A Lesson in History
In the late 1980s and early ‘90s, many of the world’s emerging countries, especially those in eastern and southern Asia, began opening their domestic markets to foreign investments. As their policy and structural changes began to solidify, many of these nations saw a huge capital inflow from the global markets. This led to a tremendous improvement in their domestic economies as their cash-starved manufacturing and services bases sprang to life, propelling rapid growth. This led to formation of new investor havens like Indonesia, Singapore, Malaysia, Thailand and South Korea, which sustained impressive growth rates of 8-12% and created a phenomenon that came to be known as the ‘Asian Economic Miracle’. To facilitate capital inflow and boost investor confidence, countries like Thailand, South Korea and Indonesia adopted policies like the maintenance of fixed exchange rates and high short term interest rates. Such practices exposed them to significant foreign exchange risks, including possible speculative attacks as a fixed exchange rate in essence meant that the central banks were willing to exchange infinite amount of dollars for the local currency at that rate. Fuelled by these initiatives, these countries witnessed huge capital inflows and had consequently run up huge current account deficits by the end of the decade. Though these policies helped garner much needed fixed capital generation, the mountainous debt created as a result severely compromised their ability to handle global financial shocks. By the mid 1990’s, global economic environment began to change due to developments like the devaluation of the Chinese and Japanese currencies (which increased their export competitiveness) and the decision by the US fed to raise interest rates to ward off inflation. Such changes began to make these ‘Asian Miracle’ economies less attractive to foreign capital inflows. This led to a large scale withdrawal of investments from these nations. Furthermore, the availability of relatively cheap credit had resulted in tremendous appreciation of asset prices in these economies, which led to the formation of a bubble as the prices started to plummet when borrowers began to default on borrowings. As a myriad of such developments began to take shape, these countries were faced with massive fight of capital, leading to a paralyzing credit crunch. To handle the immense pressure created by the credit crunch, the central banks were forced to raise the interest rates to astronomical levels, which began to rapidly erode their foreign reserves. Finally, these nations were forced to remove the pegs that they had placed on their currencies, leading to rapid devaluation. By the end of this episode, these economies were left in ruins. Millions lost their jobs and life savings. GDPs of these nations took a beating; with Indonesia’s Nominal USD GDP dropping by about 40% in 1997 (the Indonesian Rupiah fell by more than 80%). Widespread riots and political unrest followed, leading to regime changes in most of these countries. This particular catastrophe is now known famously known as the ‘Asian Contagion’.Current Scenario
In the past 2 decades, the world has seen drastic change in the capital flow patterns across its geographies. Huge transnational corporations have begun to plan and coordinate their manufacturing operations and supply chains across boundaries and are in a constant search for newer markets to sell their products and services in. Such practices have increased the flow of cross-country investments. This has led to a greater need for a strong FDI policy framework in any nation that wants to be a part of this global paradigm shift.FIIs versus FDIs
The issue of increased market volatility and crippling impact of global economic changes have been largely attributed toFIIinflows rather than FDI inflows. The FII inflows are by nature more unstable than the FDI inflows as they tend to represent the investors’ interest in more liquid asset classes like open-market equities. Due to this nature of FIIs, these capital flows are regularly considered to be ‘hot money’. These inflows manifest themselves mainly in the secondary markets and offer very little impact on the actual capital levels in businesses. Investing in liquid asset classes allow the FII investors the freedom to easily pull out their investments in times of crises. The FDI investments require a long term commitment to the entity which is invested in. These investments are made in assets with relatively less liquidity and operate predominantly in the primary markets. This usually leads to the investor taking up active control in the day to day functioning of the businesses they have invested in. In many cases, this leads to better corporate governance, a higher emphasis on good record keeping and the access to better technologies and trade partnerships which are crucial to the long term success of a business. Such practices tend to create an overall improvement in the economy in which the investment is made, mainly through the fringe benefits like investments in supply chain infrastructure. Though this might be true, the FDI flows should in no way be considered to be stable. These capital flows are also heavily influenced by global economic shocks and can suffocate the domestic credit markets if conditions are not favorable. Figure 1 illustrates the variation in the FDI flows across the world. The FDI inflows are clearly influenced by global financial changes, as can be seen from the dip following the dot com bubble and the World Trade Centre attacks in early 2000’s; the subsequent boom in middle of the decade, fuelled by cheap interest rates in developed economies; and the ultimate fall in the following the financial stress caused by the US mortgage crisis and the sovereign debt crisis in the later part of the decade.
