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Updated: September 11, 2013 00:20 IST

Easing troubles in the long run

T. T. Ram Mohan
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The Hindu

While assuaging the fears of foreign investors, the government must also consider capital controls to weather the gradual withdrawal of stimulus measures by advanced economies

India’s policymakers have been at pains to assure foreign investors that there will be no return to capital controls. This followed a lowering of the annual limit on foreign remittances of Indian nationals from $200,000 to $75,000. The move is said to have triggered a rush of outflows on the part of foreign investors fearful that their own investments too might soon be subject to capital controls.

These assurances might make sense in the present turbulent conditions where it is necessary not to further rattle foreign investors already upset by the steep depreciation in the rupee in recent months. On a longer view, however, capital controls may not be as unthinkable or reactionary as they are now thought to be. The pendulum in both academic and policymaking circles appears to be swinging further away from a whole-hearted embrace of financial globalisation. This swing is the result of the convulsions caused by the impending reversal of quantitative easing (QE) in the United States.

Battered currencies

The currencies of several emerging markets — India, Indonesia, South Africa, Brazil, to name a few — have been battered in recent months as foreign investors have withdrawn capital in anticipation of a reversal of QE. Under QE, which the U.S. Federal Reserve commenced in response to the financial crisis of 2007, the Fed starting buying up long-maturity bonds in order to keep long-term interest rates low. We are now into the third round of QE.

In the current round, the Fed has been buying up $85 billion of bonds every month or over a trillion dollars in a year. These purchases expand the flood of dollars in the U.S. market. Since not all of it can be absorbed within the U.S., a big chunk spills into other countries, including emerging markets. The flood of dollars has helped finance low-cost investment in the emerging markets and led to appreciation in their currencies. A reversal of QE spells a flight of funds and a steep fall in currencies.

At St Petersburg, emerging market leaders made a strong plea for calibrating the winding down of monetary stimulus in the advanced economies so as to take into account the impact on emerging markets. Leaders of the advanced world stopped short of giving such categorical assurances. Instead, they urged emerging markets to put their houses in order by pushing through badly needed structural reforms.

Some commentators have pointed out that it may be illegal for central banks in advanced economies to be guided by considerations other than those of their domestic economies. The best that emerging markets can hope for is that conditions in the advanced economies may themselves warrant a gradual withdrawal of monetary stimulus and, perhaps, a delay in the withdrawal. The U.S. Fed is expected to make its stance more clear on September 18.

Tapering of stimulus

The Fed will start withdrawing the stimulus when it becomes clear that economic growth is stronger. The unemployment rate target is 6.5 per cent but the trigger for a tapering, the Fed has indicated, could be an unemployment rate “in the vicinity of 7 per cent”. The August jobs data for the U.S. shows a fall in the unemployment rate to 7 per cent. So, some analysts believe the Fed will withdraw the stimulus right away. That would be bad news for emerging markets. Others believe that the Fed wants the interest rate to remain low until 2016. This would imply that any tapering of the stimulus would be very gradual. That would be excellent news for emerging markets. We should know later this month.

There are two issues that are relevant to India. First, how do we deal with the inevitable tapering in the immediate present? Secondly, how do emerging markets in general cope with the flows and ebbs in money supply emanating from the advanced world?

In respect of the first, we have seen a flurry of activity. On assuming office, RBI Governor Raghuram Rajan announced a concessional window for hedging the foreign currency risk for banks bringing in NRI deposits in dollars. This move is estimated to bring in about $5 billion-$8 billion over the next six months. Earlier, the RBI had announced that it was opening a swap window to sell dollars to oil marketing companies. This is expected to ease the demand for dollars in the market and hence the downward pressure on the rupee.

Further, at the G-20 summit, India and Japan agreed to enhance their bilateral currency swap agreement from $15 billion to $50 billion. This, in effect, enhances India’s forex reserves in the event of a major flight of funds. Again, at the G-20 summit, the BRICS countries announced the creation of a $100 billion fund to fight currency shocks. China will contribute $41 billion, with Russia, India and Brazil each adding $18 billion and South Africa providing $5 billion. These announcements have already led to an appreciation in the rupee in recent days.

