Global Finance in Indian Context

7/29/2019 Global Finance in Indian Context

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Global finance in Indian context

Introduction

The globalization process is all about reducing barriers to the free movement of capital,

goods, and labor between all the countries of the world. Most governments are, with

some reservations, broadly in favor of the process, as are most economists, because they

believe that lowering these barriers will boost world growthby co-operating, everyone

will get richer. In this view, richer countries need to be constantly moving into industries

where they have an advantage, such as high technology, allowing less developed nations

to develop and export. Low wages in a Third World country, they say, are a function of

low productivity in that countrys industry. If that industry becomes highly productive,

wage rates will rise. Singapore and Japan, for example, today enjoy comparable wages

and living standards to the West because of their success in building productive industries

over the last 40 years. Economic growth is not a zero-sum game. If Country A is rich, this

does not mean that Country B has to be poor. The more productive the world is, the

richer it gets as a whole and working to distribute wealth to all people is part of the

process of increasing productivity. A way to make everyone richer? Why would any

business person be against the idea? Perhaps this is not as odd as it seems. Businesses are

primarily interested in their own profits. A company may be able to make excellent

profits in a country where everyone else is doing badly; working for the general good is

irrelevant to the central business goal. Also, it takes decades, at least, for a country to


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become prosperous, while businesses have to focus on making profits in a much shorter

period. This book is about how macroeconomic events are affecting businesses

everywhere. Most of the time, companies must focus on microeconomic issues events

in their markets, their industries, their supply chain, and so on. When the underlying

structure of the world economy changes, as it is today, companies have to take notice; the

opportunities are immense, but so are the dangers. The availability of cheaper capital in

the global markets, a reduction in labor bargaining power, the rise of imports, the

increase in cross border mergers and acquisitions, the opening up of huge markets such as

China and India, changes in public attitudes, demographic change, and the e revolution

are just some of the factors in globalization. They are not going to go away, and

companies that ignore them or fail to understand the underlying reasons why they are

occurring, are being acquired or going out of business.


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What is global finance?

There are five basic concepts in global finance and examines the role of international

business

Macroeconomics The theory of comparative advantage Growth Types of economic system Ways of classifying economies International business.

MACROECONOMICS

Macroeconomics is the study of whole economies, as opposed to microeconomics,

which looks at how individual industries, households, and businesses function. While

macroeconomics is a vital concern of governments, it is also essential to businesses,

especially those with operations overseas. Macroeconomic concerns, such as currency

exchange, inflation, unemployment levels, economic development, and international

trade, are a major element in successfully managing operations in a complex and ever-

changing environment.


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THE THEORY OF COMPARATIVE ADVANTAGE

One of the most important ideas in economics is comparative advantage, originally

propounded by David Ricardo, a British economist and politician of the early 1800s. The

proposition is simply that nations, societies, and members of those societies collectively

benefit most by specializing in what they do best, even if some parties are absolutely

more efficient producers than others. To find the most productive way of dividing their

labor, they look at the opportunity cost

GROWTH

Every day we are exposed to the notion that growth is very important and we could be

forgiven for wondering why. While there may be philosophical differences over the true

value of growth (some people may prefer to live simply, while others want everything

they can get), many misunderstandings arise because of confusion over the concept of

economic growth. Economic growth is the increase in the total production output of an

economy. As long as output grows faster than the population, the standard of living

increases. Economic growth happens when an economy either finds new resources or

when it finds ways of producing more using existing resources. Since the Industrial

Revolution that began around 250 years or so, much of the world has done both. The

population has increased dramatically, yet living standards have, overall, gone up.


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TYPES OF ECONOMIC SYSTEM

In practice, most countries have a mixed economic system, where there is both

government involvement and a degree of freedom in the markets. In their pure form,

there are two extreme possibilities: the command economy and the laissez-faire economy.

The command economy is controlled by a central government that owns state enterprises,

and sets production targets, prices, and incomes. In recent years, command economies

have not done well the economies of the former USSR and Eastern Europe have

collapsed and undertaken a painful transition to a market economy with varying degrees

of success. While countries such as Poland have been recording real growth since 1992,

others, such as Albania and Romania, have not enjoyed much foreign investment and

remain in dire straits. China has undertaken a series of reforms that have freed its markets

dramaticallysome cities in China, such as Shanghai, are capitalist boom townswhile

retaining a large degree of government involvement. The pure laissez-faire economy

is where the government has no participation at all. Individuals and companies buy,

produce, and sell as they wish, and the outcomes are a result of countless individual

decisions. Supporters of free market systems argue that they encourage efficiency,

because an inefficient producer will be driven out by better competitors, and that the

consumers have great power because businesses will respond to their demands. Prices

will adjust themselves automatically as supply and demand fluctuates. Laissez-faire has

problems too, however. It can be demonstrated that inefficiencies can and do exist.

