Capital account liberalization is back on the table in India. In 1996, with spectacularly bad timing, the Tarapore committee recommended rapid opening of the capital account. The Asian crisis that erupted in 1997 halted that policy dead in its tracks. In 2006, with the Asian crisis a distant memory, the Reserve Bank of India revived the Tarapore committee. This time, the group’s report was more cautious, endorsing a gradual move towards a more open capital account. Another panel’s work, the Mistry committee report, has ratcheted up the debate this year by arguing that to give Mumbai a fighting chance of becoming an international financial centre, the capital account must be fully opened by the end of 2008.
Would India be putting the cart before the horse by plunging headlong into capital account liberalization? The financial system is still underdeveloped, the fiscal deficit remains high (around 7% of GDP) and the exchange rate is still managed (although, in recent weeks, the rupee has been allowed to appreciate significantly). Under such circumstances, when the economy is not equipped to handle a gush of capital flowing in or out, unbridled capital account opening in some emerging market economies has ended in tears.
Despite the risks, capital account liberalization could indeed prove to be a boon for India, but for a different set of reasons than the traditional ones associated with capital inflows. And, notwithstanding the recent complications with managing inflows, it is important to keep the big picture in mind—and reforms.
The traditional view is that opening up to inflows allows capital-poor developing countries to import capital, increase domestic investment and grow faster. The problem is that economists analysing macroeconomic data have found it difficult to detect the direct growth-enhancing benefits of foreign capital.
But a new paradigm has recently emerged in academic literature. The real benefits of financial globalization to an emerging market economy have less to do with the raw financing by foreign capital. Instead, the indirect “collateral” benefits associated with such capital are far more important. These benefits may be crucial for India’s development.
One of the key benefits is that openness to foreign capital catalyses financial market development. Foreign investment in the financial sector tends to enhance competition, raise efficiency, improve corporate governance standards and stimulate the development of new financial products. For instance, in India, even the limited entry of foreign banks has already given domestic banks a much-needed kick in the rear and forced them to improve on efficiency in order to compete and stay viable.
Liberalizing outflows has the salutary effect of giving domestic investors an opportunity to diversify their portfolios internationally. This means greater competition for domestic financial institutions, but also an opportunity to cultivate the financial savvy to offer products that would help their customers invest abroad.
Other indirect benefits associated with foreign capital include transfers of expertise—technological and managerial—from more advanced economies. When supported by liberal trade policies, foreign investment can help boost export growth. Foreign-invested firms also tend to have spillover effects in generating efficiency gains among domestic firms.
However, there is strident opposition in India to capital account opening. Some of it is based just on ideological opposition to foreign involvement. Dig deeper, though, and it turns out that much of the opposition comes from entrenched interests that view foreign-financed competition as an unwelcome intrusion that erodes the protection and privileges they have enjoyed for many years. Indeed, a “shock” like capital account opening is just the tonic to shake up the system and thwart coalitions that try to block reforms.
So, why the rush towards a fully open capital account? What is so special about the end-of-2008 date or, for that matter, any specific date? In short, nothing. But deadlines do have a way of focusing the mind. A policy commitment to fully open the capital account in a couple of years would give domestic firms time to adjust to the new landscape but force them to get to work immediately on restructuring themselves. It would give less room for reactionary forces to coalesce and block reforms. It would force policymakers to push forward with reforms such as deficit reduction and increased currency flexibility. Moreover, the historically high level of foreign exchange reserves (about $200 billion) and the benign international environment provide a window of opportunity to undertake capital account liberalization with fewer risks.
For an emerging market economy, the process of opening the capital account requires a delicate balance between its benefits and the risks of disruptions to growth if things go wrong. For the Indian economy, which has made great strides in recent years, the balance has shifted—the risks are now smaller and well worth taking to embrace financial globalization and push growth higher.