gross capital flows are indeed are much larger internationally then are net capital flows; with capital account, India could well experience a large outflow of domestic saving from high cost domestic financial intermediaries to international capital markets. The process of opening the Indian economy to foreign capital inflows is not complete and making India more attractive to FDI require more than the relaxation of constraints on inflows and foreign ownership. Domestic policy distortions and regulatory uncertainty can inhibit investment inflows, perhaps significantly. Opening up capital account to outflow could also enhance FDI.

The process was completed by the simultaneous evolution of factors encouraging the flow of private capital across the globe. The developments have stimulated a keen interest in understanding the nature and economic effects of capital flows as well as the appropriate policy responses to safeguard against financial instability that appears to be associated with the global movement of private capital.

CHAPTER 3

TYPES AND MAGNITUDE OF CAPITAL FLOWS.

The Indian Approach to Capital Controls

In the early 1990s India faced a balance of payments crisis. This crisis was followed by an IMF structural adjustment program, economic reforms and liberalization of the trade and capital accounts. Policy makers were, however, very cautious about opening up the economy to debt flows. The experience of the Balance of Payments (BOP) crises as well as the lessons learned from other developing countries suggested that debt flows, especially short term debt flows, could lead to BOP difficulties if the country faced macroeconomic imbalances and had an inflexible exchange rate. The emphasis was, therefore, on foreign investment | both foreign direct investment (FDI) and portfolio investment. Even these were opened up slowly and a system of capital controls remained in place.

Inbound FDI

India opened up slowly to FDI in the 1990s. The limits on the share of foreign ownership was slowly increased in every sector. By 2000, while most sectors were open up to 100 per-cent, sectors where FDI was restricted include retail trading (except single brand product retailing), atomic energy, and betting. Table 1 shows the areas where FDI caps exist. While inbound FDI investors have the ability to repatriate capital, so far, in the Indian experience, this reverse flow of capital has been tiny. As an example, in 2006{07, it was 0.01% of GDP. Hence, for all practical purposes, inbound FDI has been a one-way process of capital coming into the country. The easing of capital controls, coupled with strong investment opportunities in India, gave a strong rise in FDI flows into India: from 0.14% of GDP in 1992-93 to 0.53% in 1999-2000 and then to 2.34% of GDP in 2006-07.

From April 2000 to August 2007, $44 billion came into India through FDI. In terms of the country composition, the bulk of FDI into India came from Mauritius; the reason for this is that India has a preferential tax treaty with Mauritius. Services, financial and non-financial, attracted the highest amount of FDI. Between April 2000 and August 2007, US$8 billion, or 20.6of all FDI flows, came into the services sector.

Portfolio Flows

In the early 1990s, India opened up to portfolio inflows through \foreign institutional investors" (FIIs). This policy framework was largely in place by 2000. Equity investment by foreign institutional investors involves the following constraints: The aggregate foreign holding in a company is subject to a limit that can be set by the shareholders of the company. This limit is, in turn, subject to sectorial limits which apply in certain sectors. No one foreign portfolio investor can own more than 10% of a company. Foreign ownership in certain sectors (telecom, insurance, banking) is capped at various levels. Barring these constraints, portfolio investors have convertibility in the sense that they are free to bring capital in and out of the country without requiring permissions.

Unlike the Chinese QFI framework, there are no quantitative restrictions or limitations on participation by global financial firms in the Indian market. More than a thousand global firms are now registered in India as FIIs." In parallel, over the 1992-2001 period, a substantial policy effort took place in reforming the equity market. By November 2007, the market value of this set of firms stood at $1.6 trillion: this value marks a sea change when compared with the level of $0.11 trillion found in November 1997. In recent years, the two Indian exchanges (NSE and BSE) have been ranked third and fifth in the world by number of transactions.

In many emerging markets, issuance on the ADR/GDR markets has been an important vehicle for financial globalization. In the case of India, the ADR/GDR market was significant in 1994-97 because in 1993, when FII investment into India first surged, the settlement system collapsed. Issuance on the ADR/GDR markets was seen as a way to avoid the weak institutions of the domestic stock market. However, by 1997 domestic equity market reforms had made substantial progress.

We express the flow of issuance on the GDR/ADR markets as a fraction of the stock market capitalization at the end of the year. This series showed large values averaging 1.08% over the period from 1993 to 1997. By 1997, the Indian equity market reforms had started falling into place. As a consequence, annual issuance on the GDR/ADR market dropped to 0.4% of market capitalization in the period from 1998 to 2007. In this respect, India's experience has been different from that of many emerging markets, where deepening financial globalization has often been accompanied by a substantial scale of shore listing.

