Foreign Capital Movement-Assignment(Group1)_Ver4(3)

International Business Environment

FOREIGN CAPITAL MOVEMENTS

Submitted to:

Prof. V.K. Bhalla

Submitted on:20, March, 2010

By:

Amit Chawla (S-8)Anshul Khanna (S-12)Ranjit Kumar (S-51)

Sushil Kumar Sharma (S-65)Manoj Kumar Rana (N-29)

Subhadip Raychaudhuri (N-54)

MBA-PT 2007-2010

International Business Environment: Foreign Capital Movement

Faculty of Management StudiesUniversity of Delhi

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TABLE OF CONTENTS

EXECUTIVE SUMMARY..................................................................................................................4

I. INTRODUCTION.......................................................................................................................6

II. DRIVERS OF CAPITAL MOVEMENT...............................................................................8

III. FORMS OF CAPITAL MOVEMENT............................................................................19

1) INVESTMENTS............................................................................................................................192) LOANS AND BORROWINGS..........................................................................................................313) INTERNATIONAL BANKING FLOWS............................................................................................444) DONATIONS AND CHARITY........................................................................................................445) HAWALA TRANSACTIONS...........................................................................................................456) OTHERS......................................................................................................................................457) ROLE OF RESERVE BANK OF INDIA...........................................................................................47

IV. IMPACT ON NATIONAL ECONOMY.........................................................................53

V. GLOBAL FINANCIAL INSTITUTIONS...........................................................................66

1) INTERNATIONAL MONETARY FUND (IMF)...............................................................................662) WORLD BANK............................................................................................................................703) WORLD TRADE ORGANIZATION (WTO).................................................................................74

VI. GLOBAL SCENARIO - BEFORE AND AFTER CRISIS........................................78

1) BACKGROUND AND CAUSES.....................................................................................................792) FINANCIAL MARKETS IMPACTS..................................................................................................843) EFFECTS ON THE GLOBAL ECONOMY.......................................................................................854) RESPONSES TO FINANCIAL CRISIS............................................................................................87

VII. BRIC COUNTRIES POSITION......................................................................................96

VIII. GLOBAL ISSUES..............................................................................................................118

1) IMPLICATIONS FOR INDIA OF MORE MONEY PRINTING BY USA...........................................1182) IMPLICATIONS FOR NOT REEVALUATING CURRENCY (MAINLY CHINESE) FOR LONG..........122

IX. STEPS TO BE TAKEN....................................................................................................128

1) MAKING DOMESTIC BANKING INSTITUTIONS STRONG...........................................................1282) MARKET STABILIZATION SCHEME (MSS) BONDS................................................................1283) CREATE STRONG DOMESTIC MARKETS..................................................................................1294) ADDRESS PROBLEMS IN DOMESTIC FINANCIAL SYSTEM FIRST.............................................1295) LIBERALIZING LONG-TERM FLOWS AHEAD OF SHORT-TERM FLOWS...................................1306) IMPROVED TRANSPARENCY IN MARKETS................................................................................130

X. CONCLUSION........................................................................................................................131

XI. APPENDIX..........................................................................................................................135

1) COMPOSITION OF CAPITAL FLOWS (NET) OF INDIA............................................................1352) INTERNATIONAL INVESTMENT POSITION OF INDIA................................................................1363) FOREIGN EXCHANGE RESERVES OF INDIA............................................................................140

XII. Bibliography.....................................................................................................................141

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Executive Summary

Since liberalization and globalization foreign capital has come to assume an important

place in the development of the country. Foreign capital movements have increased

considerably. The resident individuals and companies are now allowed to undertake

various types of foreign exchange transactions, including investment in foreign

countries, establishing foreign subsidiaries, joint ventures, foreign collaboration,

mergers and acquisitions etc., with foreign residents and companies.

Some of the key drivers of the capital movement across international boundaries

include globalization, higher productivity of capital, tax exemptions, higher returns,

developmental needs exceeding the domestic savings, political stability, exchange rate

policies, demographic trends etc.

The key forms through which the capital moves includes investments (in the form of

private investments, FDIs, FIIs, overseas corporate bodies etc.), loans and borrowings,

international banking flows, donations and charity, remittances, hawala transactions

etc.

RBI plays a critical role in the foreign capital movements across India. In the field of

Foreign Exchange, activities of RBI include - maintenance of foreign exchange rate,

provision of sale and purchase of foreign exchange through authorized dealers and

Licensed Money changers, market intervention, sterilization, deployment of foreign

exchange reserves and representing India at various International forums.

Capital inflows play a critical role in the growth of the economy and accumulation of

foreign exchange reserves. FDIs also bring in advantages with regards to employment

and technology. However, excess of capital inflows lead to speculations with regards

to asset price increases, and also leads to an increase in exchange rates and interest

rates. Capital outflows also bear a negative impact for the home economy as it may

lead to unemployment and capital crunch for the residents of the country.

A sound fiscal and monetary policy is required to maximize the benefits of foreign

capital movement and minimize the adverse impacts of foreign capital movement. It is

important that the domestic banking institutions are made stronger. As a general rule,

nonviable institutions should be weeded out and remaining banks put on a sound

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footing before liberalizing or opening the domestic banking system. Also, it is

important that the domestic markets are made stronger. These domestic markets and

financial infrastructure for portfolio investments in equities and debt instruments are

not well developed in many emerging market countries. Finally, the long-term flows

should be liberalized ahead of the short term flows.

As per a report by a working group chaired by Dr. Rakesh Mohan, Deputy Governor,

Reserve Bank of India, the flow of capital between nations, in principle, brings

benefits to both capital-importing and capital-exporting countries. Swings in capital

inflows without offsetting changes in current account balances can lead to large, and

possibly disruptive, changes in real exchange rates. And they are frequently associated

with more volatile or fragile forms of finance. Past experience suggests that large

capital inflows - whether absorbed or not - can drive up the prices of existing assets

and may not lead to the creation of new assets. Asset market bubbles have been

disruptive in some EMEs. Policymakers need to keep these risks in mind.

How well domestic capital markets function has a major bearing on whether capital

inflows enhance growth without exacerbating financial stability. The greater presence

of foreign investors should, in principle, deepen local financial markets, enhance

investor diversity and improve liquidity. But they can also exacerbate the domestic

macroeconomic and liquidity crisis in the times of crisis through massive liquidation

of their investments in the EMEs.

Overall, it is a combination of sound macroeconomic policies, prudent debt

management, exchange rate flexibility, the effective management of the capital

account, the accumulation of appropriate levels of reserves as self-insurance and the

development of resilient domestic financial markets that provides the optimal

response to the large and volatile capital flows to the EMEs.

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I. Introduction

In earlier times the society and countries had limitations of communications and

transportation. Due to these limitations they remained in aloofness. They made efforts

towards progress and development with the help of capital and resources available

with them. With the passage of time science and technology had made significant

progress, new and faster means of communication and transport were invented and

developed, which increased interaction between people and institutions of different

areas and countries significantly. However still there were considerable restrictions on

capital movements between the countries which hindered the global economic

development.

Eminent economists stressed on liberalization of capital movements. International

economies undertook economic and financial reforms to give a boost to the economic

development.

India started economic and financial reforms in late 1980s. It liberalized various

provisions of Foreign Exchange Regulation Act 1973 and renamed the act as Foreign

Exchange Maintenance Act 1999. It made Current Account fully convertible. Capital

Accounts transactions were also liberalized partially. The Reserve Bank of India and

the central Government had decided to take a cautious view to introduce full capital

account convertibility in stages in due course.

The resident individuals and companies were allowed to undertake various types of

foreign exchange transactions liberally viz. investing in foreign countries, establishing

foreign subsidiaries, joint ventures, foreign collaboration, mergers and acquisitions

etc., with foreign residents and companies.

Since liberalization and globalization foreign capital has come to assume an important

place in the development of the country. Foreign capital movements have increased

considerably. However like every earthy thing, foreign capital had also good and bad

impacts on the economy of the recipient country. It all depended on the circumstances

and terms and conditions on which foreign capital was received, the sectors in which

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the same was employed productive or unproductive, how it was being utilized

earnestly or corruptly.

In the next few chapters an effort has been made to discuss various aspects of foreign

capital as enumerated below:

Chapter I gives a brief introduction to the subject matter, purpose of the report and

chapter scheme.

Chapter II elaborates as to what is foreign capital, why it moves what are the drivers

which make the capital to flow.

Chapter III mentions the various forms the foreign capital assumes and discusses

about the various participants and their roles in foreign capital movement.

Chapter IV presents the whole picture with data on foreign capital movement

(inbound and outbound) from India.

Chapter V evaluates impact of foreign capital movement on our national economy.

Chapter VI depicts the global scenario as regards to foreign capital movement.

Chapter VII touches upon global issues in this regard.

Chapter VIII tells about the global economic crisis and subsequent international

economic cooperation to fight the global recession.

Chapter IX considers implication of printing more money by the USA and that of

revaluation of currencies by countries.

Chapter X tries to delineate the steps to be taken to optimize on the foreign capital.

Chapter XI gives a mention of the conclusions derived by the eminent economists and

study groups.

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II. Drivers of Capital Movement

In the start we will discuss as to what capital is, what foreign capital is and why it

moves.

Capital -

In Economics capital is considered as a factor of production which is not wanted for

itself but for its ability to help in producing other goods. It is the most important input

by which other inputs like labour, raw material, building, plant and machinery etc. can

be purchased and put to use for production.

In Finance, capital is any form of wealth capable of being employed in the production

of more wealth. The capital is invested for producing more wealth. This investment of

capital takes two forms e.g. Real investment and financial investment:

Real investment – Real investment refers to money invested in purchase of tangible

and productive assets such as land, building, plant and machinery etc., as opposed to

investment in securities or other financial instruments.

Financial investment – Financial investment is the commitment of money for

purchase of financial assets e.g. shares, debentures, bonds, mutual funds units,

insurance units, fixed deposits etc.

It may be clarified that the investment in the initial public offer (IPO) of a company

provides money directly to the company and the same uses it for production and

hence may be considered as real investment. However, investment in financial assets,

in the secondary market represents financial investment.

Foreign Capital –

Capital invested in a country by the investors from the other countries is called

foreign capital.

When domestic investors of a country, having surplus investible funds which

represent domestic capital, invest in foreign countries, this domestic capital becomes

the foreign capital for the investee countries. This change of form of capital, from

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http://www.businessdictionary.com/definition/securities.html

http://www.businessdictionary.com/definition/investment.html

http://www.investorwords.com/3712/plant.html

http://www.businessdictionary.com/definition/asset.html


domestic capital to foreign capital takes place through the mechanism of foreign

exchange.

Why does capital move?

In economic and finance movement of capital is technically referred to as flow of

capital. Flow is a natural phenomenon. Just like -

◦ Water flows from higher to lower level

◦ Heat flows from higher to lower temperature

◦ Air flows from higher to lower pressure

Similarly capital has a tendency to flow

◦ For a given return, from higher risky investment to a lower risky one.

◦ For a given risk level, from an investment giving lower return to an

investment yielding higher return.

Forms of capital flow –

Capital movement means movement of capital between different countries either by

individuals on corporate. Capital movements are of two types:

Outward capital movement denotes movement of domestically held capital

from one country outwardly to other countries abroad;

Inward capital movement represents movement of foreign owned capital into a

country.

Drivers of Foreign Capital Movement –

Some of the main drivers i.e factors which causes capital tl move are listed below:

Globalization

Productivity

Taxes

Higher return (rate of interest)

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Developmental needs exceeding the domestic savings

Exchange Rate Policy

Political stability

Demographic trends

Now we shall discuss these drivers in some details:

Globalization –

Globalization is taken here to mean the growing integration of national economies and

societies, so that no society is isolated or remote from changes and developments in

other societies.

This is a process which has been going on for thousands of years, yet since the 1950s

the pace of change has increased. This is manifest in the increasing cross-border flow

of goods and services, where consumers in one country buy a substantial number of

goods produced in other countries.

At the same time there are increased capital flows between nations where savers in

one nation may invest in other nations. For example, over the period 1990-1998,

cross-border trade in goods and services has grown at an average annual rate of 6.6%,

twice the rate of growth of world GNP.

Globalization is the culmination of an evolution of markets. Historically, markets

have started as local in nature, with producers and consumers in close physical

proximity. What we then frequently see is an evolution of these local markets to

national markets and then finally international or global markets. It is this evolution

that is called globalization. It should be emphasized that not all markets evolve at the

same rate or at the same time, so that we can see markets today at all stages.

Capital markets are now more integrated. Capital is more mobile and currency

controls have been relaxed in most countries. The movement of capital to those

investment opportunities and countries where it generates the highest return can be

destabilizing - witness the controls recently placed on capital in Malaysia.

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This is due in part to the mobility of financial capital. Physical capital, represented by

physical plant, is not mobile; once built a factory is hard to move. As currency

controls have been relaxed, investment opportunities for individuals have been

increased and they can now buy shares in the US, or any number of other countries.

There has been rapid growth in the value of world trade (goods and services), much

faster than the growth in the total world economy. This reflects increasing

specialization by countries.

Productivity –

Nature has variety. It has endowed its treasure to different regions and different

countries in different proportions. Some countries have pleasant weather and some

faces vagaries of the weather. Some countries are rich in natural resources whereas

the nature has not been so generous on some others. Some countries are abundant in

natural resources and provide cheap raw material for production. Some countries like

China and India have large workforce and they provide cheap labour for productive

activities. Some are rich in oil and their whole economy is flourishing with oil

production.

Standard neoclassical theory suggests that international capital movements should

respond to differences in expected rates of return on capital across countries.

Accordingly, capital “should” flow from high-income countries to developing

countries (where capital/labour ratios are lower and the productivity of capital higher),

boosting growth for some years and allowing developing countries to run current

account deficits. In a world with perfect capital markets, capital flows can be used to

smooth consumption or finance profitable investment opportunities.

One qualification to this perspective is that the expected variance of returns also

matters: potential investors can be deterred from investing in developing countries

because of greater risks. Nevertheless, allocating capital to where risk-adjusted returns

are higher should raise global welfare.

The neoclassical perspective broadly fits the pattern seen from the late 19th century

up to 1914. Capital flowed to developing areas where the expected return on capital

was high. The associated current account imbalances were larger, measured in relation

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to GDP, than in subsequent periods. Four features of this classical period are worth

noting:

First, flows were almost entirely denominated in gold standard currencies,

mainly sterling – nominal exchange rates were in fact fixed. This arrangement

also served to stabilise inflation expectations.

Second, the main investment vehicle was bonds, and nominal long-term

interest rates were comparatively stable.

A third, partly related, feature was that the range of financial assets was

extremely limited. Denomination of contracts in gold standard currencies and

the stability of long-term interest rates eliminated much of the need for

financial diversification and hedging. In any case, the high costs of

communication and of computation impeded the development of such

activities. Hence the forms that capital flows took were much more uniform

than has been the case in recent decades. Nor were there the huge two-way

flows of capital that prevail today.

The final feature was that, much of the movement of capital was long-term in

nature, going to finance investment in capital-intensive infrastructure and

other real investment. The scope for profitable foreign investment was

considerable at that time because real output was expanding twice as fast in

capital-importing countries outside Europe than in capital-exporting countries

in Europe and because of confidence that bonds would be honoured. Increased

real investment led to deterioration in the current account of recipient

countries so that the transfer of capital could be “requited” without a change in

the real exchange rate.

In the late 1980s and early 1990s, however, there was a revival of capital flows to the

EMEs as growth in the industrial world picked up. After a short-lived tightening in

1994, US policy rates were reduced in 1995 and the decline in European rates

continued: this easing of monetary conditions in major countries increased the supply

of low-cost finance through banks and the international capital markets.15

International bank lending moved from Latin America to the rapidly growing Asian

developing countries (“Tigers”). The issuance of debt securities, mostly denominated

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in dollars, in international capital markets increased. East Asia and Russia benefited

from declining risk premia on sovereign (and even bank) debt. Substantial current

account deficits were financed in ways that created large risk exposures (see below).

This period of expansion in capital flows, punctuated by the Mexican crisis at the end

of 1994, really came to an end only with the Asian and Russian crises in 1997–98.

These crises demonstrated that capital flows into countries with weak banking

systems and underdeveloped capital markets create huge risks.

Thus the flow of capital increased to the countries which had received large capital

inflows in the past and had established better physical and financial infrastructure

leading to higher productivity of capital.

Taxes –

Logically the capital should move to the countries with low tax regimes so that the

prime motive of increasing return on investment could be attained.

Tariff reductions, falling transport costs, and reduced barriers to international capital

flows have created extensive opportunities for multinational firms and investors in

increasingly integrated global markets.

In the midst of this rapid integration, investors and firms still face tax systems and

investor protections that differ across countries, and these differences have the

potential to affect major investment and financing decisions. Governments anxious to

attract FDI often consider the use of tax incentives to lure multinational firms, and

governments of FDI source countries--including the United States--often wonder

whether their tax treatment of foreign income is appropriate. Similarly, investor

protections and the broader institutional environment remain distinctive around the

world and may influence investors' port folio decisions and firms' operational and

financing decisions. Corporate taxes and investor protections also have the potential

to influence FPI by changing the relative attractiveness of FPI and FDI as means of

achieving international diversification. The potential effects of taxation on FPI result

from the interaction between home and host country taxes. In particular, the United

States taxes multinational firms legally domiciled here on their worldwide income. As

a consequence of this policy, U.S. investors should prefer FPI as a means of accessing

foreign diversification opportunities, particularly in low-tax countries where the

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residual tax imposed by the United States will be most burdensome. In effect, FPI

allows investors to avoid any residual tax on investment income earned abroad arising

from the worldwide tax regime.

With an increasing number of governments competing to attract multinational

companies, fiscal incentives have become a global trend that has grown considerably

in the 1990s. Poor African countries rely on tax holidays and import duty exemptions,

while industrial Western European countries allow investment allowances or

accelerated depreciation. Have governments offered unreasonably large incentives to

entice firms to invest in their countries?

More recent evidence has shown that when other factors - such as infrastructure,

transport costs, and political and economic stability - are more or less equal, the taxes

in one location may have a significant effect on investors' choices. This effect is not

straightforward, however. It may depend on the tax instrument used by the authorities,

the characteristics of the multinational company, and the relationships between the tax

systems in the home and recipient countries. For example, tax rebates are more

important for mobile firms, for firms that operate in multiple markets, and for firms

whose home country exempts any profit earned abroad (Canada, France) rather than

using tax credit systems (Japan, the United Kingdom, the United States).

Even if tax incentives were quite effective in increasing investment flows, the costs

might well outweigh the benefits. Tax incentives are not only likely to have a negative

direct effect on fiscal revenues but also frequently create significant opportunities for

illicit behavior by tax administrators and companies. This issue has become crucial in

emerging economies, which face more severe budgetary constraints and corruption

than industrial countries do.

Developmental needs v/s the domestic savings –

All countries are at various different stages of economic development. All are trying

hard to attain higher level of development to raise their standard of living. Any

country in its endeavour of economic development utilises capital available with it in

the form of domestic savings. In poor countries rate of capital formation is very low

because of high consumption and consequent low rate of savings. In such cases they

welcome foreign capital to give a fill up to their development efforts. They provide

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tax holidays, import duty exemptions and other preferential treatment to foreign

investors to boost up their developmental efforts.

On the other hand availability of cheaper factors of production e.g. raw material,

labour etc., accompanied with scarcity of domestic capital in such countries provides

an opportunity to the foreign investors to make investment in these capital deficit

countries to earn a good return on their investments.

Other important aspect relating to foreign investment is repatriation of foreign capital.

The country which allows repatriation of foreign capital and interest or income earned

therefrom liberally, attracts more foreign funds compared to those which restrict such

repatriation.

Higher rate of return (rate of interest) –

Maximising the return is the ultimate goal of any investment. The total return

comprise of the interest and the currency appreciation. Thus the country which gives

more interest on foreign capital attracts more capital funds than those which offer

lower return for the equivalent risk.

Interest rates, inflation and exchange rates are all highly correlated. By manipulating

interest rates, central banks exert influence over both inflation and exchange rates, and

changing interest rates impact inflation and currency values. Higher interest rates

offer lenders in an economy a higher return relative to other countries. Therefore,

higher interest rates attract foreign capital and cause the exchange rate to rise. The

impact of higher interest rates is mitigated, however, if inflation in the country is

much higher than in others, or if additional factors serve to drive the currency down.

The opposite relationship exists for decreasing interest rates - that is, lower interest

rates tend to decrease exchange rates.

Exchange Rate Policy –

According to purchasing power parity, exchange rates are determined by relative price

of goods exchanged between countries. Countries with above-average inflation would,

until their exchange rate fell, see their exports priced out of world markets and their

home markets flooded with imports. The result would be a balance of payment deficit.

But this scenario may be reversed by currency realignment. Exchange rates would

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therefore move to equalise the prices of the traded goods between the rival economies

and help to stabilise the system.

The international money flows from where it is cheap and plentiful to where it is

scarce and expensive. It might be hypothesised that exchange rates move to equalise

expected rates of return in rival financial centres. Money moves to centres where

returns are anticipated to be highest. Bur as well as interest received, returns include

anticipated currency appreciation and depreciation. Hence there is direct feedback.

Currencies attracting funds rise and in rising become more attractive. The country

perceived to offer the highest true return has the strongest currency. Its strong

currency then prices its exports out of world markets and causes its home markets to

be flooded with imports. Whereas traditionally, a trade deficit caused a currency to

weaken, it is possible to say that in the middle eighties the relationship has been

reversed. A strong currency causes trade deficit.

This new order is certainly unstable. Currencies overshoot due to effects of positive

feedback. Exchange rate movements operate to generate, rather than to correct

imbalances in trade and payments, and these imbalances may become both large and

unbelievably long-lived. In this world it is vital, but extremely difficult to identify

whether differing expected rates of return are due to real differences in the returns

from capital investment in one economy rather than other. If they are, large

imbalances can and do persist for longer than might be thought to be the case in

traditional models.

Political stability –

Political stability refers to the stable government and stable rules and regulations

framed by such government regulating the economic activities in the country.

Political risk refers to the risk that, 1) political events and processes within the host

country, 2) changing relationships between the host and the home country, as well as

between the host country and third countries, will influence the economic well-being

of the foreign parent firm . Political risk can be classified as macro political risk and

micro political risk. Macro political risk is country-specific political risk and will

influence all foreign firms in the host country alike. Macro risks include

expropriations of all foreign firms in a country, non-discriminatory measures such as

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changes in tax laws, price controls, environmental regulations, and constraints which

affect foreign firms only, such as limitations on the repatriation of capital, restrictions

on expatriate employment and foreign ownership, and local content regulations.

Micro political risk is specific to a certain industry, firm, or project. Political risk may

affect the ownership of the assets, via full or partial forced divestitures, or the

operations of the firm. While macro risk is more visible, micro risk is of more

importance to firms. Economic well being is defined in terms of cash flows. Political

risk is defined as unexpected changes in future cash flows due to political events in

the host country. Political risk may thus lead to unexpected increases or decreases in

future cash flows.

Political risk exists because there is no legal recourse if the foreign government

chooses to expropriate an asset or otherwise increase the cost for foreign firms. The

alternatives for host governments to alter the cash flows from foreign operations range

from reducing cash flow due to higher taxes to completely eliminating any cash flows

in case of full expropriation. Foreign governments will likely choose to do so only if

the expected benefits of the expropriation or other cost to the multinational firm

exceed the expected costs to the foreign government of these actions.

The countries which are politically more stable attract more foreign funds than those

which have more political uncertainties.

