Dynamics Of Private Capital Flows To India: A Structural VAR Approach

India started adopting the policies of liberalization and globalization in 1990s and since then it has attracted large amount of private capital flows. With increased magnitude, private capital flows (such as foreign direct investment and foreign portfolio investment) now constitute an important part of India's balance of payments. While there are potential gains from these inflows, they have also exposed the economy to increased risk of volatility and sudden withdrawal, which has ramifications both for the financial and real sector of the economy. Moreover, there may be other potential costs of large capital inflows for the economy as a whole which include rapid monetary expansion causing inflationary pressure, exchange rate appreciation leading to erosion of competitiveness of domestic goods and services, and widening of current account deficits. This study, therefore, identifies and examines the determinants of private capital flows to India so that policies can be formulated to reduce the associated risks (costs) and make India a more attractive destination to invest. It also divides these determinants into domestic (pull) and external (push) factors in order to ascertain their relative importance in determining private capital flows. For this purpose, the study uses monthly data from 1995 to 2014 and estimates the empirical model based on Structural VAR framework. Under Structural VAR, the study utilizes the innovation accounting analysis (impulse response function and variance decomposition function) to derive the empirical results. The empirical results (through impulse response functions) show that domestic output, domestic stock market performance, domestic fiscal deficit, domestic creditworthiness, exchange rate, foreign interest rate and foreign output are the major determinants of private capital flows to India. The results also show that the domestic interest rate has insignificant impact on private capital flows. Further, the variance decomposition analysis reveals that there is dominance of domestic (pull) factors over external (push) factors in driving private capital flows to India, suggesting that India needs to have strong macroeconomic fundamentals in order to attract and sustain greater private capital flows.