Effects of Foreign Capital Inflow on the Economy

Recently India’s Home Minister Mr. P. Chidambaram pointed out that surge in foreign capital inflow can be a cause of the rise inflation rate in the economy. This is true! With opening up of the economy, foreign capital has become one of the important factors affecting our economy. The country’s economic policies have changed. We are now an open economy affected by the economic and political happenings of the world. We therefore need to broaden our handling of domestic economic problems like inflation. Inflation is no more only due to supply constraints caused by domestic supply constraint caused by poor monsoon or floods. It is affected by global demand and supply of goods and capital. …show more content…

Appreciation of domestic currency causes loss of competiveness of exports as they become costlier. Cheaper imports and costly exports further add to the current account deficit in the Balance of Payment. * Inflation- Foreign capital inflow adds to the domestic money supply. If it is not absorbed and utilized in profitable projects, it leads to inflation in the domestic economy. * Destabilizing effects- foreign investors are always in search of greener pastures. They are attracted to developing, emerging markets where demand, interest rates and hence returns are high. Foreign investors, particularly portfolio investors, are quick to sell and fly away at the slightest hint of economic slowdown or turmoil in the country of investment. They may even leave the country if they find it more profitable investing in some other market/country. Too many foreign investments may make the economy overvalued, which will discourage foreign investors. Foreign investments and investors come in and fly out in herds. This herd mentality can be rewarding as well as dangerous to the domestic economy. It can take the economy to great heights and it can also lead to a crash in the stock market and drop in rate of investment and growth in the domestic economy. The recent high inflation, scams and the drop in the index of Industrial Production in India has led many foreign investors to sell their shares and leave the country.

Managing Foreign Capital Inflow

Foreign Capital Inflow is