Without government involvement there can be many injustices, and it is a feature of


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laissez-faire that there are recurrent episodes of unemployment and inflation. Although

most economists agree that some government intervention is desirable, there is a

perennial debate about how, and how far, it should go

WAYS OF CLASSIFYING ECONOMIES

There are nearly 200 sovereign states in the world, each with its own economy. The

International Monetary Fund (IMF), the United Nations (UN), and the World Bank all

have different ways of classifying the worlds economies, reflecting these organizations

own agendas. The most widely used system in business is the IMFs, which classifies

Nations into three groups:

industrial economies: the 23 most industrialized countries, including the US, Canada,

Japan, Western Europe, Australia, and New Zealand;

developing countries: some 130 nations in Latin America, Asia, the Middle East, and

Africa. Some countries in this group have enjoyed substantial growth in recent years, so

there is now a subcategory of newly industrializing countries (NICs) including such

powerhouses as Hong Kong, Singapore, South Korea, and Taiwan;

transitional economies: 28 countries of the former Soviet bloc that are now trying to

develop market economies


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INTERNATIONAL BUSINESS

International trade had always been important, but during the last 20 years countries have

become markedly more interdependent. A widespread restructuring of economies to

adapt to freer trade and capital movements, and in response to the collapse of the USSR,

is occurring. While this presents many new opportunities for business, it is by no means

certain that the process is irreversible. As we will see throughout this book, there are

many forces and issues that are directly or indirectly resistant to globalization. Although

some believe that multinational companies (MNCs) are a major factor in driving further

globalization, others argue that MNCs are actually much more closely tied to their

countries of origin than is generally appreciated, and that they tend to pursue national,

rather than global, objectives. There are also worries that globalization could increase the

wealth gap between rich and poor nations.


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The Evolution of Global Finance

How did we get here? From Adam Smith and David Ricardo to twentieth century

attempts to manage increasing economic complexity. How multinationals evolved.

The evolution of macroeconomics

The evolution of multinationals

The General Agreement on Tariffs and Trade (GATT) and the World Trade

Organization (WTO)

GATTthe Uruguay round

The International Monetary System (IMS)

Timeline: Key events in the development of global trade and finance

THE EVOLUTION OF MACROECONOMICS

Although the term macroeconomics was not coined until after the Second World War,

the Depression of the 1930s marks its birth as a practically applicable body of ideas.

During the 1930s, international trade slumped and there were rounds of competitive

currency devaluations as countries tried to make their export goods cheaper. Traditional

theorists believed that wages would drop to a level where there was little unemployment,

but for a decade unemployment across the world remained high. John Maynard Keynes, a

British academic, developed a solution, arguing that what was needed was for

governments to intervene and stimulate overall demand. Following the end of the Second

World War, Keynes ideas gained wide acceptance and governments increasingly used

taxation, public spending, and intervention in interest rate levels and the money supply to


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try to manage their economies. By the 1960s, confidence in governments ability to keep

economies stable was at its height; many people believed that it was possible to fine

tune the economy to control variations in production output and employment levels. In

the 1970s, following the oil crisis of 1973 when the OPEC oil producing nations

dramatically increased prices, the developed nations experienced wild fluctuations in

inflation, unemployment, and production output. The new phenomenon of stagflation

appeared, where a rapid price inflation combined with high unemployment prior to the

1970s, inflation had only occurred during periods of prosperity and low or declining

unemployment. By the 1980s, it was clear that Keynesian economics as generally

understood was not working effectively. Criticisms ranged from the simple argument that

government bureaucracies were not efficient enough to act quickly to more complex

theoretical views that cast doubt over whether monetary and fiscal policies could actually

affect the overall economy at all. Monetarism (see Chapter 8) generally favors a slow,

steady increase to the money supply in line with growth in output and is against

governments actively trying to influence the economy by expanding the money supply

during bad times and slowing the growth in the money supply during good times. In the

1970s, the debate between monetarist and Keynesian approaches was a huge controversy

as governments struggled to cope with inflation and unemployment. Two other

macroeconomic approaches developed out of the chaos of the 1970s, new classical

economics and supply-side economics. New classical economics suggests that people

and businesses have rational expectations about the economy and that government

intervention can have little effect on overall output it advocates very little government

intervention. Supply-side economics focuses on the idea that heavy regulation and high


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taxation reduces incentives to be productive (work, save, and invest). Deregulate and

reduce tax, they say, and the economy will expand. During Ronald Reagans presidency

in the 1980s, the US experimented with supply-side ideas. Did they work? The jury is

still out, with supply-siders pointing to the facts that after tax cuts in 1981 the US

recession ended, federal receipts rose throughout the 1980s despite the tax cuts, and

inflation fell during the period. Opponents counter that the national debt increased by

$2trn between 1983 and 1992 and argue that higher tax rates would not have dampened

economic growth. Today, there is still much disagreement over the competing

macroeconomic theories. They are difficult to test conclusively because there is not

enough data the half century since WWII is simply too short a period of time. The

different theories are also difficult to standardize in ways that allow them to be tested

against one another. In short, macroeconomics is still a young science and there is much

left to learn.

