While finance ministers of the Group of Twenty (G-20) countries may have staved off a currency war—arising from the US-China dispute over the value of the yuan—in their meeting in Korea last weekend, the currency problem is taking an entirely new dimension.
Many emerging economies, most notably Brazil, have been seriously concerned over the large inflows of “hot” money—short-term capital—that have sent their currencies soaring. Brazil’s finance minister Guido Mantega has been complaining that his country is facing a “currency war”. Mantega’s concerns can be well understood—the past few months have witnessed intensifying competition among emerging economies to reduce the degree of currency appreciation, or to even trigger depreciation through direct market interventions.
India should have similar concerns. Since the beginning of June this year, the value of the rupee has appreciated by nearly 7% against the greenback. This has happened as foreign institutional investors (FIIs) have shown increasing interest in Indian markets in recent months, which has boosted fund flows to record levels. Since the beginning of the year, FII net investment had reached $34 billion; more than $ 5.5 billion has been received in the first 22 days of this month.
The steep appreciation in currencies and the consequent adverse impact on the price competitiveness of domestic players have attracted calls for action in those countries that are affected. However, in India, the Reserve Bank of India has intervened only briefly and the government seems to have adopted the policy of wait and watch.
In sharp contrast, most other countries have been more decisive in their response to the impact of the inflows on their currencies and, hence, their competitiveness. Introducing capital controls is the flavour of the times and the list of countries taking recourse to such measures is getting longer by the day.
Over the past month, Brazil has strengthened the capital controls it first put in place in October 2009. During the first week of October, the government raised the country’s financial operations tax on foreign investment in fixed-income and equities funds from 2% to 4%. Less than two weeks later, the financial operations tax was raised further to 6%.
Thailand, which has long prided itself as an open economy, has also taken recourse to measures that would have a dampening effect on foreign fund flows. The government has recently decided to impose a 15% tax on foreigners holding Thai government and state-owned corporation bonds (foreigners, unlike locals, were until now exempt from this tax). However, the government has defended this move by pointing that new levy was nothing more than a “withholding” tax, and that this should not be viewed as capital controls in disguise.
The country that would host the G-20 summit in a few weeks from now itself has been strengthening its capital control regime lately. At the beginning of this month, South Korea added to the capital controls that were initially implemented in June. Among the measures introduced recently is the new requirement whereby regulators will audit lenders working with foreign currency derivatives. The stated goal of this move is to reduce the financial instability and currency appreciation caused by the capital inflows associated with these transactions.
There is a reason these steps to introduce capital controls, in particular, have proliferated in recent months. Unlike in the past when international financial institutions derided the use of such measures, in the aftermath of the 2007-09 financial crisis, some of these agencies have seen merit in introducing curbs on capital inflows. In a recent statement, the managing director of the International Monetary Fund (IMF), Dominique Strauss-Kahn, emphasized the need to prevent an economic crisis using the range of policy options that the governments have in their toolkits, which, in his view, includes capital controls. This advocacy of capital controls—before Strauss-Kahn’s remarks, IMF published a paper in February that endorsed them—must surely be seen as one of the most decisive turnarounds for IMF from its days gone by.
What are the possible implications of these developments for the global economy? A rush of capital controls, particularly by countries where global capital has placed bets, may not augur well for the others that have not contemplated such moves—since fund flows would be diverted towards them. It is in this context that India needs to weigh its options very carefully. Excessive inflows of speculative capital, besides pushing the country’s exposure to these funds to unhealthy levels, would result in an appreciation of the rupee, thus eroding the competitiveness of domestic industries. Not only would Indian exporters suffer in international markets, domestic players would also have to face increased competition from cheaper imports.
This emerging scenario is something to which the G-20 cannot turn a blind eye. Ever since it took over the responsibility of leading the global economy out of the current crisis, this group of countries seems to be interested in pursuing only soft options for reforming the global financial system. But, at this juncture, when individual countries are taking desperate measures to insulate themselves from harmful speculative capital, unmindful of the consequent adverse impact on other countries, the collective leadership of the G-20 must take cognizance.
Biswajit Dhar is director general at Research and Information System for Developing Countries, New Delhi.
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