Inadequate capital flows

by Janaki Samant

Capital flows into India took a beating during the first quarter of 2022-23. We expect it to take a beating in the second quarter as well, albeit of a slightly lower intensity. Capital inflows are likely to be inadequate to fill the estimated current account deficit. This is reflected in a falling foreign exchange reserves.

Of the major components of capital flows, foreign portfolio investments were the worst hit. There were large FPI outflows in the first quarter of the current fiscal year. Of the remaining components, there were inflows from foreign direct investments (FDI) and external commercial borrowings (ECBs). Inflows under NRI deposits dropped sharply.

Foreign institutional investors exited Indian equity and debt markets by divesting a massive USD 14.4 billion during April-June 2022. They had drawn out an even larger USD 15.5 billion from these markets during January-March 2022. This looked like a relentless departure of overseas investors.

This retreat of the FIIs is spurred essentially by actions of the US Federal Reserve. Its reversal of the expansionary monetary policy and hike in policy rate to contain inflation is the principal motivation for the huge foreign capital outflows from the Indian financial markets.

The June US inflation reading came in at 9.1 per cent. The initial market reaction to the 4-decade high inflation was that the Fed could now go in for a much bigger rate hike of 100 bps. In India, this raised fears of further large capital outflows. But recession fears has led to some correction in commodity prices. Markets still expect a rate hike of 75 bps points in the upcoming Fed meeting on July 27. This may somewhat restrict the pace of FII outflows from India.

During the first three weeks of July, FIIs invested, on a net basis, USD 200 million into the Indian capital market. So, July 2022 is likely to record net FII inflows.

The quarter-ended June 2022 had recorded monthly average outflows from FIIs of USD 4.8 billion. We expect FIIs to continue to divest their investments into Indian capital markets during the September 2022 quarter as well. However, the quantum of outflows could be a tad lower than they were in the June 2022 quarter.

External commercial borrowings (ECBs) have remained sluggish in the current fiscal year. Only USD 1.7 billion were raised through ECBs during April-May 2022. Inflows were quite low at USD 0.33 billion in April 2022 but recovered to USD 1.4 billion in the following month. But even this is way below the average monthly foreign borrowing of over USD 3 billion recorded during each of the preceding four years.

External borrowings have become costly and so, we do not expect Indian enterprises to tap this market too enthusiastically in the near future. During the past two years, external borrowing was easy. Now, with the Fed raising policy rates and the rupee depreciating sharply, the costs have increased. Uncertainties have raised the cost of hedging exchange rate risks. In comparison, domestic borrowing rates such as the marginal cost of funds based lending rates (MCLR) have not increased much. Inflows under ECBs will remain low in the quarter-ended June 2022. They are also likely to remain low in the quarter-ended September, as well. This is because the US Fed rate hike cycle will continue in order to contain its high inflation.

NRI deposits, another significant source of capital flows for India, have also tapered off. During April-May 2022, net inflows were at USD 0.42 billion. This works out to USD 0.21 billion per month. These were lower than the average monthly inflows of USD 0.27 billion recorded during 2021-22. Inflows under NRI deposits had also dried up during 2021-22. Average monthly inflows were at USD 0.6-0.9 billion in each of the preceding three fiscal years.

After the recent easing of restrictions by the RBI on FCNR and NRE deposits, various banks hiked interest rates on these deposits. As a result, NRI deposits might record inflows in the coming months, although news reports suggest that the hike in interest rates do not adequately offset the returns on yields overseas and the risks of the rupee depreciating.

Bucking the trend of the other sources of foreign capital, inflows from foreign direct investments (FDI) remained satisfactory. Net FDI to India amounted to USD 11.4 billion during April-May 2022. Gross inflows were at USD 16.4 billion against repatriation/disinvestment of USD 5 billion.

Average monthly foreign investment in the first two months of the current fiscal year works out to around USD 5.7 billion. This is higher than the average monthly inflows of USD 4.7 billion recorded in each of the last three fiscal years. The increase was because of higher gross inflows. The monthly average works out to USD 8.2 billion during April-May 2022 compared to USD 6.8-7 billion recorded in each of the preceding two years. In comparison, average monthly repatriation/disinvestment during April-May 2022 increased only marginally compared to the monthly average in the previous two fiscal years.

The trend in FDI to India, so far, indicates that FDI flows are likely to remain buoyant in the coming months when compared to other sources of capital flows.

It is evident that inflows under capital account of the balance of payments were very low during April-June 2022 given the outflows under portfolio investments and poor inflows under ECBs and NRI deposits. Consequently, they were grossly inadequate to finance the huge estimated current account deficit of USD 32-35 billion. This is reflected in the fact that there has been a drawdown of foreign exchange reserves of USD 24.3 billion during April-June 2022. There would still be a drawdown of forex reserves during the quarter-ended September. But given the possibility of lower capital outflows and some improvement in current account deficit, the drawdown is likely to be lower compared to the June quarter.