N Chandra Mohan: U-turn on capital controls

Last Updated: Mon, Dec 24, 2012 19:40 hrs

The latest mid-2012-13 review of the Indian economy presented by Union Finance Minister P Chidambaram doesn’t mention imposing capital controls, since surging inflows of capital is not a clear and current danger to the economy. Net capital inflows were, in fact, lower during the first quarter of 2012-13 than the first quarter of 2011-12. They were slightly higher in 2011-12 as a whole but not adequate to finance the current account deficit – that widened to 4.2 per cent of the gross domestic product – which is the broadest measure of the imbalance in India’s trade in goods and services with the rest of the world.

Elsewhere in Asia, however, dynamic economies are fast gearing up for a “renewed flood of cash” – to borrow an expression from a recent article in the International Herald Tribune – as growth prospects in the most powerful economies in the world like the US and the European Union (EU) are uncertain. A couple of years ago, huge inflows from such economies headed for the buoyant emerging market economies where returns are higher, causing their currencies to appreciate against the US dollar. Worried policy makers in the Asian region are contemplating capital-control measures to deal with volatile inflows.

Speculative inflows flooding in and out of the system can destabilise the relative growth buoyancy of Asian and some emerging market economies. Such inflows are typically pro-cyclical — rising in good times and falling in bad times. A wave of liquidity is heading towards Asian economies as the US Federal Reserve continues with its programme to buy back long-term US Treasury securities. The European Central Bank, too, has plans to buyback bonds of troubled euro nations. With near-zero interest rates in the US and EU, this capital will flow to Asia and emerging economies where interest rates are higher.

Asia, of course, is no stranger to capital controls to curb volatile capital movements. During the 1997 currency crisis, Malaysia introduced controls on capital outflows to defend the ringgit from speculative attack. In 1995-96 and 2006-08, Thailand deployed unremunerated reserve requirements in which a certain percentage of inflows are placed with the central bank for a minimum period. In 2010, it also taxed foreign investments in government bonds. Last month, South Korea sought to limit foreign exchange debt held by banks. Hong Kong has introduced a 15 per cent tax on home purchases by outsiders.

The good news is that such measures are now considered a legitimate part of the policy toolkit to cope with the destabilising effect of surges and withdrawals of capital by none other than the International Monetary Fund (IMF). After being hostile to such measures, and even advocating capital account liberalisation as late as 1998, IMF’s ardour for pushing for a world where there is freer movement of capital across borders has been dampened by the global economic crisis of 2008-09. After a three-year review, it has now accepted institutionally* that controls or capital-flow measures can be useful in dealing with volatile capital flows.

IMF, however, warns that such measures should be “targeted, transparent, and generally, temporary”. The new view is that while capital flows have benefits like allowing emerging market economies with limited savings to attract financing for infrastructure projects, fostering the diversification of investment risk, promoting inter-temporal trade and so on — they also carry risks even for economies that have long remained open. The adoption of controls are useful, although they should not substitute for macroeconomic adjustment.

The U-turn on capital flow measures was prompted by experiences of Iceland and Latvia during the 2008-09 crisis. The former with limited international reserves successfully used control measures to manage currency outflows. IMF also takes note of research that establishes a negative association between capital controls that were in place before the crisis and output declines suffered during the crisis (the reference is to a detailed study of 200 crisis episodes in 90 countries during 1970-2007 in the Journal of International Economics by Poonam Gupta, Deepak Mishra and Ratna Sahay).

If emerging economies that used controls were among the least hit during 2008-09, there are certainly valuable lessons for India. True, it is not attracting the requisite level of net capital inflows at present. But the huge current account imbalances have increased the balance of payments’ vulnerability to “sudden stop” and reversal of capital, according to the mid-2012-13 review. It is vulnerable to sudden shifts in global investor sentiment, if and when its growth prospects improve and short-term capital surges in, as it did during 2007-08.

To cope with the ebbs and flows of capital – and the adverse impact they have on output growth – the first line of defence surely are capital controls, especially on debt flows, than relying on fast melting forex reserves. Not so long ago, these reserves fully covered the country’s stock of external debt. Not any more. Even if a Tobin-type tax is ruled out in view of its feasibility, there are various other innovative policy responses that must be fashioned, specific to India’s circumstances.

*“The liberalisation and management of capital flows – An institutional view”, IMF staff paper, November 2012
See also: “Capital inflows: the role of controls”, IMF Staff Position Note, Jonathan Ostry, Atish Ghosh, Karl Habermeier, Mahvash Qureshi and Dennis Reinhardt, February 19, 2010. “Liberalising capital flows and managing outflows”, prepared by IMF’s monetary and capital markets department, strategy, policy and review department, research department in consultation with the legal department, March 2012
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