Capital controls, implying restrictions on free movement of capital across national borders, have been in the news recently for two very different reasons.
Authorities in Cyprus have imposed capital controls on a wide range of transactions as a follow-up to the restructuring of its troubled banks. Large depositors are being made to pay for the bailout package.
The central idea is to prevent nervous depositors from exiting: there are limits on how much its citizens can withdraw in a single transaction during the day and how much can be taken out of the country.
While Cyprus’ experiment with capital controls will be closely watched for what it does to investors’ confidence, the subject has been in the news for very different reasons. They relate to macro-economic management of countries, especially their external sectors.
Of the two broad divisions of any country’s external economy — capital account and the current account — the former is more often subject to controls than the current account (transactions of a comparatively shorter period).
In India that certainly has been the case. The current account is for all practical purposes freed. Official policy has sought to liberalise capital account in stages, in tandem with certain well-defined macro-economic adjustments. The important point is that full capital account liberalisation has ceased to be a dogma even as capital transfers to a very large extent ($200,000 in a year) are freely allowed.
India’s stance has been at variance with global orthodoxy as preached by the International Monetary Fund (IMF), which, for nearly 70 years, has been the arbiter of external account policies. A strong advocate of capital account liberalisation, the IMF even tried in 1997 to include full convertibility among its mandates.
However, fairly recently (December 2012) the IMF has espoused a new “institutional view” in which it is willing to countenance the possibility of capital account controls doing good in certain countries under certain conditions. (Its long-term goal of full capital account liberalisation, however, remains and, for that reason, many think that the IMF approach is still considered to be faulty.)
But its new interpretation of controls is a big improvement and does not limit emerging economies from taking decisive action under certain conditions.
The IMF is willing to concede, for instance, that taxes on foreign purchases of debt or equity may limit destabilising currency appreciations. Restrictions on foreign bank lending might help stabilise the economy during crises. A whole body of literature has emerged on the subject of reining in cross-border flows. Suggestions have included a tax on forex transactions and short-term controls.
Belated but welcome
Though belated, the IMF seems to have learnt the right lessons from the less than satisfactory outcomes of capital account liberalisation in many countries. In the late 1990s, Malaysia, under Prime Minister Mahathir Mohammad, effectively challenged IMF’s prescriptions during the Asian crisis, when capital flight threatened to weaken Asian currencies and increase their foreign debt.
While the IMF advocated fiscal and monetary austerity to convince foreign investors to stay on, Malaysia took a different course and imposed heavy restrictions on foreign currency transactions.
Capital controls ensured that the Malaysian Ringitt was not threatened by speculative forces from abroad. In Argentina and many other countries, too, the experiences with full convertibility had been mixed.
The Indian model
Since the 1990s, a fast liberalising India has had much to teach others in external sector management. Its policy of ‘a managed float’ for the rupee built around well-calibrated controls has been cited as a model in many countries and has certainly stood it in good stead.
The IMF sees the wisdom of India and many developing countries which are the recipients of volatile flows, to avoid the worst effects of sudden surges and stops. Developed countries, the U.S., EU and recently Japan that are the source of excessive capital flows should pay more attention to the potentially negative spillover of the macro-economic policies.
Last but not the least, the IMF now recognises that capital flows carry risks, and that the liberation of capital flows before nations reach a certain threshold of financial and institutional development can accentuate those risks. That in a nutshell has been the considered view of India.