Relationship between the Current Account Deficit, Indian

Rupee and Foreign Investments: A Periodic Study.

Submitted By: Date: 30.06.2013

Omkar K.

Shweta Pillai

Index

1. Introduction

2. Current Account Deficit

2.1 Introduction

2.2 Causes of the Current Account Deficit

3. Movement of the Indian Rupee

4. Financing the Current Account Deficit

4.1 Successive Software Services

4.2 Capital Account

4.3 Foreign Exchange Reserves

5. Reforms in the Financial Sector

6. Conclusion

Bibliography

Abstract:

Current Account Deficit is one of the major macroeconomic problems that India faced in the

fiscal years 2011-12 and 2012-13.CAD touched record highs of 6.7% of GDP in the third

quarter of fiscal 2012-13. In this study we have tried to investigate the relationship between

the CAD, the Foreign Investment and the Exchange Rate of the Indian Rupee. Studying the

data of these variables and their movements, we can say that there is theoretically

interdependence between these three variables. The CAD is affected by negative movements

of the exchange rate and negative Foreign Investments. The RBI is now following a more

market determined exchange rate. The exchange rate is influenced, amongst other factors, by

the movement of Foreign Investments, which are dependent on the monetary policies of

global central banks. The state of the world economy in comparison with the domestic

economy is another factor that explains the change in the direction of flow of capital. The

effect of depreciation of the Rupee also affects the import bill leading to increased strain on

the CAD.

1. Introduction:

India’s travails on the Balance of Payments front started from the Second Five-Year Plan

(1956), and continued till the crisis of 1991. The 1991 Balance of Payments crisis forced

India to open her long shut doors to foreign investments. This was done in a gradual manner

by removing various restrictions, which caused India to be under a License Raj. During the

License Raj, eighty government agencies had to be satisfied for private companies to produce

goods and, the government would regulate production. After the reforms the economy saw a

turnaround, from the ease of doing or starting a business to attracting capital flows from

abroad.

The opening up the economy led to the inflow of capital from the world. The inflow of

foreign capital was good for the economy. India was more connected to the outer world.

However, India also had to bear with the uncertainty and speculation surrounding the global

financial markets.

The free flow of capital can be a blessing and a curse. Heavy dependence on the inflow of

capital in the Capital Account to balance the Balance Of Payments account is dangerous.

India is a developing economy and heavily dependent on oil and petroleum products, not just

for transport, but for many other industries as well. India is not rich in oil reserves and

depends on oil imports for her needs.

CAD has gone up sharply in the last two years on the back of higher oil and gold imports.

Export growth slowdown has also hit the CAD.

Oil imports make up a large portion of the total imports and rupee depreciate pushes up the

oil bill causing problems to the CAD. In addition to oil, gold also has joined in to cause

trouble to the CAD. The metal is a favourite with Indians and is seen as a very attractive

investment. Gold imports are increasing and this is adding to the CAD.

The exports sector is not growing at a rate to cover the import bill. The Import bill has

increased at a rate of31% during 2011-12, while exports only grew at 23% for the same

period. Oil imports have increased at a rate of 46% and gold 38%. This rise in oil and gold

imports is alarming and can negatively impact the CAD if not checked.

A high and uncontrollable CAD may scare foreign investors which in turn would weaken the

rupee, which then would cause a further strain on the CAD. This effect is a chain-effect.

Hence in this study we analyse the cause and effects of the CAD, and the Indian Rupee

(INR)-to-US Dollar (USD) exchange rate, and their interdependence. The ways of financing

the CAD is analysed. In order to understand the volatility in the INR exchange rate, a brief

analysis is done on the major components of the capital account, namely, types of foreign

investment.

2. Current Account Deficit

2.1 Introduction

We first introduce the two variables that are analysed in this study and then go in depth into

the study of various other variables that are components of the two major variables.

Current Account (CA):

Current Account measures the flow of goods, services, transfers and, investment income

between domestic residents, businesses and governments and the rest of the world.

Hence it measures the exports and imports of commodities and services, the movement of

investment income from one home country to the rest of the world and vice-versa. It

measures unilateral transfers between the agents of the domestic country and the rest of the

world. If the balance of the Current Account is negative, i.e. if the imports are greater than

the exports then there is said to be a CAD.

