Foreign Capital Inflow free essay sample

Effects of Foreign Capital Inflow on the Economy Recently India’s Home  Minister Mr. P. Chidambaram pointed out that surge in foreign capital inflow  can be a cause of the rise inflation rate in the economy. This is true! With opening up of the  economy, foreign capital has become one of the important factors affecting our economy. The country’s  economic policies have changed. We are now an open economy affected by the economic and political  happenings of the world. We therefore need to broaden our handling of domestic economic problems like  inflation.Inflation is no more only due to supply constraints caused by domestic supply constraint  caused by poor monsoon or floods. It is affected by global demand and supply of goods and capital. Today  almost all the countries of the world have opened up their respective economy to free capital movement  across borders. Foreign capital inflow has both advantages as well as disadvantages. We will write a custom essay sample on Foreign Capital Inflow or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page It depends upon the  constructive absorption capacity of the economy. Following liberalization of restrictions on inward investment in 1991-92, there was a sharp increase in capital inflows between 1992-95 and 1996-97.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 between1990-93.Overall net capital flows as percentage of GDP increased from 2. 2% in 1990 91 to around 9% in 2007 08. Advantages to the domestic economy Supplements domestic savings-  Less Developed countries lack sufficient savings, required for investment  in development projects like building economic and social infrastructure. Foreign capital bridges this  gap. Growth in rate of investment- Foreign Direct Investment brings in more industries and technology to the  country, giving a boost to production, employment and income of the host country.Covers debt and Current Account Deficit of Balance of Payment- Foreign capital inflow adds to our foreign exchange reserves, which is a cushion for the country’s  Balance Of Payments. The reserve is used  to cover maturing international debts and to cover the current account deficit of the Balance of  Payment. India has certainly reaped these benefits as now the country is recognized as a growing/emerging  economy. The country is coming out of the ‘Less Developed Country’ tag. Foreign Capital inflow has given  a boost to our industrial and social growth and also provided the savings to undertake essential  infrastructure development works.Prior to the nineties decade, the country depended heavily on foreign  aid and debt. The huge accumulation of debt from continuous international borrowings put tremendous  pressure on the country’s Balance of Payment. We had no other source of repaying debts or covering the  growing fiscal and current account deficits, other than more borrowings. The country has done away with  that painful situation. Today dependence on aid has vanished. Now FDI (Foreign Direct Investment), FPI  (Foreign Portfolio Investment) and NRI (Non Resident Indian) deposits dominate the capital flows in the  country.Drawbacks of Foreign Capital * Appreciation of Real  Exchange Rate-  As more foreign investors invest in the country, the demand for  the domestic currency rises. As a result the value of the domestic currency appreciates. Appreciation of domestic currency causes loss of competiveness of exports as they become  costlier. Cheaper imports and costly exports further add to the current account deficit in the Balance  of Payment. * Inflation- Foreign capital inflow adds to the domestic money supply.If it is not absorbed and  utilized in profitable projects, it leads to inflation in the domestic economy. * Destabilizing effects- foreign investors are always in search of greener pastures. They are  attracted to developing, emerging markets where demand,  interest rates and hence returns are high. Foreign investors, particularly portfolio investors, are quick to sell and fly away at the slightest  hint of economic slowdown or turmoil in the country of investment. They may even leave the country if  they find it more profitable investing in some other market/country.Too many foreign investments may  make the economy overvalued, which will discourage foreign investors. Foreign investments and investors  come in and fly out in herds. This herd mentality can be rewarding as well as dangerous to the domestic  economy. It can take the economy to great heights and it can also lead to a crash in the stock market  and drop in rate of investment and growth in the domestic economy. The recent high inflation, scams and  the drop in the index of Industrial Production in India has led many foreign investors to sell their  shares and leave the country.Managing Foreign Capital Inflow Foreign Capital Inflow is beneficial only till the domestic economy is able to absorb it in profitable  uses, which lead to enhancement of overall economic growth of the country through rise in rate of  investment, production and income of the country. The surge in inflows should be matched with a  corresponding growth in the absorption capacity of the country. It should be used for investments that  cannot be otherwise undertaken by the country. For handling inflows better, the fiscal deficit has to be  kept in control.A strong, deep financial system is required to utilize as well as cope with the highs  and lows of foreign capital movements. The traditional method adapted by Central banks to countering the effects of excess inflow (known as  sterilization of capital flows) is to reduce the domestic component of the monetary base. This is done  by methods like the open market operations, by selling  Treasury bills and other instruments or raising  the repo rate and CRR etc. But this traditional method has limited effect as instruments can be sold or  interest rate can be raised only up to a certain limit.The bank faces a tricky situation here. Excess  foreign capital inflow causes inflation; to check inflation Central Bank hikes interest rate; high  interest rate attracts more foreign investments. Also, too much tightening of the monetary policy may  hamper investment in the country. The government should therefore look into other ways of countering the  negative effects of surge in capital inflow. Some possible economic policies that can help to absorb  inflow while maintaining an adequate monetary base in the country are- * Ease restrictions on capital outflow.