FINANCIAL liberalisation, aimed in the first instance at attracting foreign finance capital to India, is the centrepiece of the neo-liberal growth strategy India chose to adopt 25 years back. That was indeed a dramatic change. In 1947, controls on and regulation of foreign investment were seen as prerequisites for ensuring autonomy from predatory foreign capital, and strengthening the political freedom that had been won. Since 1991, however, economic success has been measured by neo-liberal advocates by the confidence that foreign investors have in the Indian economy, reflected in the volume of cross-border inflows of foreign capital, especially foreign finance capital.

This is not to say that other aspects of liberalisation, like trade liberalisation for instance, are not significant. However, trade liberalisation needs support from financial liberalisation. Trade liberalisation was adopted on the grounds that the competition it would unleash would help restructure domestic economic activity, render firms and other economic agents in India internationally competitive, and put the country on an outward-oriented, export-led growth trajectory. Even if this does prove to be the “ultimate” result of such trade liberalisation (which it normally is not), this cannot be its immediate fall-out. Restructuring domestic capacity takes time as does the process of finding customers and building ‘goodwill’ in global markets. On the other hand, post-liberalisation, the pent-up demand, especially of the rich, for imported goods that had thus far been curbed with protection would be immediately released. This would lead to a widening of the trade and current account deficit in the balance of payments of the liberalising economy, with foreign exchange expenditures rising much faster than foreign exchange earnings. So access to foreign capital to finance that deficit is a prerequisite for “successful” liberalisation that is not aborted by a balance of payments crisis.

Not surprisingly the global turn to neo-liberalism occurred after successive oil shocks and profligate global spending by the United States had resulted in the accumulation of large volumes of liquidity in the international financial system. Desperate to find avenues to invest that liquidity, international finance chose to enter developing countries which till then had been  shunned by it on the grounds that they were too risky.

This suited elites in developing countries looking to win greater freedom for private capital by adopting a neo-liberal agenda. Since they required foreign finance to keep their deficits from proving catastrophic, an implicit Faustian bargain was struck by them with international finance capital looking for new playing fields. This paved the way for continuous liberalisation. Foreign capital favours environments where markets and private capital are allowed free rein. Once trade and investment rules are liberalised to attract foreign capital, domestic controls on the operations of capital need to be diluted or dismantled. This includes controls on the operation of financial markets and firms with implications for the financial system and economic structure. Financial liberalisation, both external and internal, becomes the driving force in the neo-liberal journey.

India is seen as a successful case among countries that have undertaken this journey, as it has emerged as one of the favoured destinations of foreign investors. But that is true only of the period after 2003. The increase in capital flows into India in the first flush of post-1991 liberalisation was small. Starting from about $100 million, total (portfolio and direct) investment rose to above $3 billion in 1993-94, largely as a result of portfolio flows into India’s equity and debt markets. It then rose to about $5 billion a year and remained at that level, till portfolio inflows were disrupted and reversed in the aftermath of the 1997 Southeast Asian crisis. But immediately thereafter, the total bounced back to more than $5 billion by 1999-00. This quantum, however, was seen as unsatisfactory by the government, given its oft-expressed target of ensuring FDI inflows of $10 billion a year.

The shift away from annual inflows in the range of $5 billion a year began in 2003-04. Besides an overall surge in capital flows to all emerging markets, a host of policy measures paved the way for India proving to be one of the favoured investment destination. Rules and caps on foreign investment were relaxed, tax benefits delivered through the external treaty route with countries like Mauritius, and the ‘long-term’ capital gains tax was abolished in the budget of 2003-04, making India’s financial markets virtual tax havens. In 2003-04, aggregate inflows rose to exceed $15 billion. That figure further rose to touch $62 billion in 2007-08 when the global financial crisis broke. While the crises resulted once again in a reversal of portfolio inflows in 2008-09, FDI inflows remained strong at more than $40 billion. Portfolio flows too bounced back taking the aggregate inflow to more than $60 billion in all years till 2013-14, when the “taper tantrum” induced by the fear that the US Federal Reserve would tighten monetary policy and raise interest rates, substantially reduced the net inflow of portfolio capital. However, once those fears were quelled aggregate inflows rose to a record $74 billion.

