Can domestic risk capital supplant foreign capital?
In my previous blog post, I described how and why the Indian financial system has quietly pivoted from relying on foreign risk capital to mobilizing domestic risk capital, reversing a dependence that goes back to the mid 1990s. This blog post moves on from there to discuss how much further this process of supplanting foreign capital can proceed, and if so, what would be the consequences of such a "decoupling".
As I stated in my last post, the pivot to domestic risk capital involved the creation of transparent capital markets, development of mutual funds and other institutional investors, channelling of retirement savings into equities, and the emergence of a new generation comfortable with equity investment. The factor that I did not mention earlier is the demographic dividend that India is enjoying currently. Demography is providing a significant net addition to the work force that boosts economic growth. Young entrants to the workforce also increase the savings pool. It appears to me that all these forces are there to stay, and there is little reason to believe that the pool of domestic risk capital would dry up in the years to come.
As regards foreign capital, it is prudent to prepare for a scenario of diminished inflow in coming years. The first reason for this scenario is that financial globalization probably peaked before the Global Financial Crisis of 2007-2008, and that it may at some point begin to retreat. In the last few years, we have seen a process of deglobalization in terms of cross border movement of goods and people. So far, there has not been much evidence of this process extending to services and to capital. But once countries begin to embrace autarky, restrictions on capital flows cannot be ruled out.
The second scenario is based on the proposition that even if capital flows are unimpeded, abundance of capital in India would cause the capital that was previously flowing into India to seek higher returns in other countries where risk capital is relatively more scarce. A historical parallel would illustrate this possibility: as English capital markets developed in the early nineteenth century, Dutch capital that used to flow into England in the eighteenth century was diverted to France where capital was more scarce. In other words, the very abundance of domestic capital tends to inflate valuations, reduce the returns to capital in India, and ultimately make the country less attractive to foreign investors.
While we cannot predict how the future will unfold, it is therefore quite possible that domestic capital might not just augment foreign capital but might (at least partly) supplant it. What would such a shift imply for India? The obvious macroeconomic consequence would be on the balance of payments; India might have to run a smaller current account deficit if there is a lower foreign capital inflow to finance it. This might be beneficial for the economy in the long run if it weakens the currency and makes the country more competitive in global markets (though the short term consequences might be somewhat less pleasant). But I am focused more on the financial implications than the macroeconomic ones.
What would a shift from foreign to domestic risk capital do to valuation and cost of capital? Theory suggests that foreign investors holding globally diversified portfolios would demand a lower rate of return on Indian stocks than a domestic investor investing only in the Indian market. This is because risks that are idiosyncratic to India get diversified away in a global portfolio. To take a topical example, the profitability of the Indian corporate sector would depend on how tariffs on India compare with that of its competitors. An Indian investor would worry about this risk, and would demand a risk premium for bearing this risk. For a global investor, this risk would matter very little as one country's loss would be another country's gain, and a portfolio spread across both countries would be largely unaffected. (A general rise in tariffs for all countries that reduces world trade and global economic growth would of course hurt the global investor also. But a redistribution of the same average global average tariff rate across different countries would not matter much.)
There is a lot of evidence that this diversification effect was significant till a few years back. First, companies found that attracting foreign institutions into their investor base reduced their cost of capital, and, therefore, many of them obtained shareholder approval for increasing the limit on foreign institutional shareholding from the default level of 24% to the regulatory sectoral cap of 74% or 100%. Several companies also listed in foreign stock markets to attract foreign investment. Second, the steady increase in foreign shareholding of Indian companies during the first two decades of this century could also be interpreted as foreign investors being willing to pay a higher price than domestic investors.
In the last few years however, the situation appears to have reversed with many foreign investors finding the Indian market overvalued. In the last couple of years, significant selling by foreign investors has been absorbed by domestic buyers without a major impact on stock prices. Either Indian investors are more optimistic than foreigners about the prospects of Indian companies, or they are demanding a lower rate of return on their investment. The latter would be contrary to the theoretical expectation that it is the globally diversified foreign investors who should demand a lower rate of return.
One possibility is that foreign investors are more nervous about certain risks than domestic investors. This does happen in the context of domestic political risks, but is unusual in a situation like the present where global geopolitical risks are dominant. It is of course possible that investors from historically highly globalized countries find the risks of deglobalization more terrifying than those from more insular countries. But I do not find this argument very compelling because of the robust foreign investment flows to emerging markets as a whole.
The intriguing possibility is that demographic factors are creating an inflow of funds into equities that is large enough to induce elevated valuations (and consequently depressed expected future returns). The obvious solution to this would be to encourage Indian investors to invest outside India. The historical experience that I alluded to in my previous post suggest that countries that build large pools of domestic risk capital tend to move to the next stage of exporting this capital. This would enable investors to earn a better risk adjusted return on their savings, and would also avoid a misallocation of capital arising from a depressed cost of capital.
I think the time has come for Indian financial markets and policy makers to prepare for a potential scenario in which India is simultaneously importing and exporting capital. The imported capital would provide Indian companies with a globally diversified shareholder base, while the capital export would provide Indian investors with the superior risk-return opportunities arising from globally diversified portfolios. This is a scenario in which Indian financial markets begin to finance investments in other countries with less developed capital markets (either in the neighbouring region or across the world).
Posted at 10:12 pm IST on Sat, 31 Jan 2026 permanent link
Categories: equity markets, Indian financial sector, international finance
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