THE EVOLUTION OF MULTINATIONALS

Although multinationals appeared in the early 1800s it was not until the 1870s that MNCs

developed in a form that we would recognize today. Technological developments and

organizational innovations allowed the creation of vast global enterprises, most of which

were based in Europe. Some of these, such as British American Tobacco, Nestl and

Michelin, are still major corporations today. In the late nineteenth century, these MNCs

were principally focused on gaining control of commodities in the colonies with which to

supply products at home and for export. They were not yet a major force on the business

scene, however, with much international business being dominated by cartels. MNCs


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came into their own after WWII. US firms entered foreign markets in force, but

concentrated mainly on developed countries, rather than on the raw material producers of

the prewar era. US MNCs employed large numbers of skilled workers, advertised

massively, and had intensive R&D programs. By the 1970s, MNCs began to change as

Japanese and European companies began to flex their muscles. Japanese firms began to

use newly industrialized countries (NICs) as export platforms for their products while

European companies entered the US market and increased their ownership of US firms.

As a result of the rapid growth of newly industrialized countries since 1980, a new

generation of multinational firms have appeared in Asia (in particular, from Taiwan,

Singapore, Hong Kong, and South Korea) and to a lesser extent in Latin America. Today,

MNCs are major players in world business, with their foreign affiliates accounting for

about a third of total world gross domestic product (GDP).

THE GENERAL AGREEMENT ON TARIFFS AND

TRADE (GATT) AND THE WORLD TRADE

ORGANIZATION (WTO)

GATT was originally signed in 1947 by 23 industrialized nations including the US, the

UK, France, and Canada. In 1995 it was succeeded by the WTO. GATT has had eight

rounds of international trade negotiations; all aimed at reducing trade barriers. In the grim

post-war atmosphere of 1947, the average import tariff in industrialized countries was

around 40%. Today it is around 5%. In the 1960s, the Kennedy round of GATT

achieved an average cut of around 30%, reducing manufacturers costs by about 10% by

1972. In the late 1970s, the Tokyo round also achieved tariff cuts of approximately a


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third, with greater cuts for trade between the most developed countries and smaller cuts

for trade between developed and newly industrialized countries. As well as addressing

tariffs, GATT also tries to reduce trade discrimination by insisting that any trade

advantage given to one member country must be given to all other members. Exceptions

are allowed for free trade areas and customs unions such as the European Union.

GATTTHE URUGUAY ROUND

The most recent completed round of multinational trade negotiations began in Uruguay in

1986 and was finally concluded in Geneva in 1993, although the US did not approve it

until 1994. It is the biggest and most comprehensive trade agreement ever made, and its

supporters claim that it will increase the volume of international trade of merchandise by

924% over what could otherwise be achieved. The three most significant features of the

Uruguay round are:

1 Tariffs and protections for agriculture are reduced. Historically, agriculture has often

been the most protected of industries. Uruguay calls for an average reduction of

agricultural tariffs on imports of 37%.

2 Uruguay bans restrictions on the import of services such as banking, insurance,

computer consulting, legal services, and accounting.


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3 Increased protections for intellectual property. Local laws usually protect domestic

intellectual property, such as copyrights, patents, and artistic works, but internationally

piracy is common. Uruguay requires its signatories to protect foreign owners of

intellectual property to the same degree as they protect their own. A major criticism of

GATT is that it lacks teeth; compliance is voluntary. Developed countries have generally

complied with GATT agreements, but there have been numerous cases where some have

not. A disagreement between the EU and the US in the early 1990s over oilseed subsidies

resulted in the EU refusing to comply with some GATT recommendations for several

years and only capitulating when the US threatened to impose tariffs in retaliation. The

WTO is intended to solve this problem by a streamlined disputes system with binding

arbitration; more than half of the disputes brought so far have been between the US and

the EU.

TIMELINE: KEY EVENTS IN THE DEVELOPMENT OF

GLOBAL TRADE AND FINANCE

1848: The protectionist Corn Laws repealed in Britain, a landmark victory for free

trade.

1870s: Multinational companies, such as Nestl and Michelin, develop to exploit new

technical processes.

1914: The First World War forces countries to abandon the gold standard. Exchange

rates fluctuate wildly, to the detriment of world trade.


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1930s: The Great Depression mass unemployment and a dramatic slowdown in

international trade casts doubt on the idea that free markets are fully self-adjusting. J.M.

Keynes argues that governments can stimulate economies by spending.

1944: The Allied powers meet at Bretton Woods to devise a system for stabilizing

exchange rates and promoting growth and trade. All currencies are tied to the US dollar,

and the IMF and World Bank are created.

1947: The GATT trade agreement, intended to reduce international trade barriers, is

signed by 23 nations.

1950s: American MNCs grow rapidly in developed foreign markets, investing heavily

in R&D and using sophisticated marketing methods.

1971: The US abandons the Bretton Woods system, and currencies are allowed to float

against one another.

1973: The OPEC oil cartel hikes the price of crude oil, throwing the developed world

into recession.

1970s: Stagflation (high inflation and unemployment) appears. European and Japanese

firms grow to become MNCs. Keynesian ideas are challenged by monetarism.

1980s: New classical economics and supply-side economics increase in influence.

Growth, especially in Asia, encourages a new generation of MNCs to emerge from the

newly industrialized countries (NICs).