Demographic Trends –

The world is in the midst of a major demographic transition. Not only is population

growth slowing, but the age structure of the population is changing, with the share of

the young falling and that of the elderly rising. Different countries and regions,

however, are at varying stages of this demographic transition. In most advanced

countries, the aging process is already well under way, and a number of developing

countries in east and south-east Asia and central and eastern Europe will also

experience significant aging from about 2020.2 In other developing countries,

however, the demographic transition is less advanced, and working-age populations

will increase in the coming decades.

As expected, the changing population and labour force have important impacts both

on private investment through changes in the expected marginal product of capital as

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well as on consumption and saving decisions. The increase in the labour force in

developing countries raises the marginal product of capital and stimulates higher

investment, with the investment to GDP ratio 4 percent higher by 2025.

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III. Forms of Capital Movement

Foreign capital movement generally takes place in the form of –

◦ Investments

◦ Loans and borrowings

◦ International Banking flows

◦ Donations and charity

◦ Remittances

◦ Hawala transactions, etc.

We shall discuss each of the abovementioned forms in detail in next pages.

1) Investments

Foreign Direct Investment in India

In terms of RBI circular, Foreign Direct Investment (FDI) in India is governed by the

FDI Policy announced by the Government of India and the provisions of the Foreign

Exchange Management Act (FEMA), 1999. Reserve Bank has issued Notification No.

FEMA 20 /2000-RB dated May 3, 2000 which contains the Regulations in this regard.

This Notification has been amended from time to time.

Entry routes for investments in India

Foreign Direct Investment is freely permitted in almost all sectors. Under the Foreign

Direct Investments (FDI) Scheme, investments can be made by non-residents in the

shares / convertible debentures / preference shares1 of an Indian company, through

two routes; the Automatic Route and the Government Route.

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1. Under the Automatic Route, the foreign investor or the Indian company does

not require any approval from the Reserve Bank or Government of India for

the investment.

2. Under the Government Route, prior approval of the Government of India,

Ministry of Finance, Foreign Investment Promotion Board (FIPB) is required.

Prohibition on investment in India

1. Foreign investment in any form is prohibited in a company or a partnership

firm or a proprietary concern or any entity, whether incorporated or not (such

as, Trusts) which is engaged or proposes to engage in the following activities:

a. Business of chit fund, or

b. Nidhi company, or

c. Agricultural or plantation activities, or

d. Real estate business, or construction of farm houses, or

e. Trading in Transferable Development Rights (TDRs).

2. It is clarified that “real estate business” does not include development of

townships, construction of residential / commercial premises, roads or bridges

educational institutions, recreational facilities, city and regional level

infrastructure, townships. It is further clarified that partnership firms

/proprietorship concerns having investments as per FEMA regulations are not

allowed to engage in print Media sector.

3. In addition to the above, investment in the form of FDI is also prohibited in

certain sectors such as

a. Retail Trading (except single brand product retailing)

b. Atomic Energy

c. Lottery Business

d. Gambling and Betting

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e. Business of chit fund

f. Nidhi company

g. Trading in Transferable Development Rights(TDRs)

h. Activities / sectors not opened to private sector investment

i. Agriculture (excluding Floriculture, Horticulture, Development of

seeds,

j. Animal Husbandry, Pisciculture and cultivation of vegetables,

mushrooms, etc. under controlled conditions and services related to

agro and allied sectors) and Plantations (other than Tea Plantations)

Participants in Investments

The primary participants in the investment are:

◦ Individuals

◦ Foreign Institutional Investors (FIIs)

◦ Companies (investees & investors)

◦ Mergers and Acquisitions

◦ Overseas Corporate Bodies

◦ Funds like Private Equity funds, Hedge fund, Venture Capital funds, sovereign

wealth funds etc.

Individuals including Non Resident Indians (NRIs) and foreigners are afforded many

alternatives for investing in India. Under the extant provisions NRIs are accorded

special treatment. Various options available to them for investment in India are

depicted below:

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Investments by Non-Resident Indians (NRIs)

NRIs are allowed to invest in shares of listed Indian companies in recognised Stock

Exchanges under the PIS. NRIs can invest through designated ADs, on repatriation

and non-repatriation basis under PIS route up to 5 per cent of the paid- up capital /

paid-up value of each series of debentures of listed Indian companies. The aggregate

paid-up value of shares / convertible debentures purchased by all NRIs cannot exceed

10 per cent of the paid-up capital of the company / paid-up value of each series of

debentures of the company.

The aggregate ceiling of 10 per cent can be raised to 24 per cent, if the General Body

of the Indian company passes a special resolution to that effect.

Payment for purchase of shares and/or convertible debentures on repatriation basis has

to be made by way of inward remittance of foreign exchange through normal banking

channels or out of funds held in NRE/FCNR(B) account maintained in India. If the

shares are purchased on non-repatriation basis, the NRIs can also utilise their funds in

NRO account in addition to the above.

The link office of the designated branch of an AD Category – I bank shall furnish to

the Reserve Bank11, a report on a daily basis on PIS transactions undertaken by it,

such report can be furnished on-line or on a floppy to the Reserve Bank.

Shares purchased by NRIs on the stock exchange under PIS cannot be transferred by

way of sale under private arrangement or by way of gift (except by NRIs to their

relatives as defined in Section 6 of Companies Act, 1956 or to a charitable trust duly

registered under the laws in India) to a person resident in India or outside India

without prior approval of the Reserve Bank.

NRIs are allowed to invest in Exchange Traded Derivative Contracts approved by

SEBI from time to time out of Rupee funds held in India on non-repatriation basis,

subject to the limits prescribed by SEBI.

NRIs, PIOs, outside residents can maintain deposit accounts:

◦ Foreign Currency (Non-Resident) Account (Banks) Scheme (FCNR(B)

Account),

22


◦ Non-Resident (External) Rupee Account Scheme (NRE Account),

◦ Non-Resident Ordinary Rupee Account Scheme (NRO Account)

Outside residents can also invest in the shares and convertible debentures of an Indian

company. Individuals invest in shares and debentures of companies situated in foreign

countries through:

◦ American Depositary Receipt (ADR) - represents ownership in the shares of

a non-U.S. company and trades in U.S. financial markets.

◦ Global Depository Receipt (GDR) - certificate issued by international bank,

which can be subject of worldwide circulation on capital markets. GDR's are

emitted by banks, which purchase shares of foreign companies and deposit it

on the accounts.

Foreign Institutional Investors (FIIs)

Foreign institutional investor means an entity established or incorporated outside

India which proposes to make investment in India. Positive tidings about the Indian

economy combined with a fast-growing market have made India an attractive

destination for foreign institutional investors.

Various provisions relating to investment by FIIs as contained in master circular of

the Reserve Bank of India are given below:

Investment by FIIs under PIS

Portfolio Investment Scheme (PIS)

Foreign Institutional Investors (FIIs) registered with SEBI and Non-resident

Indians (NRIs) are eligible to purchase shares and convertible debentures

issued by Indian companies under the Portfolio Investment Scheme (PIS).

The FIIs, which have been granted registration by SEBI, should approach their

designated AD Category - I bank (known as Custodian bank), for opening a

foreign currency account and / or a Non Resident Special Rupee Account.

NRIs can approach the designated branch of any AD Category - I bank

authorised by the Reserve Bank to administer the Portfolio Investment Scheme

23


for permission to open a NRE/NRO account under the Scheme for routing

investments.

Reserve Bank has given general permission to SEBI registered FIIs/sub-accounts to

invest under the PIS.

Shareholding

Total shareholding of each FII/sub-account under this Scheme shall not exceed 10 per

cent of the total paid-up capital or 10 per cent of the paid-up value of each series of

convertible debentures issued by the Indian company.

Total holdings of all FIIs /sub-accounts put together shall not exceed 24 per cent of

the paid-up capital or paid-up value of each series of convertible debentures. This

limit of 24 per cent can be increased to the sectoral cap / statutory limit, as applicable

to the Indian company concerned, by passing a resolution of its Board of Directors

followed by a special resolution to that effect by its General Body.

A domestic asset management company or portfolio manager, who is registered with

SEBI as an FII for managing the fund of a sub-account can make investments under

the Scheme on behalf of;

1. A person resident outside India who is a citizen of a foreign state, or

2. A body corporate registered outside India;

provided, such investment is made out of funds raised or collected or brought from

outside through normal banking channel. Investments by such entities shall not

exceed 5 per cent of the total paid-up equity capital or 5 per cent of the paid-up value

of each series of convertible debentures issued by an Indian company, and shall also

not exceed the overall ceiling specified for FIIs.

Prohibition on investments

24


1. FIIs are not permitted to invest in equity shares issued by an Asset

Reconstruction Company.

2. FIIs are also not allowed to invest in any company which is engaged or

proposes to engage in the following activities:

a. Business of chit fund, or

b. Nidhi company, or

c. Agricultural or plantation activities, or

d. Real estate business, or construction of farm houses, or

e. Trading in Transferable Development Rights (TDRs).

"Real estate business" does not include construction of housing / commercial

premises, educational institutions, recreational facilities, city and regional

level infrastructure, townships.

Short Selling by FIIs

Foreign Institutional Investors (FIIs) registered with SEBI and sub-accounts of FIIs

are permitted to short sell, lend and borrow equity shares of Indian companies. Short

selling, lending and borrowing of equity shares of Indian companies shall be subject

to such conditions as may be prescribed by the Reserve Bank and the SEBI / other

regulatory agencies from time to time. The permission is subject to the following

conditions:

a) The FII participation in short selling as well as borrowing / lending of equity shares

will be subject to the current FDI policy and short selling of equity shares by FIIs

shall not be permitted for equity shares of Indian companies which are in the ban list

and / or caution list of the Reserve Bank.

b) Borrowing of equity shares by FIIs shall only be for the purpose of delivery into

short sales.

c) The margin / collateral shall be maintained by FIIs only in the form of cash. No

interest shall be paid to the FII on such margin/collateral.

25


Exchange Traded Derivative Contracts

SEBI registered FIIs are allowed to trade in all exchange traded derivative contracts

approved by RBI/SEBI on recognised Stock Exchanges in India subject to the

position limits and margin requirements as prescribed by RBI / SEBI from time to

time as well as the stipulations regarding collateral securities as directed by the

Reserve Bank from time to time. The SEBI registered FII / sub-account may open a

separate account under their

Special Non-Resident Rupee Account through which all receipts and payments

pertaining to trading / investment in exchange traded derivative contracts will be

made (including initial margin and mark to market settlement, transaction charges,

brokerage, etc.). Further, transfer of funds between the Special Non-Resident Rupee

Account and the separate account maintained for the purpose of trading in exchange

traded derivative contracts can be freely made. However, repatriation of the Rupee

amount will be made only through their Special Non-Resident Rupee Account subject

to payment of relevant taxes. The AD Category – I banks have to keep proper records

of the above mentioned separate account and submit them to the Reserve Bank as and

when required.

FIIs are also allowed to offer foreign sovereign securities with AAA rating as

collateral to the recognised Stock Exchanges in India for their transactions in

derivatives segment. SEBI approved clearing corporations of stock exchanges and

their clearing members are allowed to undertake the following transactions subject to

the guidelines issued from time to time by SEBI in this regard:

to open and maintain demat accounts with foreign depositories and to acquire,

hold, pledge and transfer the foreign sovereign securities, offered as collateral

by FIIs;

to remit the proceeds arising from corporate action, if any, on such foreign

sovereign securities; and

to liquidate such foreign sovereign securities if the need arises.

Clearing Corporations have to report, on a monthly basis, the balances of foreign

sovereign securities, held by them as non-cash collaterals of their clearing members to

26


the Reserve Bank. The report should be submitted by the 10th of the following month

to which it relates.

Accounts with AD Category – I banks

FIIs/sub-accounts can open a Foreign Currency Account and / or a Special Non-

Resident Rupee Account with an AD Category – I bank, for the purpose of

investment.

They can transfer sums from the Foreign Currency Account to the Special Non-

Resident Rupee Account for making genuine investments in securities in terms of the

SEBI (FII) Regulations, 1995.

The sums may be transferred from foreign currency account to Special Non-Resident

Rupee Account at the prevailing market rate and the AD Category - I bank may

transfer repatriable proceeds (after payment of tax) from the Special Non-Resident

Rupee Account to the Foreign Currency account.

The Special Non-Resident Rupee Account may be credited with the sale proceeds of

shares / debentures, dated Government securities, Treasury Bills, etc. Such credits are

allowed, subject to the condition that the AD Category - I bank should obtain

confirmation from the investee company / FII concerned that tax at source, wherever

necessary, has been deducted from the gross amount of dividend / interest payable /

approved income to the share / debenture / Government securities holder at the

applicable rate, in accordance with the Income Tax Act.

The Special Non-Resident Rupee Account may be debited for purchase of shares /

debentures, dated Government securities, Treasury Bills, etc., and for payment of fees

to applicant FIIs’ local Chartered Accountant / Tax Consultant where such fees

constitute an integral part of their investment process.

Private placement with FIIs

SEBI registered FIIs have been permitted to purchase shares / convertible debentures

of an Indian company through offer/private placement, subject to the ceilings

prescribed, i.e. individual FII/sub account -10 per cent and all FIIs/sub-accounts put

together - 24 per cent of the paid-up capital of the Indian company or to the sectoral

limits, as applicable. Indian company is permitted to issue such shares provided that:

27


1. In the case of public offer, the price of shares to be issued is not less than the

price at which shares are issued to residents; and

2. In the case of issue by private placement, the price is not less than the price

arrived at in terms of SEBI guidelines or guidelines issued by the erstwhile

Controller of Capital Issues, as applicable. Purchases can also be made of

compulsorily and mandatorily Convertible Debentures / Right Renunciations /

Units of Domestic Mutual Fund Schemes.

Reporting of FII investments

An FII may invest in a particular share issue of an Indian company either under the

FDI Scheme or the Portfolio Investment Scheme. The AD Category – I banks have to

ensure that the FIIs who are purchasing the shares by debit to the Special Non-

Resident Rupee Account report these details separately in the Form LEC (FII).

The Indian company which has issued shares to FIIs under the FDI Scheme (for

which the payment has been received directly into company’s account) and the

Portfolio

Investment Scheme (for which the payment has been received from FIIs' account

maintained with an AD Category – I bank in India) should report these figures

separately under item no. 5 of Form FC-GPR (Annex - 8) (Post-issue pattern of

shareholding) so that the details could be suitably reconciled for statistical /

monitoring purposes.

A daily statement in respect of all transactions (except derivative trade) have to be

submitted by the custodian bank in floppy / soft copy in the prescribed format directly

to Reserve Bank to monitor the overall ceiling / sectoral cap / statutory ceiling.

Companies

28


Companies raise funds by inviting investments from the investors. Similarly they can

invest in other companies by acquiring equity therein.

Overseas investments in Joint Ventures (JV) and Wholly Owned Subsidiaries (WOS)

have been recognized as important avenues for promoting global business by Indian

entrepreneurs. Joint ventures are perceived as a medium of economic co-operation

between India and other countries. Transfer of technology and skill, sharing of results

of R&D, access to wider global market, promotion of brand image, generation of

employment and utilization of raw materials available in India and in the host country

are other significant benefits arising out of such overseas investments. They are also

important drivers of foreign trade through increased exports of plant and machinery

and goods and services from India and also a source of foreign exchange earnings by

way of dividend earnings, royalty, technical know-how fee and other entitlements on

such investments.

Prohibitions

Indian parties are prohibited from making investment in a foreign entity engaged in

real estate (as defined in Regulation 2(p) of the Notification) or banking business,

without the prior approval of the Reserve Bank.

Direct Investment outside India can be made under two routes –

1. Automatic route, and

2. Approval route - in which prior approval of Reserve bank of India is required.

Corporates are also allowed to enter into mergers and acquisition activities with other

foreign companies.

Overseas Corporate Bodies

Overseas Corporate Body (OCB) means a company, partnership firm, society and

other corporate body owned directly or indirectly to the extent of at least sixty per

cent by Non-Resident Indians and includes overseas trust in which not less than sixty

per cent beneficial interest is held by Non-Resident Indians, directly or indirectly, but

irrevocably. OCBs have been de-recognised as a class of investors in India with effect

29


from September 16, 2003. Erstwhile OCBs which are incorporated outside India and

are not under adverse notice of Reserve Bank can make fresh investments under the

FDI Scheme as incorporated non-resident entities, with the prior approval of

Government of India if the investment is through Government Route; and with the

prior approval of Reserve Bank if the investment is through Automatic Route.

Funds

Here, we will talk about the different funds which are used for investments.

Private Equity Funds - Private equity fund is a pooled investment vehicle

used for making investments in various equity (and to a lesser extent debt)

securities according to one of the investment strategies associated with private

equity. Private equity funds are typically limited partnerships with a fixed term

of 10 years (often with annual extensions). Investments in private equity most

often involve either an investment of capital into an operating company or the

acquisition of an operating company. P/E funds generally invest for short

duration because they aim at booking profit by selling the company acquired

as soon as its market value goes up.

Hedge Funds – Hedge funds are used by wealthy individuals and institutions.

Hedge fund is allowed to use aggressive strategies that are unavailable to

mutual funds, including selling short, leverage, program trading, swaps,

arbitrage, and derivatives.

There are no more than 100 investors per fund, and as a result most hedge

funds set extremely high minimum investment amounts from $250,000 to over

$1 million.

Venture Capital Funds – Venture Capital Fund is a type of private equity

capital typically provided for early-stage, high-potential, growth companies in

the interest of generating a return through an eventual realization event such as

an IPO or trade sale of the company.

Sovereign wealth funds (SWFs) – SWFs are government investment vehicles

that are funded by accumulation of foreign currency reserves but managed

separately from official reserves of the monetary authorities. Basically, they

30


are pools of money governments invest for profit. SWFs investments are

generally for long term. They usually have higher risk tolerance and higher

expected returns than traditional official reserves managed by the monetary

authorities. They aim at systematic professional portfolio management to

generate a sustainable future income stream. Their portfolio investment

includes bonds, equities and alternative asset classes.

Both SWFs and P/E funds have become increasingly important players in

global investment activities. However, since SWFs hold more financial

resources than private equity of hedge funds, they could have a significant

influence on financial markets worldwide.

Both SWFs and private equity funds have generated significant benefits

through their investments, but they have also given rise to some important

concerns which largely relate to regulatory issues and need to strengthen

transparency and oversight without undermining the benefits that these

institutions generate.

2) Loans and borrowings

Loans and borrowings are raised in the form of External Commercial Borrowings.

External Commercial Borrowing (ECB) refers to commercial loans in the form of

bank loans, buyers’ credit, suppliers’ credit, securitized instruments (e.g. floating rate

notes and fixed rate bonds) availed of from non-resident lenders with minimum

average maturity of 3 years.

Provisions relating ECB as contained in the RBI circular are reproduced below:

ECB can be accessed under two routes, viz.,

1. Automatic Route, and

2. Approval Route

ECB for investment in real sector-industrial sector, infrastructure sector-in India, and

specific service sectors as indicated under the following section are under Automatic

31


Route, i.e. do not require the Reserve Bank / Government of India approval. In case of

doubt as regards eligibility to access the Automatic Route, applicants may take

recourse to the Approval Route.

AUTOMATIC ROUTE

The following types of proposals for ECBs are covered under the Automatic Route.

1. Eligible Borrowers

a. Corporates including those in hotel, hospital, software sectors

(registered under the Companies Act, 1956 except financial

intermediaries, such as banks, financial institutions (FIs), Housing

Finance Companies (HFCs) and Non-Banking Financial Companies

(NBFCs) are eligible to raise ECB. Individuals, Trusts and Non-Profit

making organizations are not eligible to raise ECB.

b. Units in Special Economic Zones (SEZ) are allowed to raise ECB for

their own requirement. However, they cannot transfer or on-lend ECB

funds to sister concerns or any unit in the Domestic Tariff Area.

c. Non-Government Organizations (NGOs) engaged in micro finance

activities are eligible to avail ECB. Such NGO (i) should have a

satisfactory borrowing relationship for at least 3 years with a scheduled

commercial bank authorized to deal in foreign exchange and (ii) would

require a certificate of due diligence on `fit and proper’ status of the

Board/Committee of management of the borrowing entity from the

designated AD bank.

2. Recognized Lenders

Eligible borrowers can raise ECB from internationally recognized sources

such as

i. international banks,

ii. international capital markets,

iii. multilateral financial institutions (such as IFC, ADB, CDC, etc.,),

32


iv. export credit agencies,

v. suppliers of equipment,

vi. foreign collaborators, and

vii. foreign equity holders (other than erstwhile Overseas Corporate Bodies).

A "foreign equity holder" to be eligible as “recognized lender” under the

automatic route would require minimum holding of paid up equity in the

borrower company as set out below:

i. For ECB up to USD 5 million - minimum paid up equity of 25 per cent held

directly by the lender ; and

ii. For ECB more than USD 5 million - minimum paid up equity of 25 per cent

held directly by the lender and debt-equity ratio not exceeding 4:1 (i.e. the

proposed ECB not exceeding four times the direct foreign equity holding)

Overseas organizations and individuals complying with following safeguards may

provide ECB to Non-Government Organizations (NGOs) engaged in micro

finance activities.

Overseas Organizations proposing to lend ECB would have to furnish to the AD

bank of the borrower a certificate of due diligence from an overseas bank which in

turn is subject to regulation of host-country regulator and adheres to the Financial

Action Task Force (FATF) guidelines. The certificate of due diligence should

comprise the following:

i. that the lender maintains an account with the bank for at least a period of

two years,

ii. that the lending entity is organised as per the local law and held in good

esteem by the business/local community, and

iii. that there is no criminal action pending against it.

Individual Lender has to obtain a certificate of due diligence from an overseas

bank indicating that the lender maintains an account with the bank for at least a

period of two years. Other evidence /documents, such as audited statement of

33


account and income tax return which the overseas lender may furnish need to be

certified and forwarded by the overseas bank. Individual lenders from countries

wherein banks are not required to adhere to Know Your Customer (KYC)

guidelines are not eligible to extend ECB.

3. Amount and Maturity

(a) The maximum amount of ECB which can be raised by a corporate other than

those in the hotel, hospital and software sectors is USD 500 million or its

equivalent during a financial year.

(b) Corporates in the services sector viz. hotels, hospitals and software sector are

allowed to avail of ECB up to USD 100 million or its equivalent in a financial

year for meeting foreign currency and / or Rupee capital expenditure for

permissible end-uses. The proceeds of the ECBs should not be used for

acquisition of land.

(c) NGOs engaged in micro finance activities can raise ECB up to USD 5 million or

its equivalent during a financial year. Designated AD bank has to ensure that at

the time of drawdown the forex exposure of the borrower is fully hedged

(d) ECB up to USD 20 million or its equivalent in a financial year with minimum

average maturity of three years.

(e) ECB above USD 20 million or its equivalent and up to USD 500 million or or its

equivalent with a minimum average maturity of five years.

(f) ECB up to USD 20 million or its equivalent can have call/put option provided

the minimum average maturity of three years is complied with before exercising

call/put option.

4. All-in-cost ceilings

All-in-cost includes rate of interest, other fees and expenses in foreign currency

except commitment fee, pre-payment fee, and fees payable in Indian Rupees.

However, the payment of withholding tax in Indian Rupees is excluded for

calculating the all-in-cost.

