DO MASSIVE INFLOWS PRODUCE INFLATIONARY PRESSURES?
ABDUL RASHID & ABIDA ELLAHI
International Institute of Islamic Economics (IIIU),
International Islamic University (IIU), Islamabad
Aug 11 - 17, 2008
Since the early 1990s, there is an upsurge in foreign capital flows to developing economies, particularly into emerging markets. One view argues that capital inflows do help to increase efficiency, a better allocation of capital and to fill up the investment-saving gap. Adherents to that view advise countries to launch capital account liberalization. In this document, we investigate the effects of capital inflows on domestic price level, monetary expansion and exchange rate volatility. The key message of the analysis is that there is a significant inflationary impact of capital inflows, in particular during the last 7 years. The findings suggest that there is a need to manage the capital inflows in such a way they should neither create an inflationary pressure in the economy nor fuel the exchange rate volatility.
Despite the positive trends in most of the macroeconomic indicators over the last few years, almost all discussions about Pakistan's economy emphasizes that the economy is still facing three-major problems viz. inflation, current account deficit and federal budget deficit. It can be strongly recognized that the heat in macroeconomic activities during the past five years (GDP grew at an average annual rate of about 7 per cent) was mainly based on monetary expansion, particularly, credit to private business sector and consumer financing. Similarly, over the last five years, fiscal deficit as a percentage of GDP has significantly been declined to about 5 per cent per annum. The lower market rate of interest during this period may be one of the major reasons because government successfully replaced some higher cost debt with lower cost debt.
After enjoying a low interest rate over the six years (from FY1999 to FY2005), the State Bank of Pakistan (SBP) has finally raised the interest rate. The SBP used tight monetary policy just to control "inflation". However, the question between the lines is that if there is any connection between the rate of interest and foreign capital inflows and capital inflows causes to exchange rate appreciation ñ as many theoretical models propose ñ then what will response of current account balance and domestic prices to an increase in the value of domestic currency? Moreover, in this context, the absorption of the foreign capital inflows also significantly matters.
Despite access to foreign funds in general and foreign direct investment (FDI) in particular have helped to finance economic development and encouraged positive growth externalities - as increased in efficiency and a better allocation of resources, and associated transfer of technology ñ the abrupt improvement of the process of integration of emerging market countries with international capital markets has brought problems for the host economies. Some researchers have analyzed that capital inflows create some difficulties for the recipient countries in the form of real appreciation of their currencies. These difficulties include loss of competitiveness by exporters, spending boom, asset market bubbles, banking crises and the undermining of a strategy to achieve monetary stability by pegging the exchange rate.
Efforts to maintain domestic currency value definitely imply that the central bank must intervene by absorbing the foreign exchange brought in by the capital inflows. However, such purchases increase the monetary base, generating inflationary dynamics. Capital inflows also may lead to the expansion of bank deposits and loans. Moreover, the expansion of bank balance sheets owing to capital inflows may deteriorate the fragility of the banking system if bank supervision is not fully effective.
Theoretically, the forces driving capital inflows, although they differ country to country, can be classified into three clusters: first, an exogenous increase in the domestic productivity of capital, second, an autonomous increase in the domestic money demand function and, third, external factors, such as a reduction in international interest rates. The former two are known as "pull" factors and the latter one is called "push" factors.
Practically, there are the five significant sources of capital inflows in developing countries like Pakistan. These are (1) home remittance, (2) foreign direct investment, (3) foreign portfolio inflows, (4) privatization to non-residents, and (5) foreign assists. Table 2 provides an inclusive look on profile of capital inflows via different channels and percentage changes in Pakistan over the period of 1998 to 2007.
TABLE 2: PROFILE OF FOREIGN CAPITAL INFLOWS AND PERCENTAGE CHANGES
Total Foreign Investmentb
Foreign Direct Investmentb
Foreign Portfolio Investmentsb
External Debt and Liabilitiesa
Foreign Exchange Reservesa
'a' the estimates are in billion U.S dollars and 'b' the estimates are in million U.S. dollars.