1993: The Uruguay round of GATT is concluded.

1990s: Globalization and free markets are in the ascendancy, with countries all around

the world privatizing state-owned firms and reducing barriers to free capital flows.

1995: GATT is succeeded by the World Trade Organization (WTO).


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2000: A preliminary meeting of the WTO to discuss a new trade round in Seattle

collapses amid recriminations between developing countries, the US and the EC, while

outside there are violent protests. An anti-globalization movement gathers strength


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Global finance in Indian context

The Beginnings

With the opening up of its economy under the structural adjustment program since 1991,

there has been a significant shift in several policies and programs of the Indian

government. This shift is more pronounced in the arena of capital flows, from earlier

policy regime of official and commercial borrowings to private capital flows - in the form

of foreign direct investment (FDI) and portfolio investment (PI). Since then, various

measures have been undertaken to open Indias economy to foreign investment and

earlier restrictions have been relaxed. There is no doubt that in the post-1991 period FDI

flows in India have increased, but the growth in portfolio investment has been more

dramatic. In 1993-94 and 1994-95, the portfolio inflows outnumbered the FDI,

contributing over 70 per cent of the total capital inflows during this period. This trend

continued until 1997. It was only in the wake of Asian financial crisis in 1997, which

enhanced emerging market risk perception among the foreign investors, that the PI

suffered decline in comparison with the FDI in India. Unlike Chile and Japan, India did

not follow the Big Bang approach of financial deregulation and liberalization. But, the

content of financial liberalization in India is similar - deregulation, privatization, and pro-

market oriented policies. Given the fact that Indian financial markets are fragmented and

even not integrated domestically, the critics argue that the rapid global integration of

financial markets seems to be too early and premature. In 1992, the Indian government

began the process of integration of its financial markets with global finance capital in two

major ways. Firstly, by permitting foreign institutional investors to enter its capital


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markets and secondly, by allowing domestic companies to raise capital from abroad

through the issuance of equity, Global Depository Receipts (GDRs), and other debt

instruments. In the initial years, portfolio investments were strictly regulated by the

regulatory bodies such as the Reserve Bank of India (RBI) and the Securities and

Exchange Board of India (SEBI). Given the fact that portfolio investment is essentially

short term, quick to move in and move out and tend to be extremely volatile, the Indian

authorities initially imposed taxes to attract only genuine investors and keep off fly-by-

night operators in the Indian markets. The restrictions on foreign institutional investors

included a special 20% tax rate on dividend and interest income and 10 per cent on long-

term (12 months or more) capital gains and 30 percent on short-term capital gains. These

tax-based restrictions coupled with other measures were helpful in keeping off the

speculators, for some time, but, the foreign investors, over the years, found several

loopholes in the system. As a result, the very purpose of such measures to discourage

speculative flows has been defeated. Rather than taking appropriate measures to close the

loopholes developed in the system, the Indian authorities have been further removing

controls and regulatory mechanisms. For instance, the aggregate cap on the holding of

foreign institutional investors along with nonresident Indians (NRIs) and overseas

corporate bodies (OCBs) on domestic company was raised from 24 % to 40 % in the

1998. Beside, foreign institutional investors can purchase and sell government securities

and Treasury Bills. Forward covers in respect to fresh equity investment have been

permitted. New financial Instruments such as derivatives are to be introduced shortly in

the Indian markets.


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Capital Account Liberalization

Since 1997, the agenda of integrating Indian financial markets with the rest of the world

has been extensively pushed by successive governments. Before the onset of the

Southeast Asian financial crisis, convertibility on capital account had become the new

buzzword in Indian financial markets and policy circles. In 1994, India had introduced

current account convertibility and satisfied the VIII schedule of the IMF's Articles of

Agreement. The Indian rupee is now convertible on current account which, in simple

words, means that one can buy and sell foreign exchange for import, export and foreign

Travel. For any capital transaction, there are ceilings and controls. However, domestic

residents and companies are not allowed to invest abroad without permit and cannot

operate in currency, stock and gilt market abroad. In an attempt towards achieving capital

account liberalization, the government appointed a committee headed by S. S. Tarapore

in February 1997 to examine the issues related to capital account liberalization in India.

In its report submitted to the government in June 1997 the committee has called for full

liberalization by the year 1999-2000, provided that a few preconditions, like a lowering

of the fiscal deficit, a low inflation rate, adequate level of owned forex reserves, and

reduction in non-performing assets of the banking sector are met. The policy makers have

overlooked the concerns of many critics who argue that achieving capital account

liberalization in 1999-2000 can be ill-timed because the economy is yet to achieve a

sustainable growth rate; inflationary pressures are existing; fiscal deficit is not going

down; and its position on the external front is uncertain. Any move towards reaching the

target of full liberalization in the next two years can backfire, thereby causing a severe


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crisis in the external sector. Initially, the report received tremendous support from the

foreign institutional investors, banks, trading and business houses, and international

financial institutions. However, with the eruption of financial crisis in the Southeast Asia

in 1997, the initial euphoria was subsided for few months in India. But, now it appears

that both domestic and international lobbies have, once again, started lobbying for full

liberalization. Except for rethinking on capital account liberalization in the wake of Asian

financial crisis, the Indian authorities have, by and large, moved ahead with their plans of

financial liberalization, which became very evident when India accepted the new WTO

accord on financial services in December 1997. In a major development, the government

announced the opening of the insurance sector to the domestic private sector in the Union

Budget of 1998-99. Within a couple of months, the government suddenly reversed its

stand and decided to allow foreign investment in the Indian insurance sector. The haste in

which this decision was taken without any meaningful consultation with labor unions and

political parties has raised several doubts.

