Mumbai: Five years after raising a market furore by suggesting, when he was Reserve Bank of India (RBI) governor, that countries keep open the option of capital controls, Y.V. Reddy insists that the contentious proposal has merit.
Revisiting the topic at a seminar on financial reforms in Brussels on Monday, Reddy said he came armed this time with a “sense of freedom” (now that he’s no longer RBI chief) and “the wisdom of hindsight” (after the global financial meltdown).
Reddy, 68, retired in September 2008 days before the collapse of Wall Street icon Lehman Brothers Holdings Inc. sent global financial markets into a tailspin.
In January 2005, Reddy had said a view needs to be taken on capping market inflows from foreign institutional investors (FIIs). He also suggested monitoring the “quality and quantity” of such flows and asked the authorities to examine the efficacy of “price-based measures such as taxes” on FII inflows, although “their effectiveness was arguable”.
Straight talk: In Jan 2005, Reddy had said a view needs to be taken on capping market inflows from FIIs. Ashesh Shah/Mint
Admitting that quotas or ceilings on FII flows, as practised by some countries, might not be desirable at that stage, Reddy still said there was merit in keeping such an option open and exercising it selectively. At the time, Reddy was releasing the India Development Report 2004-05 of the Indira Gandhi Institute of Development Research (IGIDR).
Market intermediaries were not amused by his observations. They turned hostile, fearing a crash in the equity markets, and P. Chidambaram, then finance minister, had to appear on TV channels to clarify that there was no proposal to cap portfolio inflows or tax them.
At an unscheduled press conference late that same evening at RBI headquarters on Mint Road, Reddy had to say that personally he was “not in favour” of a ceiling on foreign fund inflows. By that time, minor changes had been made to his IGIDR speech on the Indian central bank’s website.
Recounting the evening, Reddy said in his prepared Brussels speech on Monday: “There was strong reaction from the participants in financial markets that the governor was advocating Tobin Tax, and that it was totally undesirable... Immediately, the finance minister had to soothe the markets, after discussing with me, with an assurance that no such proposal for taxes was under consideration of the government. However, that was not enough to cool the anger of the financial markets… and hence, a clarification had to be issued from the Reserve Bank of India that such a tax may not be desirable.”
Reddy added that “there is considerable merit in countries insisting on keeping the option of levying taxes on all financial transactions as a matter of public policy”. Such a tax may ideally cover several financial markets and, in particular, currency markets, he said.
American economist James Tobin first made the suggestion for a tax on currency transactions to dissuade currency speculation in the 1970s.
According to Reddy, the underlying approach of taxing transactions has the potential to be applicable not only to currency markets, but other markets as well, particularly after the experience of the global financial crisis.
After the unprecedented credit crunch that hit the global financial system in the wake of the collapse of Lehman Brothers, some countries have been exploring ways to moderate capital flows through the use of several instruments, including a Tobin tax.
UK Prime Minister Gordon Brown discussed the possibility of imposing a financial transaction tax at a meeting of the Group of Twenty (G-20) countries in November 2009.
The International Monetary Fund (IMF) too has reversed its stance on capital controls. In its latest policy note, released in February, IMF suggested “appropriately designed capital controls”.
According to Reddy, it is essential to address the issue of excessive reliance on market mechanisms and, in particular, “the excessive growth of financial sector”, something Lord Adair Turner, chairman of the UK’s Financial Services Authority, has also been saying.
Reddy is in favour of a tax regime, even if it’s nominal, “so that the financial markets are aware of the instrument at the command of public policy and willingness to use it”.
According to him, a Tobin tax-type mechanism should be in place “on a continuous basis” to rein in asset bubbles and the “downside of such taxes appears to be negligible”.
A Tobin tax, he said, “may be ineffective” but it does not have the “toxic potential” of “financial innovations”.
According to Reddy, “international coordination for levy of such taxes must be pursued vigorously, but national-level initiatives for Tobin tax as part of measures to achieve financial stability by individual countries also has much to commend for itself.”
RBI’s prudent supervision of the financial sector, with Reddy at the helm, is widely seen to have saved India from the brunt of the global meltdown. In an earlier interview with Mint, he blamed the short-term outlook of the political leadership, the short-term horizon of the financial markets and the clout of the financial sector for the crisis.
To be sure, Reddy is not alone in advocating capital controls. Nobel laureate Michael Spence, professor emeritus at Graduate School of Business in Stanford University, recently said funding growth with foreign capital was a risky proposal and capital controls were essential in developed economies.
“You need to have capital controls and exchange rate management so that you have some control over the volatility of the prices that determine the way you interact with the rest of the world,” Spence said.
Central bank governor D. Subbarao, Reddy’s successor, too, said active capital management—or capital control measures—should not be ruled out if foreign fund inflows surge. He was, however, not willing to debate the instruments or timing “as this will depend on how the situation evolves”, while speaking recently at a panel discussion in Mumbai in which three former RBI governors, including Reddy, participated.