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RBI Working Paper Series No. 07
Sensitivity of Capital Flows to Interest Rate Differentials: An Empirical Assessment for India
@Radheshyam Verma and Anand Prakash

*In the aftermath of the global financial crisis, multi-speed recovery and divergent inflationary trends have led to asymmetric monetary exit between Emerging Market Economies (EMEs) and the advanced economies. An outcome of this process has been return of excessive capital flows to EMEs, exerting pressure on their asset prices to inflate and the exchange rates to appreciate. The risk of attracting even larger inflows as a result of monetary policy actions has been recognized generally in these countries. This study provides empirical evidence of sensitivity of capital inflows to interest rate differential in the India specific context. Using both causality and cointegration analyses, this study suggests that FDI and FII equity flows, which together on a net basis accounted for around three fourth of the total net capital inflows during the 10-year period from 2000-01 to 2009-10, are not sensitive to interest rate differentials. In turn, debt creating flows, in particular ECBs, FCNR(B) and NR(E)RA deposits exhibit statistically significant sensitivity to interest rate differentials, even though other determinants of these inflows dominate significantly the impact of interest rate differential. At the aggregate level, cumulative gross capital inflows appear to increase by 0.05 percentage points in response to 1 percentage point increase in interest rate differential. Moreover, contrary to general perceptions, stronger growth in OECD countries actually coexists with larger capital inflows to India. The paper concludes that RBI’s monetary policy needs to continue its focus on objectives relating to inflation and growth. The magnitude and composition of capital flows that might change in response to monetary policy actions could be managed using other instruments, as has been the case in the past. Monetary policy should not be constrained by the explicit impact on capital inflows since other determinants of capital inflows could dominate the impact of interest rate differential most of the time.

  • JEL Classifications : F41, E52, F21
  • Key words : capital flows, interest rate differential, monetary policy

Section I: Introduction

Interest rate differential has often been viewed as a major determinant of capital flows to Emerging Market Economies (EMEs), and at times, monetary policy measures that may be conditioned by the inflation-growth objectives could magnify or dampen the volume of capital inflows into a country. In the recent period, the multi-speed recovery of the world economy from the Great Recession and the asymmetric monetary exit has widened the growth as well as interest rate differentials, creating concerns that there may be another wave of surges in capital flows to EMEs, which have to be managed.  While sterilised interventions to prevent overvaluation of the exchange rate, use of macro-prudential measures to stem risks to asset prices or even use of soft capital controls to contain the magnitude of inflows have been used by several EMEs as possible instruments to deal with the challenge, there is little support as yet for delaying monetary policy actions just because of the risk that such actions may pose in terms of influencing the magnitude and composition of capital flows.

In India, during the normalization of the monetary policy over the period March to November 2010 when the policy interest rates were raised six times, a general reference was made to the risk of attracting larger capital inflows, given particularly the fact that other determinants of capital inflows to India also turned significantly favourable during this period. Among the push factors, near zero policy rates maintained in advanced economies, their weak growth prospects and ample global liquidity conditions reflecting quantitative easing implied scope for  lager inflows to EMEs, including India,  in search of higher return. Stronger recovery in a stable macroeconomic environment and the general assessment of India continuing to be one of the fastest growing economies in the world for a long period of time have provided  the necessary pull to capital inflows.  Prior to the global crisis, India had exhibited surges in capital flows which were in excess of the financing needs of the current account deficit, and a number of instruments were used in combination to manage the surplus, particularly sterilized intervention, more open capital account to encourage capital outflows by residents, and occasional use of prudential measures to discourage capital inflows within the preferred hierarchy.  In the second half of 2010-11, unlike in other EMEs, a larger current account deficit of India suggested the need for higher stable capital inflows. As a result, while the concerns relating to anti-inflationary monetary policy measures attracting excessive capital inflows eased, the relevance of interest rate as an instrument to modulate the magnitude and composition of capital inflows continued. In this context, the focus of this paper is to study whether RBI’s interest rate actions have been a major determinant of capital inflows to India.

An assessment of different components of capital flows would suggest that portfolio inflows into the equity segment are unlikely to be very sensitive to interest rate actions of the RBI, unless the monetary policy changes affect the asset prices and, thereby, alter the return on equity. In the debt segment, where portfolio flows are permitted only up to a limit, one would expect interest rate sensitivity to work, though expected appreciation/depreciation of the exchange rate or the hedging cost could be a factor that needs to be taken into account while arriving at the relevant interest rate differential. FDI inflows are most likely to be driven by long-term fundamentals, and very unlikely to be influenced by short-term changes in policy interest rates. If the FDI firms depend on large leverage, cost of debt could affect their return on equity. But FDI inflows per se may not be driven by short-term changes in interest rates. Among the debt flows, ECB is a key component, which could be highly sensitive to interest rate differentials, since corporates would invariably recognize the arbitrage opportunities in their planning of financing, and they also can hedge their exchange rate risks, both in the domestic and international markets. In India, however, there are annual caps on access to ECB and ceilings on the overall cost of ECB, which are linked to international interest rates.  The scope for very large flows in response to interest rate differential is, thus, limited by the extant ECB related policies. NRI deposits represent the second most prominent debt related inflows. In this category, interest rates on FCNR deposits are linked to international interest rates, and, hence, interest rate differential may have much smaller role in explaining the pattern of FCNR inflows. Other NRI deposits, however, could be expected to be sensitive to interest-rate differentials, even though other determinants may have a more dominant role, in particular, the employment prospects and income growth of the NRIs. These impression based assessment of interest rate sensitivity of capital flows needs to be validated through empirical estimates, which is the main focus of this paper.

Against this background, Section-II of the paper presents a review of the literature, with the aim of identifying the factors that often lead to contrasting findings on interest rate sensitivity of capital flows. If some studies show high sensitivity while others do not, then identifying the contributing factors becomes important before proceeding to empirical estimates. Section-III examines the policy environment for each component of capital flows and explains why, at least in some of the segments, lack of interest rate sensitivity may be because of policy interventions. Historical evolution of such policy interventions that hinder greater interest rate sensitivity will be covered in this section. Empirical assessment of interest rate sensitivity, using data on different components of capital flows and expected determinants for each type of inflows, has been presented in Section-IV. Concluding observations in the final section draws some inferences based on empirical findings that could be relevant for the conduct of monetary policy.

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