Taking a leaf from Brazil and Indonesia, many in India have begun to advocate controls to stem the tide of capital inflows. But this policy prescription is too premature for India, whose distinctive capital account openness sets it apart from most other emerging markets. This feature allows India many more policy options. In conjunction with the current business cycle dynamics, capital controls would be a low-probability scenario.
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To start with, India’s financial markets are not all that open when compared with most Asian and Latin American markets. Its capital account liberalization strategy—the cautious opening of financial markets while ensuring risk management systems and competencies are in place, to ensure the system’s resilience to shocks—sets it apart in the extent of financial openness.
Existing controls also safeguard India from some types of capital inflows. The underlying logic of liberalization—that capital inflows in excess of the domestic absorptive capacity can lead to overheating in the economy and create asset price bubbles; abrupt reversals of short-term debt inflows, in particular, can be detrimental to the real economy —discriminates against debt flows. Foreign participation in the local government bond market is capped, and Indian companies can borrow abroad above a minimum maturity and below a maximum interest cost (limits vary per economic sector, depending on perceived needs). These controls limit interest rate differential-driven carry trade spillovers, quite unlike Brazil where the debt market is the key concern. And having never been completely dismantled they allow the calibration of debt flows in consonance with evolving macroeconomic features and situation.
The differences in the macroeconomic backdrop and the build-up of foreign capital from the earlier boom of 2006-07 can help explain why capital account restrictions would be unlikely. The comparison throws up some empirical regularities, which are useful thresholds for the current surge; it illustrates the capacity of the economy and its markets to absorb and digest a certain level of sustained inward foreign capital.
The previous boom occurred at a cyclical peak with economic growth above potential, capacity constraints in many sectors, a current account deficit and significant overheating pressures. Amid this environment was a persistent build-up of short-term capital inflows: a monthly average of $1.2 billion from January 2006 to December 2007, accelerating above $4 billion towards the end of 2007 (see chart). And, spurred by strong demand conditions, resident borrowings abroad (ECBs) and direct foreign investments added to the boom.
In 2009, growth is below trend with spare capacity in the economy, demand is weak, and the current account is in deficit, mainly due to sharp price swings; the domestic cycle has turned, but there’s uncertainty. This improvement has so far attracted an average $3 billion each month from April to October—almost equal to the July to December 2007 peak—but direct foreign investments are declining, and ECBs that averaged $2 billion monthly in 2007 are yet to revive. But we know that access to global credit has eased, that the current account deficit widens when the country grows and that foreign capital inflows ease domestic financing constraints and lower the cost of capital.
Some existing safeguards and a different macroeconomic constellation provide latitude to the central bank in managing capital account pressures. What are the likely options?
Along with some nominal appreciation, the first-round response always has been to absorb through intervention. The Reserve Bank of India (RBI) can intervene in both spot, and—depending upon market conditions and persistence of inflows—forward markets. In the previous cycle it bought close to $12 billion forward in four months, October 2007 to January 2008, building up a cumulative forward position of $17 billion at the peak. But as the cycle turned in 2008, it unwound these positions (indisputably, with some profits), selling $12 billion alone, between September and December 2008.
Domestic monetary management, which is seriously confronted when a capital inflows boom coincides with overheating pressures, is likely to be less challenged at this point. RBI is fortunate as it can handily combine some exit measures with sterilization of liquidity spillovers of foreign currency purchases. Given that cash reserve requirements were slashed by 400 basis points from its peak of 9% in September 2008, RBI can kill two birds with this stone and reserve the use of market stabilization scheme bonds for some time to prevent accumulation of further debt.
Further, RBI has many option to cope with pressures on capital the account. It could, for instance, roll back the hikes in interest rates on non-resident deposits. Lower the all-in-cost ceiling for trade credits and lower funding cost ceilings for ECBs. The cap for ECB—revised annually—could well be retained $35 billion. The central bank could, once again, revoke overseas borrowings for the “development of integrated township”. If needed, it could even park these borrowings abroad and cap funds the bank can deposit under the liquidity adjustment facility. Finally, a supportive policy environment that emphasizes financial stability—unlike 2007, when the central bank was bitterly criticized for tightening existing regulations—also helps in this regard. And if push comes to shove, I guess a beginning will be made with the bad old participatory notes—outlawed in 2007, restored in October 2008…ban again in 2010?
Renu Kohli was, until recently, with IMF. Comments are welcome at email@example.com
Graphics by Sandeep Bhatnagar / Mint