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MOSL: Fuel or Engines (Economy) - Do higher foreign capital inflows imply higher investments?

Fuel or Engines (Economy): Do higher foreign capital inflows imply higher investments?

 

• It is commonly perceived that foreign capital inflows, especially foreign direct investment (FDI), are a major source of domestic investments. In reality, though, only the part of net capital inflows that does not get converted into foreign exchange reserves adds to domestic investments. This connotes that current account deficit (CAD) - not foreign capital inflows - adds to domestic investments.
• This is true for all emerging/developing economies, wherein the central bank intervenes in the foreign exchange market. If capital inflows are higher than CAD, they add to foreign exchange reserves, not investments. On the other hand, central banks in most developed economies follow a 'hands-off' approach, and thus, capital flows are entirely offset by current account balance (CAB).
• As a corollary, policy makers in developed economies have almost no control over their CAB, while those in developing countries - due to capital controls and forex market intervention - have a better control on CAB.
• Since higher CAD could create serious imbalances, domestic savings are the most important source of domestic investments in almost all emerging/developing economies, including India.