Go with the flow

Indian Express, 18 October 2007

Stock markets responded sharply to a SEBI proposal to restrict foreign capital flows in Indian equity markets yesterday. This was yet another episode of government-induced turbulence on financial markets.

The proposal to ban participatory notes (PNs) has been under discussion for some years now. In earlier discussions, the rationale for banning PNs was claimed to be the lack of adequate information about the source of the funding. However, recent media reports suggest that RBI is advocating a ban on PNs and private equity funds primarily to curb dollar inflows, including legitimate funds, into India. It is also clear from SEBI's discussion paper that the reason for a ban on PNs in the current context is that the magnitude of capital flows is worrying RBI and the government. Concerns about investor identity have been already addressed by SEBI and are no longer an issue.

The proposal to ban PNs comes as one more step in the series of capital controls imposed by the government in recent months. First came restrictions on real estate investment, then on external commercial borrowings (ECBs) and now on FII investments. If implemented, this step too may make a temporary dent on capital flows to India, but considering that today one trillion dollars flow in and out of this high growth trillion dollar economy every year, it is going to be very difficult for the government to plug all the holes through which money moves in and out of India. As long as India is a fast growing globalising economy and remains an attractive investment destination, tinkering with capital controls will remain largely ineffective. For example, when earlier this week, a Lehman Brothers report suggested that India, already one of the fastest growing economies in the world, could see sustained GDP growth of 10 percent, there would have been increased investor interest in India. If the government bans PNs, people will find other ways of bringing money in.

The question is not whether the government will be able to effectively impose capital controls. It will not. The question is whether it is trying to do the right thing in bringing capital controls. Is closing the capital account the way forward for India? The years since 1991 saw India make a successful transition to an open trade account. The fear mongering about how Indian industry would shut down and millions would lose jobs in response to lower tariff barriers have today subsided. This was done through a roadmap for opening the trade account. Year after year, custom duties were brought down. In 2001 all quantitative restrictions were removed. Yashwant Sinha's policy of cutting rates year after year till India reached Asean levels was a source of policy stability where businesses learnt what to expect from trade policy. An essential element of India moving towards an open trade account was policy clarity. Cutting trade barriers was good for making Indian industry more competitive in a globalised world so import duties, which had been protecting Indian industry, had to go. Trade barriers had to go.

Unfortunately, the same clarity does not exist on the capital account. As a result, instead of strengthening our markets, regulatory institutions, banking, modernising our monetary and exchange rate policies and laying out a clear path towards removing capital controls and opening up the economy, despite the two Tarapore committee reports and the more recent Percy Mistry committee report, there is a lack of clarity that India needs to be preparing for moving towards convertibility. In this environment, it is not surprising that a sharp inflow of capital causes great discomfort through a lack of preparation. Since there is a lack of conviction in moving towards a globalised economy, policy makers respond by moving back to controls.

The experience of other countries suggests that countries that carefully prepared for capital account openness - such as Chile and Israel, were able to harness the benefits of globalisation much better than others who went into it unprepared and lurched from one crisis to another in an attempt to cope with a globalised economy.

So why is India going on the less optimal path of an open capital account without adequate preparation? Part of the answer lies in the institution on who the responsibility for capital controls and their removal has been vested -- the RBI. Most of the responsibility for the preparations for an open capital account also lie with the RBI. Permitting foreign exchange derivative markets and a bond market to flourish, improving and strengthening the banking system, moving towards a modern monetary policy framework are among the tasks RBI needed to have undertaken in the last 10 years, if it was serious about the move towards capital account convertibility. Most of these things were not done, and when today there is a surge in capital flows, it is natural for it to say that the flows are a source of risk to India and should be curbed.

Curbs on capital flows, or even proposals to do so, signal to the world that Indian policy makers are not ready for the big league, for integrating into the world economy. Ironically, these proposals can actually help in curbing capital flows, not because the capital controls are going to be effective, but because they indicate that the government in charge does not know how to do macroeconomic management in an open economy framework, and is thus turning backwards towards vintage Indian closed economy economics. Since macroeconomic policy is an important ingredient into growth, this lack of competence on macro policy could well mean that India will witness lower GDP growth than investors had hitherto expected, and this is what would reduce India's attractiveness as an investment destination. Surely, this is not the best way forward for India.

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