The table shows a rapid growth almost in all the sources of capital inflows, in particular, during the last three fiscal years. However, the growth seems much volatile, which implies inconsistency in capital flows. For example, the percentage change in total foreign investment during the year of 2004-05, 2005-06 and 2006-07 are 81.90, 167.54 and 87.90, respectively. Similarly, the annual growth in foreign portfolio investment is negative with a magnitude of -225.34 percent in 2003-04; however, it grows at the rate of 650.90 percent during the next year. It is interesting to note that the foreign reserves have grown with more pace during the period of 2000-01 to 2002-03, for the following years; however, this pace has significantly declined.
Table 3 presents the percentage change in different sources of capital inflows from 1990-00 to 2006-07. The total foreign capital flows has risen by 71.38 percent over the last seven fiscal years. Foreign portfolio investment has appeared as the most significant contributor of capital inflows in Pakistan, which has increased by 4400 percent from the fiscal year 1990-00 to the fiscal year 2006-07.
TABLE 3: THE PERCENTAGE CHANGE IN CAPITAL INFLOWS FROM 1990-00 TO 2006-07
Total Foreign Investment
Foreign Direct Investment
Foreign Portfolio Investment
External Debt and Liabilities
Foreign Exchange Reserves
To shed the light on the links between capital inflows and the real and monetary sectors of the economy, the trends of some selected economic indicators are given in Table 4. As percentage of GDP, the estimates on national savings do not show a significant upward trend and remain steady between a narrow rang of 16.5 ñ 20.8. On the contrary, inflation rate and weighted average lending rate both have an increasing trend and this upward trend got further heat during the last three fiscal years. Similarly, the volume of credit to private sector has increased during the examined period. It was only 103.0 billion dollar in 1998-99, which rose to 356.3 in 2006-07.
The stock market index namely KSE-100 has also increased significantly during the examined period. The current account balance as percentage of GDP has improved during the period of 1998-99 to 2002-03, after reaching at its maximum level in 2002-03, it again started declining and fell to -4.9 percent of GDP in 2006-07. Table 4 also shows that public debt was 100.4 and 94.8 percent of GDP in 1998-99 and 1999-00 respectively. However, it fell to 55.2 percent in 2006-07.
Finally, the growth rate in real GDP have risen from 1.8 percent in 2000-01 to 7.5 percent in 2003-04, further rose to 9.0 percent in the next year, dropping to 6.6 percent in fiscal year 2005-06 and then again rising 7.0 in 2006-07. The facts presented in Table 3 to 4 provide preliminary evidence on the interaction between capital inflows, interest rate, monetary expansion and inflation rate in Pakistan.
TABLE 4: SELECTED ECONOMIC INDICATORS (FY1999 TO FY2007)
Real GDP Growth
National Saving ( % of GDP)
Fiscal Deficit (% of GDP)
Credit to Private Sectora
Public Debt (% of GDP)
Weighted Avg. Lending Rate
Current Balance (% of GDP)
KSE-100 Index (1991=100)
'a' the estimates are in billion U.S dollars. Source: Ministry of Finance
Monthly data over the span from 1991 to 2007 is used. The variable are market interest rate (MMR), nominal exchange rate (NER), Manufacturing Production Index (MPI), consumer price index (CPI), the ratio of foreign reserves to GDP ratio (FRR), the ratio of net foreign assets to GDP (FAR), the ratio of abroad money supply to GDP (MSR), the ratio of capital account to GDP (CAR) and the log value domestic credit growth (LDC).
The descriptive statistics for the ratio variables and the log form variables are presented in Table 5 and Table 6, respectively. Table 6 shows that the mean values of the capital account to GDP ratio and the net foreign assets to GDP ratio are almost the same during the period of 1990 to 2007. The monthly average value of the ratio of foreign reserves to GDP is only 0.001, whereas, the mean value of the ratio of money supply to GDP ratio is highest, with the magnitude of 0.414, as compared to the remaining three ratios.