Emerging Issues:

The Growing Domination of Foreign Funds

Although India has been able to attract not more than 5 percent of the total capital flows

to emerging markets (as the bulk has gone to Latin America and Southeast and East Asia

in the 1990s), yet the impact of these flows on the Indian financial markets has been very

profound in many ways. The authorities expected that by inviting foreign institutional

investors, the Indian markets would increase in maturity and depth. But, this did not

happen. On the contrary, the markets became shallow and volatile. The markets are

unable to provide resources to promoters of new capital issues. Although there are nearly


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500 foreign institutional investors registered with the SEBI to operate in Indian financial

markets, only a handful of them dominate the markets. As the cumulative portfolio

investment in India by the foreign investors until November 1997 was about $9 billion,

just five top foreign institutional investors contributed over 40 percent of the total

investments. Much of that money is going only to a couple of capital markets in the

country and in a handful of stocks. The entry of foreign institutional investors has

weakened the strength of domestic institutional investors in India. With huge amounts of

financial resources at their disposal, the foreign institutional investors are the real prime

movers and shakers in the Indian stock markets. Except a handful of major public sector

financial institutions, such as Unit Trust of India (UTI), no Indian institutional investor

can match the resources of the foreign players. With retail business almost vanished, any

action by the foreign institutional investors (whether buying or selling) determines the

movements in the markets nowadays. Recent studies reveal a positive correlation

between net inflows by foreign institutional investors and the movement in the stock

indices.1 with the policy-makers still relying on foreign portfolio investments, it is

ignored that these investments are not reliable and sustainable. For instance, in November

1997 - for the first time since India opened its doors to foreign institutional investors -

their net investments in India turned negative, i.e. there was an outflow of funds. In a like

manner, restrictions on the external commercial borrowings (ECBs) by the Indian

companies have also been further relaxed. The ECBs have been on the rise recently, as

Indian corporate houses prefer cheap foreign loans. Since the foreign borrowings come

cheaper, many companies have used ECBs to retire their high cost rupee debt. This works

out to be much cheaper given the wide gap between the domestic and overseas interest


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rates. But, the depreciation of the rupee increases the repayment cost (in rupees) and

causes problems for the management of the balance of payments for the country as a

whole. This is what really happened in the case of Indonesia, South Korea and Thailand

in 1997.

Hot Money Flows: Cause of Concern

The growing proportion of hot money flows to forex reserves of India in the 1990s is a

matter of serious concern. It increased from 37.50 percent in 1994 to 53.52 percent by

March 1997 and then further to 78.80 percent by February 1998. The stock of potentially

hot money can be arrived at by adding the stock of short-term debt, investments by

foreign institutional investors, issuance of GDRs, and offshore funds. According to the

RBI annual report for 1996-97, India's short-term debt was $6.7 billion (but as per the

Bank for International Settlements (BIS), estimates that are considered more reliable by

international community, India's short-term debt was $7.75 billion at the end of June

1997). Similarly, the GDR figure in March 1997 was $5.4 billion and the portfolio

investments amounted to $8.8 billion. These figures add up to a staggering $20.9 billion,

Against forex reserves of $24.1 billion. In other words, the hot money flows constitute a

whopping 86.7 percent of India's total forex reserves. This figure is very high as

compared to a maximum of 60 percent recommended by the Tarapore committee.


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Lessons to be learned

Rapid global capital mobility in the decades of the eighties and nineties has been

accompanied by an increased frequency of financial crises in both the developed and

developing countries. The advocates of the financial liberalization have admitted the fact

that there is a positive correlation with international financial liberalization and financial

crises. Attracted by short-term speculative gains, hot money flows can leave the

country as quickly as they come in. The problem is further compounded by the domestic

structural weaknesses in the financial sector of recipient countries, which find it difficult

to manage the volatile capital flows. As a result of these factors, one has witnessed the

financial crises in the European Monetary System in 1992- 93 (which also affected non-

EMS countries such as Finland and Sweden), then came the Mexican currency crisis of

1994 and now the Southeast Asian crisis. Since India's financial markets were not opened

up until the early 1990s, the country was able to insulate itself from many of these

international currency and financial crises. But, now the chances of being affected by the

developments in the world markets have increased significantly because what happens all

over the world markets, affects the Indian markets. Further, when financial markets crash,

worldwide panic takes over and economic fundamentals (even if these are strong) are

ignored. The recent financial crises have exposed the dangers of capital account

liberalization and underscored the necessity for effective, constructive and well-

coordinated regulation of financial markets by the state and its agencies. The Southeast

Asian financial crisis has demonstrated how a sudden withdrawal of capital can seriously

affect the exchange and interest rates, and thereby threaten macroeconomic management

and economic stability not only in one country but several others, depending on the


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degree of economic integration. Thanks to controls on its capital account, India was not

as badly engulfed by the Asian currency crisis as Other countries in the region. Many

experts have rightly pointed out that slower deregulation of the financial sector in India

has proved to be the saving factor. If India had adopted capital account liberalization; it

would have been difficult to protect its economy from getting severely affected by the

Asian turmoil. It is in this context that the impact of the Southeast Asian crisis on the

Indian markets has to be understood.

