Capital Outflows Pose Risks to India’s Macroeconomic and Financial Stability

By Kavaljit Singh | Briefing Paper # 54 | July 1, 2022

For the past nine months, foreign portfolio investors (FPIs) have been on a heavy selling spree in the Indian financial markets. According to data compiled by the National Securities Depository Limited, FPIs have pulled out a whopping Rs.255879 crore (US $33.5 billion) from equity and Rs.16621 crore ($2.1 billion) from debt segments of Indian financial markets, for a total net outflow of Rs.271950 crore ($35.6 billion) over the period October 2021 to June 2022 (see Table 1). In the first half of this calendar year, the total net outflows were to the tune of Rs.227290 crore ($29.7 billion).

The net sell-off by FPIs for nine consecutive months is the longest monthly selling streak in the Indian equity markets, far outpacing the sell-off seen during the 2008 global financial crisis. In fact, this is the longest monthly selling streak since India opened up its financial markets to foreign investors in the early 1990s. Within the equity markets, the sell-off is more pronounced in financial services (banking and insurance), information technology, and capital goods, as these segments account for the bulk of the assets held by FPIs.

Table 1: Monthly FPI Net Investments (October 2021-June 2022)

US$ Million

Equity Debt Debt-VRR Hybrid Total
October 2021 -1807 -207 378 -21 -1658
November 2021 -790 131 333 -3 -329
December 2021 -2525 -1562 184 -36 -3938
January 2022 -4460 698 -282 229 -3815
February 2022 -4742 -412 65 15 -5075
March 2022 -5385 -741 -427 -9 -6562
April 2022 -2236 -579 -155 9 -2961
May 2022 -5178 -715 1172 -8 -4730
June 2022 -6289 -39 41 16 -6271
Total -33561 -3568 1280 190 -35659

Source: NSDL, 2022.

The Fifth Episode of Sudden Stops and Reversals

The current sell-off by the FPIs in the Indian markets marks the fifth major episode of sudden stops and reversals in capital flows seen in the past 15 years, after the 2008 global financial crisis; the 2013 “taper tantrum”; the normalization of US monetary policy in 2018; and the outbreak of the COVID-19 pandemic in early 2020 (Figure 1).

Unlike previous episodes of sudden stops and reversals, the volume of outflows in the current episode is much higher and could accentuate financial vulnerabilities and worsen overall macroeconomic instability.

Figure 1: Portfolio Capital Flows to India and EMEs

Source: Institute of International Finance, Reserve Bank of India, 2022.

Additionally, the boom-bust cycle is shorter this time than previously. Thanks to the quantitative easing and ultra-low interest rate policies implemented in advanced economies in the wake of the COVID-19 pandemic, foreign investors borrowed significant sums of money for very little and put the proceeds into high-yielding assets in India and other emerging markets. The massive increase in the supply of cheap money was short-lived, however, as central banks in the US and other advanced economies signaled interest rate hikes to tame rising inflation. Expectations of a rate hike in the United States in late 2021 prompted foreign portfolio investors to reduce their exposure to riskier assets in India (and other emerging markets) and shift funds to safe havens assets such as US Treasury bonds and gold.

The selling streak began in October 2021, when India’s $3.2 trillion equity market indices hit an all-time high. The continuous selling by FPIs severely eroded India’s stock market capitalization. However, it is still the fifth-largest market in the world (in terms of market cap) after the US, China, Japan, and Hong Kong. Unlike the US equity markets, the Indian markets has not yet entered bear territory due to large-scale net buying by domestic institutional and retail investors. Domestic retail investors have primarily acted as a buffer against the significant withdrawal by FPIs, thereby maintaining stability in the Indian equity markets. However, rising savings rates and term deposit rates in the coming months would drive retail investors away from equity markets and could therefore weaken strong support against unrelenting selling by FPIs.

Of course, India is not alone in experiencing boom-bust cycles of volatile capital flows and associated macroeconomic stability challenges. Other emerging markets in Asia, notably South Korea, Indonesia, the Philippines, and Taiwan, have also experienced large FPI outflows in recent months. In the case of poor and developing countries, the problem is further worsened by their limited fiscal space and inability to borrow money in international markets by issuing debt denominated in their own currency.

The continued capital outflows from India and other emerging markets are mainly due to global factors such as multiple rate hikes by the Federal Reserve and other AE central banks, a rise in US Treasury yields, rising commodity prices, and heightened geopolitical tensions due to the ongoing war between Russia and Ukraine. In the case of India, relatively expensive valuations relative to its peers have also fueled capital outflows in recent weeks.

