Foreign Capital Inflow in Developing Economies– Further Analysis

**This is the second part of a series on foreign capital inflow. To read the first part, click here: Foreign Capital Inflow in Developing Economies– An Overview** 

Trends in capital inflow

The earlier incidence of capital inflow in the 17th, 18th 19th and 20th century was largely through extensive borrowing and lending. Historical data reveals the cases of extensive borrowed of fund from Holland by England in the 17th and 18th century. England, however in the 19th and 20th century rose to power as an imperial strength and conquered the major domains of the globe and established its colonies. Further, during this phase it lended huge funds to its colonies and allies. The rise of USA as a strong player aroused much later, immediately after the First World War when the European powers experienced a sharp downfall and loss of capital due to war and poor economic conditions. Over this period, US emerged as a dominant player and its foreign investment grew to a much bigger share of the world total. The Great Depression of the 1930s was a setback to this high growth but the recovery again stimulated for the further strengthening of the US economy.

The 1970s witnessed the huge inflow of foreign capital to the emerging economies triggered by the oil shocks of 1973-74. Latin American countries were the major recipients of this fund. However, this inflow was reduced and the developing economies were plunged into the crisis of debt repayment with an overall increase in the world interest rate. Soon, international lending was revived and this time the benefit was extended to the economies of Asia as well.

The inflow of capital to India began with the establishment of the East India Company. Independent India witnessed the inflow of capital largely through government-to-government funding. The concept of FDI came into prominence during 1950s and 1960s among which the foreign private capital inflows occupied the big share. However, this inflow was sharply reduced after 1960s mainly due to the protectionist policies of the Indian government and extensive importance attributed to the agricultural and domestic manufacturing sector. The revival of fund inflow took place after 1990s due to the economic reform policies of the Indian government through liberalization, privatisation and globalization. The period after the policies of LPG witnessed huge capital inflow but many a times the government limited the foreign investment to 49 percent of the share, giving prime importance to the stakeholders. Even though the capital inflow rate showed sharp declines at certain point, the net investment remained to be positive. Also, the global financial crisis of 2008 was a  major setback to the inflow rate. Over these years, foreign and regulatory policies of the government have changed much to attract more investments and to raise India to the standards of a global manufacturing power. The 100 percent FDI schemes in many sectors and the Make in India Project are major milestones in this regard.

Determinants of foreign capital inflows

A number of countries have taken wide ranging steps to encourage and attract capital inflows to incentivise investment and opportunities. However, certain factors stimulating capital inflows are country-specific, like the endowment of natural resources, good institutional and political framework etc. On the other hand, certain policies can be adopted by the economies to incentivise and attract more capital inflows into their financial system. The important determinants of FIC are the deregulation of domestic activity, liberalization of capital account transactions and equity markets and regionalism.

Domestic financial liberalization refers to the reduction in the restrictions of domestic financial markets. Increased domestic deregulation of financial markets incentivises the increased flow of capital into the domestic market. As against the protectionist aspect of trade and capital flows, DFL leads to the increased flow of investments like FDI by creating equal scenario for both the foreign and domestic firms to compete for funds and finance. FDI is an important contributor to capital inflows as it stabilizes the growth prospects by making the market resistant to speculative crisis. Further, FDI results in the accumulation of assets, both tangible as well intangible which in turn results in increased credit creation and enhances productivity. DFL creates increased flow and access to domestic credit which becomes an important source of operations. Further, the deregulation of the domestic market coupled with favourable policy frameworks gradually builds confidence in the foreign investors and multinationals, providing the platform to establish their firms within this new market. Also, DFL attracts more portfolio investment through signalling the financial market developments as well as by creating positive externalities to function and facilitate the operation of more investments. The DFL also attracts more external inflows when the domestic credit outpaces the growth of deposits.

External financial liberalization refers to the reduction or deregulation of restrictions affecting the flow of capital into the system. While the DFL deals with liberalization of domestic restrictions as well as the proper channelization and integration of FDI and other components into the domestic system, external financial liberalization itself questions the possibility and pathway of these inflows. Thus, it includes the liberalization of restrictions related to FDI, investment and equity flows, etc. EFL has huge implications particularly for the flow of FDI. The liberalization policy enhances the inward FDI flow which further increases the flow of portfolio investments. Overseas borrowing is an important component of external capital sources. External liberalization thus results in the pacification of conditions on external borrowing. Simplification of these regulations will not only facilitate borrowing from sovereign sources or international financial institutions but also facilitate more capital inflow through foreign private borrowings. This is incentivised through the modes of increased tax incentives as well as through limitation of quantitative restrictions.

Equity market liberalization is the other aspect of external liberalization that facilitates increased portfolio investments as well. Restrictions on equity market prevents interested and capable foreign investment players from entering the financial market and quantitative restrictions limits the quota and size of these investments. Liberalization of the same could direct more foreign investments into the equity markets which along with provision of tax incentives and benefits will add on to the confidence of conducting business as well reduce the huge set of transaction cost that would get added up.

Other than the above three components, the type of exchange rate system a country has also plays an important role. The abolition of multiple exchange rate system could well regulate the fluctuations in trading of capital and other assets. Further, this would add to the efficiency of the government policies as well as the well maintained market discipline. Regionalism is a formal process of integration of trade and financial system with that of regional trade and systems. This process along with the provisions of tax benefits, harmonising trade relations and regulating barriers or restrictions ensure increased inflow of capital and assets. Regionalism includes the elimination of restrictions on cross border trade and investment opportunities and thus results in the international integration of trade and investment. Empirical evidences from both developing and developed economies portrays a positive relationship between increased international integration and increased capital inflows. The integration of international trade and investments with that of regional integration accrue many benefits like increased access to domestic credit, reduced production cost, free mobility of factor inputs, improved and expanded market access, increased opportunities of risk diversification and risk spreading and achievement of balanced regional development.

Thus, capital inflow and accumulation plays a fundamental role in the developing of any form of economy. Prof. John P Lewis justly notes, “...almost every developed country of the world in its developing stage had made the use of foreign capital to make up deficiency of domestic saving”. The growth and development prospect of emerging economies is closely linked in their ability for the absorption and accumulation of capital. There exists a very strong relationship between the foreign capital inflow and economic growth. Stable market and low volatility conditions are quite desirable for the successful endowment of capital resources in an economy. Along with this the institutional and regulatory policy have great role to play.

Picture Courtesy- The Hindu Businesss Line


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