An Empirical Investigation of the Impact of Capital Inflows on Domestic Investment in India

Rajiv Ranjan and Sunil Kumar
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Rajiv Ranjan: Reserve Bank of India, Postal: Reserve Bank of India, Mumbai, India.
Sunil Kumar: Reserve Bank of India, Postal: Reserve Bank of India, Mumbai, India.

Indian Economic Review, 2012, vol. 47, issue 1, 15-32

Abstract: Like many emerging market economies (EMEs), India also experienced a significant surge in capital inflows since the second the half of 1990s. Capital inflows as percentage of GDP increased from 7.2 per cent during 1990-91 to 25.8 per cent in 2008-09 reflecting the rising contribution of financial channel in India’s global integration. Notably, investment in India also made large leaps during the same period and generated an obvious debate on the contribution of capital inflows to incremental investment. The relationship between investment and capital inflows based on the national income accounting identity remains quite ambiguous on many counts. In view of above, we have attempted to empirically investigate the direct impact of capital inflows to investment in India in this paper. We have used the Johansen (1988) and Johansen and Juselius (1989) cointegration model to estimate the causality running from capital inflows to investment since the data series used in the study viz., investment and capital inflows as percentage of GDP and GDP growth are I(1) processes. The estimates of long run cointegration equation indicate that 37 per cent of the capital inflows go into higher investment. On an average basis, gross capital inflows were about 19 per cent of GDP during 2000s and going by the above results, they contributed an average of 7 percentage points to the GDCF. Thus, the contribution of capital inflows towards GDCF remains much higher than reflected in the national income identity through current account deficit. Variance decomposition analysis reveals that the contribution of capital inflows (KF) to gross domestic capital formation (GDCF) variation increased and reached to about 13 per cent by the 10th period. We have found the short-term dynamics of the cointegration model to be quite robust with error correction mechanism (ECM) term to be negative and significant. ECM coefficient suggests that about 23 per cent of deviation in the long-run equilibrium level of investment is corrected in the next period.

Keywords: Capital Inflows (KF); Gross Domestic Capital Formation (GDCF); Cointegration (search for similar items in EconPapers)
JEL-codes: E22 F34 F36 (search for similar items in EconPapers)
Date: 2012
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