Indian Rupee: At the Mercy of Global Events

One of the adverse consequences of the capital outflows is the continuous weakening of the Indian rupee. The rupee has lost more than 6 per cent against the US dollar this year. On June 29, the rupee hit an all-time low of 79.03 against the US dollar. The multiple reasons for the rupee’s depreciation include foreign investors withdrawing their money from the Indian financial markets; the strengthening US dollar; elevated international crude oil prices; and the deteriorating trade balance. Despite regular interventions by the RBI in the currency markets, the rupee continues to be one of the worst-performing currencies in Asia.

When FPIs invest in Indian equity and bond markets, they measure financial returns in US dollars and other foreign currencies. If the rupee depreciates against the US dollar, it decreases the value of their investments in dollar terms and, therefore, they may engage in distress sales of funds. A rapidly depreciating rupee will prompt even more FPIs to pull out their money as they fear it will fall further. FPIs from the United States account for 34 per cent of the total FPI investments in India. With the US dollar strengthening and interest rates rising, selling pressure from FPIs has increased in recent weeks, raising the prospect of much larger capital outflows in the coming months.

In the current Indian context, when inflation is already high, the depreciation in the value of the rupee exacerbates inflationary pressures as the country imports nearly 85 per cent of its oil needs. Higher oil and commodity prices would be catastrophic for millions of Indians living below the poverty line. A falling rupee would also cause the government to spend more (through subsidies) and make it more expensive for Indian companies to pay off their foreign currency debt.

With nearly $600 billion in forex reserves and an outstanding forward position of $63 billion, the Reserve Bank of India has regularly intervened in the spot, futures, and forwards (both onshore and offshore) currency markets to arrest the sharp decline in the rupee.

However, the impact of the RBI’s interventions in containing the downward pressure on the rupee has been somewhat limited. The central bank should exercise caution in using its firepower to stem the rupee’s fall. The reason is that central bank interventions in currency markets are considered most effective when conducted for a brief period (less than a month). Otherwise, central banks risk depleting substantial forex reserves without significant impact, as seen in China (2015) and Turkey (2019-20).

Going forward, the US dollar is likely to remain strong. Global monetary policy tightening and risk aversion towards EM assets will continue to weigh on the rupee.

A Widening Current Account Deficit: No Room for Complacency

On the current account, India’s import bill would increase substantially due to higher crude oil prices and a sharper rise in imports (driven by both oil and non-oil items) relative to exports during the current fiscal year (FY23). Since oil and other commodities are priced in US dollars globally, a stronger dollar makes India’s imports costlier.

With India importing nearly 85 per cent of its oil needs and oil imports accounting for more than 20 per cent of the total import bill, the hardening of crude oil prices due to the ongoing Russia-Ukraine war has further worsened the current account deficit (CAD) outlook.

With crude oil prices elevated above $100 per barrel, India’s CAD is expected to rise from $38 billion in FY22 to an all-time high of $100 billion (2.9 per cent of GDP) in FY23. A widening current account deficit coupled with persistent portfolio outflows on the capital account could push India’s balance of payments into deficit in FY23. Market analysts estimate that the net balance of payments deficit could be well over $40 billion in FY23.

There is no denying that India’s external sector indicators are more robust now than during the 2013 “taper tantrum” and its $590 billion FX reserves provide a good buffer, but a prolonged period of rapid CAD expansion combined with large portfolio outflows could erode this comfort and undermine India’s external sustainability. The Indian authorities need to closely monitor current and capital accounts developments to prevent the soaring balance of payments imbalances.

RBI’s Estimates of Capital Flows at Risk

In a recent article titled, “Capital Flows at Risk: India’s Experience”, published in RBI Bulletin June 2022, the RBI economists used the Capital Flows at Risk (CaR) approach to assess the risks to capital flows by examining what current global and domestic conditions can tell us about the likelihood and magnitude of future capital flows.

The article estimated that, in an adverse scenario, potential portfolio outflows from India could average up to 3.2 per cent of GDP in a year. “Our results indicate that there is a 5 per cent chance of portfolio outflows from India of the order of 3.2 per cent of GDP or $100.6 billion in a year in response to (i) a COVID-type contraction in real GDP growth, or (ii) a GFC type decline in interest rate differentials vis-à-vis the US, or (iii) a GFC type surge in the VIX. In an extreme risk scenario or a black swan event in which there is a combination of all these shocks, there is a 5 per cent chance of outflows under portfolio investments of 7.7 per cent of GDP and short-term trade credit retrenchment of 3.9 per cent of GDP. These estimates assume significance when assessed against the total stock of portfolio investment in India of $288 billion and short-term trade credit of $110.5 billion at the end of December 2021. This is indicative of the level of liquid reserves that need to be maintained at all times – in addition to standard metrics of import and debt servicing cover – to quell bouts of instability that volatile capital flows can impose in a dynamic and highly uncertain global setting in which pandemics, supply chain disruptions, and elevated commodity prices and geopolitical tensions keep interacting and intertwining”, says the article.