Responses:

The Official Response

The Southeast Asian financial crisis has marked a dramatic shift in the opinion on capital

account control among policy makers, international financial institutions and experts. In

the context of India, the official position on capital account liberalization has changed

largely because of the Asian crisis. But the pressure to move towards full capital account

liberalization has not subsided. A number of market players both domestic and

international are still advocating the need for full liberalization in India. However, it is

unlikely that the government will be able to implement it by the year 2000. The Indian

authorities are more likely to accept only partial liberalization of capital accounts in the

coming years. Surprisingly, the Indian government often takes a radically opposite stand

on financial liberalization at the international forums while pursuing liberal policies in the

domestic financial sector. This paradox was witnessed recently at the World Economic

Forum at Davos, Switzerland and at G- 15 Summit in Jamaica, both held in February

1999. In these forums, the Indian authorities strongly advocated the need to regulate

capital flows and called for rule-based system ofinternational financial flows. We can't


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allow economies to be destabilized by someone pressing a finger on a computer key and

moving billions in and out of markets. If we don't replace the present chaos with order,

then globalization will remain a 13-letter dirty word 2 said India's Finance Minister,

Yashwant Sinha in Davos. One would have expected that the Indian authorities will

follow their own advice and consequently adopt policy measures to regulate capital

flows. On the contrary, the authorities are quickly giving up policy instruments, which

would allow it to exercise some degree of control over private capital flows.

The Response of International Financial Institutions

In the aftermath of financial crisis in Asia, there has been a significant change in the

approach of the IMF on the issue of capital account liberalization and financial

deregulation. The conditions attached to the loans by the IMF required countries to

liberalize their capital account in order to enhance their attractiveness to private capital

flows. Now, the fund realizes the importance of capital controls in dealing with volatile

capital flows. The World Bank, which had been globally promoting the financial

deregulation and liberalization as part of Washington Consensus, has also done some

rethinking on this matter in the aftermath of Asian financial crisis. In its latest report,

Global Economic Prospects 1998-99, the Bank acknowledges the dangers involved in

maintaining an open capital account and recommends the use of capital controls when

necessary. In the case of India, the Bank has been asking for adopting a cautious

approach and safeguards for adopting the capital account liberalization. The Bank's Chief

Economist of the South Asia region, John Williamson, recently called for at least 20-30

years period to move towards full liberalization.


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The Response of Domestic Corporate Sector

In the 1990s, India's domestic financial corporate bodies have come to an understanding

with the global players of finance capital. This has become very evident in recent years as

a number of foreign institutional investors have carried out mergers and amalgamations

with domestic institutional investors. Some of the recent megamergers include Morgan

Stanley with India's top domestic investment company, JM Financial; Merrill Lynch with

DSP; Goldman Sachs with Kotak Mahindra and Lazard with Credit Capital. In the

insurance sector too, domestic companies are joining hands with foreign investors.

Realizing that they cannot match the financial resources of foreign investors, the

domestic corporate players have accepted the role of junior partner in the partnership

with their foreign counterparts.

The Response of Foreign Investors

The foreign investors lobby, particularly international fund managers, and the foreign

Institutional investors are the consistent advocates of liberalization of financial markets

and capital accounts. In the present global context, the investment liberalization (along

with trade liberalization) is the main item of the economic agenda set up by the

transnational capital. Since TNCs dominate much of the worlds trade and investment,

the combination of investment liberalization and free trade will immensely enable them

to expand and restructure their operations. The opening of India's financial sector

provides new business opportunities for the owners and managers of finance capital.

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The Response of Political Parties, Trade Unions, Social Movements, NGOs, and

Media In India

At the political level, except for a couple of issues such as opening up of insurance sector,

there seems to be a growing consensus among mainstream political parties to open up

India's financial markets. This is reflected by the continuation of "reform" in the financial

sector by three governments belonging to left, center and right in the 1990s. In the

absence of a major alternative political process at the national level, the political space to

express and advocate alternative policies and strategies has significantly reduced, which

makes unsound policy decisions a fait accompli. In recent years, a number of peoples'

movements, NGOs, women's and labor groups are active in the social and political

arenas. But, by and large, the areas where peoples' movements have made the most

progress are limited to social and environmental issues. Regarding issues related to

international economic relations, these groups have focused on official capital flows

(such as the World Bank, ADB, bilateral aid, etc.), trade (GATT, WTO, etc.) and FDI.

