India is attracting a lot of attention from foreign investors, especially institutional investors. And why not? The biggest economy in the world, the US, is not in good shape even though it is recovering.
Europe is down in the dumps. Last week, the European Central Bank surprised the market with $70 billion worth of bond buying programme every month till September next year. The objective is to infuse more funds into the economy for revival. The US, which was the first to start quantitative easing, met some success by infusing funds into the economy.
There are expectations of a similar exercise by China and Japan, which are struggling to boost growth. The export-led strategy of mainland China and other economies like Russia and Brazil is also impacted because of the global slowdown in demand for commodities including oil. This effectively means more money flowing into emerging markets like India .
Clearly, India is shining the most among emerging markets. The stamp of approval has come from both the International Monetary Fund and the World Bank. Both institutions have projected India's growth higher than that of China within the next two years.
There is no doubt that India will emerge as the fastest-growing economy in the world with current GDP growth expected to be around 5.5 per cent. The new stable government under the leadership of Prime Minister Narendra Modi is laying the red carpet for domestic entrepreneurs as well as foreign investors. The FDI relaxation and 'Make in India' initiatives are expected to boost the economy. There are expectations of huge foreign inflows into the country.
Should India keep its guard up? I certainly believe there is need to be vigilant as most bullishness is in the country's stock market. Backed by the hot inflows, the BSE's benchmark index has gained over 40 per cent in just one year. Foreign private equity players are pumping in money into e-commerce ventures where profitability is still an issue.
Past experience shows that the hot inflows chase growth, which in turn boost prices of real estate and other assets and also result in appreciation of the currency against the US dollar. Like they say, money flows like water and it flows in search of better returns. The smartest investors exit once there is over-valuation. We have seen this trend in early 90s when many emerging economies like South Korea, Thailand, Indonesia, Philippines, Malaysia and Taiwan were flooded with dollar inflows.
The stock markets touched crazy levels, real estate prices went up and currencies strengthened. But by 1996/97, the markets were over-heated, which resulted in foreign investors exiting en masse. This created havoc in the markets. There was massive depreciation in the currencies of these countries. For example, the Korean won, which was less than 800 to a dollar before 1997, depreciated to 1,400 won by 1998. In fact, when I visited South Korea in late 2004, I was surprised to see the prices. A beer bottle cost around 4,000 won, a water bottle Rs 1,000 won and a meal for two at a restaurant required 8,000-10,000 won. The story was similar in other emerging economies.
So what should India do in a situation when dollar inflows are expected to come to the market? First, it is time to build strong foreign exchange reserves. If the country has huge reserves, it is easy to defend the currency.
As against China's $3.8 trillion foreign exchange reserves, India has $322 billion. Many companies have been raising money abroad taking advantage of low interest rates. The companies should also hedge their currency risks because there could be a huge liability if there is a depreciation later.
The focus should be on quality inflows like FDI rather than FIIs. We should closely monitor FIIs inflows vis-a-vis FDI inflows. If FII inflows move dangerously, there is also a case of taxing them. Former RBI Governor Y.V. Reddy suggested taxing inflows in 2005, much before the 2008 global financial meltdown. There isn't an immediate need, but we have to be watchful rather than simply cheering the sudden global attention.