The CAD is said to be necessary for a growing economy, though it is recommended in a

small amount. The sustainable CAD that is safe for India is said to be in the range 2.4-2.8 %

of GDP. This is a result of a study by Rajan Goyal, Director in the Department of Economic

and Policy Research, Reserve Bank of India.

The Indian Rupee(INR):

There is pretty much no definition better than that the INR is the currency of the nation, but

what we are going to be using is exchange rate of the INR with respect to the US Dollar. The

INR is fully convertible on the current account and partially convertible on the capital

account. INR exchange rate is largely market determined though the RBI does intervene

through direct and indirect intervention to control volatility.

2.2 The Causes of the CAD

The causes of the CAD can be identified once we identify the important components of the

Current Account.

The Components of the Current Account are:

1. Merchandise Trade

2. Invisibles

Merchandise Trade

Merchandise Trade refers to the foreign trade of India . Basically it is the export and import

of goods.

Imports

India has experienced heavy imports since independence. Imports have always been greater

than exports.

In the data that we have taken, 1999-2011, the imports have increased on an average of 21%

CAGR. In the last period 2011-2012, imports have risen by almost 32%.

The main components of imports are Oil and Gold.

Oil and Gold comprise of around 42.27% of total imports in 2011-2012.

Table 1:

Years

Gold Oil

Total

Imports

Oil (%

of total

imports)

Gold(%of

total

imports)

Oil and

Gold as

% of

total

imports

%

Increase

in

Imports

1999-00 4151.8 12611.4 55383 22.77 7.49 30.26

2000-01 4121.6 15650.1 57912 27.02 7.11 34.14 4.56

2001-02 4170.4 14000.3 56277 24.87 7.41 32.28 -2.82

2002-03 3844.9 17639.5 64464 27.36 5.96 33.32 14.54

2003-04 6516.9 20569.5 80003 25.71 8.14 33.85 24.10

2004-05 10537.7 29844.1 118908 25.09 8.86 33.96 48.62

2005-06 10830.5 43963.1 157056 27.99 6.89 34.88 32.08

2006-07 14461.9 56945.3 190670 29.86 7.58 37.45 21.40

2007-08 16723.6 79644.5 257629 30.91 6.49 37.40 35.11

2008-09 20725.6 93671.7 308520 30.36 6.71 37.07 19.75

2009-10 28640.0 87135.9 300644 28.98 9.52 38.50 -2.55

2010-11 40546.9 105964.4 381061 27.80 10.64 38.44 26.74

2011-12 56249.3 154905.9 499533 31.01 11.26 42.27 31.09

Source: RBI Handbook of Statistics

As we can see from table 1, the imports have risen by about 32% in the year 2011-2012 and

by an average of 21 percent for the entire time period taken into consideration. Oil comprises

on an average nearly 30% of imports and gold around 8% of imports. Imports of oil and gold

have increased during this time period by around 25%. Hence the increase of the imports of

gold and oil has contributed to the overall increase of imports, which grew at an average of

21%.The Exports sector has not witnessed the same rise. Exports that are required to pay for

the imports of a country are not enough, growing at only 20% during this period.

We also analyse the quantity of oil imported and the value of this quantity. This helps in

understanding if the increase in the oil bill is due to increase in demand by India in terms of

quantity or is it the exchange rate depreciation and the price level of oil that inflates the oil

bill

Table 2:

Year

Total

Qty.

(‘000

tonnes)

Total

Value

(Rs

crores)

2004-05 107189 133586

2005-06 117910 203039

2006-07 135972 265839

2007-08 152454 340896

2008-09 159421 419008

2009-10 182752 419374

2010-11 189359 520101

2011-12 196429 746759

The value of oil imports has been rising at greater proportion than the quantity. This is mainly

due to depreciation of the rupee and also the price of oil.

Chart 1:

The Quantity of oil imports has doubled in the time period taken in to consideration from

107189 thousand tonnes to almost 200000 thousand tonnes. But the value of these imports

has risen by 5 times to Rs. 746759 Crores from a mere Rs. 133586 Crores in 1999-00.

0

100000

200000

300000

400000

500000

600000

700000

800000

Val

ue

an

d Q

uan

tity

Years

Oil imports

Total Qty.

Total Value

The second part of the Current Account is the Invisibles section. This section includes

receipts and payments from the services sector and unilateral transfers.

The services sector includes transportation, tourism, professional and other services, interest

and other investment income.