The article further noted that “the magnitude of outflows could be even higher when CaR is measured at 0.1 per cent probability (highly unlikely). These results show that the entire stock of portfolio investments could exit India in this extreme adverse scenario. In the face of an extreme event, other forms of capital flow considered as stable flows may also exit”.

Managing US Monetary Policy Spillovers

The US Federal Reserve is aggressively tightening monetary policy to tame domestic inflation. However, its monetary policy actions have implications for the global economy, with significant spillover impacts on the total output, inflation, trade balance, and exchange rates in emerging market economies.

Historically, US monetary policy has been the single most influential element in determining capital inflows and outflows in EMEs. Indeed, there is a strong relationship between US monetary tightening and output contractions and financial shocks in EMEs, as witnessed during the financial crisis in the Southern Cone of Latin America in the late 1970s and early 1980s (“the Volcker shock”), the “Tequila” crisis in Mexico in 1994-95, and the 2013 “Taper Tantrum”.

Despite the growing interconnectedness of world financial markets and the widespread use of the US dollar for trade and financial flows, the Fed has not taken a global view of its monetary policy stance, which is primarily guided by domestic concerns. Nor is there any international policy coordination to manage the spillover effects of the monetary policies of the US and other advanced economies. After the 1997 Asian financial crisis, numerous policy proposals to reform the international financial architecture were discussed in international policy forums. However, the reform efforts soon lost momentum due to a glaring lack of political will around the world.

In this global setting, most EMEs are accumulating large foreign exchange reserves to self-insure against future currency turmoil. India is no exception. EM central banks often raise policy rates to maintain an interest rate differential, even though their domestic economic conditions may not warrant a rate hike.

The Need to Regulate Volatile Portfolio Flows

Unlike foreign direct investment, portfolio investment flows are mostly driven by global factors and are more sensitive to spillover effects related to US monetary policy events and changes in global risk sentiment.

Portfolio flows are the most volatile component of global private capital flows. The sudden stops or quick reversals of portfolio flows can have detrimental effects on the host emerging economies, with potential negative financial stability implications.

The impact of portfolio flows on exchange rate and asset price volatility is substantial, particularly given the growing presence of passive funds and asset management companies. They are important in determining the overall balance of payments in EMEs. This brings us to the question: to what extent do India and other host EMEs allow foreign portfolio investments in their domestic financial markets?

Since host countries have no control over global events, they should regulate portfolio flows to protect against excessive capital volatility and the associated financial shocks.

For India and other EMEs, it should be evident that the IMF’s policy prescriptions, such as adjusting monetary, fiscal, and exchange rate policies, will not effectively curb excessive capital outflows, which are more difficult to manage. They should not heed the IMF’s advice, articulated in its latest Review of the Institutional View on the Liberalization and Management of Capital Flows (2022) that “risks from capital flow volatility can be managed by macroeconomic and financial sector policies supported by strong institutions, and through temporary use of CFMs and CFM/MPMs under certain circumstances”.

In the current circumstances, the imposition of capital controls could be the first line of defense to curb excessive capital volatility. In this regard, the IMF’s insistence on hierarchy and preconditions for the use of capital controls is outdated. Also, the IMF’s 2022 Review does not recommend using CFMs on outflows on a preemptive and lasting basis.

An Exit Tax

Fortunately, India’s capital account is not fully open, and the country has the legal and administrative framework to enforce capital controls. This creates an enabling environment for the deployment of capital controls. The Indian authorities could choose a variety of price-based and quantity-based controls on outflows associated with FPI investments in the financial markets.

One of the well-known price-based controls is an exit tax. The Indian authorities may consider a modest exit tax targeted at FPI investments as a stability contribution, somewhat similar to what Iceland proposed in 2015 and Malaysia introduced in 1998. With clear and well-defined schedules and rules, the exit tax can help slow the pace of capital flight from India. The tax should not remain in place for long and could be lifted once the risks of rapid capital flight are reduced. An exit tax on capital outflows has other benefits, such as raising revenue quickly without fundamental changes to the domestic tax system and creating space for the conduct of an independent monetary policy.

To conclude, the tightening of monetary policy in the US has significant global spillovers across advanced and emerging market economies. In the absence of international monetary policy coordination, the task of maintaining macroeconomic and financial stability rests solely with national authorities.

With no signs of selling exhaustion and portfolio flows likely to remain volatile in the near-term, Indian policymakers must remain vigilant about the potential macroeconomic and financial stability risks posed by large capital outflows. What is good for foreign portfolio investors may not be good for India’s macroeconomic stability.

Unprecedented times call for unprecedented measures. The Indian authorities must act early and undertake all measures available in the broader policy toolkit to safeguard macroeconomic and financial stability. It is better to be safe than sorry.

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