Académique Documents
Professionnel Documents
Culture Documents
Submitted to:
Prof. V.K. Bhalla
Submitted on:
20, March, 2010
By:
MBA-PT 2007-2010
TABLE OF CONTENTS
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International Business Environment: Foreign Capital Movement
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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International Business Environment: Foreign Capital Movement
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.
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International Business Environment: Foreign Capital Movement
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.
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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International Business Environment: Foreign Capital Movement
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 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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International Business Environment: Foreign Capital Movement
In the start we will discuss as to what capital is, what foreign capital is and why it
moves.
Capital -
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:
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.
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International Business Environment: Foreign Capital Movement
domestic capital to foreign capital takes place through the mechanism of foreign
exchange.
◦ For a given return, from higher risky investment to a lower risky one.
Some of the main drivers i.e factors which causes capital tl move are listed below:
Globalization
Productivity
Taxes
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International Business Environment: Foreign Capital Movement
Political stability
Demographic trends
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.
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
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International Business Environment: Foreign Capital Movement
investment opportunities and countries where it generates the highest return can be
destabilizing - witness the controls recently placed on capital in Malaysia.
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.
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.
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International Business Environment: Foreign Capital Movement
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 to
GDP, than in subsequent periods. Four features of this classical period are worth
noting:
• 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
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International Business Environment: Foreign Capital Movement
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
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International Business Environment: Foreign Capital Movement
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
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.
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.
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
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International Business Environment: Foreign Capital Movement
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
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.
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.
According to purchasing power parity, exchange rates are determined by relative price
of goods exchanged between countries. Countries with above-average inflation would,
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International Business Environment: Foreign Capital Movement
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
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
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International Business Environment: Foreign Capital Movement
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
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.
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International Business Environment: Foreign Capital Movement
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
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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International Business Environment: Foreign Capital Movement
◦ Investments
◦ Remittances
1) Investments
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.
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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International Business Environment: Foreign Capital Movement
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.
b. Nidhi company, or
b. Atomic Energy
c. Lottery Business
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International Business Environment: Foreign Capital Movement
f. Nidhi company
Participants in Investments
◦ Individuals
◦ 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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International Business Environment: Foreign Capital Movement
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.
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International Business Environment: Foreign Capital Movement
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:
• 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.
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International Business Environment: Foreign Capital Movement
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.
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.
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International Business Environment: Foreign Capital Movement
Prohibition on investments
2. FIIs are also not allowed to invest in any company which is engaged or
proposes to engage in the following activities:
b. Nidhi company, or
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.
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International Business Environment: Foreign Capital Movement
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.
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
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International Business Environment: Foreign Capital Movement
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.
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
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International Business Environment: Foreign Capital Movement
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:
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.
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.
Companies
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International Business Environment: Foreign Capital Movement
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.
Corporates are also allowed to enter into mergers and acquisition activities with other
foreign companies.
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
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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.
• 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.
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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.
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:
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
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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
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.
2. Recognized Lenders
Eligible borrowers can raise ECB from internationally recognized sources such
as
i. international banks,
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v. suppliers of equipment,
vii. foreign equity holders (other than erstwhile Overseas Corporate Bodies).
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)
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
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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.
(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.
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The all-in-cost ceilings for ECB are reviewed from time to time. The following
ceilings are valid until reviewed:
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.
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7. Guarantees
8. Security
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
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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
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.
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
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The following types of proposals for ECB are covered under the Approval Route.
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.
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.
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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).
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 with.
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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;
(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;
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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.
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.
7. Guarantee
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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.
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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International Business Environment: Foreign Capital Movement
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.
13. Procedure
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.
World Bank
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Others
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.
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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.
4) Hawala Transactions
5) Others
Smugglers
Terrorist’s financiers
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Sometimes due to political reasons, funds are also transferred in the form of
fake currency in an economy by rival countries to destabilize it.
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.
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
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International Business Environment: Foreign Capital Movement
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.
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.
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
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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.
• 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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• Provide a level of confidence to markets that a country can meet its external
obligations;
• Assist the government in meeting its foreign exchange needs and external debt
obligations; and
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
• Management and investment of the foreign currency and gold assets of the
Reserve Bank of India.
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Reserves Management
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
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.
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Role of banks
Banks act as
All entities issued authorization under sub-section (i) of Section 10 of the Foreign
Exchange Maintenance Act, 1999 are categorized as under:
• Regional Rural
Banks
• Others
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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.
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Capital and human resources are the pivots of development. Short supplies of
domestic capital limit the growth of developing countries. Low GDP keeps savings
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
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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
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International Business Environment: Foreign Capital Movement
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 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
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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.