Invisibles have grown on an average of 22% in this time period though in the two years 2001-

2002 and 2003-2004, they have grown by 52% and 62% respectively.

3. The Movement of the Indian Rupee.

It is important to understand the movement of the INR with respect to the US dollar, in order

to understand its effect on the Current Account and the causes that lead to the change.

The exchange rate of the Indian rupee vis-a-vis the US dollar was Rs 17 in 1990-91, before it

was devalued and made Rs 30. This was due to the BOP crisis that India had been through.

From then on, it has been a downward trend for the rupee which reached Rs 60 in June 2013.

Though in the time period taken into consideration the rupee stood at an average rate of Rs 47

and at a yearend of Rs 51 for the year 2011-2012.

We have taken the year end value into consideration rather than the average, because the

yearend value gives us the direction of the movement of the rupee.

The connection between the CAD and the Indian Rupee’s exchange rate can be explained in

layman’s term. If the exports are not enough to cover the imports then there will be a trade

deficit and if there is a continuous rise in this gap the importers who have to pay for the

commodities in dollars would demand more US dollars in the market. Hence this will create

an increase in the demand for dollars and increase in the supply of rupees. This leads to

appreciation of the dollar and depreciation of the rupee. The weakening of the rupee

(depreciation) will in turn increase the CAD as the import bill has risen due to the

depreciation.

Chart 2:

0.0000

10.0000

20.0000

30.0000

40.0000

50.0000

60.0000

INR

INR

4. Financing the CAD

The CAD is mainly caused by the trade deficit. During the period of rising trade deficit, the

growth of the invisibles sector began to emerge as a way of financing the trade deficit or the

excess imports.

4.1 Successive Software Services

The invisibles sector receives contribution mainly from the exports of software services and

private remittances (transfers). India’s software exports got a boost following the demands to

address the Y2K challenge at the turn of the 21st century. This is turn encouraged migration

of Indian software professionals abroad which in turn increased the remittance account. This

sharp rise in the invisibles account more than offset the trade deficit during the period 2001-

2004. The three years had witnessed a positive Current Account Balance, with 2003-04 being

the highest at US$14,083 million.

However, as the economy began to grow and the import needs increased, this resulted in an

increase in the imports of the country which in turn led to a negative Current Account

Balance. The income from invisibles seemed to be more credible and long lasting even as the

trade deficit increased rapidly.

Chart 3:

The receipts from software services had started to rise during the early 2000’s. This caused a

dip in the CAD initially, but the deficit soon recovered. This is due to excess income that had

come into the economy from the invisibles account that encouraged imports, which increased

continuously since 2001, from 14% to a high of 48% in 2004. The boost from the software

services and transfers account provided a temporary offset to the CAD.

-250000

-200000

-150000

-100000

-50000

0

50000

100000

150000

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

Years

Current Account

Trade balance

Invisibles

Services

Transfers

The Continuous increase in the trade deficit continued till the recent financial crisis, where in

the trade deficit decreased by 1% compared to a 30% increase in the previous year of 2008-

2009. But this was only short lived as the bad state of the global economy hit India’s exports

while imports weren’t as damaged as exports as India continued to grow and demand

commodities. The imports increased by about 45% in 2010-2011 while exports had only

increased by 23%.

The Invisibles account covers almost two-thirds of the trade deficit. But the weakening of the

global economy is threatening software businesses, which is affecting the receipts of software

services and transfers.

4.2 Capital Account

The Capital account is responsible for bringing inflows into the country in order to finance

the CAD. If the Capital Account does not have enough inflows to cover the CAD then the

Central Bank is forced to draw down from its Forex Reserves to pay for the deficit.

After a period of stability in the years 2000-2008, where there was a surplus in the BoP, India

had to draw down USD 20 billion from its reserves during 2008-2009. Though there was

some improvement during 2010-2011 this proved to be short lived as BoP was once again

under stress in 2011-2012, as slowdown in advanced economies spilled over to emerging and

developing economies, and there was a sharp increase in imports of gold and oil.

Prior to the famous reforms of 1991, capital flows was mainly debt creating, like NRI

deposits, commercial borrowing and external assistance. As the economy was closed the

inflow through foreign investment wasn’t an option.

