Caps unlock

Finance Minister P. Chidambaram is reported to be considering removing FDI caps in various sectors. The imperative for the removal of caps in sectors where they are below 100 is to attract capital flows to India in a situation where the current account is expected to be 5 per cent of the GDP. While FDI in multi-brand retail, pensions and insurance have become political issues, in other sectors such as credit information, asset reconstruction or private security agencies, where the issue is not political, it may be possible to remove restrictions more easily.

Even though it makes good economic sense to ease unnecessary capital controls at times when the country needs inflows, opponents often whip up fears of what might happen when controls are reduced. Instead, we need to determine what the objectives of controls are, the kind of controls that the country would like to keep, and which ones are detrimental and should be removed.

Capital controls, or controls on the cross-border flow of money for sale and purchase of assets, are imposed for three broad reasons. In largely open economies, concerns about terrorism or money laundering require that information be provided before money can be transferred across borders. When a country becomes a member of the Financial Action Task Force (FATF), it is required to pass laws that require it to prevent money flows from being used for such activities. These require financial firms to fulfil various know-your-customer (KYC) obligations. When India became a member of the FATF, it introduced these laws. The regulations in India that flow from these laws are, it has often been felt, far more stringent than in other FATF member countries, involving proof of residence and paper documents beyond proof of identity. While the excesses would need to be sorted, controls arising from FATF obligations will have to remain.

A second reason for capital controls is national security. Again, almost all countries in the world, including the most advanced ones, have laws that prevent foreign ownership of, say, ports, airports or other infrastructure facilities where the government feels that the security of the country may be compromised. For example, the government may choose to prevent FDI in a port by a foreign government or an entity owned by it, especially by a government it does not trust. Such capital controls are in place in India as well as in advanced open economies and it is unlikely that such restrictions will go away as long as national security remains an issue.

In addition to the above, capital controls have been seen, primarily in emerging economies, as tools for macro-economic policy. When emerging economies witness pressure on their currencies, they loosen or tighten capital controls. These controls are of many kinds. They include price-based measures or quantitative restrictions. Controls may be on various kinds of asset classes such as debt, equity, derivatives, bank capital, mutual funds or direct investment. Controls may differ according to whether residents or non-residents are investing. They may differ depending on whether they concern inflows or outflows.

Emerging economies often have many of the above kinds of restrictions. When the domestic economy is doing well, foreign inflows come in search of higher returns. This may lead to an upward pressure on the currency. In such situations, a country may impose controls on capital coming in. Similarly, when domestic business cycle conditions are bad, money may flow out, putting pressure on the currency to depreciate. The country may respond by imposing controls on outflows.

Whether such controls are able to reduce the pressure on the currency is still not settled. There is a large empirical literature examining whether controls achieve their objective at least for a short time and whether that is useful, considering the costs they impose. However, one thing appears to be clear - almost all emerging economies have slowly removed controls that permanently impede cross-border capital flows. The two exceptions are India and China. Countries such as Brazil have opened up their capital account, but have kept in place transparent price-based controls that can be imposed by the government.

In India, we have tied ourselves up in knots. Even at a time when the country needs capital inflows, it is not easy for the government to move at the required speed. The U.K. Sinha committee on capital controls documented the complex maze of capital controls that has taken the power of switching controls on and off, depending on the need of the hour, away from the government and into the hands of a number of financial regulators. Various financial sector laws and regulations treat foreign investors differently from Indian investors, with a bias against foreign investors. This has created a situation in which, even when macroeconomic stability requires that at a time when the flow of capital is weak, when the current account deficit is strong, when the government wishes to reduce capital controls, it is unable to do so.

Today, even when the FM does roadshows abroad, when he sends out the message that India wants to attract foreign capital, the experience of foreigners with the Indian financial regulatory system, the legal complexity and the tax uncertainty are such that capital does not flow in easily. As the experience after last year's Union budget showed, we cannot take foreign capital flows for granted. Considering how vulnerable a large trade account makes the country, it is not surprising that other emerging economies have got rid of the complex capital controls and moved to simple, transparent frameworks.

Hopefully, the finance minister will be able to attract more foreign capital as he proposes to. But it is equally important that the system of controls now be re-examined and rationalised keeping in mind the objectives they serve.

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