34


The all-in-cost ceilings for ECB are reviewed from time to time. The following

ceilings are valid until reviewed:

Average Maturity Period All-in-cost Ceilings over 6

month Libor*

Three years and up to five years 300 basis points

More than five years 500 basis points

* for the respective currency of borrowing or applicable benchmark

5. End-use

1. ECB can be raised only for investment [such as import of capital goods (as

classified by DGFT in the Foreign Trade Policy), new projects,

modernization/expansion of existing production units] in the real sector -

industrial sector including small and medium enterprises (SME), infrastructure

sector and specific service sectors, namely hotel, hospital and software - in

India. Infrastructure sector for the purpose of ECB is defined as (i) power, (ii)

telecommunication, (iii) railways, (iv) road including bridges, (v) sea port and

airport, (vi) industrial parks, (vii) urban infrastructure (water supply, sanitation

and sewage projects) and (viii) mining, refining and exploration.

2. Overseas direct investment in Joint Ventures (JV)/Wholly Owned Subsidiaries

(WOS) subject to the existing guidelines on Indian Direct Investment in

JV/WOS abroad.

3. Utilization of ECB proceeds is permitted for first stage acquisition of shares in

the disinvestment process and also in the mandatory second stage offer to the

public under the Government’s disinvestment programme of PSU shares.

4. Payment for obtaining license/permit for 3G Spectrum.

5. For lending to self-help groups or for micro-credit or for bonafide micro

finance activity including capacity building by NGOs engaged in micro

finance activities.

35


6. Premature buyback of FCCBs (facility is available up to December 31, 2009),

subject to compliance with the terms and conditions detailed in Para A (x) (b)

ibid.

6. End-uses not permitted

1. For on-lending or investment in capital market or acquiring a company (or a

part thereof) in India by a corporate.

2. In real estate sector.

3. For working capital, general corporate purpose and repayment of existing

Rupee loans.

7. Guarantees

Issuance of guarantee, standby letter of credit, letter of undertaking or letter of

comfort by banks, Financial Institutions and Non-Banking Financial Companies

(NBFCs) from India relating to ECB is not permitted.

8. Security

The choice of security to be provided to the lender/supplier is left to the borrower.

However, creation of charge over immoveable assets and financial securities, such as

shares, in favour of the overseas lender is subject to Regulation 8 of Notification No.

FEMA 21/RB-2000 dated May 3, 2000 and Regulation 3 of Notification No. FEMA

20/RB-2000 dated May 3, 2000, respectively, as amended from time to time.

9. Parking of ECB proceeds

Borrowers are permitted to either keep ECB proceeds abroad or to remit these funds

to India, pending utilization for permissible end-uses.

ECB proceeds parked overseas can be invested in the following liquid assets (a)

deposits or Certificate of Deposit or other products offered by banks rated not less

than AA (-) by Standard and Poor/Fitch IBCA or Aa3 by Moody’s, (b) Treasury bills

and other monetary instruments of one year maturity having minimum rating as

indicated above, and (c) deposits with overseas branches / subsidiaries of Indian banks

36


abroad. The funds should be invested in such a way that the investments can be

liquidated as and when funds are required by the borrower in India.

ECB funds may also be remitted to India for credit to the borrowers’ Rupee accounts

with AD Category - I banks in India, pending utilization for permissible end-uses.

10. Prepayment

Prepayment of ECB up to USD 500 million may be allowed by AD banks without

prior approval of the Reserve Bank subject to compliance with the stipulated

minimum average maturity period as applicable to the loan.

11. Refinancing of an existing ECB

The existing ECB may be refinanced by raising a fresh ECB subject to the conditions

that the fresh ECB is raised at a lower all-in-cost and the outstanding maturity of the

original ECB is maintained.

12. Debt Servicing

The designated Authorized Dealer banks has the general permission to make

remittances of installments of principal, interest and other charges in conformity with

ECB guidelines, issued by Government / Reserve Bank of India from time to time.

13. Procedure

Borrowers may enter into loan agreement with recognized lender for raising ECB

under Automatic Route complying with the ECB guidelines without prior approval of

the Reserve Bank. The borrower must obtain a Loan Registration Number (LRN)

from the Reserve Bank before drawing down the ECB. The procedure for obtaining

LRN is detailed in the following section.

APPROVAL ROUTE

1. Eligible Borrowers

37


The following types of proposals for ECB are covered under the Approval Route.

a) Financial institutions dealing exclusively with infrastructure or export finance

such as IDFC, IL&FS, Power Finance Corporation, Power Trading

Corporation, IRCON and EXIM Bank are considered, on a case by case basis.

b) Banks and financial institutions which had participated in the textile or steel

sector restructuring package as approved by the Government are also

permitted to the extent of their investment in the package and assessment by

Reserve Bank based on prudential norms. Any ECB availed for this purpose so

far will be deducted from their entitlement.

c) ECB with minimum average maturity of 5 years by Non-Banking Financial

Companies (NBFCs) from multilateral financial institutions, reputable

regional financial institutions, official export credit agencies and international

banks to finance import of infrastructure equipment for leasing to

infrastructure projects.

d) NBFCs, which are exclusively involved in financing of the infrastructure

sector, can avail of ECBs from multilateral / regional financial institutions and

Government owned development financial institutions for on-lending to the

borrowers in the infrastructure sector.

e) Foreign Currency Convertible Bonds (FCCBs) by housing finance companies

satisfying the following minimum criteria: (i) the minimum net worth of the

financial intermediary during the previous three years shall not be less than Rs.

500 crore, (ii) a listing on the BSE or NSE, (iii) minimum size of FCCB is

USD 100 million, (iv) the applicant should submit the purpose / plan of

utilization of funds.

f) Special Purpose Vehicles, or any other entity notified by the Reserve Bank, set

up to finance infrastructure companies / projects exclusively, will be treated as

Financial Institutions and ECB by such entities will be considered under the

Approval Route.

38


g) Multi-State Co-operative Societies engaged in manufacturing activity satisfying

the following criteria (i) the Co-operative Society is financially solvent, and

(ii) the Co-operative Society submits its up-to-date audited balance sheet.

h) SEZ developers can avail of ECBs for providing infrastructure facilities within

SEZ, as defined in the extant ECB policy, viz. (i) power, (ii)

telecommunication, (iii) railways, (iv) road including bridges, (v) sea port and

airport (vi) industrial parks (vii) urban infrastructure (water supply, sanitation

and sewage projects) and (viii) mining, refining and exploration. However,

ECB will not be permissible for development of integrated township and

commercial real estate within SEZ.

i) Corporates which have violated the extant ECB policy and are under

investigation by Reserve Bank and / or Directorate of Enforcement, are

allowed to avail ECB only under the Approval route.

j) Cases falling outside the purview of the automatic route limits and maturity

period indicated above.

2. Recognized Lenders

(a) Borrowers can raise ECB from internationally recognized sources such as (i)

international banks, (ii) international capital markets, (iii) multilateral financial

institutions (such as IFC, ADB, CDC etc.), (iv) export credit agencies, (v)

suppliers' of equipment, (vi) foreign collaborators, and (vii) foreign equity holders

(other than erstwhile OCBs).

(b) From 'foreign equity holder' where the minimum paid up equity held directly by

the foreign equity lender is 25 per cent but ECBs: equity ratio exceeds 4:1 (i.e. the

amount of the proposed ECB exceeds four times the direct foreign equity

holding).

3. Amount and Maturity

Corporates can avail of ECB of an additional amount of USD 250 million with

average maturity of more than 10 years under the approval route, over and above the

existing limit of USD 500 million under the automatic route, during a financial year.

Other ECB criteria, such as end-use, recognized lender, etc. need to be complied

39


with. Prepayment and call/put options, however, would not be permissible for such

ECB up to a period of 10 years.

4. All-in-cost ceilings

All-in-cost includes rate of interest, other fees and expenses in foreign currency

except commitment fee, pre-payment fee, and fees payable in Indian Rupees.

Moreover, the payment of withholding tax in Indian Rupees is excluded for

calculating the all-in-cost.

The all-in-cost ceilings for ECB are indicated from time to time. The all –in- cost

ceilings have been dispensed with until December 31, 2009. Accordingly, eligible

borrowers, proposing to avail ECB beyond the permissible all in cost ceiling may

approach RBI under approval route .This relaxation in all in cost ceilings will be

reviewed in December 2009.

5. End-use

(a) ECB can be raised only for investment [such as import of capital goods (as

classified by DGFT in the Foreign Trade Policy), implementation of new

projects, modernization/expansion of existing production units] in real sector -

industrial sector including small and medium enterprises (SME) and

infrastructure sector - in India. Infrastructure sector for the purpose of ECB is

defined as (i) power, (ii) telecommunication, (iii) railways, (iv) road including

bridges, (v) sea port and airport (vi) industrial parks (vii) urban infrastructure

(water supply, sanitation and sewage projects) and (viii) mining, refining and

exploration;

(b) Overseas direct investment in Joint Ventures (JV)/Wholly Owned Subsidiaries

(WOS) subject to the existing guidelines on Indian Direct Investment in

JV/WOS abroad.

(c) The first stage acquisition of shares in the disinvestment process and also in the

mandatory second stage offer to the public under the Government’s

disinvestment programme of PSU shares;

(d) ECB can be raised by corporates engaged in the development of integrated

township as defined by Ministry of Commerce and Industry, DIPP, SIA (FC

40


Division), Press Note 3 (2002 Series) dated January 4, 2002. Integrated township

includes housing, commercial premises, hotels, resorts, city and regional level

urban infrastructure facilities such as roads and bridges, mass rapid transit

systems and manufacture of building materials. Development of land and

providing allied infrastructure forms an integrated part of township’s

development. The minimum area to be developed should be 100 acres for which

norms and standards are to be followed as per local bye-laws/rules. In the

absence of such bye-laws/rules, a minimum of two thousand dwelling units for

about ten thousand population will need to be developed. This permission is

available up to December 31, 2009.

(e) Buyback of FCCB subject to terms and conditions as detailed in the sections

above.

6. End-uses not permitted

a. Utilization of ECB proceeds is not permitted for on-lending or investment in

capital market or acquiring a company (or a part thereof) in India by a

corporate except banks and financial institutions eligible.

b. Utilization of ECB proceeds is not permitted in real estate. However, the term

real estate excludes development of integrated township as defined by

Ministry of Commerce and Industry, DIPP, SIA (FC Division), Press Note 3

(2002 Series) dated January 4, 2002.

c. Utilization of ECB proceeds is not permitted for working capital, general

corporate purpose and repayment of existing Rupee loans.

7. Guarantee

Issuance of guarantee, standby letter of credit, letter of undertaking or letter of

comfort by banks, financial institutions and NBFCs relating to ECB is not normally

permitted. Applications for providing guarantee/standby letter of credit or letter of

comfort by banks, financial institutions relating to ECB in the case of SME will be

considered under the approval route on merit subject to prudential norms.

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With a view to facilitating capacity expansion and technological up-gradation in

Indian textile industry, issue of guarantees, standby letters of credit, letters of

undertaking and letters of comfort by banks in respect of ECB by textile companies

for modernization or expansion of textile units will be considered under the Approval

Route subject to prudential norms.

8. Security

The choice of security to be provided to the lender / supplier is left to the borrower.

However, creation of charge over immovable assets and financial securities, such as

shares, in favour of the overseas lender is subject to Regulation 8 of Notification No.

FEMA 21/RB-2000 dated May 3, 2000 and Regulation 3 of Notification No. FEMA

20/RB-2000 dated May 3, 2000 as amended from time to time, respectively.

9. Parking of ECB proceeds

Borrowers are permitted to either keep ECB proceeds abroad or to remit these funds

to India, pending utilization for permissible end-uses.

ECB proceeds parked overseas can be invested in the following liquid assets (a)

deposits or Certificate of Deposit or other products offered by banks rated not less

than AA (-) by Standard and Poor/Fitch IBCA or Aa3 by Moody’s; (b) Treasury bills

and other monetary instruments of one year maturity having minimum rating as

indicated above, and (c) deposits with overseas branches / subsidiaries of Indian banks

abroad. The funds should be invested in such a way that the investments can be

liquidated as and when funds are required by the borrower in India.

ECB funds may also be remitted to India for credit to the borrowers’ Rupee accounts

with AD Category I banks in India, pending utilization for permissible end-uses.

10. Prepayment

Prepayment of ECB up to USD 500 million may be allowed by the AD bank without

prior approval of Reserve Bank subject to compliance with the stipulated minimum

average maturity period as applicable to the loan.

Pre-payment of ECB for amounts exceeding USD 500 million would be considered

by the Reserve Bank under the Approval Route.

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11. Refinancing of an existing ECB

Existing ECB may be refinanced by raising a fresh ECB subject to the condition that

the fresh ECB is raised at a lower all-in-cost and the outstanding maturity of the

original ECB is maintained.

12. Debt Servicing

The designated AD bank has general permission to make remittances of instalments

of principal, interest and other charges in conformity with ECB guidelines issued by

Government / Reserve Bank from time to time.

13. Procedure

Applicants are required to submit an application in form ECB through designated AD

bank to the Chief General Manager-in-Charge, Foreign Exchange Department,

Reserve Bank of India, Central Office, External Commercial Borrowings Division,

Mumbai – 400 001, along with necessary documents.

Borrowers are required to submit ECB-2 Return certified by the designated AD bank

on monthly basis so as to reach DSIM, Reserve Bank within seven working days from

the close of month to which it relates.

For providing greater transparency, information with regard to the name of the

borrower, amount, purpose and maturity of ECB under both Automatic Route and

Approval Route are put on the Reserve Bank's website

http://www.rbi.org.in/scripts/ECBView.aspx on a monthly basis with a lag of one

month to which it relates.

International Financial Institutions

Some of the international financial institutions involved in international loans and

borrowings are listed below:

World Bank

International Monetary Fund (IMF)

Asian Development Bank (ADB)

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International Finance Corporation (IFC)

Organization for Economic Cooperation and Development (OECD)

International Bank for Reconstruction and Development (IBRD)

Others

Activities of the abovementioned entities are covered in the later chapter.

3) International Banking Flows

International banking flows comprise of

Lending and borrowings by banks.

Treasury operations by the banks.

Issue of Foreign Letter of Credit.

Issue of Foreign currency denominated guarantees.

Usually characterized by excess liquidity.

More dependence of banks on foreign funding leads to liquidity, forex, credit

etc. risks.

A heavy presence of foreign banks may also accentuate the risk of monetary or

financial contagion. There is evidence that monetary policy shocks at home

prompt global banks to change flows to their affiliates overseas.

4) Donations and Charity

Governments give grant – in – aid and donations to rehabilitate people affected by

natural calamities, war, riot, civil unrest etc., all over the world.

44


International charity organizations give charity and donations for social cause e.g. to

fight epidemic, for research in medical and social fields, for spread of education, for

cultural and sports activities.

5) Hawala Transactions

Hawala is a system for remitting money, primarily in Islamic societies, in which a

financial obligation between two parties is settled by transferring it to a third party, as

when money owed by a debtor to a creditor is paid by a person who owes the debtor

money. Hawala transactions are usually based on trust and leave no written record.

Customers entrust money to hawala bankers or operators (hawaladars), who facilitate

money movement worldwide through personal connections, sometimes using

legitimate bank accounts, but leaving a minimal paper trail. The few records kept are

encoded. Dubai, India and Pakistan form a "hawala triangle," responsible for the

heaviest traffic in worldwide financial transfers.

6) Others

Undernoted entities/activities also add to foreign capital movement

Smugglers

Transfer the goods illegally to evade tax.

Transfer banned goods and commodities

Subsequently, money also transferred through illegal channels. Gives rise to

black economy.

Terrorist’s financiers

Transfer huge funds to promote destructive terrorist activities in other

countries to destabilize them.

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Fake currency supply

Sometimes due to political reasons, funds are also transferred in the form of

fake currency in an economy by rival countries to destabilize it.

International banking network

Domestic banks in a country establish arrangements with their counterpart in foreign

countries to facilitate their foreign exchange related transactions. These arrangements

take the under noted forms:

Correspondent banks – An informal linkage between banks and different

countries is set up when banks maintain correspondent accounts with other.

The purpose of maintaining foreign correspondents is to facilitate international

payments and collections for customers. The banks maintain NOSTRO and

VOSTRO accounts for the purpose and international foreign exchange

transactions are carried through these accounts. This obviates physical

movement of currencies.

Correspondent banking allows banks to help their customers who are doing

business abroad, without having to maintain any persons or officers overseas.

The relationship between the banks is primarily for settling customer

payments, but it can extend to providing limited credit for each other’s

customers and to setting up contacts between local business people and the

clients of the correspondent banks.

Resident Representative Offices – Resident Representative Offices are

established by banks in other countries for rendering help to their residents.

These offices do not undertake normal banking activities. These are formed

mainly to provide information about local business practices and conditions

including credit worthiness of potential customers to their residents who wish

to establish commercial relations in those countries. The resident

representatives will keep in contact with local correspondent banks and

provide help when needed.

Bank Agencies – These act like a full fledged bank, deal in local money

market and forex market, arrange loans, clear bank drafts and cheques and

46


channel foreign funds into financial markets. They are more like investment

arms. Agencies also often arrange long-term loans for customers, but they deal

primarily on behalf of the home office to keep it directly involved in the

important foreign financial markets.

Foreign branches – Foreign branches operate like local banks except that

their control resides elsewhere. Generally, foreign branches are subjected to

both local banking rules and the rules at home. The foreign branch also offers

bank customers in small countries all the services and safety advantages of a

large bank that the local market might not itself be able to support.

Foreign subsidiary – These are subsidiaries established by banks in foreign

countries. These act as locally incorporated bank owned completely or

partially by foreign parent. Foreign subsidiaries do all types of bankings and it

may be very difficult to distinguish them from an ordinary locally owned bank

except perhaps by name.

Consortium banks – They are joint ventures of the large commercial banks.

They are primarily concerned with investment and they arrange large loans

and underwrite stocks and bonds. They are not concerned with taking deposits

and they deal only with large corporations or perhaps governments.

7) Role of Reserve Bank of India

In the field of Foreign Exchange, activities of RBI include – maintenance of foreign

exchange rate, provision of sale and purchase of foreign exchange through authorized

dealers and Licensed Money changers, market intervention, sterilization, deployment

of foreign exchange reserves and representing India at various International forums.

In terms of the preamble of the RBI Act, 1934, RBI maintains country’s foreign

exchange reserves.

Section (3) (a) of the act authorizes to purchase from and sale to scheduled banks the

foreign exchange. RBI does not deal with the public directly. Public is required to

carry out their foreign exchange transactions through entities authorized by RBI to

deal in foreign exchange popularly known as ‘Authorized Dealers’. With the

47


progressive liberalization in foreign exchange related transactions a large segment of

population can now undertake a variety of current account transactions on their

individual accounts, without approaching Reserve Bank. With a view to providing

adequate foreign exchange facilities to common persons, to widen the scope of

activities which the rightful persons are eligible to undertake, to increase the number

of entities that are eligible to sell foreign exchange to the public for day-to-day current

account transactions and to ensure efficient customer service through competition,

Reserve Bank has decided to issue authorization to select entities as given below, for

undertaking release / remittance of foreign exchange for various current account non-

trade related transactions.

With a view to maintain orderly foreign exchange rates RBI time to time intervene in

the foreign exchange market and sale / purchase foreign exchange through Authorised

dealers. In turn it absorbs/ releases rupee funds from/ in the market.

In the aftermath of globalisation Indian economy faced a sudden surge of foreign

capital inflow. RBI was required to release large rupee funds to mop up the foreign

exchange from the market. However, large increase of rupee flow in the economy

started to build up inflationary pressure, which was a matter of concern for RBI and

the government. With a view to keep inflation under control a new scheme of issuing

Market Stabilisation Scheme Bonds was introduced. Under the scheme RBI purchased

the excess foreign exchange from the dealers against issue of MSS bonds( Treasury

Bills) and thus sterilised the rupee funds. Rupee funds so sterilised are used only for

the purpose of redemption of MSS bonds.

Maintenance and Deployment of Foreign Exchange Reserves

Objectives of Holding Reserves

Foreign Exchange reserves are held in support of a range of objectives including to –

Support and maintain confidence in the policies for monetary and exchange

rate management including the capacity to intervene in support of the national

currency.

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Limit external vulnerability by maintaining foreign currency liquidity to

absorb shocks during times of crisis or when access to borrowing is curtailed

and in doing so;

Provide a level of confidence to markets that a country can meet its external

obligations;

Demonstrate the backing of domestic currency by external assets;

Assist the government in meeting its foreign exchange needs and external debt

obligations; and

Maintain a reserve for national disasters and emergencies.

The foreign exchange reserves consist of foreign exchange assets, gold, Special

Drawing Rights (SDRs) and Reserve Tranche Position. Foreign Exchange reserves are

managed keeping in view the factors of a) safety, b) liquidity and c) profitability.

With the prominent objective being the safety of funds, a balance is required to be

established between the liquidity needs of the reserves and the yield thereon. These

functions are attended to by a separate department namely ‘Department of External

Investments and Operations’.

Functions

The main function of this department is management and investment of foreign

exchange reserves of the Reserve Bank of India:

Management and investment of the foreign currency and gold assets of the

Reserve Bank of India.

Handling external transactions on behalf of Government of India (GOI)

including transactions relating to IMF.

All matters incidental to India's membership of the Asian Clearing Union.

Other matters relating to gold policy, membership of the Bank for

International Settlements (BIS) and matters incidental to international

cooperation/arrangements

Reserves Management

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The principal objectives behind the Reserve Bank's approach to reserves management

continue to be safety and liquidity. Within these parameters, return optimisation

dictates operational strategies. The legal framework for reserves management is

provided in the Reserve Bank of India Act 1934. Specifically, Sections 17 (12),

17(12A), 17(13) and 33(1) of the RBI Act 1934 lay down the scope of investment of

foreign exchange reserves by RBI. Broadly, the following investment categories are

permitted under the RBI Act:

Deposits with other central banks and Bank for International Settlements

Deposits with foreign commercial banks

Investments in securities issued by the Government of any other country or by

any institution incorporated outside India provided such securities are

guaranteed by the Government of the country concerned. The maturity period

of such investments should not exceed more than ten years from the date of

such investment.

Other instruments/institutions as approved by Central Board of RBI.

Further, in order to ensure safety and liquidity of our reserves, RBI has also framed

internal guidelines/procedures to manage the various risks like credit risk, liquidity

risk, operational risks and market risk incidental to the reserves management.

Prudent maintenance and gainful deployment of foreign exchange reserves by RBI

ultimately build up the international confidence in Indian economy and help it to grow

with increased public welfare.

Role of banks

Banks act as

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◦ Authorized dealers in Foreign Exchange

◦ Respondent banks for other foreign banks

◦ Have credit and they facilitate foreign exchange transactions by issuing

letters of credit, guarantees, covers for hedging the clients exposures in

foreign exchange

◦ Purchase and sell forex from/to the public.

All entities issued authorization under sub-section (i) of Section 10 of the Foreign

Exchange Maintenance Act, 1999 are categorized as under:

S No. Entities Category Major Activities

1 Commercial Banks

State Co-op Banks

Urban Co-op Banks

Authorized Dealer Category - I

All current and capital account transactions according to RBI directions issued from time-to-time.

2 Upgraded Full fledged Money

Changers (FFMCs)

Urban Co-op Banks

Regional Rural Banks

Others

Authorized Dealer Category - II

15 specified non-trade related current account transactions as also all the activities permitted to FFMCs. Any other activity as decided by RBI.

3 Select Financial and other Institutions

Authorized Dealer Category – III

Transactions incidental to the foreign exchange activities undertaken by these institutions

4 Dept. of Posts FFMCs Purchase of foreign exchange and sale for

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Urban Co-op banks

Other FFMCs

private and business visits abroad

Table: Categorization of Authorized Dealers

We have 88, 36 and 8 authorized Dealers in category I, II, and III respectively.