During the 80’s external assistance comprised of 0.6% of GDP and NRI deposits and

commercial borrowing, 0.4% of GDP. This composition of capital inflows had dramatically

changed after the reforms of 1991. During 2000-2009, foreign investment comprised of 2.5%

of GDP whereas it was nil during the 80’s. External assistance declined to nearly zero,

though commercial borrowing and NRI deposits continued to remain the same. The opening

of the economy had given India a new way to attract capital, and a non-debt creating one.

This replaced the external assistance way of obtaining finance.

The main components of the Capital Account that draw inflows are:

1. Foreign Investment

a) Foreign Direct Investment

b) Foreign Portfolio Investment

2. Loans

a) External Commercial Borrowing

3. Banking Capital

a) NRI Deposits

The Foreign Investment account has been the major source of finance for the Capital

Account. Under the Foreign investment account, foreign direct investment and foreign

portfolio investment are responsible for the inflow.

Foreign Investment is the flow of capital from one nation to another in exchange for

significant ownership stakes in domestic companies or other domestic assets.

The foreign investment account has witnessed continuous inflows and it has been in the

positive square always. However this inflow is very volatile due to its heavy dependence on

foreign portfolio Investment rather than direct investment.

Foreign Direct Investment (FDI): FDI is direct investment into production or

business in a country by a company in another country, either by buying a company in

the target country or by expanding operations of an existing business in that country.

Foreign Portfolio Investment (FPI): This is also called Foreign Institutional

Investment (FII). This is a short term investment where there is an entry of funds into

a country by foreigners, where they make purchases in the country’s stock and bond

markets, sometimes for speculation.

Hence what we can see is that if the financing of the CAD is being done by the inflows of the

FPI, then there is a reason to worry as this inflow is volatile and may anytime turn back due

to speculative reasons. Whereas the FDI is a more stable and reliable source of inflow.

Though it would be perfect to have the FDI in charge of the Foreign Investment, in reality it

is not so. The FPI is a much larger source of capital inflow than the FDI and the trend and

movement of foreign investment graphs move as an imitation of the FPI graph.

The Foreign Investment in the decade taken into consideration shows a continues rise, except

for a fall in 2008-09 due to the global financial crisis, which originated in the developed and

advanced economies causing the investments that came from these countries to fall. Hence

there was a dramatic decrease in the inflow though foreign investment. The year 2009-10

witnessed an increase in the foreign investment more than the years before the crisis, but this

lasted only a year and the foreign investment fell again though not as bad as in 2008-09.

Table 3:

Source: RBI Handbook of Statistics 2011-12

Years

Foreign

Investments

(Rs crores)

FDI

(Rs

crores)

FPI

(Rs

crores)

1999 5117 2167 3024

2000 5862 3272 2590

2001 6686 4734 1952

2002 4161 3217 944

2003 13744 2388 11356

2004 13000 3713 9287

2005 15528 3034 12494

2006 14753 7693 7060

2007 43326 15893 27433

2008 8342 22372 -14031

2009 50362 17966 32396

2010 39653 9360 30292

2011 39231 22060 17170

The graph below shows the extent to which foreign investment depends on Foreign Portfolio

Investment.

Chart 4:

The movement of Foreign Investment is as if it imitates the movement of FPI.

The FDI is more consistent than FPI and is less volatile.

The composition of the Foreign Investment between FDI and FPI has continuously been

changing.

The trend of FPI shows us how volatile FPI capital is and depending on this capital to fund

the CAD can be dangerous.

The second account of the Capital account is the Loans section.

India has always been dependent on debt creating inflows prior to the reforms of 1991 and

hence this section has always created an inflow of dependence, though it leads to the creation

of debt, which requires repayment at some date.

External assistance was a major source of inflow of capital prior to 1991. This section

contributed around 0.6 % of GDP during the 80’s and 0.5% during the 90’s. It then

dramatically decreased to almost nil during 2000-09. This was replaced by funds from

foreign investment.

-20000

-10000

0

10000

20000

30000

40000

50000

60000

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

Foreign investment

Foreign inv

FPI

FDI

Chart 5:

Data Source: RBI Handbook of Statistics 2011-12

External Commercial Borrowings

Commercial Borrowings has always been a source of capital for Indian companies and

comprises of around 0.4-0.6% of GDP.

NRI deposits have always provided as a source of capital for India and have remained stable

at around 0.4%of GDP over the years.

