A capital idea

Indian Express, 8 April 2008

USD billion

Q1 2007(apr-jun)

Q2 2007(Jul-Sept)

Q3 2007(Oct-Dec)

Capital inflows, net




1. Loans, net inflows




Of which :





Net short term foreign loans




2. Banking capital, net




3. Foreign investments, net




a. Foreign direct investments in India, net




b. Foreign direct investments by India, net




c. Portfolio investments in India, net




4. Other foreign capital, net




In mid-2007, there were two competing views about India's capital flows "problem". The first view believes that India is able to calibrate capital flows, to be able to selectively switch off or on certain components of capital flows and thus achieve a judicious mix and quantity of capital flows. The alternative view believes India is too open today for this central planning mentality to work. If one door is closed, money will move through other doors, as long as the basic reason for money to move is unchanged. In this view, small changes to capital controls are ineffective and not worth the political cost. The only thing that would work in affecting capital flows is far-reaching and draconian capital controls.

In 2007, the traditional view supporting capital controls won the policy debate. In August, restrictions were brought in against external commercial borrowing and in October, restrictions were brought in against portfolio flows. The world economy took a turn for the worse, which normally reduces capital flows into emerging markets. But US interest rates have dropped, and even though India pegs the rupee to the dollar, Indian interest rates have not dropped. This interest rate differential has been pulling money into India.

It is now time to look at the evidence, to take stock of the impact. Did events work out as the policy makers hoped?

In Q2 USD 33.5 billion net capital inflows came to India. In Q3, net capital inflows were USD 31.5 billion. This was despite the turmoil in global financial markets in which capital was moving away from risky assets and emerging economies like India are seen as more risky.

Q1 2007 (April-June) is the old, undistorted environment. By Q2, capital controls against ECB were in place. In most of Q3, controls against portfolio flows were also in place. The evidence shows that these did not work. In Q2 and Q3, net capital inflow was roughly twice that seen in Q1. It rose from an average inflow of about USD 3 billion per month in the quarters preceeding July 2007, to USD 10 billion per month after July.

The restriction on Participatory Notes (PNs) imposed in October 2007 does not appeared to have reduced portfolio flows into India. Portfolio flows grew from USD 10.89 billion in the second quarter to USD 14.56 billion in the third quarter.

Despite various restrictions on External Commercial Borrowings (ECBs) inflows on account of ECB went up from USD 4.7 billion in the second quarter to USD 5.26 billion in the third quarter. Short term loans remained high. They were USD 4.79 billion in the second quarter, and USD 4.25 billion in the third quarter.

In the past it has been seen that private transfers to India have responded to interest differentials with the rest of the world. When interest rates in India are higher, people prefer to bring their money into India. Since the interest rate on NRI deposits is linked to global interest rates, when global rates fall, it becomes more profitable to withdraw from NRI deposits and bring money into India as remittances. Among invisible receipts, one the items that saw a sharp increase was remittances. Private transfers grew from USD 7.6 billion in the first quarter, to USD 9.3 billion in the second quarter, and to USD 10.9 billion in the third quarter of 2007-08. About half of private transfers this year have been on account of local withdrawals of NRI deposits. The RBI notes that the higher growth in inflows through local withdrawal by the overseas Indians may be attributed to higher returns domestically vis-a-vis holding such deposits in NRI accounts.

The result is thus visible on the debate about India and capital controls. The control raj was ineffective. Capital is supple; it is relatively easy to repackage it from one form to another. If the policy says that debt is good and equity is bad, then capital will come through as debt. If policy says that equity is good and debt is bad, then capital will come through as equity. The private sector focuses on reality, on issues such as interest rate differentials, and then figures out how to achieve the objective while not violating the stated rules.

Small tinkering with capital controls damages India's image, it introduces microeconomic distortions, and achieves nothing in terms of macroeconomics. Large tinkering with capital controls are not feasible given India's current level of global trade and investment and leads to central bank governors and finance ministers losing their job. For this reason, the focus in Indian policy making should now be to get the monetary policy framework right, which can cope with fluctuations in capital flows. There is no point in yearning for the good old days before India had started off on reintegrating into the world economy.

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