In 2008, when Lehman Brothers fell, India was expected to escape the worst of the reverberations across the global financial markets. After all, India had elaborate and significant restrictions on capital flows. Reality turned out to be vastly different. When London, which is a global financial hub, experienced tight liquidity, the Indian money market also experienced a near-synchronous squeeze. In fact, the crisis travelled home at an unexpected speed.In a recent paper, economists Ila Patnaik and Ajay Shah have explored the post-Lehman fall scenario (Why India choked when Lehman broke) and have offered a new hypothesis for the impact of the credit crisis on India. They conclude that the large presence of Indian multinationals overseas helped transmit the crisis to India rapidly, despite the controls. These companies through overseas subsidiaries escape the capital controls on offshore borrowings that are imposed on Indian companies. When the crisis broke, they borrowed in the Indian market, and converted to dollars to pay for their overseas obligations.
Says the report: "When the global money market became illiquid on 13/14 September, these firms were faced with dollar shortages associated with liabilities which could not be rolled over. It would be efficient for these firms to respond to this situation by borrowing in rupees in India, moving this money abroad, and thus discharging their dollar liabilities."
The authors back their supposition with numbers. According to Patnaik and Shah, the dominant theme in the October-December quarter of 2008 was outflows from India through banks (banking capital) and through non-bank corporations (FDI by Indian companies) which added up to $10.8 billion. In comparison, the net capital outflow through portfolio investors was only $5.78 billion. Patnaik and Shah argue: "These large values were not about Indian companies buying assets or building a business overseas. They were about Indian companies transferring capital to overseas subsidiaries, which had been using the global money market, and were now short of dollar liquidity."
Clearly, capital controls have not insulated India completely from any turbulence in global financial markets.