We have seen that CAD has to be financed by the Capital account if the RBI shouldn’t dig

into its FOREX coffers. However the Capital account relies heavily on FPI and this being

very volatile has always caused speculation about whether there would be enough investment

to cover the CAD.

There is an increased importance of the contribution of software services and remittances to

reduce the CAD. NRI deposits are encouraged to play a bigger role in financing of the CAD,

thereby trying to make the CAD less reliant on FPI. FDI is also being encouraged.

We now go on to see the relationship between the exchange rate of the INR, the CAD and the

Foreign Institutional Investments.

Foreign Institutional Investments (FII)

Foreign Investment in India can take the form of investments in listed companies (i.e., FII

investments), investments in listed/unlisted companies other than through stock exchanges,

-5000

0

5000

10000

15000

20000

25000

Years

ECB

ECB

(i.e., through foreign direct investment or private equity/foreign venture capital investment

route), investment through American Depository Receipts/Global Depository Receipts, or

investment by NRI's and Persons of Indian Origin(PIO).

ForeignInvestment in India

Investment in

listed/unlisted

companies (except

through the route

of stock exchange)

Institutional

investment in

listed companies

through stock

exchange

ADR/GDR Investment

by NRI and

PIO’s

FDI PE/F

VCI

FII

We take into consideration FII inflow into the country and see how it is affected by the INR

and the CAD.

Table 4:

Years

FPI

(USD

million) CAD/GDP USD/INR

1999 3024 -1.0 43.60

2000 2590 -0.6 46.64

2001 1952 0.7 48.80

2002 944 1.2 47.50

2003 11356 2.3 43.44

2004 9287 -0.4 43.75

2005 12494 -1.2 44.60

2006 7060 -1.0 43.59

2007 27433 -1.3 39.98

2008 -14031 -2.3 50.94

2009 32396 -2.8 45.13

2010 30292 -2.7 44.64

2011 17170 -4.2 51.16 Source: RBI Handbook of Statistics 2011-12.

In the early part of 2000-2010 periods the CAD continued to fall in view of increasing

receipts from the services section of the Current Account. This increase is mainly due to the

sudden rise in software services receipts. The software services contribution increased from

US$5,750 mn in 2000-01 to US$12,324 mn in 2003-04 an increase of 114%. This increase

had caused a reversal in the CAD, from -1.0% of GDP in 1999-00 to2.3% of GDP in 2003-

04. This reversal in the CAD gave a positive outlook for the economy causing the rupee to

strengthen. The exchange rate which was Rs 48.8 to the USD in 2001-02 rose to Rs 43.44 in

2003-04. The rupee remained strong from then onwards and rose to Rs 39 during 2007-08

the year before the 2007-08 financial crisis, which then caused a major outflow of Foreign

Institutional Investment. The FPI ran into negative numbers as a consequence of the financial

crisis. It was US$14,031 mn in 2008-09. The CAD continued downward to -2.3% of GDP.

The financial crisis affected the exports sector and this lead to the rise in the CAD. Though

the FPI flows returned the following year, this was mainly due to the relative stable Indian

Economy as compared to the other developed economies which were affected badly by the

crisis. The inflow of Foreign Investments continued, but the CAD increased ever more

rapidly due to heavy imports of oil and gold. Due to the unsustainable level of CAD the rupee

weakened, reaching to a level of Rs 51 in 2010-11. The Rupee depreciation has continued

and the currency touched all time lows of Rs 61.21 in July 2013.

4.3 Financing the CAD: Foreign Exchange Reserves

India has maintained a strong Foreign Exchange Reserves account after a bitter experience

which was the Balance of Payments crisis in the 1990’s when the country had to pledge gold

for USD. India experienced CAD very frequently, the inflow from the Capital Account was

needed to maintain and finance this deficit, failing which the RBI would then be forced to dip

into its foreign exchange reserves.

The Foreign exchange reserves are also used by the central bank as a tool for exchange rate

management. India follows a managed-floating exchange rate regime, wherein the central

bank intervenes in the exchange rate market to “curb volatility” caused by speculations.

Speculations disturb the market and cause the exchange rate to be very volatile for a short

period of time. To negate this, the RBI intervenes in the market.

The exchange rate fluctuations affect inflows of international investment portfolios and also

the export and imports of a country.

