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The Economist had two interesting articles last week about capital flows in India. The Indian government is currently confronted with the a challenge of nurturing the growth of India's financial markets and multinationals, while mitigating the risks of excessive "hot money" flowing into the economy.

Proponents of capital controls point to India's success in avoiding the worst of the Asian financial crisis in the late 1990s and the current crisis, which was in part achieved by limiting the amount of money flowing in and out of the economy (for example, foreigners are limited in the amount of local bonds they can purchase).

Yet, India remains a sponge for foreign capital. The Economist notes that foreigners have invested $13.8 bn in India’s stock markets since April, having withdrawn $8.6 billion over the same period last year. The Sensex, India’s most widely watched stock market index, has surged by almost 100% since its March lows.

Advocates of a stricter capital controls are facing a strong resistance from the market...

India is steadily becoming more financially stitched in to the rest of the world. Its foreign assets and liabilities add up to over 60% of GDP. In the 1990s that ratio was only about 40%. It has risen partly because India’s own companies are eager to acquire foreign firms. In March 2009 India’s stock of direct investment abroad was worth over $67 billion, more than twice the figure in March 2007.

A 2007 report commissioned by the government to assess Mumbai’s prospects of becoming an international financial centre argued that India has a comparative advantage in financial services, like the one it has in information technology. India, after all, has a common-law legal tradition and a stockmarket that is 130 years old. Many bankers working in London, Dubai and Singapore have their roots in India.

...and from India's growing corporate champions:

As more big Indian firms become multinational companies, it will be harder for politicians to resist the demands for a freer flow of finance. “It’s one thing for India to impose restrictions upon foreign multinationals like Enron or IBM,” says Ajay Shah of the National Institute of Public Finance and Policy, “but it’s harder for the Indian government to hobble its own multinationals. I think this is a qualitative change.” Indian companies are too ambitious to confine themselves to their borders. Likewise, India itself is too big a prize for foreign capitalists to ignore. Money has a way of finding opportunity.

Furthermore, it is unclear whether additional capital controls would have much of an effect on curbing of inflows. Brazil's recent introduction of a 2 percent tax on certain capital flows is unlikely to tame the Bovespa's animal spirits (it is beginning to claw back much of its initial losses from the announcement) and the rise of the real. Moreover, Brazil's measures have attracted a range of international criticism, including from the IMF.

As growth lags in the US, Europe and Japan, investors will continue to seek higher returns elsewhere. The impressive recovery of India and Brazil will only add to their attractiveness as alternative, high-yield, investment destinations (Brazil's credit rating was recently elevated to investment grade. The World Bank no longer considers India a low-income country).

By attempting to limit capital controls, while simultaneously using their place in a globalized economy as a trojan horse for growth, emerging markets are faced with the challenge of wanting to have their cake and eating it too. As Brazil's experience is proving thus far, this is going to be a very difficult task.

Source: The Double-Edged Sword of Emerging Market Growth