A recent decision by the Brazilian government to impose a 2 per cent tax on all foreign exchange inflows has revived interest on a subject, very mention of which has been considered retrograde and impractical in some quarters in India.
The subject broadly covers capital controls, which connote a restraint on inflows of foreign portfolio money rather than an outright ban. What is sought to be curbed is the huge influx of short-term capital that can flit in and out of countries at short notice. Their size can be huge.
In many cases, they represent money borrowed in countries such as Japan having low interest rates. These ‘carry trades’, as they are called, have been one of the biggest threats to macro economic management in many countries.
Quite recently, the historically low interest rates in the U.S. have also fuelled such trades. Emerging markets such as Brazil and India have started attracting once again foreign portfolio managers, who are attracted by the higher returns they offer.
At the height of the financial crisis these funds fled India and other countries. Driven by extreme risk aversion they chose the safety of the U.S. and dollar denominated assets.
As the global crisis slowly lifts these emerging markets are once again proving to be attractive. But their presence in these countries has not been an unmixed blessing. Generally there is no objection to other forms of capital inflows.
Foreign direct investment (FDI) is particularly welcomed, especially when it goes into greenfield ventures. The recipient country benefits in a number of ways, including employment generation, technology transfer and so on. However, in India there are sectoral caps, which do restrict FDI in specific sectors.
In India, the issue is also tied to capital account convertibility or full convertibility of the rupee. India has achieved convertibility on current account. There has also been a substantial liberalisation on capital account. But full convertibility is to be achieved only after several important signposts such as fiscal consolidation are reached.
This calibrated approach has served India well. The Indian economy has been resilient in the face of the global crisis.
Capital controls are of different types. It can be on the basis of price as in the case of Brazil’s new tax. It can be in the form of ceilings or quotas. In India, there is a ceiling on foreign investment in debt instruments including government paper but none at all in the equity market.
Brazil’s chief concern is the debt market, although the tax covers investment in equities too.
Foreign inflows in large quantities may pose problems for interest rate management apart from currency appreciation.
Brazil like India has been receiving plenty of foreign capital. An immediate consequence has been an appreciation of its home currency, the real.
Since the beginning of the year until the third week of October it had appreciated by 36 per cent against the dollar. Brazil’s export competitiveness has suffered in much the same way India’s has in the wake of the rupee appreciation. The rupee is now worth 47 to a dollar up from the above 50 levels last year.
India and Brazil have another important feature in common. Both are considerably less dependent on exports than China or Japan for their growth.
Both have a large middle-class, whose purchasing power has grown hand in hand with the size of the market. For overseas investors the large number of potential consumers is a big attraction.
But is it feasible to restrict portfolio investors in India, Brazil style? There has to be a more nuanced debate on the role of foreign institutional investors.
Broadly speaking, there are two diametrically opposite views of their role in the external economy.
On the one hand, there have been many investors in Indian stocks. But so disproportionate has been the size of their investments — both in relation to domestic institutions and the desirable investors — that their actions have caused huge swings in the stock markets.
Too much liquidity flowing in from abroad has fuelled a bubble in stock prices. Up to September this year FII investment was $68.75 billion in net terms.
During the same period last year they sold nearly $12 billion of stocks. The market’s sharp decline last year and its spectacular rally this year are a direct consequence.
However, it may be impractical to stop FII flows altogether. One has to look at the macro economic picture. India is one of the few emerging economies with both a current account deficit and a large fiscal deficit.
Foreign capital flows have been one of the main props to the country’s balance of payments. But the debate on whether portfolio capital should be reined in must go on. There would be plenty of learning experiences from Brazil.