Fund exodus

So far, so prudent. The crucial question is: will these measures be adequate to deal with a massive exodus of funds? That depends on just how massive the exodus will turn out to be. FII investments in debt in India stood at $28 billion on September 6; those in equity at $137 billion. Since the end of May, when the Fed announced its plans to taper QE, we have had an exit of $9 billion in debt but only $3 billion in equity. This does indicate that it is debt investments that will be primarily in jeopardy once the Fed commences its tapering. These are clearly of a magnitude that India can deal with.

Some commentators have argued that we are in for a repeat of the East Asian crisis of 1997 and that India cannot escape mauling this time. Such pessimism is misplaced for several reasons. First, the flight of funds in 1997 was primarily on account of loans made by foreign banks and domestic residents taking their savings abroad. FII outflows were a relatively small factor in the flight. Secondly, banks in East Asia were vulnerable because they had borrowed from abroad to finance a domestic property boom. This is not true today of India or, for that matter, the East Asian economies.

Thirdly, East Asian economies learnt that the way to deal with the ‘impossible trinity’ in an open economy — an independent monetary policy, free flows of capital and fixed exchange rates — is to let go of exchange rates. Floating exchange rates provide a natural corrective to volatile flows. Lastly, foreign exchange reserves in East Asia as well as India are at a higher level than in 1997 relative to imports.

1997 crisis

One other lesson from the crisis of 1997 was that it makes sense for emerging economies to go slow on full capital account convertibility. India and China both won plaudits for having done so. The IMF, which had forcefully advocated full convertibility until then, has undergone a significant conversion since.

Is that all there is to coping with volatile capital flows? Alas, the financial crisis of 2007 has brought fresh revelations. At a conference at Jackson Hole in the U.S. last month, a professor at London Business School, Helene Rey, argued that, given the present scale of financial globalisation, even floating exchange rates may not offer emerging markets adequate protection.

Monetary policy in these economies will be at the mercy of the policies of central banks in the main centres of global finance. What emerging markets face is not so much the classical ‘trilemma’ posed by the ‘impossible trinity’ but a dilemma: to have an independent monetary policy or free capital flows. They cannot have both.

Rey thinks it unrealistic to expect central banks of advanced economies to do much to prevent spillovers of their monetary policies to the rest of the world. That leaves emerging markets with three options. One, curb the expansion of credit at a time when money comes flooding in. Two, impose limits on the leverage of financial intermediaries. These two measures fall within the category of ‘macro-prudential measures’. However, macro-prudential measures are not easily put in place or in time. There may be no escape, therefore, from the third option, namely, imposing capital controls. The challenge for policymakers in emerging markets in the years to come may well be to focus on a set of capital controls that will work, at least for short periods.

(The author is a professor at IIM, Ahmedabad. ttr@iimahd.ernet.in)

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While the article should be lauded for the analysis, it falls short of providing a viable solution or alternative. The ending or conclusion of the article seemed like the author was in hurry to finish the article.

from:  Srikanth
Posted on: Sep 14, 2013 at 13:33 IST

As Suvojit Dutta has observed below, the decline in Indian Rupee's value is a
symptom of the underlying policy problems of the country which can only be
addressed by systematic, thoughtful and resolute application of sound policies to
promote growth and economic productivity. Capital controls at this stage of India's
opening can only compound the problems. As India and our citizens join the world,
there will be ups and downs but we must be firm in our resolve to go forward and
not backwards in fixing our economic problems and thereby lifting our masses. We
know from our past that slogans like Garibi Hatao do little except to divert our
attention from the task ahead.
India has a huge population, if we were to create an economy where most of our
people had productive employment, India will have a powerful currency, just like
China's. It may take 50 more years but let us stick to the right track and not look for
easy outs. What we need above all is sound governance.