We look at the Foreign exchange reserves of the country during the period and look at its

gradual rise and stability.

The foreign exchange reserves grew from US$ 38 bn to US$ 294 bn during the period 1999-

00 to 2011-12. This increase happened gradually during the period owing to the surge in

inflows in the capital account. The percent change in the reserves has been rising over the

period except for two periods where it has fallen.

Table 5:

Years

Forex

reserves

(USD

Million)

Forex(-

/+) (USD

Million)

Actual

Change in

Forex

reserves

(USD

Million)

1999 38036 -6142

2000 42281 -5842 -4245

2001 54106 -11757 -11825

2002 76100 -16985 -21994

2003 112959 -31421 -36859

2004 141514 -26159 -28555

2005 151622 -15052 -10108

2006 199179 -36606 -47557

2007 309723 -92164 -110544

2008 251985 20080 57738

2009 279057 -13441 -27072

2010 304818 -13050 -25761

2011 294398 12831 10420

Source: RBI Handbook of Statistics 2011-1

Table 6:

Year

Purchase

(USD

Million)

Sale

(USD

Million)

Net

(USD

Million)

Outstanding

Net Forward

sales (-) /

purchase (+)

at end of

month (USD

Million) USD/INR

1999-00 24077 20828 3249 -10,129 43.6050

2000-01 28203 25847 2356 -20,324 46.6400

2001-02 22822 15759 7063 -7,225 48.8000

2002-03 30635 14926 15709 10,254 47.5050

2003-04 55414 24941 30473 27,592 43.4450

2004-05 31398 10551 20847 781 43.7550

2005-06 15239 7096 8143 0 44.6050

2006-07 26824 0 26824 0 43.5950

2007-08 79696 1493 78203 68,323 39.9850

2008-09 26563 61485 -34922 62,533 50.9450

2009-10 4010 6645 -2635 4,643 45.1350

2010-11 2450 760 1690 1,970 44.6450

2011-12 1665 21803 -20138 -8,999 51.1600

Source: RBI Handbook of Statistics 2011-12.

The table above gives us the Purchase and Sale of USD by the RBI.

Foreign Institutional investors and trends of foreign institutional investment over the

past few years

Foreign Institutional Investors (FII) is entities established or incorporated outside India and

make proposals for investments in India. These investment proposals are made on behalf of

sub accounts which may include foreign corporate, individuals, funds, and other such

investors. FII’s have designated banks that are authorised to deal with them. The biggest

source through which FII’s invest is the issuance of Participatory Notes (P-Notes), which are

also known as Offshore Derivatives.

5. The Reforms in Foreign Investment in equity and debt markets in India

for FIIs

The FII investment initiated after the reforms of 1991

In April 1998, FII’s were permitted to invest in dated government securities subject to a

ceiling of US$ 1 billion, which was increased to US$ 1.75 in 2004.

In November 2004, an outstanding corporate debt limit of US$ 0.5 billion was prescribed.

The objective was to limit short term debt flows.

In April 2006, outstanding corporate limit increased US$ 1.5 billion. The limit on investment

in government securities was increased to US $ 2 billion.

In January and October 2007, FII’s were allowed to invest US$ 3.2 billion in government

securities.(Limits were raised in two phases of 0.6 billion each, in January and October).

In June 2008, the while reviewing the External Commercial Borrowing Policy, the

government increased the cumulative debt investment limits from US$3,2 billion to US$ 5.0

billion and from US$ 1.5 billion to US$ 3.0 billion for FII investments in government

securities and corporate debt, respectively.

In October 2008, the government increased the cumulative debt investment limits from US$ 3

billion to US$ 6 billion for FII investment in corporate debt.

In November 2010, investment cap for FII’s increased by US$ 5 billion each in government

securities and corporate bonds to US$ 10 billion and US$20 billion respectively.

In March 2011, the investment limit in corporate debt was increased to US$ 40 billion, an

increase of US $25 billion. The US $25billion increase constituted of a

i. US $ 10 billion investment in infrastructure Debt Funds (IDF) - (a) lock in period of

1 year (b) residual maturity of at least 15 months.

ii. US $ 12 billion for FII investment in long term infrastructure bonds – (a) lock in

period of 1 year (b) residual maturity of at least 15 months

iii. US $ 3 billion for QFI investment in MF debt schemes which hold at least 25% of

their assets (either in debt or in equity or in both) in the infrastructure sector.

