A number of phenomena we observe in India in the last few years can be interpreted as incipient capital flight:
1. Gold imports have risen sharply, both in value and volume terms. The nature of the gold demand has also changed. In recent years, we have seen a significant amount of gold being bought by the rich as an investment. A poor household buying gold jewellery could be interpreted as a form of social security, but a rich household buying gold bars and biscuits is a form of capital flight. Instead of dollars or Swiss francs, they are converting rupees into gold.
2. Many Indian corporates are investing more outside India than in India, often on the ground that the investment climate in India is poor.
3. It is difficult to explain India’s large current account deficit and poor export growth solely on the basis of low growth in the developed world. First, many of our competitors in Asia and elsewhere are posting large trade surpluses in the same environment. Second, the depreciation of the rupee has improved competitiveness of Indian companies in world markets. Indian companies used to complain loudly about their lack of competitiveness when the dollar was worth only Rs40, but with the dollar fetching Rs55, these complaints have disappeared. I fear that some of the current account deficit is actually disguised capital flight via under-invoicing of exports and over-invoicing of imports.
While economists have focused on the impossible trinity (open capital account, independent monetary policy and fixed exchange rates), I am more concerned about the unholy trinity that leads to full-blown capital flight. This unholy trinity has three elements: (a) a de facto open capital account, (b) poor perceived economic fundamentals and (c) heightened political uncertainty. I believe that the first two elements of this unholy trinity are already in place; we can only hope that the 2014 elections do not deliver the third element.
While our policymakers keep up the pretence that India has a closed capital account, the reality is that during the last decade, the capital account has in fact become largely open. Outward capital flows were largely opened up by liberalising outward FDI and allowing every person to remit $200,000 a year for investment outside India.
This means the first element of the unholy trinity (an open capital account) has been in place for some time now. If the other two elements were also to materialise, a full-blown capital flight is perfectly conceivable. India’s reserves may appear comfortable in terms of number of months of imports, but in an open capital account, this is not a relevant metric. What is relevant is that India’s reserves are about 20% of the money supply (M3), and in a full-blown capital flight, a large part of M3 is at risk of fleeing the country.
Prof Varma teaches at IIM, Ahmedabad
