'Allowing foreign investment in stock markets helped economy'

Cornell University economist Eswar Prasad says foreign inflows have helped deepen and increase liquidity in India's stock markets

India has benefited greatly from the ease with which foreign investors can invest in its stock markets, says Cornell University economist Eswar Prasad.

"This presents a stark contrast with China, where equity investment by investors from other countries is heavily restricted," he writes in his new book "The Dollar Trap: How the US Dollar Tightened Its Grip on Global Finance".

Prasad says foreign inflows have helped deepen and increase liquidity in India's stock markets.

"Inflows have provided a useful source of financing for Indian corporations that no longer have to rely just on the domestic banking system, which has limited capacity to fund the country's mega corporations," he writes in the book, published by Penguin.

According to Prasad, for all their benefits, however, foreign equity inflows have also added to the volatility of India's stock markets and to currency volatility.

"The saving grace is that foreign investors bear both the currency and return risks on their stock investments, so the burden of this volatility does not fall solely on Indian residents."

Policymakers in emerging markets, Prasad says, have developed a strong aversion to relying on the IMF's largesse in their times of distress and have instead turned to self-insurance.

"The humiliation of going to the IMF when India's foreign currency reserves had run down to just one billion dollar is seared in the minds of Indian officialdom to this day... Whatever the merits of this adjustment, the fact that the IMF had India by the throat and could extract a steep price in exchange for a loan stuck in the craw of Indian officials and has influenced their behaviour since then," he says.

Prasad, also a Senior Fellow at the Brookings Institution, feels that though India has a high private savings rate and needs a high investment rate to grow but undisciplined government spending has created large budget deficits that in turn contribute to large current account deficits.

"Thus, when capital inflows dry up, India either has to cut its consumption and investment or must eat into its international reserves. Neither of these is an attractive option," he says.