RBI undertakes inspection of Authorise Dealers and FFMCs to ensure the compliance

of various regulations and instructions.

IV. Impact on National Economy

Capital and human resources are the pivots of development. Short supplies of

domestic capital limit the growth of developing countries. Low GDP keeps savings

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and investment rates low which, in turn, limit growth. Low technological base of

production is another factor impinging upon growth of developing countries. Capital

inflows in the form of FDI/FII mitigate these constraints to growth to some extent.

FDI brings capital with foreign technology and modern managerial techniques and

organizational structures. Besides, inflows and growth, like several other variables,

are bi-directionally related. FDI/FII has both in and out flows, since developing

economies like Korea, China and India are also the suppliers of FDI/FII. Foreign

Investment Outflows (FIO) depends basically on supply of capital in the home

country. Developed rather than developing countries may, therefore, be hypothesized

to be the main suppliers of FDI/FII, and hence, FIO. As against this, countries of the

third world could be envisaged to be the net recipients of FDI, howsoever high their

growth rate and development status may be.

With the globalization of the various markets, international financial flows have so far

been in excess for the goods and services among the trading countries of the world. Of

the different types of financial inflows, the foreign direct investment (FDI) and

foreign institutional investment (FII)) has played an important role in the process of

development of many economies. Further many developing countries consider foreign

direct investment (FDI) and foreign institutional investment (FII) as an important

element in their development strategy among the various forms of foreign assistance.

The Foreign direct investment (FDI) and foreign institutional investment (FII) flows

are usually preferred over the other form of external finance, because they are not debt

creating, nonvolatile in nature and their returns depend upon the projects financed by

the investor. The Foreign direct investment (FDI) and foreign institutional investment

(FII) would also facilitate international trade and transfer of knowledge, skills and

technology.

International capital investment can play a useful role in development by adding to the

savings of low and middle- income developing countries in order to increase their

pace of investment. However, foreign investment can also prove unproductive to

developing economies by exposing them to disruptions and distortions from abroad,

and by subjecting them to surges of capital inflows or massive outflows of capital

flight. International capital flows can best help economies develop and spread the

benefits of prosperity to all their citizens when those flows are steady and do not

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undermine the stability of the financial systems of the developing economies. The

idea is to best help economies develop and spread the benefits of prosperity to all their

citizens. This is accomplished when the magnitudes of flows are steady and the types

of investments are suited to local economic needs and involve an appropriate sharing

of market risks. Although the useful purpose of foreign capital is to augment domestic

savings in order to raise investment, the volatility of these flows sometimes results in

the opposite.

Impacts of Capital Flow

Capital inflows can help domestic economies in various ways: portfolio inflows—or

more generally capital inflows—can help finance domestic investment and contribute

to long-run economic growth. Foreign portfolio inflows can provide a better

opportunity for local capital market development, generally providing increased

liquidity and price recovery mechanisms. And as foreign capital flows into the

market, economic authorities may come under greater peer pressure to adopt more

internationally accepted practices and standards in financial systems.

A surge of capital inflows into a developing country can be triggered by the lifting of

restrictions on the capital account, known as capital account liberalization, and by a

policy to privatize what were formerly publicly owned assets such as the telephone or

railway system. Foreign capital can also be “pushed” from abroad when the rates of

return on capital decline in the advanced capital market economies.

There are many motivations for international capital investment, and generally it is the

pursuit of a higher rate of return. Some particular motivations that raise grave

concerns are the outflanking of labor standards and environmental protections in

the home country. In addition, FDI seeks out special natural resources and

opportunities to acquire newly privatized assets. Foreign lending, through bank loans

or bonds, helps developing countries adjust gradually to external shock such as an oil

price hike or natural disaster, and provides the lenders some geographical

diversification of their assets. While these motivations can be identified and

accounted for, the actual behavior of financial markets sometimes appears less

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rational or dependable than these economic factors would indicate. The consequences

of this include unstable or undependable international capital flows.

However, the consequences of this rush or excessive capital inflow can be

devastating. It puts upward pressure on the developing country's exchange rate and if

it is not sterilized through central bank intervention then it appreciates the currency

and reduces the competitiveness of the country's traded goods. The capital inflow can

also lead to speculative booms in the price of local assets such as real estate and

equity shares. Thailand experienced a boom and bubble in its real estate and stock

markets before they burst during the financial crisis in 1997, and recently, the US sub-

prime crisis impacting the whole world was also related to the boom and bubble in the

real estate market in US.

It is also seen that rapid capital outflow can often follow periods of rapid inflow,

generating boom-bust cycles. The initial period of capital inflows is often

characterized by real exchange rate appreciation, domestic credit expansion, booming

consumption and/or investment, and asset price bubbles. Over time, the process tends

to reverse itself: real exchange rate appreciation weakens the current account and

reduces the attractiveness of domestic assets to foreign investors. Net capital inflows

turn into net outflows, and boom turns to bust, with adverse consequences for local

asset prices and, often, the real economy.

As already mentioned, massive outflows depress the prices of real estate, equity

shares and other domestic assets, and they cause a loss of bank deposits that leads to

lending constraints and tight credit conditions. The result is a rise in unemployment

and poverty, and the weight of these social dislocations has proven to fall

disproportionally on women and the poor. Women are often the targets for lay-offs

during an economic contraction, and families respond to following incomes by

increasingly sending wives and daughters into the labor force.

Making matters even worse is the tendency for international capital markets to spread

the effects of a financial crisis in one country to others in a process known as

contagion. In this way, financial market disruptions in one country inflict severe costs

on other countries that played no role in the cause of the original crisis. This is exactly

what happened in the US subprime crisis, where the crisis started in US, and within a

year, spread to the complete world.

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We will discuss these impacts in details now.

Impact on Asset Prices

Capital inflows may result in an increase in asset prices. Capital inflows can affect

asset prices in three ways. First, foreign portfolio inflows can directly affect the

demand for assets. For example, capital inflows to stock markets increase the demand

and, therefore, price of stocks. In addition, portfolio inflows may subsequently affect

other markets. For example, as capital flows into stock markets, prices increase, but

the expected return on stocks may decrease. Investors may then seek higher returns in

other asset markets, such as real estate and bonds, thereby putting upward pressure on

other asset prices.

Second, capital inflows may result in an increase in money supply and liquidity,

which in turn may boost asset prices. Capital inflows tend to cause nominal and real

exchange rates to appreciate. If monetary authorities wish to avoid that they must

intervene in the foreign exchange market to offset excess demand for the local

currency by buying foreign currency. This results in an accumulation of foreign

exchange reserves and, accordingly, domestic money supply. When this leads to an

increase in liquidity flows into asset markets, asset prices may surge. The foreign

exchange intervention may be sterilized by selling government securities through an

open market operation. However, if sterilization is partial, then liquidity and asset

prices may increase.

Third, capital inflows tend to fuel strong economic growth—as past studies have

shown— and lead to an increase in asset prices in several ways. Monetary expansion

following capital inflow may lead to an economic boom. Falling world interest rates

may lead to consumption and investment booms, and also lower domestic interest

rates, which in turn may boost investment. And, for a debtor country, a fall in world

interest rates will induce income and substitution effects, which may also lead to a

consumption boom.

Impact on Nominal and Real exchange rates

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Capital inflows tend to lead to an appreciation of nominal and real exchange rates.

Under a floating exchange rate regime, foreign portfolio inflows would directly affect

the demand for domestic currency assets, which leads to appreciation in the nominal

exchange rate. Combined with sticky prices, the real exchange rate can also

appreciate. On the other hand, under a managed float, if the monetary authority

intervenes in the foreign exchange market the nominal appreciation may be avoided.

However, the real exchange rate may still appreciate. As discussed, consumption and

investment booms are likely to increase the price of non-traded goods more than the

price of traded goods because the supply of non-traded goods is more limited than the

supply of traded goods.

This situation however puts a great deal of pressure on fixed exchange rate systems in

the developing world. Investors and speculators alike know the consequences of a

general US dollar appreciation on the ability of a smaller, poorer country to maintain

its peg to the rising dollar. This makes parallel appreciation of the pegged currency,

reduces the competitiveness of the developing country exports and harms the trade

balance. If the central bank finds it necessary to raise interest rates in order to

maintain the peg, then it also dampens the developing economy. Alternatively, if the

central bank tries to avoid raising interest rates by intervening in the foreign exchange

market in order to defend the peg, then investors and speculators alike will watch the

level of foreign reserves closely for signs of weakness in the central bank's ability to

maintain the peg.

On a similar note, the capital flows to developing countries that are invested as bank

loans or bonds have been almost entirely denominated in US dollars or other major

currencies such as the euro or yen. When the dollar appreciates, say in response to

tighter monetary by the Federal Reserve, then borrowers in developing countries will

face higher debt payments when measured in either the own local currency or other

major currencies.

Impact of FDI to home and host country

It is very interesting to see how the FDI impacts the country which is making the

direct investment, and the country in which the investment is made. If country A

makes a direct investment in country B, there is an addition to the physical capital of

country B, and new production capacity is created there. Apart from that, country B

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would have also acquired some technological knowledge or expertise, which was

earlier not there in country B, but used in country A. The investing firm in A will have

chosen to use some of its capital in B instead of in A. If the output is tradable, some

production that now takes place in country B may replace production that formerly

took place in country A. The investing firm may have reduced its production in its

home country, A, possibly by shutting down or selling a plant, and opened up a new

plant abroad to serve the same market. In such a scenario, it may have had a positive

impact on country B, but a negative impact on country A. This kind of a scenario is

more often seen in the IT industry, where for instance DELL decided to assemble all

the computers catering to Asian markets in Malaysia.

A different possibility is that a firm in country A makes a direct investment in country

B, but the stock of physical capital and the level of production are unchanged in both

countries. Country A owners and managers in industry X, perhaps using the skills

they have acquired in home production, buy out country B owners with lower skills in

that industry and operate the industry X plants in country B more efficiently than

before. Country B owners use their capital, released by the buyout, in other industries.

They might, for instance, lend it to other owners and managers in country B, skilled in

industry Y, to enable them to buy out less competent owners in that industry in

country A. No net movement of physical or financial capital is necessarily implied,

although it could take place.

Impact of FDI on Domestic investment

FDI from outside also has its share of positive and negative impacts on the

investments happening from within the country, also called domestic investment.

Capital flows can affect domestic investment in several ways.

1. First, FDI contributes directly to new plant and equipment (“greenfield” FDI).

2. Second, FDI may produce investment spillovers beyond the direct increase in

capital stock through linkages among firms. For example, multinational

corporations (MNCs) may purchase inputs form domestic suppliers thereby

encouraging new investment by local firms. FDI for mergers and acquisitions

(M&A) does not contribute to capital formation directly unless the new

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foreign owners modernize or expand their acquisitions by investing in new

technology.

3. FDI may also “crowd out” domestic investment, if MNCs raise productivity

and force local competitors out of the market. This is usually the case when

MNCs use imported inputs or enter sectors previously dominated by state-

owned firms.

4. Finally, FDI, foreign loans and portfolio investment may reduce interest rates

or increase credit available to finance new domestic investment. On this last

point, a study by Harrison, Love and McMillan finds that FDI in particular

eases the financing constraints of firms in developing countries and that this

effect is stronger for low-income than for high-income regions.

In addition to these direct effects, foreign capital can have indirect impact on

domestic investment. To attract foreign investors governments of developing

countries have to implement sound macroeconomic policies, develop their institutions

and improve governance. Loans and portfolio flows also contribute to the deepening

and broadening of financial markets. In addition to the “collateral benefits”, FDI

usually results in the transfer of managerial skills and new technology and,

consequently, improves productivity. Lastly, even when not applied toward capital

formation directly, foreign loans may be used to raise or smooth consumption, thus

increasing GDP growth during periods of sluggish demand.

Capital Flows and India

India is the second largest country in the world, with a population of over 1 billion

people. As a developing country, India’s economy is characterized by wage rates that

are significantly lower than those in most developed countries. These two traits

combine to make India a natural destination for foreign direct investment (FDI) and

foreign institutional investment (FII). Till 1991, India attracted only a small share of

global foreign direct investment (FDI) and foreign institutional investment (FII),

primarily due to government restrictions on foreign involvement in the economy. But

beginning in 1991 and accelerating rapidly since 2000, India has liberalized its

investment regulations and actively encouraged new foreign investment, a sharp

reversal from decades of discouraging economic integration with the global economy.

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The government of India(GOI) also recognized the key role of the foreign direct

investment (FDI) and foreign institutional investment (FII) in its process of economic

development, not only as an addition to its own domestic capital but also as an

important source of technology and other global trade practices. In order to attract the

required amount of foreign direct investment (FDI) and foreign institutional

investment (FII), it brought about a number of changes in its economic policies and

put in its practice a liberal and more transparent foreign direct investment (FDI) and

foreign institutional investment (FII) policy with a view to attract more foreign direct

investment (FDI) and foreign institutional investment (FII) inflows into its economy.

These changes have heralded the liberalization era of the foreign direct investment

(FDI) and foreign institutional investment (FII) policy regime into India and have

brought about a structural breakthrough in the volume of foreign direct investment

(FDI) and foreign institutional investment (FII) inflows in the economy.

Foreign institutional investors (FIIs) poured inflows heavily to bet on the India growth

story. Overseas investors have infused US$ 816.69 million into the stock market in

the first trading week of 2010, reflecting a positive start for the year after record

inflows in the last year. Foreign institutional investors (FIIs) were gross buyers of

shares worth US$ 3.03 billion, and sold equities valued worth US$ 2.2 billion,

resulting in a net investment of US$ 823.74 million, according to the capital market

regulator, Securities and Exchange Board of India (SEBI). FIIs were net investors of

US$ 973.22 million in debt instruments in the first trading week of the year, according

to data released by SEBI

According to SEBI, FIIs transferred a record US$ 17.46 billion in domestic equities

during the calendar year 2009. This FII investment in 2009 proved to be the highest

ever inflow in the country in rupee terms in a single year, breaking the previous high

of US$ 14.96 billion parked by foreign fund houses in domestic equities in 2007. FIIs

infused a net US$ 1.05 billion in debt instruments during the mentioned period.

During the October-December period in 2009-10, FIIs made a net buy of shares worth

US$ 5.19 billion, according to data compiled from market regulator, the Securities

and Exchange Board of India (SEBI).

In the quarter, December attracted the highest inflow of US$ 2.2 billion, followed by

October US$ 1.95 billion and November US$ 1.18 billion. FIIs poured a net US$ 1.26

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billion in debt instruments during the mentioned period. The trend of strong FII

inflows to the tune of about US$ 6.3 billion witnessed during April-June quarter

gained further during the September quarter of current fiscal with an infusion of US$

7.2 billion.

The number of FIIs who registered themselves with SEBI this year was higher by 7

per cent over 2008. Data sourced from the SEBI shows that number of registered FIIs

stood at 1706 and number of registered sub-accounts rose to 5,331 as of December 31,

2009. A number of market and equity analysts indicate that a large part of FII inflows

have come from long-only funds, signaling that the quality of foreign investment is

good.

India has in fact, emerged the most lucrative markets for short and medium-term

investments. The US is once again at the top of the list of foreign investors in the

Indian stock market, as per data presented in the Lok Sabha by the Finance Ministry.

According to the latest data, till mid-November 2009, US-based foreign institutional

investors (FIIs) had net investments of about US$ 4.46 billion in the Indian markets,

as compared with US$ 702.37 million in 2006. They are followed by the US$ 2.57

billion net investments routed through Luxembourg. These two countries are further

followed by France, Mauritius and the UK.

FIIs appear to be betting big on the primary market rather than the secondary market.

Roughly US$ 9 million-US$ 10 million came in the primary issuance – through

qualified institutional placements (QIPs) or preferential allotment or initial public

offerings (IPOs). Private equity firms invested US$ 1.4 billion over 84 deals in India

during October-December quarter of 2009, taking the annual investment numbers to

US$ 3.82 billion over 232 deals, according to a study by Venture Intelligence, a

research service focused on private equity (PE) and merger and acquisition (M&A)

transactions.

Investment Scenario

Amid signs of improving liquidity, January 2010 has seen private equity investments

in India double to US$ 386 million, from US$ 191 million in January 2009, according

to the financial research body, VCEdge.

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US-based private equity firm, New Silk Route Partners LLC (NSR), has picked up a

little over 30 per cent stake in Chandigarh-based listed pharmaceutical company

Nectar Lifesciences Ltd for US$ 54.5 million. US-based investment management firm

T Rowe Price Group (TRP), has bought a 26 per cent stake in UTI Asset Management

Company (AMC) and UTI Trustee Company for US$ 140.03 million. During 2009,

Kohlberg Kravis & Roberts (KKR) PE firm's investment for increasing its stake in

telecom software firm Aricent to 79 per cent for US$ 255 million was the largest deal.

Another remarkable deal was Goldman Sachs’ US$ 115 million investment in

healthcare firm Max India for a 9.4 per cent stake. Credit Suisse (Singapore) bought

1.12 per cent stake in Bharati Shipyard for US$ 1.48 million.

Stocks that had more than 10 per cent of FII stake (in BSE-500) in March went from

205 to 232 by end September. Indiabulls RealEstate, IVRCL Infrastructure, Educomp

Solutions and United Spirits are a few stocks where FIIs accumulated more shares

despite already big holdings.

Government Initiatives

The Securities and Exchange Board of India (SEBI) has allowed equity investors to

lend and borrow shares for 12 months compared with the current limit of one month.

The new norms will also allow a lender or a borrower to close his position before the

agreed-upon expiry date. No single entity (FII) shall be allocated more than US$

62.78 million of the government debt investment limit for allocation through bidding

process.

An investment limit of US$ 73.25 million in Government debt shall be allocated

among the FIIs/sub-accounts on a first-come first-served basis, subject to a ceiling of

US$ 10.46 million per registered entity. The Government of India reviewed the

External Commercial Borrowing (ECB) policy and increased the cumulative debt

investment limit by US$ 9 billion (from US$ 6 billion to US$ 15 billion) for FII

investments in corporate debt.

India's foreign investment policies allow foreign direct investment up to 26 per cent

and foreign institutional investments of (an additional) 23 per cent in stock exchanges.

Under the regulation, FIIs have been allowed to acquire shares of unlisted stock

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exchanges through transactions outside a recognized stock exchange provided it is not

an initial allotment of shares.

The Reserve Bank of India (RBI) and the Securities and Exchange Board of India

(SEBI) have jointly unveiled norms enabling exchange-traded interest rate futures

(IRF). Foreign portfolio investors have been allowed to trade in IRFs with capped

limits.

FIIs and the non-resident Indians (NRIs) are allowed to invest in Indian Depository

Receipts (IDRs), according to the operational guidelines issued by the RBI on July 22,

2009.

Summary – Impacts of Capital flow

In this section, we will summarize the positive and negative impacts of capital flows

(inflow and outflow).

Benefits of capital inflow may be summarized as follows:

1. External capital can supplement domestic savings and stimulate economic

growth.

2. International borrowing and lending enable countries to neutralize fluctuations

in income and attain smooth consumption streams. This improves welfare.

3. The lenders gain from higher return and better International portfolio

diversification.

4. Accumulation of FER. This also leads to an accumulation of foreign

exchange reserves, which is good if it leads to an additional investment which

cannot be undertaken through domestic capital of expertise. In such a case, it

leads to a stronger and stable economy (if they are within limit).

5. It improves the employment situation of the country, especially if more FDIs

are coming in.

6. In case of FDI, the home country also gets the advantage of getting a

technological expertise which may not be earlier accessible.

Problems of too much capital inflow are summarized as follows:

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1. Appreciation of real exchange. For instance, in most Latin American

countries inflow has been accompanied by marked real appreciation.

2. Accumulation of FER. How much FER should a country hold at any point in

time to counter speculative attack on its currency? There is no unique answer.

However, as discussed earlier, government policies in a demand-deficient

situation should try to ensure that the economy’s expenditure on capital

accumulation is met through domestic, not foreign finance. FDI can be

beneficial if it leads to additional investment which cannot otherwise be

undertaken or if it acts as a vehicle of better technology or other positive

supply-side factors.

3. Financial crisis. Increased openness to international capital flows has been

associated with an increasing frequency of financial crisis. Pure currency

crises have declined as countries have moved towards more flexible exchange

rate systems but banking crisis have loomed larger with the dismantling of

capital controls and regulations. For preventing financial instability,

regulations that limit the exposure of banks to the volatility of equity and real

estate markets, as well as ensuring risk-based capital adequacy are in order;

but the flip side is that these policies may promote disintermediation, which

refers to new institutions that develop to bypass these restrictions. Moreover,

greater control on banks may amount to a reversal of the trend of

financial liberalization currently in progress in developing countries.

4. Exchange rate appreciation. Under a floating exchange rate regime, foreign

portfolio inflows would directly affect the demand for domestic currency

assets, which leads to appreciation in the nominal exchange rate.

5. Asset price appreciation. Capital inflows may result in an increase in asset

prices. It may directly affect the demand for assets or it may result in an

increase in money supply and liquidity, which in turn may boost asset prices.

It may also tend to fuel strong economic growth, which can lead to an increase

in prices.

6. Wage rate appreciation. With greater inflows, and hence greater growth and

demand of human resources, the wage rates start appreciating which also tend

to increase the prices and costs.

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Problems which arise to the home country when there is too much of capital outflows

are:

1. Unemployment. As discussed earlier, when the outflows happen, it is usually

when you move the manufacturing or development of some product from the

home country to an outside, low cost country. This leads to an increasing

unemployment in the home country, and more layoffs.

2. Cash crunch. This is an after effect of the unemployment, and it is essentially

because with more work going outside, the cash in the hands of the normal

people decreases, which leads to a cash crunch.

V. Global Financial Institutions

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The global financial system (GFS) is a financial system consisting of

institutions and regulators that act on the international level, as opposed to those

that act on a national or regional level.

The Global Financial System constitutes of International Institutions,

Government Institutions, Private participants and Legal Framework and

Treaties.

1) International Monetary Fund (IMF)

The IMF was conceived at a United Nations conference convened in Bretton

Woods, New Hampshire, United States, in July 1944. The 45 governments

represented at that conference sought to build a framework for economic

cooperation that would avoid a repetition of the vicious circle of competitive

devaluations that had contributed to the Great Depression of the 1930s.

IMF's responsibilities

The IMF's primary purpose is to ensure the stability of the international

monetary system-the system of exchange rates and international payments that

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enables countries (and their citizens) to buy goods and services from each

other. This is essential for sustainable economic growth, increasing living

standards, and alleviating poverty.

Key IMF activities

The IMF supports its membership by providing

Policy advice to governments and central banks based on analysis of

economic trends and cross-country experiences;

Research, statistics, forecasts, and analysis based on tracking of global,

regional, and individual economies and markets;

Loans to help countries overcome economic difficulties;

Concessional loans to help fight poverty in developing countries; and

Technical assistance and training to help countries improve the

management of their economies.

Surveillance of economies: To maintain stability and prevent crises in

the international monetary system, the IMF reviews national, regional,

and global economic and financial developments through a formal

system known as surveillance. The IMF provides advice to its 186

member countries, encouraging them to adopt policies that foster

economic stability, reduce their vulnerability to economic and financial

crises, and raise living standards. It provides regular assessment of

global prospects in its World Economic Outlook and of capital markets

in its Global Financial Stability Report, as well as publishing a series

of regional economic outlooks.

