With global rates firming up, will we see a flight of capital?

ISSUE

Outflows will be mild

S Mathur
A currency strategist with a leading bank

The developing world has started to tighten interest rates as indicators confirm the setting in of an economic revival and raise fears of inflation.

Meanwhile, interest rates in India are likely to remain stable: the Reserve Bank of India maintains a benign inflationary outlook and a surfeit of excess liquidity will keep government bond yields low.

This contraction in rate differentials renders India a less attractive destination for international investors, and threatens to weaken India's share in foreign capital flows.

Though these concerns are valid, the impact will not be significant: only a fraction of India's capital inflows are sensitive to the level of interest rates, and India has accumulated enough reserves to remain largely unaffected by temporary capital flow shocks.

The level of short-term interest rates is an important driver (among several others) of capital flows in international currency markets.

Ceteris paribus, capital tends to flow out of economies with low interest rates and into those with higher rates (and thus higher returns), adjusted, of course, for investor perceptions about credit risk.

India is not insulated from this trend: the RBI last year sharply reduced interest rates available to non-resident Indians in order to moderate the pace of inflows.

As interest rate differentials shrink further in 2004, these inflows may slow as well.

It is important to note, however, that interest rate differentials will not collapse steadily "" the RBI will raise domestic rates, but perhaps with a lag to the tightening in developed economies.

Thus, the trend of narrower interest rate differentials is probably only a temporary phenomenon; consequently, its disadvantageous impacts will also be limited.

In the 12-months till October 2003, incremental non-resident rupee deposits totalled $5.2 billion and debt FII flows another $0.9 billion. Capital flows in India are still regulated, and these two are the primary source of interest rate-sensitive flows.

If we assume that the combined inflows from these sources halves as a result of the smaller rate differentials, and that the recently permitted retail investments abroad result in a $1 billion outflow, the net impact over a 12-month period will be a restricted to $4 billion.

Note that this is not a conservative estimate; the actual impact will probably be milder.

This shortfall will be more than made up by inflows into Indian equity markets (incidentally, low domestic interest rates should enhance FII flows) and by the continued growth in India's services exports in the same period.

Indeed, though the trade deficit will probably expand as the economy recovers, India's balance of payments is likely to remain comfortably in surplus for the next several years.

India is also well placed to deal with a temporary external shock: not only has the RBI amassed $105 billion in reserves, but the banking system also currently enjoys about a $10 billion (cushion) of excess liquidity.

Temporary shifts in capital flow trends are thus unlikely to dent the Indian economy.

Inflation is a concern

U Venkataraman
Chief dealer, forex,
IDBI Bank

Bank of England was the first off the block of G7 to raise interest rates by 25 basis points on November 6 and again on February 5 by the same percentage points. New Zealand and Australia soon followed suit, raising their interest rates.

The question now on everyone's mind is "are we at the end of the global interest easing cycle? Will the trend start reversing now?

A rise in yen interest rates looks distant as foreign trade continues to feed Japan's economic recovery and the currency remains under constant upward pressure against the dollar.

The US yield curve still shows steepness with the 10-year treasury yields and the three-month money rate at a difference of over 300 basis points.

The factors that can cause further rise in the yields are ballooning federal budget deficits, widening current account deficits, downward spiral of the dollar inducing inflation in the economy and accelerated GDP growth.

The US Fed maintains that low inflation will allow the central bank to remain "patient" before raising interest rates.

Low borrowing costs, profit growth from productivity gains and rising confidence should help the economy to expand 4.5 per cent to 5 per cent.

This is quarter point better than Fed's July forecast of 2004. With the growth engines on a high, it is a matter of time before the Fed acts.

If you look at recent history, there has been a positive correlation between US interest rate cuts and the Indian rate cuts, which mean the converse, may also happen though with a time lag.

Will the rate hike in developed economies, particularly the US, lead to capital flight from India?

FIIs and global fund managers are looking at India as a favourable investment destination. As per Sebi data, the combined FII inflow (debt and equity) stands over $1.2 billion in 2004, that is, in less than two months.

Today, India, Asia's third largest economy has the fifth largest reserves after Japan, China, Taiwan and South Korea.

The high level of reserves is a reflection of the economy and strong faith of international investors in India's growth potential. It also represents a "no default" situation.

If NRI remittances continue to flow into India in spite of rates being lower than those offered to domestic investors, it goes to show that there has been a "flight to quality" and not "flight to yield".

It is a matter of pride for all Indians that in a study of 20 select industrial and developing countries, IMF described India's policies as being "comparable to global best practices".

The real GDP growth of 8.4 per cent in the second quarter of 2003-04 places India among the fastest growing economies during the current year.

India has been adopting a policy of liberalisation with regard to capital account inflows and outflows but at the same time ensuring that the ratio of short-term debt to reserves is kept low.

Three years back, the regulators were concerned with how to protect the depreciating rupee but now the concern is how to prevent its further appreciation.

RBI has been liberalising outward remittances including the recent one permitting resident Indians to remit up to $25,000. The concern at the moment is not the flight of capital but inflation caused by an increase in commodity prices, including oil.