Mumbai: Global capital flows are a two-way traffic between emerging and advanced economies, but the developing world remains vulnerable to volatility in such flows because they have limitations in borrowing in their own currencies in global markets, according to the RBI.
Speaking at the Indian Institute of Technology-Kanpur (IIT) last week, Reserve Bank Executive Director Deepak Mohanty said even as availability of foreign capital alleviates domestic resource constraints, it could also destabilise the economy.
"Global capital flows now increasingly show a two-way movement between emerging and developing economies (EDEs) and advanced economies. However, EDEs remain vulnerable to volatility and sudden stops in capital flows. This is because EDEs have limitation in borrowing in their own currencies in international capital markets," Mohanty said.
His speech was uploaded on the RBI's website on Tuesday. Elaborating further, Mohanty pointed to the global economic crisis of 2008.
"The epicentre of the 2008 crisis was the US, but capital flows to EDEs, including India, were severely affected. Now the epicentre has shifted to Europe, but capital flows to EDEs continue to be impaired," he said.
The Executive Director said availability of foreign capital is not an unmixed blessing.
"While it alleviates domestic resource constraints, it could also destabilise the economy in two ways: one, excess capital inflows could result in asset price inflation and loss of competitiveness through over-valuation of the exchange rate," he said.
According to Mohanty, emerging economies seem to have learnt some lessons from previous debt and currency crises, particularly from the Latin American debt crisis of the 1980s and the East Asian currency crisis of 1997.
"This has reinforced the hierarchy of capital flows with a preference by EDEs for equity flows. This is also reflected in a discernible shift in the composition of capital flows to EDEs in favour of equity, particularly FDI," he said.
Mohanty further said, "Capital flows to EDEs depend on push factors emanating from low interest rates and lack of investment opportunity in advanced economies as well as by pull factors emanating from strong economic fundamentals and growth prospects in the recipient country. Particularly, stable flows like FDI are guided more by pull factors."
The RBI official said the dominant view was earlier tilted toward unfettered capital movement.     

"But following the recent global financial crisis of 2008, there is explicit recognition -- even by multilateral bodies such as the IMF, World Bank and the G20 -- that capital controls may be desirable under certain circumstances," he said.
According to Mohanty, India's external sector policy had always believed in some form of management of capital account with a preference for equity inflows.
"This policy of cautious opening of the capital account has served us well as reflected in the stability of our Balance of Payment (BoP) since the 1991 crisis. The composition of our capital account has shifted from almost entirely debt to predominantly equity," he said
However, Mohanty warned that notwithstanding relative stability of India's BoP, some stress has developed following the 2008 global financial crisis as capital inflows have moderated amid an expanding current account deficit.
"This is reflected in worsening of some of the vulnerability indicators of the external sector. Our dependence on private capital inflows to finance our current account deficit has increased.
"Moreover, we have to factor in uncertainties in the global financial markets. These developments call for vigorous domestic policy reforms with a greater emphasis on trade competitiveness and energy security so as to enhance the pull factor for FDI to reinforce our BoP," he said.