In November 2011, the investment limits in government securities was increased to US $ 15

billion.

In June 2012, investment limits in both, corporate debt and government securities were

increased to US $ 46 billion and US $ 20 billion respectively (US $ 45 billion +1 billion of

investment by QFI in corporate bonds and mutual fund debt schemes).

In January 2013, the RBI enhanced the limit of investments by FII’s in government securities

to US $ 25 billion. The limit of investments in corporate debt was also hiked to US $ 50

billion.

Table 7:

Foreign Institutional Investment Components

FII

INVESTMENT

IN

INR(CRORES)

Year Equity Debt Total %Equity %Debt

1999-00 9670 453 10122 95.53 4.47

2000-01 10207 -273 9933 102.75 -2.74

2001-02 8072 690 8763 92.11 7.87

2002-03 2527 162 2689 93.97 6.02

2003-04 39960 5805 45765 87.31 12.68

2004-05 44123 1759 45881 96.16 3.83

2005-06 48801 -7334 41467 117.68 -17.68

2006-07 25236 5605 30840 81.82 18.17

2007-08 53404 12775 66179 80.69 19.30

2008-09 -47706 1895 -45811 104.13 -4.13

2009-10 110221 32438 142658 77.26 22.73

2010-11 110121 37317 146438 75.19 25.48

2011-12 43738 49988 93726 46.66 53.33

Average 88.56 11.48

Source: SEBI

Foreign Institutional Investors invest in equity and debt market. Hence, the performance of

these two markets directly affects the inflows of foreign capital to the country, and in turn

affects the exchange rate through the capital movements.

Putting it all Together: The FPI, CAD and the INR

Table 8:

Source: RBI Handbook of Statistics 2011-12

The table 7 above shows us the trend of FPI, CAD and the exchange rate of the Indian rupee.

What can be noticed is that there has been a depreciation of the rupee, based on the flow of

FPI and also the strain on the CAD. The last year has seen a steep fall in all three variables. A

fall in the flow of foreign investment can dampen the spirit of the economy, by reducing the

funding of the Current Account and which in turn affects the INR.

Years

FPI

(USD

Million) CAD/GDP USD/INR

1999 3024 -1.0 43.60

2000 2590 -0.6 46.64

2001 1952 0.7 48.80

2002 944 1.2 47.50

2003 11356 2.3 43.44

2004 9287 -0.4 43.75

2005 12494 -1.2 44.60

2006 7060 -1.0 43.59

2007 27433 -1.3 39.98

2008 -14031 -2.3 50.94

2009 32396 -2.8 45.13

2010 30292 -2.7 44.64

2011 17170 -4.2 51.16

6. Conclusion

It has been noticed that there is an interlink between the CAD, the INR and the FII. What has

to be noticed is the trend that they follow in comparison with each other. An outflow of

foreign investment may lead to the depreciation of the rupee, with foreign investors selling

their rupee investments for dollars, thereby increasing the supply of rupee and demand of

dollar. This may in turn affect the CAD by increasing the import bill, which has been

increasing more than the growth in exports, thereby offsetting any gains by increased exports

due to the depreciation.

This high CAD may in turn reflect badly on the market and create an outflow of investors,

due to an unsustainable CAD number. This will once again follow a similar pattern of

depreciation of the INR and then increase in the CAD.

This will lead to a slump in the economy which will decrease the imports and demand of the

economy, leading to a stable period before revival. Hence it can be interpreted that the

present slump in the economy is due to volatile foreign investment, combined with a

depreciating INR and an unsustainable number of the CAD.

Reforms have opened up the economy not only to opportunity but also to vulnerability. The

heavy dependence on the foreign investment to finance the CAD, is precarious, as we noticed

during 2007-08, there was an outflow of foreign investment leading to the RBI to dip into its

coffers for financing the CAD.

The heavy volatility of Foreign Investment needs to be stabilised if India is to possess a stable

exchange rate for a sustainable CAD. Regulations that encourage FDI and increase in the

exports are required.

The problem of CAD is mainly due to the imports of Oil and Gold. The latter can be

regulated, but the former is a necessity. The value of imports of oil has increased rapidly

owing mainly due to the depreciation of the Indian Rupee. Hence in order to ensure a

sustainable CAD it is imperative that there is stability in the exchange rate.

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