Regarding volatility, the estimates on standard deviation indicate that the ratio of net foreign assets to GDP is modestly volatile relative to the others ratios. In contrast to this, standard deviation of the ratio of foreign reserves to GDP is lowest implying that it is least volatile among the examined ratios.
TABLE 5: DESCRIPTIVE STATISTICS FOR RATIO FORM VARIABLES (JAN. 1990 TO DEC. 2008)
TABLE 6: DESCRIPTIVE STATISTICS FOR LOG FORM VARIABLES (JAN. 1990 TO DEC. 2007)
Table 6 shows the descriptive statistics for the log value of consumer price index, the log value of manufacturing index, the log value of money market rate, the log value of real effective exchange rate and the log value of nominal exchange rate. As can be observed from the table, the consumer price index and manufacturing output index have the same degree of volatility.
We divide the full-sample period into two sub-sample periods. The first sub-sample period ranging from January 1990 to December 2000 and the send sub-sample spans from January 2001 to December 2007. As the core objective of the analysis is to quantify the affect of capital inflows on interest rate, exchange rate and inflation level, this division seems rational because a large capital surge arrived during 2001 to 2007.† The correlation matrixes for first and second sub-periods are presented in Table 7 and Table 8, respectively.
TABLE 7: CORRELATION COEFFICIENTS OVER THE PERIOD JANUARY 1990 TO DECEMBER 2000
LOG FORM FIRST-DIFFERENCE SERIES
* Bold values indicate that the correlation is significant at the 0.05 level.
Table 7 and 8 provide some fascinating information about the relationship among the variable during both the sub-periods. The relationship has been changed dramatically during the massive capital surge episode in 2001-2007. For instance, the ratio of money supply to GDP is only significantly correlated, it is also interesting to note that the magnitude is negative, with capital account ratio to GDP during the period from 1990 to 2000 when the capital inflows was stumpy and inconsistence.
TABLE 8: CORRELATION COEFFICIENTS OVER THE PERIOD JANUARY 2001 TO DECEMBER 2007
LOG FORM FIRST-DIFFERENCE SERIES
* Bold values indicate that the correlation is significant at the 0.05 level.
During the period of large capital inflows from 2001 to 2007, however, not only the magnitude of correlation between the ratio of money supply to GDP and the net foreign assets to GDP and foreign reserves to GDP ratios has considerably improved but also appeared statistically significant. It implies that after 2001, the foreign capital inflows have played a significant role in expanding the monetary base of the economy.
The estimates of the correlation between the rate of inflation and the net capital inflows to GDP, the balance of capital account to GDP and the foreign reserves to GDP ratios provide another interesting insight about the association of capital inflows and inflationary pressures. The inflation rate is significant and positive correlated with the four ratios during the period of 2001-2007, whereas it was only significantly related with the capital account ratio to GDP over the period from 1990 to 2000.
Table 9 provides another offensive piece of evidence that is the change in domestic debt is approximately 50% correlated with the monetary base of the economy during the latter sub-period, though both were independent of each other in earlier periods. The coefficients of correlation are providing some evidence of the dynamic interactions between capital inflows and inflationary pressures: an issue that should be explored in more details.
In sum, we can conclude that foreign capital has been playing significant role in monetary expansion, particularly, during the period from 2001 to 2007. The findings therefore are of particular interest to Government and SBP. Our analysis suggests that there is a need to manage the capital inflows in such a way they should neither create an inflationary pressure in the economy nor fuel the exchange rate volatility. "Sterilization" may be an effective instrument to limit the impact of foreign capital inflows upon domestic monetary base. In addition, the SBP should put some restriction on credit to both government and private sector, especially on non-productive borrowing. The recent hike in discount rate by SBP seems a rationalized step in this context. The analysis may establish useful base for future empirical work in this field and suggests that researchers should also consider nonlinearity in modeling for inflationary dynamics (this study is based on another large study funded by PIDE, Islamabad).