Financial assistance: IMF financing is available to give member

countries the breathing room they need to correct balance of payments

problems. A policy program supported by IMF financing is designed

by the national authorities in close cooperation with the IMF, and

continued financial support is conditional on effective implementation

of this program. To help support countries during the global economic

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crisis, the IMF has strengthened its lending capacity and has approved

a major overhaul of how it lends money. In low-income countries, the

IMF provides financial support through its concessional lending

facilities. The IMF has doubled loan access limits and is boosting its

lending to the world's poorer countries, with interest rates set at zero

until 2011.

Special Drawing Rights (SDRs): The IMF issues an international

reserve asset known as Special Drawing Rights that can supplement

the official reserves of member countries. Members can also

voluntarily exchange SDRs for currencies among themselves.

Technical assistance: The IMF offers technical assistance and training

help member countries strengthen their capacity to design and

implement effective policies. Technical assistance is offered in several

areas, including tax policy and administration, expenditure

management, monetary and exchange rate policies, banking and

financial system supervision and regulation, legislative frameworks,

and statistics.

Resources

At the April 2, 2009 G-20 summit, world leaders pledged to support growth in

emerging market and developing countries by boosting the IMF's lending

resources to $750 billion. The IMF's resources are provided by its member

countries, primarily through payment of quotas, which broadly reflect each

country's economic size. The annual expenses of running the Fund have been

met mainly by the difference between interest receipts (on outstanding loans)

and interest payments (on quotas used to finance the loans' "reserve

positions"), but the membership recently agreed to adopt a model based on a

range of revenue sources more suited to the diverse activities of the Fund.

Governance and organization

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The IMF is accountable to the governments of its member countries. At the

top of its organizational structure is the Board of Governors, which consists of

one Governor from each member countries. All Governors meet once each

year at the IMF-World Bank Annual Meetings.

Twenty-four of the Governors sit on the International Monetary and Finance

Committee (IMFC) and meet twice each year. The day-to-day work of the

IMF is conducted by its 24-member Executive Board; this work is guided by

the IMFC and supported by the IMF's professional staff. The Managing

Director is Head of IMF staff and Chairman of the Executive Board, and is

assisted by three Deputy Managing Directors.

Factual Snapshot of IMF

Membership: 186 countries

Headquarters: Washington, DC

Executive Board: 24 Directors representing countries or groups of

countries

Staff: approximately 2,478 from 143 countries

Total quotas: $325 billion (as of 3/31/09)

Additional pledged or committed resources: $500 billion

Loans committed (as of 9/1/09): $175.5 billion, of which $124.5

billion have not been drawn

Biggest borrowers: Hungary, Mexico, Ukraine

Technical assistance: Field delivery in FY2009-173 person years

during FY2009

Surveillance consultations: Concluded in 2008-177 countries in 2008,

of which 155 voluntarily published information on their consultation

(as of 03/31/09)

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Original aims: Article I of the Articles of Agreement sets out the IMF's

main goals:

o promoting international monetary cooperation;

o facilitating the expansion and balanced growth of international

trade;

o promoting exchange stability;

o assisting in the establishment of a multilateral system of

payments; and

o Making resources available (with adequate safeguards) to

members experiencing balance of payments difficulties.

2) World Bank

Since inception in 1944, the World Bank has expanded from a single

institution to a closely associated group of five development institutions. Its

mission evolved from the International Bank for Reconstruction and

Development (IBRD) as facilitator of post-war reconstruction and

development to the present day mandate of worldwide poverty alleviation in

close coordination with affiliates, the International Development Association,

and other members of the World Bank Group.

Reconstruction remains an important part of World Bank's work. However, the

global challenges in the world compelled it to focus on:

poverty reduction and the sustainable growth in the poorest countries,

especially in Africa;

solutions to the special challenges of post-conflict countries and fragile

states;

development solutions with customized services as well as financing

for middle-income countries;

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regional and global issues that cross national borders--climate change,

infectious diseases, and trade;

greater development and opportunity in the Arab world;

Pulling together the best global knowledge to support development.

At today's World Bank, poverty reduction through an inclusive and sustainable

globalization remains the overarching goal of its work.

The World Bank aims to provide funding, take up credit risk or offer favorable

terms to development projects mostly in developing countries that couldn't be

obtained by the private sector. The other multilateral development banks and

other international financial institutions also play specific regional or

functional roles. The World Bank differs from the World Bank Group, in that

the World Bank comprises only two institutions: International Bank for

Reconstruction and Development (IBRD) and International Development

Association (IDA). Whereas the latter incorporates these two in addition to

three more: International Finance Corporation (IFC), Multilateral Investment

Guarantee Agency (MIGA), and International Centre for Settlement of

Investment Disputes (ICSID).

Operations

The World Bank's two closely affiliated entities-the International Bank for

Reconstruction and Development (IBRD) and the International Development

Association (IDA)-provide low or no interest loans (credits) and grants to

countries that have unfavorable or no access to international credit markets.

World Bank does not operate for profit. The IBRD is market-based.

Fund Generation

IBRD lending to developing countries is primarily financed by selling AAA-

rated bonds in the world's financial markets. While IBRD earns a small margin

on this lending, the greater proportion of its income comes from lending out its

own capital. This capital consists of reserves built up over the years and

money paid in from the Bank's 185 member country shareholders. IBRD's

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income also pays for World Bank operating expenses and has contributed to

IDA and debt relief.

IDA is the world's largest source of interest-free loans and grant assistance to

the poorest countries. IDA's funds are replenished every three years by 40

donor countries. Additional funds are regenerated through repayments of loan

principal on 35-to-40-year, no-interest loans, which are then available for re-

lending. IDA accounts for more than 40% of World Bank lending.

Loans

Through the IBRD and IDA, World Bank offers two basic types of loans and

credits: investment operations and development policy operations.

Countries use investment operations for goods, works and services in support

of economic and social development projects in a broad range of economic

and social sectors. Development policy operations (formerly known as

adjustment loans) provide quick-disbursing financing to support a country's

policy and institutional reforms.

Each borrower's project proposal is assessed to ensure that the project is

economically, financially, socially and environmentally sound. During loan

negotiations, the Bank and borrower agree on the development objectives,

outputs, performance indicators and implementation plan, as well as a loan

disbursement schedule. While the World Bank supervises the implementation

of each loan and evaluates its results, the borrower implements the project or

program according to the agreed terms.

Trust Funds and Grants

Donor governments and a broad array of private and public institutions make

deposits in Trust funds that are housed at the World Bank. These donor

resources are leveraged for a broad range of development initiatives. The

initiatives vary significantly in size and complexity, ranging from multibillion

dollar arrangements-such as Carbon Finance; the Global Environment Facility;

the Heavily Indebted Poor Countries Initiative; and the Global Fund to Fight

72


AIDS, Tuberculosis, and Malaria, to much smaller and simpler freestanding

ones.

The Bank also mobilizes external resources for IDA concessionary financing

and grants, as well as funds for non-lending technical assistance and advisory

activities to meet the special needs of developing countries, and for co-

financing of projects and programs.

Analytic and Advisory Services

While World Bank is best known as a financier, another of its roles is to

provide analysis, advice and information to our member countries so they can

deliver the lasting economic and social improvements their people need. It

does this in various ways. One is through economic research and data

collection on broad issues such as the environment, poverty, trade and

globalization Another is through country-specific, non-lending activities such

as economic and sector work, where it evaluate a country's economic

prospects by examining its banking systems and financial markets, as well as

trade, infrastructure, poverty and social safety net issues, for example.

Capacity Building

Another core Bank function is to increase the capabilities of its partners, the

people in developing countries, and its own staff -to help them acquire the

knowledge and skills they need to provide technical assistance, improve

government performance and delivery of services, promote economic growth

and sustain poverty reduction programs.

Structure

The World Bank is like a cooperative, where its 186 member countries are

shareholders. The shareholders are represented by a Board of Governors, who

is the ultimate policy makers at the World Bank. Generally, the governors are

member countries' ministers of finance or ministers of development. They

meet once a year at the Annual Meetings of the Boards of Governors of the

World Bank Group and the International Monetary Fund.

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Because the governors only meet annually, they delegate specific duties to 24

Executive Directors, who work on-site at the Bank. The five largest

shareholders, France, Germany, Japan, the United Kingdom and the United

States appoint an executive director, while other member countries are

represented by 19 executive directors.

The President of the World Bank chairs meetings of the Boards of

Directors and is responsible for overall management of the Bank. By

tradition, the Bank president is a U.S. national and is nominated by the

United States, the Bank's largest shareholder. The President is elected

by the Board of Governors for a five-year, renewable term.

The Executive Directors make up the Boards of Directors of the World

Bank. They normally meet at least twice a week to oversee the Bank's

business, including approval of loans and guarantees, new policies, the

administrative budget, country assistance strategies and borrowing and

financial decisions.

The World Bank operates day-to-day under the leadership and direction of the

president, management and senior staff, and the vice presidents in charge of

regions, sectors, networks and functions. Vice Presidents are the principal

managers at the World Bank.

3) World Trade Organization (WTO)

The World Trade Organization (WTO) is an international organization dealing

with the global rules of trade between nations. Its main function is to ensure

that trade flows as smoothly, predictably and freely as possible.

History

The World Trade Organization came into being in 1995. One of the youngest

of the international organizations, the WTO is the successor to the General

Agreement on Tariffs and Trade (GATT) established in the wake of the

Second World War.

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The system was developed through a series of trade negotiations, or rounds,

held under GATT. The first rounds dealt mainly with tariff reductions but later

negotiations included other areas such as anti-dumping and non-tariff

measures. The last round - the 1986-94 Uruguay Round - led to the WTO's

creation.

In 2000, new talks started on agriculture and services. These have now been

incorporated into a broader agenda launched at the fourth WTO Ministerial

Conference in Doha, Qatar, in November 2001. The work programme, the

Doha Development Agenda (DDA), adds negotiations and other work on non-

agricultural tariffs, trade and environment, WTO rules such as anti-dumping

and subsidies, investment, competition policy, trade facilitation, transparency

in government procurement, intellectual property, and a range of issues raised

by developing countries as difficulties they face in implementing the present

WTO agreements.

WTO Agreements

The WTO's rules - the agreements - are the result of negotiations between the

members. The current set were the outcome of the 1986-94 Uruguay Round

negotiations which included a major revision of the original General

Agreement on Tariffs and Trade (GATT). The complete set runs to some

30,000 pages consisting of about 30 agreements and separate commitments

(called schedules) made by individual members in specific areas such as lower

customs duty rates and services market-opening.

Through these agreements, WTO members operate a non-discriminatory

trading system that spells out their rights and their obligations. Each country

receives guarantees that its exports will be treated fairly and consistently in

other countries' markets. Each promises to do the same for imports into its

own market. The system also gives developing countries some flexibility in

implementing their commitments.

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Goods

It all began with trade in goods. From 1947 to 1994, GATT was the forum for

negotiating lower customs duty rates and other trade barriers; the text of the

General Agreement spelt out important rules, particularly non-discrimination.

Since 1995, the updated GATT has become the WTO's umbrella agreement

for trade in goods. It has annexes dealing with specific sectors such as

agriculture and textiles, and with specific issues such as state trading, product

standards, subsidies and actions taken against dumping.

Services

Banks, insurance firms, telecommunications companies, tour operators, hotel

chains and transport companies looking to do business abroad can now enjoy

the same principles of freer and fairer trade that originally only applied to

trade in goods. These principles appear in the new General Agreement on

Trade in Services (GATS). WTO members have also made individual

commitments under GATS stating which of their services sectors they are

willing to open to foreign competition, and how open those markets are.

Intellectual property

The WTO's intellectual property agreement amounts to rules for trade and

investment in ideas and creativity. The rules state how copyrights, patents,

trademarks, geographical names used to identify products, industrial designs,

integrated circuit layout-designs and undisclosed information such as trade

secrets - "intellectual property" - should be protected when trade is involved.

Dispute settlement

The WTO's procedure for resolving trade quarrels under the Dispute

Settlement Understanding is vital for enforcing the rules and therefore for

ensuring that trade flows smoothly. Countries bring disputes to the WTO if

they think their rights under the agreements are being infringed. Judgments by

specially-appointed independent experts are based on interpretations of the

agreements and individual countries' commitments.

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The system encourages countries to settle their differences through

consultation. Failing that, they can follow a carefully mapped out, stage-by-

stage procedure that includes the possibility of a ruling by a panel of experts,

and the chance to appeal the ruling on legal grounds. Confidence in the system

is borne out by the number of cases brought to the WTO - around 300 cases in

eight years compared to the 300 disputes dealt with during the entire life of

GATT (1947-94).

Policy review

The Trade Policy Review Mechanism's purpose is to improve transparency, to

create a greater understanding of the policies that countries are adopting, and

to assess their impact. Many members also see the reviews as constructive

feedback on their policies. All WTO members must undergo periodic scrutiny,

each review containing reports by the country concerned and the WTO

Secretariat.

Organizational Structure

The WTO has nearly 150 members, accounting for over 97% of world trade.

Around 30 others are negotiating membership. Decisions are made by the

entire membership. This is typically by consensus. A majority vote is also

possible but it has never been used in the WTO, and was extremely rare under

the WTO's predecessor, GATT. The WTO's agreements have been ratified in

all members' parliaments. The WTO's top level decision-making body is the

Ministerial Conference which meets at least once every two years. Below this

is the General Council (normally ambassadors and heads of delegation in

Geneva, but sometimes officials sent from members' capitals) which meets

several times a year in the Geneva headquarters. The General Council also

meets as the Trade Policy Review Body and the Dispute Settlement Body. At

the next level, the Goods Council, Services Council and Intellectual Property

(TRIPS) Council report to the General Council. Numerous specialized

committees, working groups and working parties deal with the individual

agreements and other areas such as the environment, development,

membership applications and regional trade agreements.

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VI. Global Scenario - Before and after crisis

Over the past four years, the world has witnessed some of the most tumultuous

periods in the financial world due to meltdown of economies and slowly but steadily,

since the latter half of 2009, the markets have risen along with the steadying of

economies globally.

However, the scale and magnitude of the recoveries have varied over socio-economic

status of the countries and geographical spreads, much like the extent of damage to

the economies.

In this chapter, we shall discuss the impact and extent in 2 parts:

1. Financial crisis of 2007–2009;

2. The turn around and recovery of economies since 2009 and future predictions.

Financial crisis of 2007–2009

The financial crisis of 2007–2009 has been called by leading economists the worst

financial crisis since the Great Depression of the 1930s. It contributed to the failure of

key businesses, declines in consumer wealth estimated in the trillions of U.S. dollars,

substantial financial commitments incurred by governments, and a significant decline

in economic activity. Many causes have been proposed, with varying weight assigned

by experts.

The collapse of a global housing bubble, which peaked in the U.S. in 2006, caused the

values of securities tied to real estate pricing to plummet thereafter, damaging

financial institutions globally. Questions regarding bank solvency, declines in credit

availability, and damaged investor confidence had an impact on global stock markets,

where securities suffered large losses during late 2008 and early 2009.

Economies worldwide slowed during this period as credit tightened and international

trade declined. Critics argued that credit rating agencies and investors failed to

accurately price the risk involved with mortgage-related financial products, and that

governments did not adjust their regulatory practices to address 21st century financial

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http://en.wikipedia.org/wiki/Mortgage

http://en.wikipedia.org/wiki/Financial_risk

http://en.wikipedia.org/wiki/Credit_rating_agency

http://en.wikipedia.org/wiki/Stock_market

http://en.wikipedia.org/wiki/Solvency

http://en.wikipedia.org/wiki/Real_estate_pricing

http://en.wikipedia.org/wiki/Security_(finance)

http://en.wikipedia.org/wiki/Housing_bubble

http://en.wikipedia.org/wiki/Government

http://en.wikipedia.org/wiki/United_States_dollar

http://en.wikipedia.org/wiki/Wealth

http://en.wikipedia.org/wiki/Consumer

http://en.wikipedia.org/wiki/Business

http://en.wikipedia.org/wiki/Great_Depression

http://en.wikipedia.org/wiki/Financial_crisis


markets.[8] Governments and central banks responded with unprecedented fiscal

stimulus, monetary policy expansion, and institutional bailouts.

1) Background and causes

The immediate cause or trigger of the crisis was the bursting of the United States

housing bubble which peaked in approximately 2005–2006.

High default rates on "subprime" and adjustable rate mortgages (ARM), began to

increase quickly thereafter. An increase in loan incentives such as easy initial terms

and a long-term trend of rising housing prices had encouraged borrowers to assume

difficult mortgages in the belief they would be able to quickly refinance at more

favorable terms. However, once interest rates began to rise and housing prices started

to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more

difficult. Defaults and foreclosure activity increased dramatically as easy initial terms

expired, home prices failed to go up as anticipated, and ARM interest rates reset

higher.

In the years leading up to the start of the crisis in 2007, significant amounts of foreign

money flowed into the U.S. from fast-growing economies in Asia and oil-producing

countries. This inflow of funds made it easier for the Federal Reserve to keep interest

rates in the United States too low from 2002–2006 which contributed to easy credit

conditions, leading to the United States housing bubble. Loans of various types (e.g.,

mortgage, credit card, and auto) were easy to obtain and consumers assumed an

unprecedented debt load. As part of the housing and credit booms, the amount of

financial agreements called mortgage-backed securities (MBS) and collateralized debt

obligations (CDO), which derived their value from mortgage payments and housing

prices, greatly increased. Such financial innovation enabled institutions and investors

around the world to invest in the U.S. housing market. As housing prices declined,

major global financial institutions that had borrowed and invested heavily in subprime

MBS reported significant losses. Falling prices also resulted in homes worth less than

the mortgage loan, providing a financial incentive to enter foreclosure.

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http://en.wikipedia.org/wiki/Financial_innovation

http://en.wikipedia.org/wiki/Collateralized_debt_obligations

http://en.wikipedia.org/wiki/Collateralized_debt_obligations

http://en.wikipedia.org/wiki/Mortgage-backed_securities

http://en.wikipedia.org/wiki/United_States_housing_bubble

http://en.wikipedia.org/wiki/Federal_Reserve

http://en.wikipedia.org/wiki/Interest

http://en.wikipedia.org/wiki/Foreclosure

http://en.wikipedia.org/wiki/Default_(finance)

http://en.wikipedia.org/wiki/Adjustable_rate_mortgage

http://en.wikipedia.org/wiki/Subprime_lending



http://en.wikipedia.org/wiki/Bailout

http://en.wikipedia.org/wiki/Monetary_policy

http://en.wikipedia.org/wiki/Fiscal_policy

http://en.wikipedia.org/wiki/Fiscal_policy

http://en.wikipedia.org/wiki/Central_bank

http://en.wikipedia.org/wiki/Financial_crisis_of_2007-2009#cite_note-Declaration_of_G20-7


While the housing and credit bubbles built, a series of factors caused the financial

system to both expand and become increasingly fragile.

These losses impacted the ability of financial institutions to lend, slowing economic

activity. Concerns regarding the stability of key financial institutions drove central

banks to provide funds to encourage lending and restore faith in the commercial paper

markets, which are integral to funding business operations.

Easy credit conditions

Lower interest rates encourage borrowing. From 2000 to 2003, the Federal Reserve

lowered the federal funds rate target from 6.5% to 1.0%. This was done to soften the

effects of the collapse of the dot-com bubble and of the September 2001 terrorist

attacks, and to combat the perceived risk of deflation.

80

http://en.wikipedia.org/wiki/Deflation

http://en.wikipedia.org/wiki/September_11_attacks

http://en.wikipedia.org/wiki/September_11_attacks

http://en.wikipedia.org/wiki/Dot-com_bubble

http://en.wikipedia.org/wiki/Federal_funds_rate


U.S. Subprime lending expanded dramatically 2004-2006

The term subprime refers to the credit quality of particular borrowers, who have

weakened credit histories and a greater risk of loan default than prime borrowers. The

value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007,

with over 7.5 million first-lien subprime mortgages outstanding.

In addition to easy credit conditions, there is evidence that both government and

competitive pressures contributed to an increase in the amount of subprime lending

during the years preceding the crisis.

Predatory lending

Predatory lending refers to the practice of unscrupulous lenders, to enter into "unsafe"

or "unsound" secured loans for inappropriate purposes..

Former employees from Ameriquest, described a system in which they were pushed to

falsify mortgage documents and then sell the mortgages to Wall Street banks eager to

81

http://en.wikipedia.org/wiki/Ameriquest

http://en.wikipedia.org/wiki/Lien


make fast profits. There is growing evidence that such mortgage frauds may be a

cause of the crisis.

Increased debt burden or over-leveraging

U.S. households and financial institutions became increasingly indebted or

overleveraged during the years preceding the crisis. This increased their vulnerability

to the collapse of the housing bubble and worsened the ensuing economic downturn.

Leverage Ratios of Investment Banks Increased Significantly 2003-2007

From 2004-07, the top five U.S. investment banks each significantly increased their

financial leverage (see diagram), which increased their vulnerability to a financial

shock.

82

http://en.wikipedia.org/wiki/Financial_leverage

http://en.wikipedia.org/wiki/Mortgage_fraud


Commodity bubble

A commodity price bubble was created following the collapse in the housing bubble.

The price of oil nearly tripled from $50 to $140 from early 2007 to 2008, before

plunging as the financial crisis began to take hold in late 2008. Experts debate the

causes, which include the flow of money from housing and other investments into

commodities to speculation and monetary policy or the increasing feeling of raw

materials scarcity in a fast growing world economy and thus positions taken on those

markets, such as Chinese increasing presence in Africa. An increase in oil prices tends

to divert a larger share of consumer spending into gasoline, which creates downward

pressure on economic growth in oil importing countries, as wealth flows to oil-

producing states.

Systemic crisis

Another analysis, different from the mainstream explanation, is that the financial

crisis is merely a symptom of another, deeper crisis, which is a systemic crisis of

capitalism itself.

83


"Manager's capitalism" which he argues has replaced "owner's capitalism,"

meaning management runs the firm for its benefit rather than for the

shareholders, a variation on the principal-agent problem;

Burgeoning executive compensation;

Managed earnings, mainly a focus on share price rather than the creation of

genuine value; and

The failure of gatekeepers, including auditors, boards of directors, Wall Street

analysts, and career politicians.

2) Financial markets impacts

Impacts on financial institutions

The International Monetary Fund estimated that large U.S. and European banks lost

more than $1 trillion on toxic assets and from bad loans from January 2007 to

September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S.

banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6

trillion. The IMF estimated that U.S. banks were about 60 percent through their

losses, but British and eurozone banks only 40 percent.

Wealth effects

There is a direct relationship between declines in wealth, and declines in consumption

and business investment, which along with government spending represent the

economic engine. Between June 2007 and November 2008, Americans lost an

estimated average of more than a quarter of their collective net worth. By early

November 2008, a broad U.S. stock index the S&P 500, was down 45 percent from its

2007 high. Housing prices had dropped 20% from their 2006 peak, with futures

markets signaling a 30-35% potential drop.

Global effect

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http://en.wikipedia.org/wiki/Principal-agent_problem


The crisis rapidly developed and spread into a global economic shock, resulting in a

number of European bank failures, declines in various stock indexes, and large

reductions in the market value of equities and commodities.

Both MBS and CDO were purchased by corporate and institutional investors globally.

Derivatives such as credit default swaps also increased the linkage between large

financial institutions. Moreover, the de-leveraging of financial institutions, as assets

were sold to pay back obligations that could not be refinanced in frozen credit

markets, further accelerated the liquidity crisis and caused a decrease in international

trade.

