Net capital flows to South Asia reached a record $40.1 billion in 2006, up from $28.3 billion in the previous year, with most of the increase going to India, the World Bank says in its annual report.
In GDP terms the flows rose from 2.8 per cent to 3.6 per cent, noted the report Global Development Finance 2007, released on Tuesday.
But sustaining recent high growth in South Asia will require continued economic reform, expansion of infrastructure capacity, and further reduction of security threats, it said predicting that these efforts will also contribute to higher capital inflows as they did in recent years.
Revamping tax collection systems to reduce evasion and improve tax collection to help finance the extensive government agendas is also important.
Increased political instability represents another main risk. Heightened security concerns could hurt investor sentiment and undermine foreign capital inflows, which have contributed to the region's record four-year expansion, the report said.
The continued easing of political tensions between the governments of India and Pakistan bodes well for continued progress toward improved relations, it said.
GDP in South Asia expanded a robust 8.6 per cent in 2006, reflecting generally expansionary policy conditions. Growth was down slightly from 2005 due primarily to a deceleration of growth in Pakistan, the report said.
In India, GDP increased by 9.2 per cent although signs of slowing appeared at the end of the year. On the other hand, Pakistan's GDP increased by 6.6 per cent in 2006 significantly down from the 7.8 per cent growth rate recorded the previous year.
India's restrictive policy conditions are expected to lead to deceleration in investment growth and weaker private consumption and government spending, contributing to a slowdown in GDP growth to 7.8 per cent and 7.5 in 2008 and 2009, respectively, World Bank report said.
Strong capital inflows were largely due to a $12 billion expansion in net private debt flows, while net equity inflows to the region increased only slightly, as a $3 billion increase in FDI was partly offset by a decline in portfolio equity flows.
At $22.9 billion in 2006, net equity inflows nonetheless account for the bulk (60 per cent) of net private inflows to the region. Much of the FDI inflows into India were concentrated in the service sector (telecommunications in particular) in response to liberalization policies designed to attract FDI, such as easing ownership restrictions.
FDI outflows from India are also on the rise due to increasing cross-border M&A (mergers & acquisitions) purchases by Indian companies, mainly in high-income economies. Since 2004, FDI flows from India to Britain exceeded flows from Britain to India. The Indian multinational Tata acquired the Dutch steel company Corus for more than $10 billion in early 2007.
Rapid growth and the relatively expansionary stance of fiscal and monetary policies in the region have provoked a rise in inflation.
Higher oil prices in the first half of 2006 and strong domestic demand contributed to deterioration in the region's current account balance despite strong exports and remittances inflows.
Since 2003, the period for which imports could be covered by foreign reserves has declined by about four months in both India and Pakistan.
While reserves in India remain significantly above the level of three months worth of imports, they are much closer to that level now in Pakistan and below it in both Bangladesh and Sri Lanka, suggesting that each country would be vulnerable to a significant terms-of-trade shock, such as another hike in oil prices, the report said.
The high growth rates posted in recent years have helped South Asia make significant progress toward achieving the Millennium Development Goals (MDGs), it said.
Most notably, the percentage of people living on less than a dollar a day declined to just over 30 per cent in 2003 from 40 per cent in 1990, and is now projected to reach about 13 per cent in 2015 - below the initial goal of 20 per cent.
Sustained growth will be necessary for continued poverty reduction, and achieving further improvements in institutional service delivery will be critical to making progress in all other dimensions of the MDGs, Word bank said.