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Diminishing capital flow Implications on Economy

March 11, 2009

The spectacular rise in capital flows from FY05 (fiscal year ending March 2005) had significantly reinforced India’s growth and asset price cycles. The termination of this episode of strong capital flows, a fall-out of the current global credit crisis, is unleashing a significantly more challenging macro environment characterised by lower growth, structural fiscal deterioration and constrained liquidity.

India’s medium term potential growth rate should shift to a lower trajectory of 6.5% from the lofty 9% averaged during FY05-09. Tighter availability of external financing, greater pre-emption of domestic resources by the government and more normalised asset prices will constrain faster growth.

Subdued revenue collections coupled with recalcitrant expenditures imply a medium term fiscal deterioration and a higher level of borrowings. In the absence of sizeable capital flows, domestic bond yields are set to back up from the unusually low levels over the last five years.

Slower growth implies a more moderate earnings cycle while diminished excess liquidity will weigh on valuations. The era when Indian equities were acceptably the most expensive in emerging Asia is now behind us.

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