The combination of easing capital controls, strong investment opportunities in India, and the sophistication of the domestic equity market led to sharp growth in portfolio in Flows.

These went from 0.11% of GDP in 1992{93 to 0.73% of GDP in 1999-00 and further to 0.84% of GDP in 2006-07. The time-series of portfolio flows, expressed as percent to GDP. Unlike FDI, a remarkable feature of portfolio flows has been substantial inbound and outbound flows, which leave a small net in flow. This reflects the de facto convertibility that has been granted to foreign portfolio investors on the equity market.

In 2007, the government introduced fresh capital controls against \participatory notes," which are OTC derivatives sold by a financial firm which is a registered FII to an investor who is not registered. This was sought to be done in order to reduce capital in flows into the country that were inducing difficulties for the implementation of the pegged exchange rate. However, the economic impact of this was limited, since the capital control was only against the sale of OTC derivatives. Registration of FIIs took place at an accelerated pace, and there was no significant change in either net portfolio purchases by FIIs, or the role ofFIIs in the domestic market.

Sovereign Debt

One element of the policy framework of the early 1990s was encouragement for equity flows but barriers against debt inflows. Technically, the government of India has no sovereign debt program. Aid flows are miniscule. There is a cap on the stock of ownership of government bonds by FIIs which is set at a miniscule number of $1.5 billion. Hence, as a practical matter, FII investment into rupee -denominated government bonds is zero. However, from time to time, banks have borrowed abroad depending on the government's assessment of the stock of foreign exchange reserves and their adequacy. One form this has taken is borrowing in the form of bank deposits of Non-Resident Indians (NRIs).

The interest rates on these deposits are set by the RBI and fluctuate according to whether the government wishes to encourage or discourage inflows. Three -quarters of Indian bank deposits are with government-owned banks, which are explicitly guaranteed by the government. Even with private banks, there is an implicit liability of the State, for no significant private bank has ever been followed to fail. The borrowing of an Indian bank is, then, visibly backed by the government. The authorities claim that a massive reduction in offshore debt, particularly offshore sovereign debt, took place in the 1990s.

By the official classification, the external debt of GOI stagnated at between $45 billion and $50 billion over 1998-2007. However, a more accurate rendition of the situation requires addressing a phenomenon that we term \quasi-sovereign" debt. Quasi-sovereign borrowing, based on a reclassification of the detailed statistics for debt stock. While sovereign debt measured in dollars has stagnated, implying a rapid decline in sovereign debt expressed as percent to GDP (from 20% in 1992 to 6% in 2007), this decline is exaggerated by keeping quasi-sovereign debt out of this reckoning. Until 2000, the private sector had roughly one-fourth of total debt. Between 2000 and 2007, the share of the private sector rose to roughly 40%, reflecting the liberalization of ECB. However, the economic significance of these changes is limited, for private debt to GDP in 2007 was below the level seen in 1992.

Debt of Firms

Firms are allowed to borrow abroad through \External commercial Borrowing." These include loans or bond issues abroad that are foreign currency denominated. Small transactions are processed by the government with automatic approval," and bigger transactions require permission. Under the present policy framework:External borrowing by firms must be of at least 3 years' maturity for borrowing below $20 million, and at least 5 years' maturity beyond.Borrowing up to $500 million by a firm for certain specified end-uses is allowed without requiring permissions.The evolution of ECB, expressed as percent of GDP. The borrowing of a given year inevitably induces repayment in the following years; the net inflows on account of ECB reflects the combination of fresh issuance of the year and repayments owing to older transactions.Apart from ECB, foreign institutional investors can buy rupee-denominated corporate debt on the domestic market. However, there is a miniscule cap on ownership of corporate bonds by all FIIs put together at $2.5 billion. Hence, as a practical matter, FII investment into corporate debt is non-existent.

Capital Outflows

Outward capital flows primarily take two forms. The first and massive mechanism is the purchase of US treasury bills and other foreign assets by RBI when it builds reserves. The other form of capital outflows that has become important in recent years is outbound FDI by Indian companies. Outbound FDI flows from India have risen sharply since 2004.

India's overseas investment policy was liberalized in 1992. The rationale for opening up Indian investment overseas was to provide Indian industry access to new markets and technologies with a view to increasing their competitiveness. The policy was further liberalized in 1995. Since 2004 Indian companies have been allowed to invest in entities abroad up to 200% of their net worth in a year.In response, thousands of Indian firms have embarked on turning themselves into multinational corporations.

