Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Is India experiencing incipient capital flight?

A number of phenomena we observe in India in the last few years can be interpreted as incipient capital flight:

  1. Gold imports have risen sharply not only in value terms but also in terms of quantity. The nature of the gold demand has also changed. In recent years, we have been seeing a significant amount of gold being bought by the rich as an investment. A poor household buying gold jewelry could be interpreted as a form of social security, but a rich household buying gold bars and biscuits is a form of capital flight. Instead of converting INR into USD or CHF, many rich investors are converting INR into XAU.
  2. Many Indian business groups are investing more outside India than in India. Many of them are openly justifying it on the ground that the investment climate in India is poor. This is of course a form of capital flight.
  3. It is difficult to explain India’s large current account deficit and poor export growth solely on the basis of low growth in the developed world. First, many of our competitors in Asia and elsewhere are posting large trade surpluses in the same environment. Second, the depreciation of the Indian rupee has improved competitiveness of Indian companies in world markets. Indian companies used to complain loudly about their lack of competitiveness when the dollar was worth only 40 rupees, but with the dollar fetching 55 rupees, these complaints have disappeared. I fear that some of the current account deficit that we see today is actually disguised capital flight via under-invoicing of exports and over-invoicing of imports.

While economists have focused on the impossible trinity (open capital account, independent monetary policy and fixed exchange rates), I am more concerned about the unholy trinity that leads to full blown capital flight. This unholy trinity has three elements: (a) a de facto open capital account, (b) poor perceived economic fundamentals and (c) heightened political uncertainty. I believe that the first two elements of this unholy trinity are already in place; we can only hope that the 2014 elections do not deliver the third element.

While our policy makers keep up the pretence that India has a closed capital account, the reality is that during the last decade, the capital account has in fact become largely open. Outward capital flows were largely opened up by liberalizing outward FDI and allowing every person to remit $200,000 every year for investment outside India. This means that the first element of the unholy trinity (an open capital account) has been in place for sometime now. If the other two elements were also to materialize, a full blown capital flight is perfectly conceivable. India’s reserves may appear comfortable in terms of number of months of imports, but in an open capital account, this is not a relevant metric. What is relevant is that India’s reserves are about 20% of the money supply (M3), and in a full blown capital flight, a large part of M3 is at risk of fleeing the country.

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2 responses to “Is India experiencing incipient capital flight?

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