A bad time to lose control

Indian Express, 16 April 2011

The debate on the effectiveness of capital controls has come alive after an IMF staff proposal supporting the use of controls by emerging economies facing large volatile inflows. The impact of controls on the magnitude and composition of capital flows, on cost of transaction and monetary policy have been a subject of enormous debate. There is however little consensus on the issue. Experience about the effectiveness of capital controls varies according to country-specifics. To the extent that there are country specific characteristics that make capital controls effective, understanding individual experiences with capital controls gains significance.

There has been considerable interest in India's experience, for two reasons. One is that India has long had an extensive system of administrative controls. While capital controls may have limited effectiveness in a country that has removed controls completely and then attempts to reintroduce them in a limited way, India has a long standing legal and administrative structure in place that can support imposition or tightening of a comprehensive array of controls. On the well-known Chinn-Ito measure of de jure restrictions, India stood at -1.13 in 2008, implying that it is much less open than most other major emerging markets like Brazil, South Korea and Russia, and about as closed as China. Also, in contrast to market based controls which are often seen to be effective in the short run, the experience of countries such as India and China who have administrative controls has not been studied in the literature.

The second reason is that India fared relatively well in the global crisis. As the global economy slowed, so did the Indian economy, with seasonally adjusted GDP growth dropping from a peak of annualised growth of 11.7 per cent (quarter ended Dec 2005) to 4.0 per cent (quarter ended December 2008), a decline of 7.7 percentage points. While this was a very large drop by any standard, growth remained positive in the downturn, and no large financial firm went bankrupt.

The juxtaposition of extensive controls and a favorable economic performance has suggested to some that the two were causally linked. It has been argued, for example, that controls made India more resilient, by isolating it from shocks that occurred elsewhere, and preventing a build-up of foreign debt. However, did the system of controls actually work as a tool for macroeconomic policy?

While the structure of controls remained in place, there was a continous, albeit slow movement towards reducing controls and opening up of the capital account for a decade starting in 1991. In the period after the Asian crisis, especially in the years 2001-2004, the Indian economy started attracting larger capital inflows. The policy of maintaining a low volatility of the exchange rate of the rupee was implemented through central bank intervention in the foreign exchange market. The Reserve Bank of India sterilised its intervention. International experience suggests that sterilised intervention increases capital inflows, especially short-term capital. India too saw a sharp growth in capital inflows as expectations of rupee appreciation added to the higher interest rate differential and enhanced the attractiveness of the rupee as an asset. After 2004, when RBI ran out of its stock of government bonds which it had been using to sterilise its intervention, and starting using the newly created Market Stabilisation Scheme bonds that were meant only for sterilising its intervention, that sterilisation became partial, expectations of appreciation sharply increased, and India witnessed a surge of capital flows. It was then that restrictions on the capital account were increased.

A recent NIPFP working paper focusses on these increased restrictions within the existing elaborate system of capital controls, which were imposed in a period of a surge in capital flows. These restrictions included tightening cost and end-use controls on foreign currency borrowing, tax and administrative changes to the regime for venture capital, registration provisions for non-resident Indians who were foreign portfolio investors, bans on offshore derivative products, and so on.

In India, the structure of capital controls has not been dismantled despite the easing of restrictions in the capital account on various fronts. The purpose is to be able to control the composition of flows as well as use this framework when there is a surge of capital, this structure can be used to achieve policy objectives. It is thus relevant to ask whether in the period when there was a surge of capital, the raison d etre of the capital controls regime, it achieved its objectives or not? Here is the evidence:

Magnitude and composition of inflows: The capital controls reduced particular types of inflows (such as long-term foreign currency borrowing), but could not ensure that the overall magnitude of capital inflows was small. Indeed, by 2007 overall flows had reached 9 percent of GDP -- large not only by historical Indian standards, but also by comparison with other major emerging markets, most of which had more liberal \textit{de jure} regimes.

Monetary policy regime: Despite a series of reinforcing measures, the controls were not tight enough to preserve the monetary policy regime. The de facto exchange rate peg gave way, in two steps, to a more flexible exchange rate regime. On 23 May 2003, there was a structural break in the exchange rate regime, and for the next four years, rupee-dollar volatility doubled to 3.9 per cent annualised. This arrangement worked till 23 March 2007, when there was another structural break and for the next four years, flexibility doubled once again to 9.0 per cent annualised.

Financial stability: The attempt to uphold the exchange rate regime with capital controls actually eroded financial stability. Since the controls proved porous and sterilisation was only partial, the large scale purchase of dollars spilled over into loose monetary policy. The largest ever credit boom in India's history came about, with credit to the private sector growing by around 30 percent year-on-year for three consecutive years.

India also experienced an asset price boom on the stock market which was more extreme than that seen with most emerging markets, some of which had open capital accounts.

In sum, the evidence suggests that India's capital control system did not work. Even an unusually extensive set of controls proved unable to sustain India's macroeconomic and financial framework at a time when the economy was integrating rapidly with the rest of the world.

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