Foreign capital inflows into India have resumed of late. The three-month moving average of net foreign portfolio investments has moved steadily from $1.7 billion in May to $2.3 and $2.5 billion in June-July. Near-term prospects appear even brighter as a liquidity glut and a resurgent risk appetite come together once again to flood emerging markets—India, being the second fastest growing economy at this point, is exceptionally poised as the host. And after nine months of supporting the rupee, the Reserve Bank of India (RBI) is back in the business of purchasing foreign currency. These developments revive the hard issues of well-sequenced capital account liberalization, rupee appreciation and the real economy. The good thing is that we now have a boom-bust cycle to illuminate public policy.
Illustration: Jayachandran / Mint
In recent years, the pace, timing and sequencing of capital account opening in consonance with domestic and global macroeconomic conditions had become old orthodoxy; replaced, as it were, by the new paradigm of financial market development with a central role for an open capital account. Caution, or calibration of capital account liberalization with the blowing winds, head or tail, came to be regarded as impeding financial market development. In hindsight, we now know, or at least ought to know, that much of the deluge of foreign capital in 2006-07 was cyclical and short-term, driven by a global liquidity-interest differential-strengthening currency combination, and that both residents and non-residents arbitraged in “carry trades”, through whatever channels they could.
The capital inflows’ boom in 2006-07 coincided with extensive liberalization of foreign debt inflows—well understood to be pro-cyclical, unstable and risky, unlike foreign direct investment (FDI) and portfolio equity flows that by nature involve risk-sharing between foreign investors and their host countries. Capital account liberalization was thus of the stand-alone variety—devoid of any financial-real sector linkages; positive shocks were amplified and the exchange rate-inflation-trade linkages were ill-analysed, if at all. With gross domestic product growth above trend, rising money supply, unprecedented credit growth, booming asset prices and eventually rising inflation, the pro-cyclical liberalization exacerbated real appreciation pressures, destabilized monetary conditions and caused needless volatility.
When the cycle reversed in September 2008 with the sudden, en bloc exit of foreign portfolio investors, capital account liberalization continued, albeit counter- cyclically. Foreign investment limits in corporate debt were hurriedly raised (to little effect, by the way, as they go with the cycle); overseas loans by residents, restricted since August 2007, were reversed and portfolio equity investments through issue of participatory notes to overseas clients, banned in 2007, were restored. Liberalization was then a crisis response, aimed at retaining and attracting foreign capital to alleviate the domestic liquidity crunch and support the exchange rate. During this period, the exchange rate depreciated 15% in three months, reserve money growth shrank by 50% in a month, the current account deficit widened, inflation sank into negative territory and output fell steeply with a sharp and prolonged contraction in exports.
So India liberalized during the boom and through the bust. While we can all have a good laugh at the dogmatic liberalizer who opened the gates when there was a flood and opened them further during a drought to display commitment to financial reforms, there are public policy issues in this sequence of events that need to be debated and resolved, so as to avoid the dangerous dissociation of financial liberalization with the real economy.
The first is the objective of capital account liberalization —growth or financial market development? This is like the chicken and egg problem, so unravelling it is slightly tricky—we need an open capital account for higher economic growth, but the financial openness-growth link is through financial market development (is that the only route?), so we need to develop those; but to develop financial markets, we need foreign investors, etc. We can go on like this until the cows come home, but at the end of the day, it’s a judgement call—there’s no growth, or a cost, if you go too fast and hurtle into a financial crisis because either your gears were faulty or your path had a boulder too many (read macroeconomic risks, e.g., fiscal imbalances).
Next, the pace, timing and sequencing of capital account liberalization—should it be a gradual, evolving process (most recently reiterated by RBI governor D. Subbarao) or is a big-bang, speedier approach needed? Note that the case for a speedier route in some recent reports, based largely upon the benefits of financial liberalization obtained from cross-country evidence, glaringly omits history of the advanced countries: From the adoption of the OECD code on capital movements in the early 1960s to the complete dismantling of controls in the 1980s, Japan, the US, UK and Germany took an average 20-25 years to fully liberalize their capital accounts. Further, there’s been a dramatic change in the institutional landscape in global finance faced by liberalizing emerging economies: The emergence of the international institutional investors as a class, which didn’t exist in the 1970s and 1980s, and technological and financial innovation increasing the speed and extent of transmission of shocks, are but two factors making speedy liberalization riskier.
Should capital account liberalization be sequenced with financial market development and synchronized with the macroeconomic circumstances? This is critical for India for several reasons. One, while inflation and external sector indicators have reduced India’s external vulnerabilities, its public finances are yet to reach a sustainable trajectory and are a source of enormous vulnerability. Two, it is well accepted since the East Asian crisis that capital account liberalization should be preceded by, and coordinated with, domestic financial market development; a sound, resilient financial system is a pre-requisite to withstand and absorb the shocks associated with rapid and sudden capital account movements in either direction. Three, cross-country studies suggest threshold conditions that influence the cost-benefit trade-off between financial liberalization and growth, which vary with the type of foreign capital—India has not yet reached that threshold level of financial and institutional development as far as foreign debt is concerned. Four, India is a transition economy where real economic structures and processes are changing rapidly in some sectors with rigidities in others —this segmentation requires that financial and real sector changes keep pace with each other as resources reallocate. And last, “leaning with the wind” liberalization can amplify shocks in India, so coordination with economic conditions ensures that positive and negative fluctuations are well absorbed.
Finally, the issue of exchange rate appreciation and the real economy. The on-off love affair with rupee appreciation in 2007 brought to the fore the exchange rate-inflation-trade relationship, which was either ignored or ill-analysed. The asymmetric effects of upward and downward adjustments in the real exchange rate, the respective import and export elasticities in relation to exchange rate change, demand elasticity that determines the scale of impact of deterioration in price competitiveness in damping demand, as well as the sluggish, limited and incomplete price response—due to known barriers to price adjustments such as administered prices, the role of markup adjustment, lack of competition in retail, local costs—are issues that need serious analysis. Exchange rate-based stabilization rests critically upon the pass through to local prices, so a delayed and incomplete response of prices doesn’t help much there.
Finally, does the source of appreciation pressures deserve consideration? In 2007, much of it arose from short-term, reversible capital movements and speculative carry trades instead of fundamentals. So the belief that relative prices should adjust to sharp and random swings in the asset markets without regard to price determination in the goods markets needs some serious introspection. The link between the capital account and the exchange rate is more significant in a country running a current account deficit than a surplus.
One-size-fits-all economics, which is what you get when you do not supplement cross-country research with country-specific analysis, doesn’t necessarily translate into good economic policy. It is time the peculiarities of the Indian economy are recognized in designing public policy on these issues.
Renu Kohli was with IMF until recently. Comments are welcome at firstname.lastname@example.org