World political leaders, national ministers of finance and central bank directors

coordinated their efforts to reduce fears, but the crisis continued. At the end of

October 2008 a currency crisis developed, with investors transferring vast capital

resources into stronger currencies such as the yen, the dollar and the Swiss franc,

leading many emergent economies to seek aid from the International Monetary Fund.

3) Effects on the global economy

A number of commentators have suggested that if the liquidity crisis continues, there

could be an extended recession or worse.

The continuing development of the crisis has prompted in some quarters fears of a

global economic collapse although there are now many cautiously optimistic

forecasters in addition to some prominent sources who remain negative.

Three days later UBS economists announced that the "beginning of the end" of the

crisis had begun, with the world starting to make the necessary actions to fix the

crisis:

1. Capital injection by governments;

2. Injection made systemically;

3. Interest rate cuts to help borrowers.

85

http://en.wikipedia.org/wiki/Systemic

http://en.wikipedia.org/wiki/Financial_capital

http://en.wikipedia.org/wiki/Economic_collapse

http://en.wikipedia.org/wiki/Recession

http://en.wikipedia.org/wiki/International_Monetary_Fund

http://en.wikipedia.org/wiki/Leverage_(finance)


The United Kingdom had started systemic injection, and the world's central banks

were now cutting interest rates.

UBS emphasized the United States needed to implement systemic injection.

UBS quantified their expected recession durations on October 16,2009:

The Eurozone's would last two quarters,

The United States' would last three quarters, and the United Kingdom's would

last four quarters.

The economic crisis in Iceland involved all three of the country's major banks.

Relative to the size of its economy, Iceland’s banking collapse is the largest

suffered by any country in economic history.

With a recession in the U.S. and the increased savings rate of U.S. consumers,

declines in growth elsewhere have been dramatic.

For the first quarter of 2009, the annualized rate of decline in GDP was

14.4% in Germany, 15.2% in Japan, 7.4% in the UK, 9.8% in the Euro area and

21.5% for Mexico.

By March 2009, the Arab world had lost $3 trillion due to the crisis.

In April 2009, unemployment in the Arab world is said to be a 'time bomb'

In May 2009, the United Nations reported a drop in foreign investment in Middle-

Eastern economies due to a slower rise in demand for oil

In June 2009, the World Bank predicted a tough year for Arab states.

In September 2009, Arab banks reported losses of nearly $4 billion since the onset of

the global financial crisis.

4) Responses to financial crisis

86

http://en.wikipedia.org/wiki/Iceland

http://en.wikipedia.org/wiki/2008%E2%80%932009_Icelandic_financial_crisis


Emergency and short-term responses

The U.S. Federal Reserve and central banks around the world have taken steps to

expand money supplies to avoid the risk of a deflationary spiral, in which lower

wages and higher unemployment lead to a self-reinforcing decline in global

consumption. In addition, governments have enacted large fiscal stimulus packages,

by borrowing and spending to offset the reduction in private sector demand caused by

the crisis. The U.S. executed two stimulus packages, totaling nearly $1 trillion during

2008 and 2009.

This credit freeze brought the global financial system to the brink of collapse. The

response of the USA Federal Reserve, the European Central Bank, and other central

banks was immediate and dramatic.

During the last quarter of 2008, these central banks purchased US$2.5 trillion of

government debt and troubled private assets from banks. This was the largest liquidity

injection into the credit market, and the largest monetary policy action, in world

history. The governments of European nations and the USA also raised the capital of

their national banking systems by $1.5 trillion, by purchasing newly issued preferred

stock in their major banks.

Regulatory proposals and long-term responses

United States introduced a series of regulatory proposals in June 2009.

The proposals address consumer protection, executive pay, bank financial cushions or

capital requirements, enhanced authority for the Federal Reserve to safely wind-down

systemically important institutions, among others.

A variety of regulatory changes have been proposed by economists, politicians,

journalists, and business leaders to minimize the impact of the current crisis and

prevent recurrence. However, as of November 2009, many of the proposed solutions

have not yet been implemented.

The turnaround and recovery

87


http://en.wikipedia.org/wiki/Preferred_stock

http://en.wikipedia.org/wiki/Preferred_stock

http://en.wikipedia.org/wiki/European_Central_Bank


http://en.wikipedia.org/wiki/Deflation



The acute phase of the financial crisis has passed and a global economic recovery is

under way.

Moreover, the recovery is fragile and expected to slow in the second half of 2010 as

the growth impact of fiscal and monetary measures wane and the current inventory

cycle runs its course.

Indeed, industrial production growth is already slowing (albeit from very high rates).

As a result, employment growth will remain weak and unemployment is expected to

remain high for many years.

The overall strength of the recovery and its durability will depend on the extent to

which household- and business-sector demand strengthens over the next few quarters.

While the baseline scenario projects that global growth will firm to 2.7 percent in

2010 and 3.2 percent in 2011 after a 2.2 percent decline in 2009, neither a double-dip

scenario, where growth slows appreciably in 2011, or a strengthening recovery can be

ruled out.

Financial markets have stabilized and are recovering, but remain weak. Interbank li-

quidity as measured by the difference between the interest rates commercial banks

charge one another and what they have to pay to central bankers have declined to pre-

crisis range.

Currencies, which fell worldwide against the U.S. dollar in the immediate

aftermath of the crisis, have largely recovered their pre-crisis levels.

And international capital flows to developing countries have recovered—with a

rapid run-up during the last months of 2009. Also, borrowing costs for emerging

market borrowers have stabilized over the last few quarters, but remain elevated.

However, the Dubai World event and ripple effects to credit downgrades for Greece

and Mexico can be expected to raise concerns about sovereign debt sustainability and

will impact risk assessments, capital flows, and financial markets in 2010.

On the positive side, the real economy is recovering as well. Although global

industrial production in October 2009 remained 5 percent below its level a year

earlier, it is recovering, with output in both high-income and developing countries

expanding at more than a 12 percent annualized rate in the third quarter of 2009.

88


Trade too is recovering but remains depressed. Quarterly growth rates have moved

into positive territory in recent months, but the U.S. dollar value of trade was still off

17 percent from its September 2009 level.

Nevertheless,

1. International metal prices, measured in U.S. dollars, are 20 percent below their

July 2008 levels,

2. oil prices are 44 percent lower, and

3. food prices 24 percent lower.

Recent developments in financial markets

The unprecedented steps that were taken by policy makers in both developed and

developing countries since September 2008 have gone a long way toward

normalizing financial markets and restoring capital flows to developing countries.

The immediate outflow of international capital from developing countries to safe ha-

vens in the United States and Europe has reversed itself.

As a result, a large number of emerging-market exchange rates have recovered their pre-

crisis levels viz.-a-viz. the U.S. dollar, equity markets have recovered much of their initial

losses, and, capital flows to developing countries have begun to recover. Towards the

end of 2009, gross capital inflows to developing countries began to gain momentum

as uncertainty subsided and risk aversion declined.

Developing countries’ access to international capital markets has also revived.

Both sovereign and corporate borrowers have benefited from rising global liquidity,

improved market conditions, and better long-term fundamentals of emerging

economies vis-à-vis advanced economies.

The improved bond and equity markets reflect normalization of financial markets and,

to an unknown extent, the opening up of a carry trade precipitated by low real interest

rates in high-income countries.

89


Some middle-income countries (notably Chile and Brazil) are attracting very large

inflows, which if sustained at current rates, pose real policy challenges and could

generate significant stress.

Global growth

After a deep global recession, economic growth has turned positive, as a wide range

of policy interventions has supported demand and reduced uncertainty and systemic

risk in financial markets. However, the recovery is expected to be slow, as financial

markets remain impaired, stimulus measures will need to be withdrawn in the not too

distant future, and households in countries that suffered asset price busts are forced to

rebuild savings while struggling with high unemployment. Although global growth is

expected to return to positive territory in 2010, the pace of the recovery will be slow

and subject to uncertainty. After falling by an estimated 2.2 percent in 2009, global

output is projected to grow 2.7 and 3.2 percent in 2010 and 2011, respectively.

The main drag on global growth is coming from the high-income countries, whose

economies are expected to have contracted by 3.3 percent in 2009. Japan experienced

the sharpest growth contraction (25.4 percent). Growth rates of 2.5 and 2.9 percent are

expected in 2010 for the United States and for high-income countries that are not

members of the Organization for Economic Co-operation and Development (OECD).

The global economic crisis affected developing countries first and foremost through a

sharp slowdown in global industrial activity due to a sudden cut in investment

programs, consumer durable demand, and a widespread effort to reduce inventories in

the face of uncertain future conditions. Falling export demand, commodity prices, and

capital flows exacerbated and extended the downturn. Overall, growth in developing

countries declined to an estimated 1.2 percent in 2009, down from 5.6 percent in

2008.

90


South Asia

South Asia appears to have escaped the worst effects of the crisis, with GDP growth

in the region estimated at 6.0 percent in 2009, down from 6.9 percent in 2008. The

slowdown in GDP growth mainly reflected weaker investment and private sector

demand, which were only partially offset by an increase in public expenditures.

Despite enduring a 5 percent decline in goods and services export volumes, an even

sharper decline in import demand (partly explained by weaker investment demand)

and lower food and oil prices meant that trade and current account balances improved

in 2009 Remittance flows to the region, which equal some 4.7 percent of GDP, fell an

estimated 1.8 percent, representing a significant drop in household incomes and

foreign currency earnings.

91


Improved investor sentiment, particularly related to relatively strong growth outturns

in India and ongoing or new IMF stabilization programs. The recovery in the region is

expected to be less marked than elsewhere, partly reflecting the relative shallowness

of the downturn. Growth is expected to rebound to 7.0 and 7.4 percent in 2010 and

2011, respectively, compared with 6.0 percent in 2009.

Speaking of India specifically, the following are the World Bank Predictions dated

20th February, 2010:

2007 2008 2009 2010 2011

A. Real Expenditure Growth

1. GDP at market prices 9.1 6.1 6.0 7.5 8.0

2. Private consumption 7.6 2.9 4.0 6.7 7.5

3. Government

consumption7.6 20.2 10.0 7.0 6.5

4. Fixed investment 14.0 8.3 4.9 10.5 10.9

5. Exports, GNFS 2.8 12.8 -6.8 11.1 13.1

6. Imports, GNFS 7.5 17.9 -8.0 11.6 13.3

B. Contribution to GDP Growth


2. Government

consumption0.8 2.0 1.1 0.8 0.8


C. Price Deflators

1. GDP at market prices 17.7 -6.7 4.5 10.8 8.9

2. Private consumption 18.6 -2.5 1.1 11.4 8.3

3. Exports, GNFS 14.8 4.9 -8.4 1.8 1.4

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4. Imports, GNFS 15.6 14.5 -16.3 6.7 0.9

D. Share of GDP


2. Government

consumption10.7 12.6 12.6 12.5 12.2


4. Change in stocks 0.0 0.0 0.0 0.0 0.0

5. Total investment 35.5 37.8 36.1 37.2 37.9

6. Exports, GNFS 21.3 25.5 19.7 18.7 18.2

7. Imports, GNFS 25.5 34.8 24.2 24.2 23.5

E. Memo

1. Nominal GDP (USD

billions)

1,123

.4

1,111

.9

1,232

.1

1,467

.0

1,725

.1

2. Population (millions)1,169

.0

1,183

.2

1,197

.2

1,210

.9

1,224

.3

3. GDP per capita, current

USD961.0 939.7

1,029

.2

1,211

.6

1,409

.1

4. Real per capita GDP

growth7.5 4.8 4.8 6.3 6.8

5. USD Fx rate 40.1 44.6 48.5 47.0 46.0

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Global scenario is as show below:

94


The major concerns of the coming days:

95


Going through the charts below, it seems a herculean task awaits the economists and

leaders around the developing world on the issues of:

"People in the developing world have had to deal with two major external

shocks:

1. the upward spiral in food and fuel prices followed by the financial crisis,

and

2. banking systems and threatening job losses around the world,“ was stated

by

Justin Lin, World Bank Chief Economist & Sr VP.

More generally speaking, the challenges remain the following:

Fluctuations in Security Markets

Deepening of local Financial Crisis due to dependence on FI

Volatility in local market

Inflation and political instability

VII. BRIC Countries Position

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What is BRIC?

BRIC or BRICs are the acronym used to refer to the combination of the four biggest

emerging-market countries: Brazil, Russia, India and China.

President: Luiz Inacio Lula da Silva President: Dmitry Medvedev

Brazil Russia

President:Pratibha Patil President: Hu Jintao

India China

BRIC origins

The acronym BRIC was coined in 2001 by an analyst for Goldman Sachs who argued

that, by 2050, the combined economies of the BRIC nations would eclipse the

combined economies of the current richest countries in the world. The investment

bank never posited that BRIC would organize itself into an economic bloc, although

recently there have been signs that the BRIC has come to represent much more than

was originally intended.

97


"The economic crisis is what pushed them together,". "The term BRIC wrongly

implies that they are actually a bloc in any concrete way," . "They are more of an

informal group within the international forums who meet sometimes to exchange their

points of view and who, when they reach common agreement, will defend their

position. But while they have many things that unite them, there is also a lot that

divides them."

BRIC, with 40% of the world's population, account for about 20% of its gross

domestic product, a share will rise to equal that of the G7 industrialized countries as

early as 2032.

There was a sign this year (2009) of the shape of things to come as China overtook the

United States as the world's biggest car market. And as incomes of 2.5 billion people

steadily rise, company profits as well as stock markets will feel the effect.

No surprise that cash -- direct investment and portfolio capital -- is increasingly

gravitating to these giants. BRIC-geared equity funds absorbed almost $20 billion in

January to November 2009. This is double 2007 levels and equivalent to 40% of what

was taken by emerging stock funds, some of which also went to the BRICs.

"The trend of BRIC outperformance has been very powerful and should continue as

growth is concentrated in these markets," said Martial Godet, who helps manage €37

billion in emerging stocks at BNP Paribas Asset Management in Paris.

"We are betting on the largest, highest-growth markets with the biggest populations

and good liquidity levels."

To capitalize on BRIC consumer demand, Goldman Sachs suggests investing in a

basket of 50 developed market stocks positioned to benefit from the BRICs theme,

and one of 50 BRICs companies that are likely to emerge as global market winners.

Already, BRICs are outgunning broader emerging stocks -- the MSCI BRIC index is

up 90% in 2009 versus 70% for MSCI EM, with only China lagging.

98


An investment in Brazilian stocks in 2000 would have quadrupled by now while cash

put in emerging stocks would merely have doubled. And a buyer of world stocks

would have lost money.

As monetary policies start to tighten next year, investors on average expect BRIC

stocks to rise 20-25% in 2010 after the near triple-digit returns of 2009.

But in future, the BRICs as the most liquid emerging markets will gain most from

higher allocations to emerging markets.

Goldman Sachs economist Jim O'Neill, who first came up with the BRIC concept,

projects the BRICs to comprise almost half global stock markets by 2050 from less

than 10% now. He says it is inevitable more cash will move to the BRIC markets.

"If you think of a GDP-weighted benchmark, it would be considerably higher than the

current MSCI-type ones," O'Neill said, referring to indices that use GDP to weight

countries, rather than the usual practice of weighting by market value.

"For some asset managers, especially the sovereign wealth funds, this is what they are

moving towards."

Fund managers say cash will go where growth is -- or where the value is. With China

and India posting the highest growth in the world, and Russia trading at a 40%

discount to emerging markets, the bloc should remain an investment magnet.

Consumer demand is seen as key to the post-crisis global recovery, and at the heart of

the BRIC story is the consumer.

This is the main driver behind the surging tide of direct investment into the BRICs

which took in 16 percent of global direct investment flows in 2008. This is a third up

from the previous year, a total $265 billion, or over half of what was received by the

16-nation European Union, United Nations agency UNCTAD says.

China's car market made headlines earlier this year. With 10 cars per 1,000 Chinese,

there is a lot more room for sales growth than the US which has one car for two

people.

99


What is happening is a rebalancing of global consumption, away from advanced

economies and towards emerging markets, says Goldman Sachs, a process expedited

by the shock caused to household wealth and employment by the financial crisis.

GS predicts Chinese household consumption to rise 10% in 2010, with Brazilian and

Indian demand also up over 5% while spending in the developed world remains flat.

Global corporates have cottoned on. Japanese electronics firm Panasonic for instance

said last month it aims for 15-20 % annual sales growth in the BRICs to compensate

for falling demand from Japan's shrinking population.

No wonder then that firms are rushing to set up production in the BRICs --

UNCTAD's 2009-2011 investment outlook survey found all four countries to be in the

top five most favored investment destinations with China topping the list.

"What investors in BRIC are saying is: we believe in GEM (global emerging markets)

but to a great extent, what's happening in GEM is in these four countries," said Alex

Tarver, who helps manage $1.9 billion in BRIC stocks at HSBC. "It is a microcosm

and one that's large enough to drive regional growth."

The four nations, representing emerging economic powers, demanded that developing

economies have a "greater voice and representation in international financial

institutions, and their heads and senior leadership should be appointed through an

open, transparent and merit-based selection process."

“We also believe there is a strong need for a stable, predictable and more diversified

international monetary system," the statement continued, delivering a warning

against the global domination of the US dollar as the world’s standard reserve

currency.

Russian President Dmitry Medvedev had voiced similar sentiments before the

summit, saying the current reserve policies "have not managed to perform their

functions."

Russia’s chief economic aide, Arkady Dvorkovich, suggested that the International

Monetary Fund (IMF) should revise the basket of currencies used to value its financial

100


products to include the Russian ruble and Chinese yuan. At the moment the currencies

included are the dollar, euro, yen and sterling.

Increased economic power was underscored when Brazil and Russia joined China in

announcing they would shift some $70 billion (50 billion euros) of reserves into

multicurrency bonds issued by the International Monetary Fund. The move was

interpreted by some as an attempt to topple the dollar; in part because the Russian

president said at the time that his proposal to create a new world currency could be

discussed at the summit.

But fiscal experts say that BRIC will tread carefully where the dollar is concerned, as

triggering a dollar crisis would be akin to shooting themselves in the foot.

"The BRICs are putting the US on notice that there has to be a cutback on spending

and that they need to get their house in order," Mark Mobius, emerging markets

expert at Templeton Asset Management. "Any attack on the dollar will hurt them. But

they want to make sure this kind of mess doesn't happen again."

Clearly though, BRIC is using its new influence to put pressure on the IMF to reshape

its voting structure to better reflect the shift in economic power. Brazil, for example,

is the world's 10th largest economy, but has just 1.38 percent of the IMF board's

votes, compared to 2.09 percent for Belgium, an economy one-third the size.

China as a superpower?

China, too, is well-positioned to become a greater actor on the world stage, despite its

past preference for playing a supporting role.

"China has realized that it might become a global power much faster than it thought,"

says Renard. "And the US is realizing that now, too. It is treated as a de facto global

power by the US, at least with regard to economic matters, with the two countries for

all intents and purposes forming a 'G2'."

But while the thought of China as a superpower is perceived by many in the West as a

threat, Renard says that it's an unfounded fear.

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"The world today is characterized by interdependence," he says. "Even for China, it's

not a time to think about individual gains, rather it's about minimizing the damage that

we all suffer."

The "rise of the rest"

While Renard is certain that the current trend is from a unipolar world to a multipolar

one, he says we're unlikely to witness the emergence of a new superpower to rival the

US anytime soon.

"To be a world power, you need more than money," Renard said. "You need military

power and soft powers, such as cultural power. And in these respects, the US is still

the leader."

Instead, Renard says it's more accurate to talk about bad US policies that have

damaged American influence abroad coinciding with the "rise of the rest."

The "rest" not only includes new emerging powers, such as the BRIC nations, but also

"non-state actors such as transnational organizations like al Qaeda and supranational

institutions like the EU, all of which are increasingly challenging American

predominance."

India Dreaming with BRICs: The Path to 2050

In 2003 Goldman Sachs (a leading global investment management firm) came up with

a research report called “Dreaming with BRICs: The Path to 2050″.

According to that BRIC (Brazil, Russia, India, and China) is a coalition of regional

and superpowers reportedly proposed by Russian President Vladimir Putin.

102


The BRIC research findings:

If things go right, the firm’s economists argued that, given sound political decision-

making and good luck, the BRIC economies together could become larger than those

of the world’s six most developed countries in less than 40 years. i.e BRIC economies

of Brazil, Russia, India and China together would be larger than G6 (G7 excluding

Canada) in USD in less than 40 years. Of the current G6, only the US and Japan may

be among the six largest economies in US dollar terms in 2050.

103


BRIC in future

The following list shows the top 22 countries by nominal GDP from year 2010 to

2050. The bottom chart lists the top 22 countries by nominal GDP per capita (the

rankings for this bottom chart do not reflect the GDP per capita for all the world's

countries). The figures are in ‘000. BRIC countries are highlighted below.

Rank Country 2010 2015 2020 2025 2030 2035 2040 2045 2050

1 United

States

14,53

5

16,19

4

17,97

8

20,08

7

22,81

7

26,09

7

29,82

3

33,90

438,514

2 Japan 4,604 4,861 5,224 5,570 5,814 5,886 6,042 6,300 6,677

3 Germany 3,083 3,326 3,519 3,631 3,761 4,048 4,388 4,714 5,024

4 China 4,667 8,13312,63

0

18,43

7

25,61

0

34,34

8

45,02

2

57,31

070,710

5 United

Kingdom2,546 2,835 3,101 3,333 3,595 3,937 4,344 4,744 5,133

6 France 2,366 2,577 2,815 3,055 3,306 3,567 3,892 4,227 4,592

7 Italy 1,914 2,072 2,224 2,326 2,391 2,444 2,559 2,737 2,950

8 Canada 1,389 1,549 1,700 1,856 2,061 2,302 2,569 2,849 3,149

9 Brazil 1,346 1,720 2,194 2,831 3,720 4,963 6,631 8,740 11,366

10 Russia 1,371 1,900 2,554 3,341 4,265 5,265 6,320 7,420 8,580

11 India 1,256 1,900 2,848 4,316 6,68310,51

4

16,51

0

25,27

837,668

12 South

Korea1,071 1,305 1,508 1,861 2,241 2,644 3,089 3,562 4,083

13 Mexico 1,009 1,327 1,742 2,303 3,068 4,102 5,471 7,204 9,340

104

http://en.wikipedia.org/wiki/Mexico

http://en.wikipedia.org/wiki/South_Korea

http://en.wikipedia.org/wiki/South_Korea

http://en.wikipedia.org/wiki/India

http://en.wikipedia.org/wiki/Russia

http://en.wikipedia.org/wiki/Brazil

http://en.wikipedia.org/wiki/Canada

http://en.wikipedia.org/wiki/Italy

http://en.wikipedia.org/wiki/France

http://en.wikipedia.org/wiki/United_Kingdom

http://en.wikipedia.org/wiki/United_Kingdom

http://en.wikipedia.org/wiki/People's_Republic_of_China

http://en.wikipedia.org/wiki/Germany

http://en.wikipedia.org/wiki/Japan

http://en.wikipedia.org/wiki/United_States

http://en.wikipedia.org/wiki/United_States


14 Turkey 440 572 740 965 1,279 1,716 2,300 3,033 3,943

15 Indonesia 419 562 752 1,033 1,479 2,192 3,286 4,846 7,010

16 Iran 312 415 544 716 953 1,273 1,673 2,133 2,663

17 Pakistan 161 206 268 359 497 709 1,026 1,472 2,085

18 Nigeria 158 218 306 445 680 1,083 1,765 2,870 4,640

19 Philippine

s162 215 289 400 582 882 1,353 2,040 3,010

20 Egypt 129 171 229 318 467 718 1,124 1,728 2,602

21 Banglades

h81 110 150 210 304 451 676 1,001 1,466

22 Vietnam 88 157 273 458 745 1,169 1,768 2,569 3,607

BRIC funds: Many mutual fund companies have come up with a type of fund called

The BRIC funds, which invest primarily in the BRIC countries.