from:  Virendra Gupta
Posted on: Sep 11, 2013 at 22:36 IST

Emerging from World War II, the Bretton Woods system strictly
regulated capital mobility. This ensured a long period of stability
for the entire world. As nations states prospered they broke the
Bretton Woods compact one by one. Greed it appears knows no bounds.
America finally had no recourse but to take the US dollar off the
gold standard because the Germans refused to devalue the Deutsch mark
to account for the depreciation of the dollar due to America's
vanishing gold reserves. The developing world especially needs to
impose strict limits on the mobility of capital that enters and
leaves the country. Allowing the free flow of Capital across nation
states benefits no one except speculators on Wall Street and
elsewhere. It is time we stopped playing the game that financial
speculators have foisted on us.

from:  Anand Richard
Posted on: Sep 11, 2013 at 22:25 IST

It is surprising that 40 years of misery after independence has still not convinced
people that controls are not the best solution for the economy. Untold millions are
born and they will die in poverty due to lost opportunity if we continue to espouse
these kind of arguments. Need of the hour is to nuture high growth rates combined
with redistributive policies.

from:  enjay
Posted on: Sep 11, 2013 at 17:48 IST

We are needlessly worried over the sudden exodus of the FIIs from Indian stock market. All that is taken to be FII money in Indian stock market is not really, in my view, owned by foreigners. It is reported that $137 billion of FII money is currently in portfolio investment. FIIs own 74 % of shares of HDFC . A little calculation shows that, while, from Sept. 2008 to Sept. 2013, investment in HDFC has given, in INR , a CAGR of 9.9 % but, in USD, the CAGR is, due to depreciation of the INR, a paltry 2.3%. A similar situation applies also to other stocks which have high FII holdings. Then, why are FIIs not pulling out their entire investment and take it to more profitable markets? The answer is simple. A good, if not most, part of the so-called FII money is really black money stashed away in foreign banks by Indian nationals and have now made a ‘round-trip’ to India in the garb of FII investment. It is stuck here because it has nowhere else to go!

from:  V Nagarajan
Posted on: Sep 11, 2013 at 17:02 IST

Malaysia was able to manage capital controls through the Asian crisis because of its
current account surplus. India cannot do so as it is dependent on foreign capital to
finance the savings-investment gap. Not at all advisable to contemplate such control
on foreign capital outflows, as it will freeze fresh inflows. A floating currency such as
the rupee should be left to bring about the necessary balance of payment
adjustments through depreciation, eventually providing a floor, stabilising flows and
facilitating lower rates and higher growth. In the long term India should focus on
growing its exports to reduce deficit. Controlling foreign capital inflows at entry,
counter cyclically in times of feast not famine, is a better option as was contemplated
by Brazil last year. Current market dislocation is largely due to absence of fresh financing for the deficit. Gold imports should be controlled. Not foreign capital outflows. Unfortunately, high twin deficits will extract a price.

from:  k chandra
Posted on: Sep 11, 2013 at 15:25 IST

A very brilliant and elaborative article. Though indian economy is in a deep crisis, which does mean it would not overcome or does not have potential to overcome this rough patch. The slew of measures taken by the government and RBI has begun to show encouraging outcomes. The need of the hour is to reduce the burden of import or pol, incrase export and undertake pending structural reform.

from:  Gopendra Dwivedi
Posted on: Sep 11, 2013 at 11:32 IST

I am surprised the author advocated capital control instead of
earnestly addressing India's structural problems that would genuinely
alleviate CAD and BoP issue as the long term solution. India's
manufacturing export is miniscule in the global market, it imports
huge amount of manufactured goods from China that are low-tech and no
reason cannot be produced cost effectively within India. India imports
coal and iron ore when we have both in abundance within the country.
If India can address its domestic supply constraints by improving
infrastructure, making conducive environment for manufacturing and
removing onerous labour laws that discourage hiring of workers or
expand economic of scale by increased production capacity. Today's
financial problem is mainly India's own making, fall in rupee value is
the symptom. If India can take care of its structural reform issues
the rupee will appreciate on its own and foreign investors will be
eager to keep money invested in India for the long term

from:  Suvojit Dutta
Posted on: Sep 11, 2013 at 06:13 IST
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