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
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International Business Environment: Foreign Capital Movement
interest rates will induce income and substitution effects, which may also lead to a
consumption boom.
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.
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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
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.
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).
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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 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.
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
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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.
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
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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
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
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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.
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.
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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
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.
In this section, we will summarize the positive and negative impacts of capital flows
(inflow and outflow).
3. The lenders gain from higher return and better International portfolio
diversification.
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6. In case of FDI, the home country also gets the advantage of getting a
technological expertise which may not be earlier accessible.
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.
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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.
Problems which arise to the home country when there is too much of capital outflows
are:
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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.
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.
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Head of IMF staff and Chairman of the Executive Board, and is assisted by
three Deputy Managing Directors.
• Headquarters: Washington, DC
• Original aims: Article I of the Articles of Agreement sets out the IMF's
main goals:
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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.
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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
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
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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.
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
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.
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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.
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.
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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.
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.
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
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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.
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
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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.
Policy review
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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.
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.
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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
markets.[8] Governments and central banks responded with unprecedented fiscal
stimulus, monetary policy expansion, and institutional bailouts.
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
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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.
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.
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
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effects of the collapse of the dot-com bubble and of the September 2001 terrorist
attacks, and to combat the perceived risk of deflation.
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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
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make fast profits. There is growing evidence that such mortgage frauds may be a
cause of the crisis.
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.
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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.
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• Managed earnings, mainly a focus on share price rather than the creation of
genuine value; and
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
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Global effect
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.
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:
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The United Kingdom had started systemic injection, and the world's central banks
were now cutting interest rates.
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 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.
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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.
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.
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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.
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
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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,
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.
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.
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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.
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.
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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.
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Speaking of India specifically, the following are the World Bank Predictions dated
20th February, 2010:
C. Price Deflators
D. Share of GDP
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E. Memo
4. Real per capita GDP growth 7.5 4.8 4.8 6.3 6.8
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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
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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.
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.
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"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.
"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."
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.
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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.
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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
products to include the Russian ruble and Chinese yuan. At the moment the currencies
included are the dollar, euro, yen and sterling.
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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.
"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."
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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."
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.
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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.
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
United
1 14,535 16,194 17,978 20,087 22,817 26,097 29,823 33,904 38,514
States
2 Japan 4,604 4,861 5,224 5,570 5,814 5,886 6,042 6,300 6,677
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3 Germany 3,083 3,326 3,519 3,631 3,761 4,048 4,388 4,714 5,024
4 China 4,667 8,133 12,630 18,437 25,610 34,348 45,022 57,310 70,710
United
5 2,546 2,835 3,101 3,333 3,595 3,937 4,344 4,744 5,133
Kingdom
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 6,683 10,514 16,510 25,278 37,668
South
12 1,071 1,305 1,508 1,861 2,241 2,644 3,089 3,562 4,083
Korea
13 Mexico 1,009 1,327 1,742 2,303 3,068 4,102 5,471 7,204 9,340
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 Philippines 162 215 289 400 582 882 1,353 2,040 3,010
20 Egypt 129 171 229 318 467 718 1,124 1,728 2,602
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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.
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.
1st Year:
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10th Year:
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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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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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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).
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.
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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.
A substantial minority (28%) said they were unaware of specific products and
tools available.
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
However, the importance of political risk does not translate into high
usage of political risk insurance
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FDI LANDSCAPE
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India could not attract foreign investment in both products and services market,
only seen as a service industry especially in IT.
Wasted Capital
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China’s fund going to State Own Enterprises rather than the private sector
Reason for this skwed types of lending in both countries is preserving jobs.
ROUND TRIPPING
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45
40
GDP in Trllion Dollars
35
US
30
25 INDIA
20 CHINA
15
10
5
0
2018
2028
2030
2040
2008
2010
2012
2014
2016
2020
2022
2024
2026
2032
2034
2036
2038
2042
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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.
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
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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.
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
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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. China has done well
in the international dimension and now needs to focus on development of domestic
markets and a more balanced trade position.
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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.
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.
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,
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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
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
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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.
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.
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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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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
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.
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The Controversy
The hue and cry for revaluation of Yuan was primarily because of following
reasons:
• 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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growth of China and have considerable impact (as FDI is very high in
China because of less stringent norms).
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.
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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
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.
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
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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.
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.
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X. Conclusion
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.
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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.
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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.
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.
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
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XI. Appendix
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+ Stable Flows are defined to represent all capital flows excluding portfolio flows and short-term trade credits.
Mar- Mar-
Period Mar-07(R) 08(PR) 09(PR)
International Investment Position, net -62,463.11 -49,572.30 -62,901.51
A. 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
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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
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
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
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XII. Bibliography
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