Very little work has been done by these groups on financial issues despite the fact that

financial issues have a considerable impact on poor people, labor and natural

environment. The issues related to financial markets are new to Indian groups. As global

financial issues are much more complex, the Indian groups lack the expertise to

understand and deal with them. As a result, there is very little input from Indian groups

on these issues as compared to earlier developmental debates on environment, women,

poverty and sustainable development. The social movements and groups in India has yet

to familiarize themselves with these debates and respond to these debates by putting

forward their concerns and perspectives. Although a number of research institutes


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working on financial matters exist in the country, most of them only serve the

information requests of the corporate sector. Since the reports and journals published by

these institutes are very expensive, the grassroots groups and movements cannot afford

these. Thus, the task of providing regular information to movements has been left to a

handful of independent research groups and socially committed intellectuals. In recent

months, a few efforts have been made to demystify the complex issues related to

globalization of finance in order to democratize the debates. Furthermore, I am of the

opinion that Indian groups cannot effectively use the same strategies of campaigning,

lobbying and advocacy in the case of finance capital (because it is largely footloose in

nature) which they have successfully used in the case of official capital flows (e.g.

Narmada dam campaign against the World Bank) and FDI (e.g. campaign against deep

sea fishing). In the case of finance capital, the NGOs, labor groups, and movements will

have to pay more attention to the regulatory mechanisms and regulatory agencies such as

the SEBI and RBI. In the given economic and political context, an action program calling

for total elimination of global financial flows is unlikely to succeed. Action programs

based on restricting international financial liberalization and selective delinking from

short term and speculative funds may have better chances of success. At the international

and regional levels, a series of discussions on the need to regulate financial flows and

restructuring of international financial architecture are taking place at both official (e.g.,

G-7, G-15, Group of 22, Commonwealth) and non-official levels (e.g., World Economic

Summit). But, just a handful of economists, experts, and concerned officials from India

are taking part in these deliberations; there is hardly any process of democratization of

these debates in India in order to involve vast sections of society and their representatives


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in these debates. Lastly, as far as national media is concerned, its response on financial

issues is mixed. In particular, the financial media in India has been supporting financial

liberalization in India largely as part of a general liberalization spirit and ethos, rather

than as part of a well-argued and well thought- out strategy.

Global Financial Reforms and Developing Countries

At present, the debate on global financial reforms is focused on strengthening the

financial systems of the developed economies the epicenter of global financial crisis.

Even though the financial systems of poor and developing countries are considered to be

undeveloped and unsophisticated, these countries can bring new perspectives into the

ongoing debates. It is likely that the perspectives of developing countries would be

sharply different from the developed one given the diverse roles and objectives of

financial system in their economies. For developing countries, systemic risk issues are of

greater importance because, more often than not, the main sources of systemic risk and

Vulnerability is beyond their jurisdictions. Take the case of capital flows. For decades,

developing countries have been finding it difficult to cope with volatile capital flows. The

management of volatile capital flows becomes more difficult for those developing

countries which follow a highly open economy. Several developing economies have

experienced sudden reversals in capital flows due to changes in the monetary policies of

Developed economies. The domestic authorities in the developing countries have no

control over such developments. The costs of financial instability and crisis are more

pronounced in the poor and developing world because of weak regulatory and

supervisory institutions. The social costs of financial crises are also much higher in the


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poor and developing countries since they lack social security nets and fiscal space for

counter-cyclical measures is rather limited. Therefore, it is very important for these

countries to maintain financial stability.

Managing Volatile Capital Flows

A boom and bust cycle of capital flows engenders both macroeconomic and financial

instability. Periods of large capital inflows are usually followed by a sudden outflow of

capital. A surge of capital inflows can contribute to higher inflation and asset price

bubbles. The sudden withdrawal of capital can seriously affect the exchange and interest

rates, and thereby threaten macroeconomic management and economic stability

Not only in one country but several others, depending on the degree of economic

integration. There was a sudden reversal of capital flows during the crisis due to global

deleveraging. Large-scale reversals of capital flows were witnessed even in those

developing countries with strong macroeconomic fundamentals. For developing

countries, the problems associated with capital flows are two-fold: First, capital flows

dont enter a country at the right time. But capital can leave a country quickly at a time

when it is badly needed. Second, the quality of capital flows poses new risks and policy

Dilemmas. The developing countries have witnessed a sharp rise in hot money and

portfolio investments in recent years. Since the bulk of portfolio investments are short-

term and speculative in nature, their contribution to economic growth in host countries is

minimal. Besides, much of portfolio investments are prone to reversals. Several episodes

of financial crisis in Mexico, Southeast Asia and Turkey in the 1990s point to the


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preeminent role of unregulated short-term portfolio flows in precipitating a financial

Crisis.

The Impossible Trinity

For developing countries, it becomes very difficult to maximize the benefits and

minimize the costs of capital flows. How to manage the impossible trinity free capital

movement, a fixed exchange rate and an independent monetary policy? As noted by D.

