India's calibrated approach to rupee convertibility has stood the country in good stead
Should cross-border capital flows be restrained? Far from being an academic question, the idea of imposing controls on capital flows has been engaging policy makers in several emerging economies.
The debate over the need for such restraints has been there for a long time, at least since the fall of the fixed exchange rate system. It has gained a certain degree of urgency and topicality now. As the global economy comes out of the recession, large amounts of capital flows from the developed world are seeking investment avenues in the better performing emerging markets that, as a rule offer higher returns than in their home countries.
During the intense phase of recession, footloose capital sought the safety of their home countries. Ironical as it seems, the U.S., though being at the epicentre of the crisis, attracted plenty of capital as extreme risk aversion took hold. In times of extreme global uncertainty investors have traditionally sought the sanctuary of the dollar and the U.S. government paper. The recent crisis was no exception: safety considerations weighed far more than returns.
However, with recession lifting, risk aversion has reduced considerably and considerations of returns are back in the reckoning. India, Brazil and many other emerging markets have become the favoured destinations. For the recipient countries however that has not been an unmixed blessing. In India where the debt markets are not fully open to foreign investors, but equity markets are.
One of the visible consequences of the return of the FIIs has been the sharp rise in the benchmark indices. While other factors — strong and improving economic fundamentals, reasonable corporate performance and more recently, a budget without unpleasant surprises — have also boosted the share prices, it is the FIIs who have been the principal cause.
Huge fiscal costs
Inflows far in excess of the absorptive capacity of the economy pose macro economic challenges. On previous occasions marked by a ‘glut' of inflows, the RBI had intervened to check the rupee appreciation. The two stage process involved a mop up of dollars in the first instance and sterilising the rupees, flooding the system as a consequence of the central bank's purchase of dollars. There are huge fiscal costs. Reserves have accumulated to such high levels that the question of deploying them in more lucrative assets became a hot topic. Amidst such large additions to reserves, it was very often forgotten that India's incremental reserves have not been ‘earned' as has been the case in exports led-Chinese economic growth, FII flows are not stable. The RBI has for long been concerned over the possibility of these flows reversing. The fear is that the volatility in flows will not merely affect the stock markets but the broader economy as well.
On the related issue of according full convertibility of the rupee, India's calibrated approach has stood the country in good stead. Expert committees which had recommended full capital account convertibility over the medium-term had required certain well defined preconditions to be met. Almost all current account transactions are permitted without restrictions. Even capital transfers of very large amounts have already been allowed. There was never any convincing case to rush headlong into full convertibility of the rupee. After the recent crisis the RBI's gradualism stands vindicated.
In October 2009, Brazil imposed a 2 per cent tax on capital inflows. Large forex inflows had caused a sharp appreciation of the Real, the local currency. Domestic industry became uncompetitive and exporters suffered. Earlier, Chile had required foreign investors to keep a portion of the remittance in a deposit with its central bank. In the late 1990s, Malaysia under Prime Minister Mahathir Mohammed applied capital controls to defend a fixed exchange rate and came out relatively unscathed from the Asian currency crisis.
The IMF has for long been opposed to capital controls. In fact it has tried to both implicitly and explicitly tried to promote capital account liberalisation among member countries, it has argued that capital controls are expensive as they can cause distortions to resources allocation. Besides, they can be evaded. Surprisingly, the IMF has recently gone back on this staunch ideological belief. A recent paper published by a group of IMF economists says that controls are sometimes justified as part of the policy framework for an economy seeking to tackle surging inflows. The IMF study has found among others that the GDP fell less sharply during the financial crisis in countries that had put restraints on capital flows.
The IMF's new thinking on capital controls shows that it is adjusting to ground realities. In the past the IMF wanted countries facing surging inflows to let their currencies appreciate and accumulate reserves. As the experiences of India and many countries has shown that following the outcomes flowing from such policy prescriptions have not been beneficial and were in fact counter-productive.