But as recognition dawned that hopes of recovery from the Great Recession may not be realised, China’s GDP growth began to slow and uncertainty overcame global financial markets, there occurred a flight to safety of capital to the US and to safer assets. According to the IMF’s World Economic Outlook April 2016, when the year ending the third quarter of 2015 is compared with calendar year 2010, net capital inflows to 45 emerging market economics (EMEs) declined by $1.123 trillion or the equivalent of 4.9 percent of the GDP of this set of countries. Net capital inflows into these countries moved from 3.7 percent of their GDP in 2010 to a negative 1.2 percent of GDP over the five years ending the third quarter of 2015. That was a huge swing. This affected India as well, with net portfolio inflows turning negative and touching (minus) $4billion and direct and portfolio net inflows together totalling $32 billion.

There are two noteworthy features that emerge from this brief survey of foreign capital flows to India starting 2003-04. First, inflows have been huge and far in excess of what was required to finance its current account deficit, or excess of foreign exchange expenditures over earning. Second, these inflows, especially the portfolio component, tended to be volatile, for reasons that often had little to do with developments in the Indian economy.

This volatility mattered because India has run a current account deficit in almost all of these years (excepting for three), as compared to a country like China, for example, which had accumulated a substantial part of its foreign exchange reserves as a result of continuous surpluses on its current account. India had not earned its foreign reserves, in the sense that they were the result at least in part of an excess of foreign exchange earning relative to the country’s foreign exchange expenditures. It had “borrowed” them, in the sense that associated with the foreign exchange reserves were future foreign exchange payment commitments in the form of returns to be paid and capital that investors are eligible to repatriate if and when they choose to. The exposure to large foreign capital inflows that liberalisation ensured has resulted in the accumulation of legacy capital, much of it footloose, that can exit at short notice, depleting India’s reserves and even possibly precipitating a currency and financial crisis. As past experience has shown this can occur even for reasons completely unrelated to developments in the Indian economy. Thus an important consequence of the increased reliance on foreign capital, especially foreign finance capital, is a high degree of vulnerability to a crisis that can require adoption of austerity measures that can be severely damaging for the livelihoods and quality of life of the majority of the country’s population.

Two ‘benefits’, one illusory and the other real but temporary, have helped the government divert attention from this vulnerability that only increases with time. The first is the asset price inflation in India’s equity markets as portfolio investors rush in to capture the ‘gains’ engineered by earlier bouts of capital inflow, and domestic institutional and high net worth individuals follow. This boom can end rather quickly if there is any medium term reversal in capital inflows. The other is that the huge liquidity injected into the Indian economy has set off a credit boom, that has triggered a process of growth that rides on a credit bubble. The ratio of bank credit to GDP in India has risen from around 22 to 60 percent in the years after 2002-03. This credit splurge has been accompanied by a significant diversification of bank credit away from industry to retail lending or the personal loan sector (housing, automobiles, consumer durables, education, etc) and within industry away from manufacturing to infrastructure.

The immediate consequence of this credit boom is that the demand generated by this debt-financed, largely private, spending has spurred growth. India was put on a so-called high growth trajectory, though that growth bypassed much of the population and did little to mitigate the deprivation that India’s poor suffers. But with time it has become clear that a lot of this increased lending, especially to infrastructure, was misdirected, and defaults and the non-performing assets of the banking sector have risen sharply. Banks are now recording losses providing for the bad loans that need to be written off, and are unlikely to be recovered. Besides the danger this spells for the banking system, it also implies that the credit boom must end as banks that have burnt their fingers withdraw and borrowers turn cautious. This would spell the end of even that growth that benefitted a minority, which was garnered by riding a credit bubble.

This is of significance because one of the consequences of India’s growing reliance on foreign finance capital has been an erosion of economic sovereignty, especially on fiscal matters. Committed to appeasing whimsical foreign investors and fearful of undermining their ‘confidence’, the government has accepted in full the demand of international finance that it should abjure any attempts at pursuing a pro-active fiscal policy, that involves spending more to push employment and output growth, provide basic services to all and address the worst forms of deprivation. It was in 2003, just before the high growth era began, that the government tied its own hands in this area by enacting the Fiscal Responsibility and Budget Management Act that set stringent fiscal targets and did away with any semblance of fiscal sovereignty in the name of fiscal consolidation. The implementation of the targets under this Act (even if delayed) had depressing effects on growth and severely damaging effects on the State’s welfare expenditures. This did not seem to matter initially since increasing debt-financed private expenditure neutralised the adverse effects on growth of the decline in public expenditure. Now as the latter trajectory approaches a dead end, the fact that the government gave up its sovereign policy space in fiscal and other areas has left it with no options.