Risks Associated with Foreign Investments
Allowing foreign capital inflows creates a significant exposure to exchange rate risks. To boost the confidence of international investors, governments in many capital-starved nations try to maintain currency pegs, which fix the local currency’s exchange rate to a more liquid currency, usually the US dollar. Such measures are intended to signal to the global markets that the risk of the domestic currency’s devaluation is low. These signals can have strong influences on the ability of the sovereigns to borrow as well. For example, the monetary consolidation under the euro allowed many sovereign states in the Euro Zone to issue Euro-bonds which had significantly lower yields. But with many financial policies, this is a double sided sword. To maintain a fixed exchange rate, the central banks have to be able to supply the reference foreign currency in exchange for any quantity of their local currency if demand arises. This can put a severe strain on their foreign exchange reserves, which can rapidly deplete if the investors decide to pull back on a large scale. Having a peg on a highly liquid and largely traded currency also exposes the markets to speculative attacks. After the contagion, former prime minister of Malaysia accused the Hungarian tycoon George Soros of engaging in massive currency speculation with the Ringgits. The ultimate aim for any entity investing in a foreign economy is to get monetary returns on the investment in the long run. This puts a strain on the invested nation’s economy once the investments start making profits. These outflows can severely offset the balance of payment levels in the country. Another crippling requirement of nations trying to attract large foreign capital inflows is the need to maintain high interest rates in their local markets. This is needed to avoid flight of capital to other more secure economies which might offer similar returns on significantly safer investments. A of standard comparison in this aspect are the US bonds. Actions such as the Federal Reserve increasing its benchmark interest rates can trigger a massive flight to quality unless the domestic rates of return are high enough. This reduces the domestic central bank’s ability to control their rates to stimulate their domestic economies. As mentioned, most nations try to induce as much FDI inflows as possible. This creates a huge demand for these inflows and the entities which are willing to make these investments are highly sought after. The FDI inflows also require the investors to lock their capital in long term investments and incur large capital expenditures before they are able to draw returns. This puts an onus on them to ensure long term safety on their investments and their returns. To ensure this, many entities make significant policy changes requirements and government guarantees. This can lead to these entities forming strong lobbying groups to help promote their interests, especially with the governments which desperately seek out such inflows. At times, these interests do come in direct conflict with the national interests in these countries. In the absence of a strong policy framework and a regulatory body, this can lead to the national interests being compromised to induce these capital inflows. Lobbying efforts by these investors can also lead to rampant corruption in the related domestic agencies.FDI in India
Growth in India has traditionally been powered by the high domestic savings and investments. India did not openly embrace the FDI powered growth model that was adopted in many of the East Asian economies. The government closed key sectors to FDI inflows and even in sectors which have been opened up, government regulations and control in may crucial sectors act as active deterrents to large foreign capital investments. When the capital flows to Asia slow down, many of the region’s economies take a bad hit while India remains relatively immune to changes in the global economy. This structure went a long way in shielding its markets from the Asian Contagion to a large extend. Recent turbulence in the global economic environment has led to a massive stall in India’s economic activities. The export demands are slacking and the growth has slowed down. The sovereign debt crisis has given rise to massive flight to quality on a global scale with investors rallying on gold and US treasuries. This has led to a massive depreciation of the rupee in comparison with the US dollar. Imports are more expensive and the demand constraints are dampening the economy’s ability to harness on its increased export competitiveness due to a weak Rupee. This has led to a large fiscal deficit which is triggering more outflows. This spiraling loop has sent alarm bells ringing throughout the system and the government has started to open up newer sectors to FDI, most notably the retail sector.
Figure 1: Distribution of FDI inflow across states. Source: www.ft.com
