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— India, Indonesia, South Africa, Brazil, to name a few — have been battered in recent months as foreign investors have withdrawn capital in anticipation of a reversal of QE.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)