Overseas investment approvals have been steadily increasing since 1996. Approvals for investment abroad were at 1395 ($2,855 million) in 2005-06 as compared to 290 approvals ($557 million) in 1996-97. But the sharpest growth took place in 2006-07. In 2006-07, between April and October, 870 approvals were granted to Indian companies for overseas investments worth $6,034.87 million as compared with 822 approvals worth $1,191 million in the corresponding period of last year, a sharp jump of more than 5 times.

Inbound and outbound (net) FDI flows, both expressed as percent to GDP. Outbound flows have risen sharply, to a level of over 1% of GDP a year. In 2006 the flow of outbound FDI as a percentage of gross fixed capital formation in India rose to gross outbound FDI rose to 1.5. Software firms were among the first Indian firms that used overseas acquisitions as a way to better access the US market. Pharmaceutical firms were next, and they employed acquisitions to reach out to regulated overseas markets like Europe and the US. The share of the primary sector in overseas investment is still flow; it consists of natural resource seeking companies such as ONGC, HPCL, BPCL and GAIL that have sought to get control over oil resources in several countries like Russia, Iran, Sudan, Angola, etc. Mining of coal and metals has also attracted investment by Indian companies. Three fourths of outbound investment from India between 2000 and 2007 went to developed countries, mainly the US and Europe.

A third front on which capital controls have been eased in recent years has been on out-bound portfolio flows. There has been some response to these as various funds are inflow offering international diversification to the Indian customer. In addition, individuals are now permitted to take $200,000 per person per year out of the country. However, so far, the magnitudes seen have been negligible.

CHAPTER 4

CHANGES OF FINANCIAL MARKETS IN INDIA AFTER LIBERALIZATION, 1991

Financial structure evolves over time with market practices earlier reflecting government policies and five years plan priorities. The stock market in India has been fairly well developed. Its role in financial markets had increased during the 1980s with household savings in corporate securities increasing between 1985 to 1986 and 1994 - 95. But an important feature of the pattern of stock holding had been; the large proportion of share belongs to government owned financial institution e.g. UTI (Gokarn, 1996). Government was capable, indirectly influencing the financial markets because of these implications.A distinctive feature of the financial reforms of 1990s had been accent on financial sector reforms. Till the reforms in the early 1990s pricing was not determined by market conditions. Though the volume of transaction was very high, securities continued to exist in the physical form creating uncertainties for the investor, and increasing transaction cost. Long and uncertain settlement cycles created serious problem for clearing houses. International capital flows to the participant were also defiant. Raising of capital from the securities market before 1992 was regulated. Under the capital issues (control) act, 1947, firms were required to obtain the approval from the Controller of Capital Issues (CCI) for raising resource in market. New companies were allowed to issue shares only at par. In 1992, the capital issues (control) act of 1947 was renewed and with this ended all controls relating to raising resource from market. Securities and Exchange Board of India (SEBI) was given statutory powers in 1992 to undertake the tasks of regulations and supervision (Khanna, 1999). The most important fall out of the reform was the free pricing and setting up of new guidelines regarding new issues.Initially, only fixed price mechanism of floating new capital issues were followed. An alternative mechanism of book building1 was introduced in 1995 giving the issuer the choice to raise resources either through this or through the fixed price mechanism. Although the book building guidelines were prescribed in 1995, no issue was floated due to certain restrictive guidelines, which were modified in 1999. The book building mechanism of floating new capital issues has been devised in such a way that those small investors will also be able to subscribe to securities at a price arrived at, through transparent process. Issuers of capital are required to meet the guidelines of SEBI on disclosure and investors protection (Reddy, 1997). In September 1992, Foreign Institutional Investors (FIIs) were allowed unrestricted entry in terms of volume of investment in both primary and secondary markets. In the secondary market, major reforms were the laying down of capital adequacy ratio for brokers; the banning of inside trading and the introduction of computer based trading system (Pal, 1998 and chitre, 1996).Till recently, trading on the Indian stock exchanges took the place through open outery system baring NSE and OCTEI, which adopted screen based trading system from the beginning (i.e. 1994 and 1992, respectively). At present all other stock exchanges have adopted on-line-screen-based electronic trading. It has replaced the open outery system of the two large stock exchanges; the BSE, which provides a combination of order and quote driven trading system, and NSE, which has only an order driven system. All stock exchanges operating in India have over 8000 terminals spread wide across the country. In 1999-00, the SEBI issued guidelines for opening and maintaining the trading terminals abroad, while no trading terminal could be opened abroad due to high cost of connectivity. For ensuring greater market transparency, the SEBI has recently banned, negotiated and crossed deals (where both the buyer and the seller operate through the same broker) in Sept. 1999. All private off market deals in both shares, as well as listed corporate debts were banned. All such deals were now rotated only through the trading screens. There were three main advantages of electronic trading over floor-based trading as observed in India, viz. transparency, more efficiency price discovery and reduction in transaction costs. It also reduces the segmentation of markets (Bhole, 1999).Thus, emphasis has been on disclosure of information, safeguarding of investors interest and opening up to foreign investors. The result of this has been a dramatic increase in the number of new issues and amount of capital raised after 1991-92. While traditionally; mainly two instruments viz., debt and equity were traded, a large number of new and hybrid instruments were introduced in the first half of nineties through an increase in the new issues (Chakrabrati, 2001 and Samal, 1997).Markets have widened with an increase in the number of players such as mutual funds and Foreign Institutional Investors (FIIs)2. A major implication of this resulted in giving the firms a position to substitute one source of funds for another, depending on relative costs. When the foreign markets were modest this enabled the firms to diversify their source of funds (Mishra, 1997).