Subbarao, Governor of RBI, If central banks do not intervene in the foreign exchange

market, they incur the cost of currency appreciation unrelated to fundamentals. If they

intervene in the forex market to prevent appreciation, they will have additional systemic

liquidity and potential inflationary pressures to contend with. If they sterilize the resultant

liquidity, they will run the risk of pushing up interest rates which will hurt the growth

prospects. If the developing countries hold large foreign exchange reserves to buffer

against sudden capital outflows, it poses new risks. Large forex reserves put pressure on a

countrys exchange rate so that the currency appreciates, negatively affecting the

competitiveness of exports. Excessive reserves could induce asset price bubbles and

higher inflation by way of an excessive money supply. There are fiscal costs as well, as

the authorities may lose control of monetary policy.

Is FDI a Panacea for Growth?


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There is a common assumption that foreign direct investment (FDI) offers immense

benefits to developing countries in terms of transfer of technology, creation of jobs,

quality products and services, along with managerial efficiency. These perceived benefits

may hold true for some investments, but it would be a serious mistake to make broad

generalizations because hosting investment flows is not without its potential costs. The

foreign investment has important implications for governments and domestic firms as

well as for workers, consumers, and communities in the host countries. Unfortunately,

neoliberal approaches do not give adequate attention to these economic, social, and

environmental costs and thus fail to establish the links between foreign investment and

poverty reduction and development. These concerns become even more relevant in the

present context when attracting foreign direct investment flows is seen by policy makers

as an important instrument to achieve higher economic growth and to reduce poverty.

There is hardly any reliable cross-country empirical evidence to support the claim that

FDI per se accelerates economic growth. In the present circumstances, it is quite difficult

to establish direct linkages between FDI and economic growth if other factors such as

competition policy, labor skills, policy interventions and comprehensive regulatory

framework are not taken into account. Further, in the absence of performance

requirements and other regulations, many of the stated benefits of FDI would not occur.

In the last two decades, the attributes of FDI flows, known for their stability and spillover

benefits, have also changed profoundly. FDI is no longer as stable as it used to be in the

past. The stability of FDI has been questioned in the light of evidence which suggests that

as a financial crisis becomes imminent, large transnational corporations indulge in

hedging activities to cover their exchange rate risk which, in turn, generates additional


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pressure on the local currencies. Since bulk of FDI flows are associated with cross-border

mergers and acquisitions, their positive impact on the domestic economy through

technological transfers and other spillover effects has been significantly diluted. In most

developing countries such as India, China and Malaysia, FDI is often encouraged because

it is considered to be a non-debt creating capital. It is true that FDI does not involve the

direct repayment of debt and interest, but at the same time, it does involve substantial

foreign exchange costs. Capital can move out of a country through remittance of profits,

dividends, royalty payments, and technical fees. In the case of Brazil, foreign exchange

outflows in the form of profits, royalty payments, and technical fees rose steeply from

$37 million in 1993 to $7 billion in 1998. Due to rapid financial liberalization, the trend

of significant foreign exchange outflows with a resulting negative impact on a countrys

balance of payments has gained additional momentum. This trend is most evident in

several African economies such as Botswana, Democratic Republic of Congo, Gabon,

Mali, and Nigeria where profit remittances alone were higher than FDI inflows during

1995-2003. If FDI is not oriented towards exports, it can have serious implications for

developing countries which are usually short of foreign exchange reserves. In recent

years, the share of services in total FDI inflows to the developing world has increased.

Since many services (such as telecom, energy, construction and retailing) are usually not

tradable, investments in such services would involve substantial foreign exchange

outflows over time in the form of imports of inputs, technology, royalty payments, and

Repatriation of profits.

Curb Illicit Capital Flows


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Capital can move out of the country via illegal means such as abusive transfer pricing and

creative accounting practices. It is an established fact that transnational corporations often

indulge in manipulative transfer pricing to avoid tax liabilities. Only recently, tax

authorities in the developing world have taken cognizance of widespread abuse of

transfer pricing methods by TNCs. The issues of illicit financial flows needs serious

attention as corrupt rulers, drug cartels and mafia have used Western banks and tax

havens to move millions of dollars out of their countries. A recent study by Global

Financial Integrity estimated that illicit financial flows out of developing countries are

some $850 billion to $1 trillion a year.

Access to Trade Finance

Trade finance is another area where the impact of global crisis was disproportionately felt

by small-and medium-enterprises (SMEs) in the poor and developing world. Evidence

suggests that SMEs in Philippines, India and Mexico were crowded out by large firms

trying to access to trade finance. The deterioration in trade finance markets led to a sharp

rise in spreads on credit and insurance costs, which in turn made trade finance

transactions highly expensive. In the earlier episodes of financial crises in emerging

markets such as the Southeast Asian financial crisis in 1997 and the Argentine crisis in

2001, trade finance (particularly short-term segment) dried up


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Bibliography

"Global Financial System." Wikipedia. Wikimedia Foundation, 18 Sept. 2012. Web. 01

Oct. 2012. .

Global finance in India by Kavaljit Singh

International financial architecture by Friedrich-Ebert-Stiftung

Documents

Global Finance in Indian Context