Will the second Covid wave dent resilient foreign investment inflows into India?
Over the five years prior to 2020, India had capital account surpluses that compensated its current account deficits leading to an annual balance of payments surplus, except for CY2018 when there was a deficit. The Reserve Bank of India appears to have been intervening in foreign exchange markets to stem a real effective exchange rate (REER) appreciation and steadily built up its foreign reserves by $149 billion. With the onset of COVID-19 in the first quarter of 2020, there was a sharp withdrawal of portfolio capital that was offset by FDI inflows. FDI inflows have been a relatively stable source of external financing over the years in comparison to volatile portfolio flows (see Figure 1). Quantitative easing by the US Federal Reserve and other major central banks in response to the pandemic likely resulted in ‘spillovers’ into emerging markets such as India. Record foreign capital inflows of $79.7 billion into India between the second and fourth calendar quarters, a trade surplus in two consecutive quarters, and substantial remittance inflows led to an increase in RBI’s reserves by $103.9 billion in 2020. A large part of the foreign inflows was related to
’s $USD 20 billion sizeable fundraising.
The gush of foreign currency inflows in 2020 posed challenges for India’s export competitiveness and had repercussions for domestic liquidity conditions. Despite the RBI’s extensive interventions in foreign exchange markets (with the US Treasury department adding India to its watchlist of “currency manipulators”), the Indian rupee stayed at elevated levels in real terms. The trade-weighted 36-country REER index for the Indian Rupee was 119 by October 2020, near December 2019 levels; thus adversely impacting India’s trade competitiveness. One can visualize the foreign currency markets in 2020 as a bathtub where a tap is running at high speed on one end, and water is draining on the other; the drain is barely able to take out enough water. The appreciation of the REER is not a recent phenomenon but dates back to the first half of 2019. While in previous periods the RBI would have sterilized foreign inflows to moderate an effect on domestic liquidity, the excess rupee liquidity on account of the RBI’s foreign exchange interventions in 2020 is likely to have supported its efforts to counter the upward pressure on yields on government securities (G-Secs).
As the second COVID wave intensified in India, foreign portfolio investors pulled out about $2 billion in the second quarter to date reversing inflows of $7.6 billion in the first quarter of 2021, as per data from NSDL’s FPI Monitor. With comparatively lower FDI inflows expected this year, global liquidity conditions and India’s recovery from the current wave are expected to steer FPI inflows and in turn the Indian rupee. While the impact of the second COVID wave on the economy so far has been less intense than last year, its effect on human health and lives has been quite significant. Workers across sectors in both urban and rural locations have been affected. The services sector viz. hospitality, entertainment and travel which was limping back to normalcy in 2021 received a rude shock from the resurgence of COVID and state-level lockdowns. In early May, Moody’s revised its 2021-2022 GDP growth forecast to 9.3 per cent from an earlier estimate of 13.7 per cent while CRISIL has predicted a sub 10 per cent GDP growth. Bottlenecks in vaccinations and a surge of cases in rural India have introduced considerable uncertainty about the projected recovery in the current year. Global companies with R&D arms and back offices in India have been re-evaluating their country level exposure to India due to COVID-19 from an overall risk concentration standpoint.
To instill confidence for future foreign investments, we must enhance our contribution to the health sector. India’s annual expenditure of 3.5 percent of GDP (including both public and private expenditure) is significantly lower than the world average of 9.8 percent. As a comparison, Brazil, South Africa, and China invest 9.5, 8.3, and 5.4 per cent of GDP, respectively, according to World Bank data. Without significant investments in healthcare, the boon of favorable demographics may turn out to be a bane with labour productivity being impacted. Health indicators could also be made a part of state-level rankings based on Business Reforms Action Plans that impact the ease of doing business. This would encourage states to compete in improving healthcare for attracting both foreign and domestic investments, with the added benefit that over the medium to long term it effectively results in better health facilities for their residents and improves the quality of human capital.
Sanket Mohapatra is a faculty member in the Economics Area at IIM Ahmedabad. Sushil Thaker is a student in the ePGP Programme at IIM Ahmedabad. The views are the authors’ own and do not represent those of their respective employers or institutions.