Do capital controls work?

Indian Express, 8 Janaury 2008

India has witnessed a capital surge in recent months. Even though there was a reversal of reforms on several fronts with the re-introduction of capital controls, there was a $17.4 billion increase in net capital flows in the Jul-Sep quarter when compared with the previous one. India is too integrated into the world economy, today, for capital controls to be brought back.

The latest quarterly balance of payment data released by the Reserve Bank of India shows that the country saw a surge in capital inflows in the period July to September 2007. Net capital flows in a single quarter of USD 34 blllion dollars has been unprecedented in the history of India. This figure was nearly 4 times that of the rather meek USD 8.7 billion that came into India in the same quarter last year. The flows in July-Sept 2007 were more than double the USD 16.5 billion the amount that came into India in the previous quarter, April- June 2007. What is equally striking is that this surge in capital was not caused by a sudden change in policy to open up to inflows. No, indeed, it was the opposite. It was witnessed when India had started moving towards restricting capital inflows such as the restrictions on ECB flows.

Net inflows on account of loans fell from USD 9.4 billion in the first quarter to USD 7.6 billion in the second. The biggest component of loans -- ECBs witnessed a decline of USD 3.4 billion (From USD 7 billion in the first quarter to USD 3.6 billion in the second). However, short term loans went up.

Apr-Jun 2007

Jul-Sept 2007


USD billion

USD billion

USD billion

Capital inflows, net




1. Loans, net inflows




a. Foreign assistance, net




b. External commercial borrowings, net




c. Short term foreign loans, net




2. Banking capital, net




a. Commercial bank assets, net




b. Commercial banks liabilities, net (other than NRI deposits)




(i)NRI deposits, net




c. Other 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




d. Portfolio investments by India, net




4. Other foreign capital, net




All values in this table are in billion USD. It shows that 88 percent of the increase in capital flows in the second quarter came from sources that the RBI does not control.

If restrictions on loans reduced capital inflows, where did the increase of USD 17.4 in net inflows come from? The biggest chunk of the increase came from a category known as "other capital flows". This increased by USD 8.2 billion compared to the previous quarter. "Other capital flows" comprises leads and lags in exports, funds held abroad, advances received pending issue of shares under FDI and other capital receipts not included elsewhere. The category "other" is mainly capital that comes through channels that cannot be accounted for properly.

The second biggest chunk of the increase came from net banking capital. This amounted to an increase of USD 7.1 billion over the previous quarter. According to the RBI this mainly reflects a draw down of assets held by the banking system abroad. In this category NRI deposits fell. The RBI controls the interest rate on NRI deposits and this had been lowered to reduce inflows to India. So while the growth in NRI deposits was very small at less than USD 1 billion, that in banking assets and liabilities, which the RBI does not control, saw a sharp increase.

FII flows accounted for USD 3.5 billion of the total increase. Net foreign investment into India the second quarter was USD 2.7 less than in the first quarter.

The most striking fact about the sources of increase in capital flows is that the bulk of the increase, of USD 15.3 billion out of USD 17.4 billion, came from categories such as "other capital flows" which is a lot of flows that cannot be accounted for properly, and net banking capital where capital flows take place on the balance sheets of banks and are not directly controlled by RBI.

This evidence about the effectiveness of capital controls is not surprising. When capital controls are imposed it has often been seen in international evidence that the category for which the specific control is imposed shows a reduction in inflows, but the total continues to rise through an increase in some other form.

Part of the capital that households and firms want to bring into the country will show up on the current account; capital account transactions will be disguised as current account activities. For this reason, the problem that is faced in trying to manage the exchange rate is even bigger than that seen on the capital account. The sharp growth in remittances is part of the story being enacted on the current account.

Balance of Payment data for the third quarter Oct-Dec 2007-08 is not available yet. But reserves data gives us an indication that the capital surge continued. In the second quarter the RBI's foreign exchange reserves increased by USD 29 billion. In the following months RBI data shows that from Oct 1, 2007 to Dec 28, 2007 RBI's foreign exchange reserves increased by USD 27 billion, similar to the USD 29 billion added in the quarter of the capital surge. The restrictions on Participatory Notes in October might have led to a reduction in FII flows. The continuing restrictions on ECBs might mean that debt flows are smaller. However, total inflows may be nearly the same or even bigger.

These experiences of flirting with capital controls have clear policy implications. As long as there are incentives for people to bring in money into India, they will find ways to do so. If the government wishes to go after FIIs, it can do so. If the government wishes to go after exporters to reduce leads and lags, it can do so. If it wishes to restrict FDI also, it can do so. The component that is targeted for reversal of reforms might show smaller numbers, thus allowing RBI to claim victory. But the money that is blocked through one path will show up in other paths. Only a far-reaching array of capital controls - reminiscent of FERA - might work, by closing down India. But this is now politically infeasible. The politically feasible tinkering with capital controls does not achieve much.

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