Common sense on capital flows

As India’s external balances continue to flounder, the fact that the International Monetary Fund’s thinking on cross-border capital flows has slowly come in line with emerging countries is a cause for some comfort. In December 2012, the Fund, which has been the global arbiter of external account policies for the past 70 years, endorsed a new institutional view on capital account liberalisation and management of capital flows. While earlier it dogmatically espoused capital account liberalisation as the ultimate goal for all countries, it is now much more accommodative to contrarian views: it is prepared to concede that under certain conditions it would be adequate to regulate capital flows. Though subject to caveats, the new thinking, which will condition the IMF’s surveillance and reporting efforts, explicitly recognises a few scenarios that call for intervention by individual countries to protect their interests. For emerging markets whose financial institutions and markets are still not fully developed, unbridled capital flows carry greater risks. This is a view that the Indian policy establishment has for long supported. Way back in July 2006, the Tarapore Committee on capital account convertibility prescribed macroeconomic adjustments and market development as essential prerequisites before relaxing capital controls. More recently, India, Brazil and a number of developing countries have had to reckon with the worst effects of short-term capital flows surges and sudden reversals. At the same time, advanced economies like the U.S., the European Union and Japan need to be more aware of the harmful consequences of their ultra-soft monetary policies on emerging markets.

A striking feature of the IMF’s current view on capital flows is that it differs sharply from the ground rules governing several trade and investment treaties which generally do not allow regulation of cross-border finance. The old “one size fits all” approach has been discredited and each country can set its own time table for capital account liberalisation. The fact that the IMF has not given up on its eventual goal has come in for criticism, though it is certain that it has loosened its stance after learning from several countries in Asia and Latin America. Malaysia’s successful defiance of the then prevailing orthodoxy at the time of the Asian currency crisis in the late 1990s had demonstrated the value of controls in crisis management. When capital flight threatened to weaken several Asian currencies and swell their foreign currency debts, the IMF prescribed fiscal and monetary austerity to convince investors to stay put. Malaysia came out on top after taking a diametrically opposite course, imposing heavy restrictions on foreign exchange transactions and capital flows. For India, which has won kudos for its calibrated approach to capital account liberalisation, the new orthodoxy should strengthen its intellectual and political resolve to deal with its external sector problems in a manner best suited to its national conditions.