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http://www.thepicky.com/investing/funds/list-of-bric-funds-to-invest-in-brazil-russia-india-china-bric/

http://en.wikipedia.org/wiki/Vietnam

http://en.wikipedia.org/wiki/Bangladesh

http://en.wikipedia.org/wiki/Bangladesh

http://en.wikipedia.org/wiki/Egypt

http://en.wikipedia.org/wiki/Philippines

http://en.wikipedia.org/wiki/Philippines

http://en.wikipedia.org/wiki/Nigeria

http://en.wikipedia.org/wiki/Pakistan

http://en.wikipedia.org/wiki/Iran

http://en.wikipedia.org/wiki/Indonesia

http://en.wikipedia.org/wiki/Turkey

http://en.wikipedia.org/wiki/File:GDP_nominal_2010_2050.jpg


BRIC Country Returns for 1 year and 10 year vs. the US

The 4 horsemen of growth (B)razil (R)ussia (I)ndia and (C)hina. At this point China

is China, and basically Brazil is a 2nd derivative to China (i.e. when China runs, it

needs to buy commodities. Who has commodities? Brazil. And Brazil is like Russia

without the political risk) India is a unique case in and of itself.

- A comparison of the BRIC countries stock returns versus the U.S. in both the 1 year

and 10 year time horizons. If you have a 10 year horizon and can ignore the stomach

turning shorter term losses in the stock market - throw money at the next 500 million

people (Chindia) who are going to move from poverty to middle class & check back

in 2019.

1 st Year:

10 th Year:

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http://www.fundmymutualfund.com/2009/03/bespoke-investment-bric-country-return.html

http://4.bp.blogspot.com/_vIR9lEpVYYw/Sb4fKPErpbI/AAAAAAAAGRY/cB97KH1e6fA/s1600-h/BRIC+1+year.png


Political Risk Perceptions and the Financial Crisis

Rapid Growth of FDI outflows from developing countries.

Share of developing countries in global outflows increased from 1.4 in 2000 to

10.8% in 2008

BRIC countries account for bulk of FDI outflows from developing countries.

In 2008: Brazil ($20.5 billion), Russian Federation ($52.6 billion), India

($17.7 billion) and China ($ 53.5 billion)

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http://2.bp.blogspot.com/_vIR9lEpVYYw/Sb4fSXTgTdI/AAAAAAAAGRg/jmghzya_kts/s1600-h/BRIC+10+year.png


Political Risk Survey in the BRICs

Investors from emerging markets view political risk as a significant constraint

on investment plans.

Political risk was the leading concern this year for Russian, Brazilian and

Indian investors (jointly with microeconomic instability) and the second most

significant concern for Chinese investors.

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Top constraints on investments for investors in the BRICs

Top political risks of investors from the BRICs

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Similarities and differences among the BRICs on the most important political

risk

Most investors from the BRICs considered breach of contract as the principal

political risk this year and over the next three years (on par with transfer and

convertibility restrictions for the latter).

This was followed by transfer and convertibility restrictions and non-honoring of

sovereign guarantees.

Political violence was considered the most significant risk for Chinese investors

over the next three years; it was of least concern for investors from Brazil and the

Russian Federation.

11 percent of BRIC respondents said they did not mitigate political risks at all

Over a third of BRIC respondents said that the level of risk in destination

countries did not warrant mitigating political risk.

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A substantial minority (28%) said they were unaware of specific products and

tools available.

Risk capabilities of investors from the BRICs

Thought well of own abilities to assess political risk.

Much less confident in own abilities to anticipate new risks.

Good ability to evaluate risk mitigation strategies.

Less able to implement new mitigation strategies

How do MNEs from the BRICs mitigate political risk?

Primarily informal and indirect means (no difference from respondents

of the global survey)

Most and engaging in joint ventures and popular tools are producing

political risk analysis and assessments, engaging with host country governments

alliances with host country firms

Political risk insurance ranks low (except for Russian investors)

The BRIC survey suggests that emerging market investors’ attitude

toward political risk overall is similar to that of industrialized countries’

investors. This challenges the view that investors from emerging markets are

comfortable with political perils

However, the importance of political risk does not translate into high

usage of political risk insurance

BRIC investors manage most risks without resorting to formal risk

mitigation products

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Reason of Rapid Growth in FDI in China and India

Abundance of labour and its low cost

Rapid expansion of china’s Domestic market

Role of Overseas Chinese

Increasing Integration with World Economy

For data of FDIs in India, please refer to the annexures.

FDI LANDSCAPE

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India and China: the Difference

India could not attract foreign investment in both products and services market,

only seen as a service industry especially in IT.

To eliminate this difference, three steps can be taken to stimulate domestic

demand

RBI to keep interest rates regionally competitive

Implementation of Value Added Tax (VAT) throughout the country

Government to reduce budget deficit

China’s Financial Assets – 220% of GDP

India’s Financial Assets – 160% of GDP

China’s Financial system shows greater strength in countries saving and

investment

Wasted Capital

Majority of financial capital of both countries going to less-productive areas

China’s fund going to State Own Enterprises rather than the private sector

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India’s major share taken over by government to finance budget deficit

Much of what’s left goes to Agriculture, tiny Household etc.

Reason for this skwed types of lending in both countries is preserving jobs.

ROUND TRIPPING

Chinese firms illegally transfer domestic (unaccounted) money to other foreign

countries and then invest it in the mainland as FDI inflows in order to benefit from

the preferential treatment given to FDI in terms of taxation, labor policy, etc.

Under reporting of FDI by India because of non-conformity of India’s method of

measuring FDI to the international standards.

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Accounting for Growth: Comparing China and India

The emergence of China and India as major forces in the global economy is one of the

most significant economic developments of the past quarter century. Their continued

growth is likely to dominate the course of the world economy for the next several

decades. Up to now, only a small fraction of the world’s population has enjoyed the

fruits of economic well-being, with high-income industrial countries accounting for

less than a fifth of the world’s population. However, China and India together

comprise over a third of the world’s population; and since 1980, they have achieved

remarkable rates of economic growth and poverty reduction.

China’s GDP per capita is now 2.2 times higher than India’s (in USD PPP terms).

Until the early 1990s, GDP per capita in China and India was at comparable levels,

but China adopted wide-ranging economic reform one decade earlier than India.

The Chinese economy is much more integrated with the world economy through

international trade and investment, which helps to explain its stronger rate of GDP

growth during most of the past 3 decades. For its economic development, China has

relied on industry and India on services. China’s ratios of domestic savings and

investment to GDP are roughly double those of India’s.

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Both economies currently enjoy strong external positions, with ample foreign

exchange reserves. Higher oil prices are not likely to have a significant adverse

impact on external liquidity. China and India have low external debt as a percentage

of GDP, and the ratio of short-term external debt to foreign reserves is low.

Despite declining fiscal deficits, the level of public sector debt is a cause for

concern, especially in India. In particular, interest payments as a percentage of

general government revenue are very high in India, making the prospect of fiscal

consolidation more remote. Excess domestic liquidity presents a bigger challenge to

China than India. M2 in China is heading toward 200% of GDP with domestic credit

almost 170% of GDP. This explains the rapid rise in CPI inflation during 2004, on

which the Chinese authorities are still keeping a tight rein.

Surveys indicate India has better corporate governance standards and its

companies are more commercially-driven. This explains why, despite China’s

superior economic growth and macroeconomic stability, India’s rate of return on

assets has been much higher, non-performing loans in the banking sector lower, and

stock market performance much better.

Social indicators reflect generally improving living conditions for the average

Chinese. China also enjoys superior physical infrastructure, although India’s

availability of skilled workers, especially engineers, is much better regarded.

China’s early steps to liberalize its economy and invest heavily to modernize its

physical infrastructure gave it a substantial edge over India in terms of income

per capita levels. They also made China a more attractive destination to foreign

investors. However, although India started economic reforms only a decade later than

China, it is far more advanced in its institutional infrastructure and corporate

governance. This is reflected in contrasting outcomes: foreign direct investment is

considerably lower than in China, but returns on investment are better on average. The

key to unlock India’s potential to rival China as an FDI destination is a decisive effort

by the Indian authorities to push ahead with reforms.

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To summarize:

China and India provide empirical documentation for much of the prior discussion of

their growth performance. In international comparisons, China’s achievements have

truly been extraordinary, but India has also grown at a rate that matches the other

industrializing economies of East Asia. Key differences between the two economies

also stand out, with China’s concentration of growth in industry while India’s growth

has been strongest in various service-producing industries; but China’s growth is

remarkably broad across agriculture, industry and services. Overall, the growth of

services in China actually exceeds that of India. Thus, juxtaposing the experiences of

China and India offers a valuable perspective on each country’s individual

performance.

Our work also extends the growth accounting literature for these economies in a

number of ways. First, it incorporates all of the recent data revisions, some of which

are quite large. Second, the analysis disaggregates by major economic sector. This

provides new estimates of the contributions to overall labor productivity growth from

growth within sectors versus from the gains due to reallocation of labor and capital

among sectors. In China, we document the strong contribution to growth that is

provided by both increases in capital per worker and TFP. Surprisingly, we find no

support for some of the recent arguments that China is experiencing a significant

deceleration of growth in TFP due to wasteful and excessive expansions of capital

investment. The comparison of China and India highlights the weak performance of

India’s manufacturing sector as much as the strong growth of services.

Looking forward, supply-side factors suggest that both economies should be able to

sustain their growth. They have plentiful supplies of underutilized labor, though India

faces greater challenges of raising educational attainment. Both have high rates of

private saving, although again China stands out. India currently devotes much of its

saving to finance the large fiscal deficit.

The growth prospects for both depend upon continued integration with global

economy, including trade in goods and services, and investment flows. India in

particular will need to broaden its trade beyond the current emphasis on services.

Only an expansion of goods production and trade can provide employment

opportunities for the current pool of underemployed and undereducated workers.

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China has done well in the international dimension and now needs to focus on

development of domestic markets and a more balanced trade position.

China in a stronger position compared to India

But INDIA can do better if it opens more sectors for FDI

Eliminate barriers in foreign investment

Improve productivity and population control to increase Per Capita income

More efforts to decouple economy and equity market’s over dependence on FII

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VIII. Global Issues

1) Implications for India of more money printing by USA

The money printed by USA will be routed to India to take advantage of

interest rates differentials. In India, the onus to control and take control of the

situation of inflation is upon the Reserve Bank of India (RBI). The Reserve

Bank of India (RBI) follows a multiple indicator approach to arrive at its goals

of growth, price stability and financial stability, rather than targeting inflation

alone.

Steps taken by RBI to tackle inflation

The steps generally taken by the RBI to tackle inflation include a rise in repo

rates (the rates at which banks borrow from the RBI), a rise in Cash Reserve

Ratio and a reduction in rate of interest on cash deposited by banks with RBI.

The signals are intended to spur banks to raise lending rates and to reduce the

amount of credit disbursed. The RBI's measures are expected to suck out a

substantial sum from the banks. In effect, while the economy is booming and

the credit needs grow, the central bank is tightening the availability of credit.

The RBI also buys dollars from banks and exporters, partly to prevent the

dollars from flooding the market and depressing the dollar - indirectly raising

the rupee. In other words, the central bank's interactions have a desirable

objective - to keep the rupee devalued - which will make India's exports more

competitive, but they increase liquidity.

To combat this, the RBI does what it calls "sterilization" - it sucks out the

rupees it pays out for dollars through sale of sterilization bonds. It then sells

these bonds to banks. Economists point out that there has not been much

success in such sterilization attempts in India. The central bank's attempt to

offload Government bonds on banks has not been too successful inasmuch as

the banks sell the bonds and get rupees instead.

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Economists also contrast this with the successful experience of China, where

the state-owned banks strictly abide by the central bank's dictates and absorb

the sterilization bonds. That discipline is lacking in India. The net effect is that

the RBI has to resort to indirect methods of sterilization, such as raising

interest rates and raising CRR to contract liquidity. This makes India more

attractive for foreign capital flows that seek better returns and a vicious cycle

follows. RBI has to buy more foreign currency and sterilize. The cycle

becomes worse.

Consequences of RBI Policy

The economy was growing at a stupendous 9 per cent, second only to China

worldwide, however the brakes have been firmly pressed by the RBI due to

their anti - inflationary policy. If the CRR and REPO rate are hiked frequently,

the economy may take a U - turn, as most commercial banks religiously

increase their lending rates, without actually studying the impact.

The last time that the RBI had imposed its policy, the markets had signaled

their resounding reaction by a sharp fall in the Sensex by nearly 500 points.

The impact on economic growth is also likely to be sharp, judging by effects

of similar therapy applied with disastrous effect in the mid-1990s.

This would reduce the level of investment activity in the economy, particularly

in the infrastructure sector. Big corporate may ask for, and get, access to

external commercial borrowing, but not so favoured are the bulk of small and

medium entrepreneurs (SME). Housing activity will suffer an impact because

most loanees are on floating rates and will face increased equated installments.

These measures generally taken by the RBI do not effectively tackle inflation

but on the other hand effectively stunts the growth pattern of the economy.

The RBI seems to believe that by merely reducing the credit flow and money

flow in the economy, inflation can be curtailed. Inflation is a consequence of

increasing demand vis - a - vis the supply in the economy. The demand must

be effectively curtailed or pushed down, which the present CRR policy is not

managing to do effectively. The RBI, in an ideal world, would have also

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looked towards a mechanism to bolster the supply forces to meet the

requirements of the consumers and thereby combat inflation.

Economists admit that while RBI's efforts to contain inflation will reduce

borrowings, prices would continue to rise.

There are two major drawbacks in the CRR - REPO policy adopted by the RBI

to combat inflation. Firstly, monetary tools have proved more effective in

economies with greater financial inclusion. They are less effective in

economies such as India's, where the majority of the population still has no

access to banks, and those with access barely have the resources to open bank

accounts.

The increasing cost of funds and rising interest rates are of little consequence

in the economic life of a financially excluded population. The impact will be

critical on smaller segments and will take a while to yield results for the

economy. Much more remains to be achieved on the financial inclusion front.

This contrasts poorly with India, where the ratio of deposit accounts to total

adult population is only 59 per cent. But even this figure is suspect, as the

average urban middle-class income-earner often has more than one bank

account. This is bound to reduce further the percentage of people with bank

accounts. Most account holders are urban-centric, leaving large segments of

the rural population with no access to banks or the means to save or borrow.

Secondly, in spite of its being an indirect weapon of credit control, CRR does

impact the level of money supply in the economy and plays some role in the

fight against inflation. But the impact of the CRR hike will not distinguish as

between productive credit and credit meant for consumption. This will hurt

growth and the creation of assets in the economy.

Farmers today keep several acres of land uncultivated as the financial returns

are not commensurate with the expenses incurred for cultivation. Irrespective

of the increasing cost of funds, large segments of the borrowing public,

especially the small, medium and large farmers, have no option but to

approach the commercial and cooperative banks, or the multitude of

unregulated moneylenders at the beginning of every crop cycle.

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As a result, lendable resources of the system will be reduced to that extent and

bank credit will be dearer. This hike will result in increase of the lending rates,

whether for production or consumption. The RBI can address only the demand

side through such an approach. The need of the hour is to curb only

consumption credit and not production.

The monetary measures are meant to increase the cost of funds for banks,

make loans dearer and temper the demand for credit. While there is a greater

possibility of banks passing on the increased costs to the consumer, it is

debatable whether this will choke the demand for funds in some specific

inflation-impacting sectors.

Impact on prospects of growth of economy

Today, the prime lending rate (PLR) of the banks varies between 12.75% and

13.25%. That means no SME can get working capital loan at less than 15%.

Compare that with the rest of Asia. China has a negative real interest of 2.64

% (interest rate on three-month loans at 3.86% minus inflation at 6.5%). South

Korea's real interest rate is 3%. Thailand's is 1.45%. Malaysia's is 1.72%.

Taiwan's is at a negative 0.5%. In fact, it is well understood that real interest

rates in excess of 3.5% universally hurt competitiveness and growth.

Our high interest rates are not only hurting business, but have become a

magnet for foreign portfolio funds. Which, in turn is rapidly appreciating the

domestic currency, and giving foreign institutional investors (FIIs) and their P-

note beneficiaries a double bonus: first through returns on their investment and

then on the appreciating exchange rate.

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Figure 1:Summary of impact on India of more money printed by USA

2) Implications for not reevaluating currency (mainly Chinese) for Long

On July 21, 2005, China abandoned the 11-year peg of its currency, Yuan, at

RMB 8.28 to the dollar. From now on, the Yuan will be linked to a basket of

currency (write currency and number of currency), the central parity of Yuan

is decided to set at the end of each day. The Yuan central rate was devalued by

2.1% at RMB 8.11 (far lesser than what the actual value should be). The new

exchange-rate regime might prove taxing to the Chinese firms but would help

to control the over-heated Chinese economy, the burgeoning US trade deficit

and asset pricing bubble.

Brief History

The Yuan has been pegged to US dollar since Jan'1994 when China adopted a

new managed floating rate regime within narrow band. Under this Chinese

Central Bank (the People's Bank of China) unified rate for all authorized

foreign transaction at RMB 8.7 per dollar. The rate was flexible to adjust

123


within a narrow band of 0.25% of previous day's reference date. The Yuan

began to appreciate in the year '94 and for the first time in May 1995 touched

RMB 8.3 per dollar (5% increase) and remained around the same value for

next two years finally appreciating to RMB 8.21 per dollar and had been

maintained till it was pegged to a basket of currency.

Although the regime was known as market driven managed float, it was de

facto pegged to dollar since '94.

Currency Evaluation

The Goal: Under a "float", which China says it wants someday, a currency

rises and falls on global markets according to supply and demand. This is the

system that applies to many major currencies such as the US Dollar, the Euro

and the British Pound.

The Old System: Under a "peg", which China has had since 1995, the

currency's value is fixed - in China's case, at 8.28 Yuan per US Dollar.

The New System: Under a "managed float", which China adopted in July' 05,

the currency can rise and fall but only within prescribed limits.

The Controversy

The hue and cry for revaluation of Yuan was primarily because of following

reasons:

In PPP terms, Yuan is substantially under-valued. The Big Mac index

assesses Chinese currency as undervalued by 59% in the release of Jun

9, 2005.

One fourth of the US trade deficit (which was shot up to US$ 600 bn,

5% of US GDP). Given the extravagant life style of Americans, social

security proposal, prospect of continued increasing outlays because of

rising tension with North Korea, Syria and Iran, the US budget deficit

is expected to inflate. Appreciation of Chinese currency is expected to

curb this deficit up to some extent, if not completely.

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Given the healthy Balance of Trade, Balance of Payments, FDI,

Exchange Reserves, GDP growth in last few years, Yuan has become

stronger along with Chinese economy and demand for its currency has

also improved.

Advantages & Disadvantages of Yuan Becoming More Valuable

Advantages for China

1. Cheaper Imports: China imports technologies, petroleum, metals,

machinery and skills from other countries. China is the biggest

consumer of many commodities such as aluminum, steel, coal and

copper and second largest consumer of oil. With the increasing prices

of these commodities, appreciating Yuan will put less pressure.

2. Overseas Investment and Expansion: With huge forex reserve (US

$514 bn in Sept'04), a stronger Yuan and government loosening the

control on capital outflow, it will be economically rewarding to invest

abroad. On the other hand, Chinese firms may desist from investing

abroad if they fear further depreciation may not provide required rate

of return. In short run, they prefer to wait before dollar depreciates

before making investment.

3. Control of Inflation: Inflation can act as damper to overheating prices

and excess liquidity. Increased income and more confident mindset of

Chinese has improved the marginal propensity of consumer, fostering

to excess liquidity and made Chinese Central bank's sterilization

strategy of issuing bonds less effective.

4. Reduced Foreign Debt Obligation: The dollar denominated debt

obligation would be reduced (in Yuan terms) once Yuan will be

revalued (because of depreciation of Dollar vis-a-vis Yuan). As per

estimate, the principal of foreign denominated bond will be reduced up

to 15%.

5. Focus on Domestic Economy: Revaluation of Yuan will force

Chinese economy to become more productive, in order to counter the

125


disadvantage occurring because of revaluation of currency. Chinese

economy is excessive export-oriented which is dangerous (Japan has

faced chronic deflation and three recessions in last decade because of

its export focus and had left internal demand under-developed).

Initially, this step of Yuan revaluation may hurt Chinese economy as

prices may rise and take hit on profit margin. In long term, if efficiency

is achieved and domestic demand is adjusted, enterprise would be able

to generate more wealth.

Disadvantages for China

1. Growth can be stagnated: Purchasing power of US customers will be

affected because of Yuan appreciation; hence China will lose 'cost

advantage' leading to fall in exports. This will show decreases in output

and increased unemployment, which is already a big problem (even

though there is boom in export after lifting the quotas).

2. Impact on FDI: FDI flow may decease drastically as the new

investment will become unviable and existing one will no longer be

economically beneficial as they used to be. Moreover, there will be

increased forex risk associated with it. This could hamper economic

growth of China and have considerable impact (as FDI is very high in

China because of less stringent norms).

3. Immature Market: The financial market of China (which is not most

robust market) may not be able to handle revaluation. The Shenzhen

and Shanghai Exchange were formed in late 90's and even then they

were used for funneling the fund in state-owned enterprise. A sudden

appreciation of currency will badly affect many financially

unsophisticated and unhedged firms.

4. Increase in NPAs of Bank: The weak banking system of China has

huge NPAs and it is being mobilized and sold to US investors.

Increased value of Yuan will reduce its appeal to US investors.

126


5. Hot Money & Increase in Volatility: There has been huge capital

influx into China recently purely through speculation. Once revaluation

is done and investors gain sufficient return, this capital will flow out of

country. If it revaluates too slowly, it might be indicator to investors

that more appreciation is to come, but if it happens too fast, there

would be too many funds at once. Depending upon the rate of

revaluation, it may or may not be a threat of fund outflow. Either way

high volatility is assured. In case of deliberate pull back of economy,

curbing possible gain from non-currency means lead to investors will

to remain invested.

Advantages for USA

1. Control over Deficit: China alone forms one third of US $600 bn

global trade deficit. A revaluation of Yuan would definitely help US

control the deficit.

2. Political Pressure: The political debates in US are heating up over the

rising menace of the Chinese dragon. Outsourcing and steady stream of

job losses in past years have increased the pressure on the policy

makers to act.

3. Increased Export: With the increasing Yuan, the US export to China

would become more affordable to Chinese consumer, and hence, will

get a boost.

Disadvantages for USA

1. Rise in Interest Rate: With dollar becoming`g weaker, FDI flows in

China will decrease leading to decrease in Chinese Central bank

investment in US Treasury Bill. The current trend of reverse

diversification, where central banks across the globe are widening their

investing by divesting in dollars investment and investing in other

currencies, as china move towards pegging the RMB to a basket of

127


currencies, there will be a notable impact on Euro. China is world's

third largest investor in US Treasury Bill. This revaluation will force

Chinese policy maker to sell their holding in US Treasury Bill and buy

in Euro and Yen. This will ultimately decrease the demand for federal

T-Bill and interest rate will rise. The falling dollar and increasing

interest rate will not only hurt US but also impact Asian countries such

as Japan, China, India and to an extent Russia as well. Therefore, these

countries will also try to play diplomatically and diversifying their

investment back stage.