CONCLUSION AND SUGGESTIONS

This study, therefore, made a modest attempt to analyze the dynamics of some major macroeconomic variables during the post-reform period in India. The main focus of this study lies in analyzing the behavior of some selected macro-economic indicators in relation to the surge in inflows of private foreign capital in India since 1995, the year in which several major reform programs were initiated. A review of the analytical literature shows that macroeconomic consequences of financial liberalization are the results of the combined effect of monetary, fiscal as well as trade and exchange rate policies followed by the government of a country. So, there is no straightforward way of predicting the resulting macro- economic effects of financial liberalization in any country. The trends of total international capital flows into India are positive, where portfolio investment flows are negative in the year of 1998-99. The Foreign Direct Investment (FDI) does not reveal stable trend so far in India. The composition of capital inflows in India makes a significant size both in terms of impact and smooth management. The impact of total capital flows on economic growth is positive in India. The Foreign Direct Investment (FDI) that has huge contribution to influence the economic behavior is also positively affecting the economic growth. The Foreign Portfolio Investment (FPI) is indirectly affecting the economic growth, which has less impact on economy. The Foreign Institutional Investment (FII) has negative impact on growth, but it is very negligible.

Portfolio capital flows are invariably short term and speculative and are often not related to economic fundamentals but rather to whims and fads prevalent in international financial markets. There are three-policy implications, which emerge from this analysis. First India should move to influence both the size and composition of capital flows. Second India should focus on strengthening theyre banking system rather than promoting financial markets. Banks can provide the surest vehicle for promoting long-term growth and industrialization. Thirdly since financial markets in India are here to stay, Government should try to shield the real economy from their vagaries. Economic growth in India is financed either by its domestic savings or foreign saving that flow into the country. We had to largely depend on domestic savings to give impetus to our growth, prior to financial sector reform in the country. Though, the foreign capital flows into the country in the form of aid, External Commercial Borrowing (ECB) and NRI deposits, it did not and was not expected to contribute much towards are capital formation or economic growth. After 1993, when capital account was partially liberalized, it was hoped that capital inflows would contribute towards our economic growth. It concludes that capital inflows have not contributed towards industrial production or economic growth. There are two reasons for this, one the amount of capital inflows to the country has not been enough. Two, the amount of capital that does flow in, is not utilized to its full potential (Mazumdar, 2005).

BIBLIOGRAPHY

1. A published volume from the National Bureau of Economic Research - Publication Date: May 2007 Title: Indias Experience with Capital Flows: The Exclusive Quest for a Sustainable Current Account Deficit

2. Economic Reforms, Capital Flows And Macro Economic Impact On India by Narayan Sethihttps://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&source=web&cd=10&cad=rja&uact=8&ved=0CFgQFjAJ&url=http%3A%2F%2Fwww.igidr.ac.in%2Fmoney%2Fmfc_10%2FNarayan%2520Sethi_submission_51.pdf&ei=ezDoVJyzPMG1uQTLpYCYBA&usg=AFQjCNEfMMRqfHvc-c783UAEDx4FGaW9bg&sig2=0w-9-_91r9a4goZ9YNYvtA

3. Managing capital flows: The case of India by Ajay Shah, Ila Patnaik May 2008 NIPFP-DEA Research Program on Capital Flows and their ConsequencesNational Institute of Public Finance and PolicyNew Delhihttp://www.nipfp.org.in/nipfp-dea-program/index.html

4. Capital Flows And TheirMacroeconomic Effects In IndiaRenu KohliMarch, 2001http://icrier.org/pdf/renu64.pdf

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