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Capital flows a big headache

business Updated: Dec 30, 2010 01:02 IST

Amid hopes of returning to the heady days of 9% growth, the government’s macro-economic managers will have to walk the wedge to manage a surge in foreign capital inflows in a capital-scarce country.

Abundant global liquidity, particularly since the US government pumped in more money into the economy, has created notable policy challenges in emerging economies associated with dollar depreciation, portfolio reallocation, and an increase in global inflation expectations.

Many emerging countries are beginning to impose tighter capital controls to prevent domestic asset price bubbles and sharp appreciation in currencies. In October, Brazil tripled its financial transaction tax on foreign portfolio inflows into fixed income securities to 6%.

Thailand is ceasing a 15% foreigners’ tax exemption on income from domestic bonds, while Taiwan has restored curbs on foreign investment in debt instruments. Other countries too are mulling similar options.

India has so far avoided imposing any controls on foreign capital inflow on grounds that such controls work temporarily, but start hampering growth and productivity.

“Developing deeper domestic capital markets to facilitate flows into longer-term and risk bearing assets is an important aspect,” the finance ministry’s mid-year analysis on the economy said. During the first half of the current fiscal year, India received $27.5 billion from foreign institutional investors (FIIs) compared to $7.2 billion last year

“A reversal in capital inflows and lack of an investment revival are downside risks to the Indian economy,” said Sonal Varma of Nomura.