Inflows pose risk to Indian economy

Strong capital inflows pose substantial challenges to India, according to a report by the International Monetary Fund (IMF). They are causing the rupee to appreciate, raising concerns about inflation and could undermine India’s competitiveness.

This development is in contrast to the view that sees India as relatively immune to external economic influences. Other large emerging economies have experienced similar inflows but India is the only one to have a current account deficit.

In its recent staff report on the Indian economy the IMF points out that overseas investors bought a net $18.8 billion (9.4 billion) of equities and bonds from January-November 2007, compared with the previous record of $9.5 billion in the same period in 2006.* However, such investment was only a small proportion of total flows with other forms of capital flows accounting for much more.

The strong capital inflows are a result of India’s recent economic strength. As the IMF staff report says: “The productivity driven growth boom and India’s increasing financial integration have attracted record capital inflows.”

But such inflows can have side effects despite the positive impetus behind them. The IMF refers to these as the “impossible trinity”: rising exchange rates, inflationary pressures and concerns about competitiveness. The rupee rose by 7% in real effective terms between December 2006 and August 2007, after being stable from 2000, prompting the authorities to intervene in the foreign exchange markets. Its surge has fuelled concerns that India’s exports could become less competitive. In addition, India’s reserve bank has hiked interest rates since late 2006 to head off inflationary pressures.

Meanwhile, figures from India’s statistics ministry estimate GDP growth in the 2007-8 financial year at 8.7% compared with 9.6% in 2006-7.* Available at www.imf.org