2. Short-term Inflation: In short run, Chinese products will be available

at low price. Given the high spending habits of US consumer, it will

definitely increase the inflation at least in short run.

Advantages for India

1. Improved Export: As compared to before revaluation of RMB, the

Indian products will be cheaper now and India Inc. surely would be

able to capitalize on this opportunity.

2. Outsourcing Advantage: Apart from IT and ITES, India's relatively

cheap labour will be now exploited by the US firms. As the Yuan

appreciates, the NPV of investment in China will start decreasing; the

money might be diverted to India as well.

Disadvantages for India

1. Absence of Cheap Chinese Goods: There will be same effect of

revaluation to India as I have previously discussed in case of USA

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IX. Steps to be taken

In an earlier section, both benefits of adverse impacts of the foreign capital

movement are listed. A sound fiscal and monetary policy is required to

maximize the benefits of foreign capital movement and minimize the adverse

impacts of foreign capital movement.

1) Making domestic banking institutions strong

It is usually a mistake to liberalize the domestic banking system or to open it

fully to inflows if important parts of the system are insolvent or likely to be

pushed into insolvency by liberalization. As a general rule, nonviable

institutions should be weeded out and remaining banks put on a sound footing

before liberalizing or opening the domestic banking system. Nonviable

institutions should be weeded out and remaining banks put on a sound footing

before liberalizing or opening the domestic banking system.

2) Market Stabilization Scheme (MSS) bonds

Inflow of dollars by FIIs (Foreign Institutional Investors) to buy Indian stocks

in 2004 resulted in an oversupply of US dollars in the Indian market. RBI

bought dollars, thus creating an equivalent amount of rupees. This dollar

buying raised forex reserves from $100 bn in January 2004 to about $300 bn

by 2007-08. Thus there was a liquidity overhang that was caused by the inflow

of dollars. This forced the government to mop up the rupees by creating the

MSS bonds.

MSS was introduced by way of an agreement between the government and the

Reserve Bank of India (RBI) in early 2004. Under the scheme, RBI issues

bonds on behalf of the government and the money raised under bonds is

impounded in a separate account with RBI. The money does not go into the

government account. MSS bonds are interest bearing securities meant

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primarily for investing banks' surplus deposits. Unlike usual central

government bonds, MSS bonds do not impact inflation as the proceeds of

these bonds are retained by RBI and not passed on to the government for

spending.

3) Create strong domestic markets

The domestic markets and financial infrastructure for portfolio investments in

equities and debt instruments are not well developed in many emerging market

countries. Creating the domestic infrastructure is necessary before these

markets can be opened internationally. The economy can also benefit from the

development of domestic financial markets that allow financial flows to be

less heavily dependent on the banking system.

4) Address problems in domestic financial system

first

Because banking systems play a central role in the financial affairs of most

emerging market countries, capital flows to and through the domestic banking

system are already significantly liberalized in many of these countries.

Reversing this situation by going back to detailed restrictions on capital flows

through domestic banks hardly seems sensible. But the fact that capital inflows

are already a reality only highlights the danger of removing most restrictions

on capital account transactions too quickly, before major problems in the

domestic financial system have been addressed. Inadequate accounting,

auditing, and disclosure practices weaken market discipline. Implicit

government guarantees encourage excessive, unsustainable capital inflows and

inadequate prudential supervision and regulation of domestic financial

institutions and markets can breed corruption, connected lending, and

gambling for redemption. Countries in which these problems are severe should

liberalize the capital account gradually, in conjunction with steps to eliminate

these distortions.

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5) Liberalizing long-term flows ahead of short-term

flows

Regarding the liberalization of capital outflows, the main concern arises when

the restrictions to be removed are supporting either a significant

macroeconomic imbalance or a distorted financial system. If an overvalued

exchange rate has been maintained with the help of restrictions on capital

outflows, then the government must be prepared to adjust the exchange rate

when the restrictions are removed. Similarly, if policies have kept interest

rates for savers artificially low, market participants must be prepared for a rise

in rates. To avoid such costly accidents, countries should liberalize outflows

after they have reduced macroeconomic imbalances and financial distortions

to manageable proportions.

6) Improved transparency in markets

Critics of open capital markets, point to the inefficiencies resulting from

adverse selection, moral hazard, and herding behavior, all of which are

byproducts of asymmetric information-a situation in which not all parties to a

transaction have equal information. Government policies, however, can lessen

or mitigate the potential damage from asymmetric information problems.

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X. Conclusion

A working group chaired by Dr. Rakesh Mohan, Deputy Governor, Reserve

Bank of India was established by the Committee on Global Financial System to

explore the consequences of capital flows for EMEs: both the macroeconomic

effects and the impact on the domestic financial system.

An outline of the main issues to address was described in their report as follows:

1. The composition of gross capital inflows and their risk characteristics for the

receiving EMEs.

2. The sectoral destination of some components of gross inflows.

3. The size and composition of capital outflows, with particular emphasis on

financial asset investment abroad intermediated by financial institutions.

4. Consequences of inflows for domestic asset markets: equity price

developments, bank balance sheets, land price developments, non-financial

corporate balance sheets and domestic currency interest rates.

5. Implications for the conduct of monetary policy: exchange rate

developments, international reserve accumulation, sterilisation, control over

short-term interest rates, and long-term interest rates.

6. Macroeconomic consequences: inflation, current account positions, wealth

effects and government budget balances.

7. Implications for domestic financial infrastructure development: local capital

markets, domestic financial institutions, the activities of foreign financial

institutions and the development of new financial instruments.

8. Challenges posed to regulation of the domestic financial sector.

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The working group submitted its report in January 2009. As per the report the

group has concluded as follows:

The flow of capital between nations, in principle, brings benefits to both capital-

importing and capital-exporting countries. But the historical evidence,

reinforced by the current global financial crisis, clearly shows that it can also

create new exposures and bring new risks. The failure to analyse and

understand such risks, excessive haste in liberalising the capital account and

inadequate prudential buffers to cope with the greater volatility in more market-

based forms of capital allocation have at one time or another compromised

financial or monetary stability in many emerging market economies. On the

other hand, rigidities in capital account management can also lead to difficulties

in macroeconomic and monetary management.

The co-existence of large-scale private capital flows to the emerging economies,

taken as a group, with substantial current account surpluses is problematic. In

many ways, the ideal for rapidly growing developing economies is to have

current account deficits financed by stable forms of foreign investment. Swings

in capital inflows without offsetting changes in current account balances can

lead to large, and possibly disruptive, changes in real exchange rates. And they

are frequently associated with more volatile or fragile forms of finance. The

capacity to absorb capital inflows is more limited the less domestic financial

intermediation is able to channel financial flows into real investment. However,

given the large volume of net capital inflows experienced by many EMEs in the

recent years - 10% of GDP or even more - it is not apparent that such a large

volume of capital inflows could have been absorbed by the recipient economy,

even in the presence of well-developed domestic financial markets. Past

experience suggests that large capital inflows - whether absorbed or not - can

drive up the prices of existing assets and may not lead to the creation of new

assets. Asset market bubbles have been disruptive in some EMEs. Policymakers

need to keep these risks in mind.

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There is no doubt that closer international financial integration creates

challenges for monetary policy. Long-term interest rates are increasingly subject

to global rather than purely local influences. Monetary policy works via changes

in short-term interest rates and short-term capital flows are very sensitive to

domestic short-term rates, which explains why restrictions on short-term flows

have often been the last to be removed.

How well domestic capital markets function has a major bearing on whether

capital inflows enhance growth without exacerbating financial stability. The

Report finds that the links between the resilience of the financial system and

capital inflows go in both directions. The greater presence of foreign investors

should, in principle, deepen local financial markets, enhance investor diversity

and improve liquidity. But they can also exacerbate the domestic

macroeconomic and liquidity crisis in the times of crisis through massive

liquidation of their investments in the EMEs, as has been clearly evident in the

current round of turmoil. A sophisticated and diverse domestic investor base is,

therefore, also essential for enhancing the resilience of the financial system.

In September and October 2008, a further round of de-leveraging by major

international banks, hedge funds and other investors put very heavy downward

pressure on almost all emerging market assets, even as the fundamentals of the

major EMEs are widely believed to be robust. Volatility rose sharply across the

board and policymakers in the EMEs faced very difficult dilemmas.

Although this shock appears to have reversed the focus of much of this report

(which was on the problems of capital inflows), some lessons were reinforced.

Countries with open capital accounts need to prepare for shocks from the

financial systems abroad. Flexibility in exchange rates can be an effective buffer

to such shocks and may help deter the build-up in the private sector of

imprudent forex exposures. Countries with substantial forex reserves were better

able to cushion the impact of downward pressure on the exchange rate brought

about by sudden and large capital outflows. Not only could they intervene on a

substantial scale to counter extreme movements in the exchange rate, but they

were also able in the crisis to fund their banks in dollars or other foreign

currencies. Some also bought back foreign currency debt when credit spreads

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widened. Similarly, countries that had taken measures to constrain the liquidity

of these banks (eg by increasing reserve requirements) in the phase of heavy

inflows were able to alleviate liquidity pressures by relaxing these restrictions.

Hence countries that had put in place effective "prudential buffers" believe that

they resisted the crisis better than others. It is interesting to note that the large

build-up of forex reserves by most EMEs during 2004-2007 was at that point of

time believed to be excessive. It seems that many EME authorities viewed the

large capital inflows or commodity-related current account surpluses during

2004-2007 as potentially temporary, rather than permanent. Such flows were,

therefore, absorbed into forex reserves. These reserves have turned out to be a

first line of defense in the current episode of reversal of capital flows. This

approach to capital flows, when combined with appropriate exchange rate

flexibility, appears with hindsight to have been prudent. Coordinated action

amongst major central banks, especially the provision of swap facilities, also

has been helpful in containing, to an extent, contagion and volatility in financial

markets.

Overall, it is a combination of sound macroeconomic policies, prudent debt

management, exchange rate flexibility, the effective management of the capital

account, the accumulation of appropriate levels of reserves as self-insurance and

the development of resilient domestic financial markets that provides the

optimal response to the large and volatile capital flows to the EMEs. How these

elements are best combined will depend on the country and on the period: there

is no "one size fits all".

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XI. Appendix

1) Composition of Capital Flows (NET) of India

APPENDIX TABLE 53 : COMPOSITION OF CAPITAL FLOWS (NET)

Item2001-

022002-

032003-

042004-

052005-

062006-

07 2007-08PR

2008-09P

1 4 5 6 7 8 9 10 11Total Capital Flows ( Net) (US $ mn) 8,551 10,840 16,736 28,022 25,470 45,203 107,993 9,146Percentage share in total net flows1 Non- Debt Creating Inflows 95.2 55.5 93.7 54.6 84.0 65.8 58.9 231.0 a) Foreign Direct Investment ** 71.6 46.5 25.8 21.4 34.9 50.3 31.7 382.5 b) Portfolio Investment 23.6 9.0 67.9 33.2 49.1 15.5 27.2 -151.52 Debt Creating Inflows 12.4 -12.3 -6.0 35.2 41.0 64.2 38.9 87.2 a) External Assistance 14.1 -28.6 -16.5 7.2 6.9 4.0 1.9 28.9

b)External Commercial Borrowings # -18.6 -15.7 -17.5 19.4 10.8 36.4 21.0 75.9

c) Short term Credits -9.3 8.9 8.5 13.5 14.5 14.6 15.9 -63.4 d) NRI Deposits $ 32.2 27.5 21.8 -3.4 11.0 9.6 0.2 46.9 e) Rupee Debt Service -6.1 -4.4 -2.2 -1.5 -2.2 -0.4 -0.1 -1.13 Other Capital @ -7.6 56.8 12.3 10.2 -25.0 -30.0 2.2 -218.24 Total (1 To3) 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0Memo:Stable flows + 85.6 82.0 23.7 53.2 36.4 69.9 56.9 314.8PR : Partially Revised. P : Preliminary.

** Data on FDI have been revised since 2000-01 with expanded coverage to approach international best practices. FDI data for previous years would not be comparable with those figures. # Refers to medium and long-term Borrowings $ Including NR (NR) Rupee Deposits

@ Includes leads and lags in exports (difference between the custom and the Banking channel data), Banking Capital (assets and liabilities of Banks excluding NRI deposits), and investments and loans by indian residents abroad. India’s subscription to International Institutions and quota payments to IMF. + Stable Flows are defined to represent all capital flows excluding portfolio flows and short-term trade credits.

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2) International Investment Position of India

COUNTRY NAME: INDIA IFS CODE: 534 INTERNATIONAL INVESTMENT POSITION:EXTERNAL ASSETS AND LIABILITIES AT THE END OF MARCH 2009UNIT:Million REPORTING CURRENCY: USD

Period Mar-07(R)Mar-

08(PR)Mar-

09(PR)International Investment Position, net -62,463.11 -49,572.30 -62,901.51A. Assets 247,270.53 386,917.19 345,886.34 1. Direct Investment Abroad 30,946.35 49,781.35 67,276.35 1.1 Equity Capital and Reinvested Earnings 27,623.50 43,128.50 57,779.50 1.1.1 Claims on Affiliated Enterprises 27,623.50 43,128.50 57,779.50 1.1.2 Liabilities to Affiliated Enterprises (-) 1.2 Other Capital 3,322.85 6,652.85 9,496.85 1.2.1 Claims on Affiliated Enterprises 3,322.85 6,652.85 9,496.85 1.2.2 Liabilities to Affiliated Enterprises (-) 2. Portfolio Investment 931.14 1,526.39 828.82 2.1 Equity Securities 523.06 1,442.64 812.36 2.1.1 Monetary Authorities 2.1.2 General Government 2.1.3 Banks 337.24 356.93 306.78 2.1.4 Other Sectors $ 185.82 1,085.71 505.58 2.2 Debt Securities 408.08 83.75 16.46 2.2.1 Bonds and Notes 389.68 73.53 5.81 2.2.1.1 Monetary Authorities 2.2.1.2 General Government 2.2.1.3 Banks 386.70 73.03 4.34 2.2.1.4 Other Sectors $ 2.98 0.50 1.47 2.2.2 Money-market Instruments 18.40 10.22 10.65 2.2.2.1 Monetary Authorities 2.2.2.2 General Government 2.2.2.3 Banks 18.40 10.22 10.65 2.2.2.4 Other Sectors 3. Financial Derivatives 3.1 Monetary Authorities 3.2 General government 3.3 Banks 3.4 Other sectors 4. Other Investment 16,214.04 25,886.45 25,796.17 4.1 Trade Credits 680.00 1,226.00 2,720.00 4.1.1 General Government 4.1.1.1 Long-term 4.1.1.2 Short-term 4.1.2 Other Sectors 680.00 1,226.00 2,720.00 4.1.2.1 Long-term 4.1.2.2 Short-term 680.00 1,226.00 2,720.00

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4.2 Loans 3,490.18 11,623.79 6,173.96 4.2.1 Monetary Authorities 4.2.1.1 Long-term 4.2.1.2 Short-term 4.2.2 General Government 864.02 901.79 840.72 4.2.2.1 Long-term 864.02 901.79 840.72 4.2.2.2 Short-term 4.2.3 Banks 1,840.07 9,129.42 4,371.92 4.2.3.1 Long-term 1,840.07 9,129.42 4,371.92 4.2.3.2 Short-term 4.2.4 Other Sectors 786.09 1,592.58 961.32 4.2.4.1 Long-term $ 786.09 1,592.58 961.32 4.2.4.2 Short-term 4.3 Currency and Deposits 7,839.58 7,779.66 10,336.53 4.3.1 Monetary Authorities 4.3.2 General Government 5.01 1.45 1.43 4.3.3 Banks 7,039.23 6,879.56 9,642.14 4.3.4 Other Sectors $ 795.34 898.65 692.96 4.4 Other Assets 4,204.28 5,257.00 6,565.68 4.4.1 Monetary Authorities 4.4.1.1 Long-term 4.4.1.2 Short-term 4.4.2 General Government 725.67 740.19 735.07 4.4.2.1 Long-term 725.67 740.19 735.07 4.4.2.2 Short-term 4.4.3 Banks 2,550.93 3,480.19 5,026.88 4.4.3.1 Long-term 2,550.93 3,480.19 5,026.88 4.4.3.2 Short-term 4.4.4 Other Sectors 927.68 1,036.61 803.72 4.4.4.1 Long-term $ 927.68 1,036.61 803.72 4.4.4.2 Short-term 5. Reserve Assets 199,179.00 309,723.00 251,985.00 5.1 Monetary Gold 6,784.00 10,039.00 9,577.00 5.2 Special Drawing Rights 2.00 18.00 1.00 5.3 Reserve Position in the Fund 469.00 436.00 981.00 5.4 Foreign Exchange 191,924.00 299,230.00 241,426.00 5.4.1 Currency and Deposits 138,928.00 195,661.00 106,634.00 5.4.1.1 With Monetary Authorities 92,175.00 189,645.00 101,906.00 5.4.1.2 With Banks 46,753.00 6,016.00 4,728.00 5.4.2 Securities 52,996.00 103,569.00 134,792.00 5.4.2.1 Equities 5.4.2.2 Bonds and Notes 5.4.2.3 Money-market Instruments 5.4.3 Financial Derivatives (net) 5.5 Other Claims B. Liabilities 309,733.64 436,489.49 408,787.85 1. Direct Investment in Reporting economy 77,037.08 118,786.79 125,168.26 1.1 Equity Capital and Reinvested Earnings $$ 73,221.15 114,402.80 120,229.19 1.1.1 Claims on Direct Investors (-) 1.1.2 Liabilities to Direct Investors 73,221.15 114,402.80 120,229.19 1.2 Other Capital 3,815.93 4,383.99 4,939.07 1.2.1 Claims on Direct Investors (-) 1.2.2 Liabilities to Direct Investors $$$ 3,815.93 4,383.99 4,939.07

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2. Portfolio Investment 79,444.37 117,866.75 83,101.36 2.1 Equity Securities 63,266.89 96,481.18 63,123.76 2.1.1 Banks @@ 2.1.2 Other Sectors $$ 63,266.89 96,481.18 63,123.76 2.2 Debt securities 16,177.48 21,385.57 19,977.60 2.2.1 Bonds and notes 15,711.53 20,659.40 17,853.60 2.2.1.1 Monetary Authorities 2.2.1.2 General Government 108.53 79.40 45.60 2.2.1.3 Banks 534.98 584.69 580.27 2.2.1.4 Other Sectors ## 15,068.02 19,995.31 17,227.73 2.2.2 Money-market Instruments 465.95 726.17 2,124.00 2.2.2.1 Monetary Authorities 2.2.2.2 General Government 465.95 726.17 2,124.00 2.2.2.3 Banks 2.2.2.4 Other Sectors 3. Financial Derivatives 3.1 Monetary Authorities 3.2 General Government 3.3 Banks 3.4 Other Sectors 4. Other Investment 153,252.19 199,835.95 200,518.23 4.1 Trade Credits 27,727.00 43,975.00 41,961.00 4.1.1 General Government 1,073.00 1,292.00 1,275.00 4.1.1.1 Long-term 1,073.00 1,292.00 1,275.00 4.1.1.2 Short-term 4.1.2 Other Sectors 26,654.00 42,683.00 40,686.00 4.1.2.1 Long-term 675.00 782.00 722.00 4.1.2.2 Short-term* 25,979.00 41,901.00 39,964.00 4.2 Loans 80,794.07 106,845.01 113,915.93 4.2.1 Monetary Authorities 4.2.1.1 Use of Fund Credit & loans from the fund 4.2.1.2 Other Long-term 4.2.1.3 Short-term 4.2.2 General Government 46,809.00 53,040.00 51,906.00 4.2.2.1 Long-term 46,809.00 53,040.00 51,906.00 4.2.2.2 Short-term 4.2.3 Banks 1,543.00 1,650.00 1,990.00 4.2.3.1 Long-term 1,543.00 1,650.00 1,990.00 4.2.3.2 Short-term 4.2.4 Other Sectors 32,442.07 52,155.01 60,019.93 4.2.4.1 Long-term*`* 32,442.07 52,155.01 60,019.93 4.2.4.2 Short-term 4.3 Currency and Deposits 41,741.00 44,787.00 42,318.00 4.3.1 Monetary Authorities 501.00 1,115.00 764.00 4.3.2 General government 4.3.3 Banks @ 41,240.00 43,672.00 41,554.00 4.3.4 Other sectors 4.4 Other Liabilities 2,990.12 4,228.94 2,323.30 4.4.1 Monetary Authorities 4.4.1.1 Long-term 4.4.1.2 Short-term 4.4.2 General Government 1,029.00 1,120.00 1,018.00 4.4.2.1 Long-term# 1,029.00 1,120.00 1,018.00

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4.4.2.2 Short-term 4.4.3 Banks 1,089.00 1,916.00 464.00 4.4.3.1 Long-term 4.4.3.2 Short-term 1,089.00 1,916.00 464.00 4.4.4 Other sectors 872.12 1,192.94 841.30 4.4.4.1 Long-term 4.4.4.2 Short-term $ 872.12 1,192.94 841.30 R : Data are Revised PR : Data are Partially Revised. P : Data are Provisional. $ : Based on survey on Foreign Liabilities & Assets $$ : Foreign Direct Investment (FDI) & Portfolio Investment are not adjusted for price changes. $$$ : All liabilities (other than equity) between direct investor & direct investment enterprises are treated as other capital. @ : Include accrued interest * : Suppliers Credit upto 180 days are included. ** : Includes Buyers' Credit. Loan transactions between direct investor & direct investment enterprises are treated as other capital. ## : Include Foreign Currency Convertible Bonds. @@: Equity Investments in Banks by Non-residents included under FDI. #:: includes SDRs 3,082.5 million allocated under general allocation and SDRs 214.6 million allocated under special allocation by the IMF done on August 28, 2009 and September 9, 2009, respectively. Note: i) NRO deposits are included under NRI deposits from the quarter ending June 2005. Supplier's Credits upto 180 days and FII investment in short term debt instruments are included under short term debt from the quarter ending March 2005. ii) Vostro credit balance is included in the liabilities of banking system under Other Liabilities,since September 2006 iii) As per BPM6, SDR allocation is treated as debt liability

140


3) Foreign Exchange Reserves of India

141


XII. Bibliography

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International Monetary Fund Website, http://www.imf.org

World Bank Website, http://www.worldbank.org

World Trade Organization Website, http://www.wto.org

Wikipedia, http://www.wikipedia.org

Securities and Exchange Board of India Website, http://www.sebi.gov.in

Annual Report 2008-2009, Reserve Bank of India.

Committee on the Global Financial System, “Capital flows and emerging market

economies”. CGFS Papers.

Burdekin, CK (2005), “China and the Depreciating US dollar, Colombia

International Affairs Online”

Goldstein, M., “China's Exchange Rate Regime, testimony before the

Subcommittee On Domestic and International Monetary Policy, Trade”.

Available online at www.iie.com/publications/papers/ goldstein1003.htm

Hilsenrath, J. E., and M. Kissel, “Currency Decision Marks Small Shift toward

Flexibility'', Wall Street Journal, July 22, 2005, p. A1, col. 6.

Ganbhir, N., Goel, M., “Foreign Exchange Derivatives Markets in India – Status

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Dodd, Randall, (2004), “Managing the Economic Impact from Foreign Capital

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http://www.sebi.gov.in/

http://www.wikipedia.org/

http://www.wto.org/

http://www.worldbank.org/

http://www.imf.org/

http://www.rbi.org.in/