With the Dow hitting new highs, driven by strong liquidity, it is easy to believe that global financial markets have recovered even if the physical economy is taking time to sort itself out. But as a McKinsey Global Institute (MGI) report points out, nothing could be further from the truth. The fact is that global cross-border capital flows have fallen 60% from the pre-crisis levels of 2007, from $11.8 trillion in 2007 to $4.6 trillion in 2012. While this is of concern to EMEs like India, even more worrying is the fact that eurozone banks have reduced foreign claims by $3.7 trillion since 2007—a significant part of India’s trade credit is financed by eurozone banks. The sharp fall in cross-border flows has been accompanied by an equally sharp fall in the financialisation of economies like Europe and the US as households and corporates are still in the process of balance sheet repair—the ratio of financial assets to global GDP, which rose from 120% in 1980 to 355% in 2007 has fallen by around 43 percentage points since then, and by 54 percentage points if you exclude the rise in government debt in the US and Europe.
The good news for emerging markets like India is that while overall flows have come down, the share going into emerging markets has risen—from 5% of global flows in 2000, the share going to emerging economies was 32% in 2012. Even more encouraging, around 40% of cross-border flows are made up of FDI, which is relatively more stable. Interestingly, south-south foreign investment in 2012 rose to $1.9 trillion, signalling a potential new area that countries like India can tap.
India’s ability to tap into this market depends on how quickly it can get its act together. Increasing FDI limits in pension and insurance, for example, would help India improve access to these resources. Despite the slowing of global flows, for instance, India has managed to get over $41 billion in the April-January FY13 period, a number which takes it pretty close to the all-time high of $50.4 billion in FY10. But such flows tend to be volatile and explain the sharp swings in the rupee in recent times. While forex flows of all kinds came in at $43.3 billion in FY08, these collapsed to just $8.3 billion in FY09. In a nutshell, in a situation of declining global flows and at a time when countries like the US and Europe have large capital requirements for balance sheet repairs, India cannot afford to be complacent. MGI outlines ways to get global capital flows back on track—one is for corporates in advanced economies to free up bank financing by moving around $1 trillion to bond markets—but India can ill afford to bet on an uncertainty.