Former Reserve Bank of India Governor Y V Reddy is attending a meet in Daejon – organised by the International Monetary Fund (IMF) and the Korean government – to discuss what the world can learn from Asia and the challenges that need to be addressed in the region. On the sidelines of the conference, he spoke to Sidhartha on dealing with capital flows and regulatory issues. Edited excerpts:
Will capital flows be one of the biggest challenges for emerging economies like India?
Given the problems in other parts of the world and the general appreciation for Asia, there is an expectation that there will be capital inflows. The managing director of IMF also raised the issue this morning. The point raised was if it is foreign direct investment (FDI), there is not so much of a problem. For India, the major issue is volatility, because of global reasons and also because of the nature of our capital account. Globally, there are uncertainties about how things are going to move in Europe. Second, we depend very heavily on portfolio flows. So, India will have to be particularly careful and capital account management will be challenging. Even in case of FDI inflows into India, we have to make a distinction between greenfield and non-greenfield. If it’s greenfield, it means a new unit is coming up. If it’s non-greenfield, it means money is just coming in. So, it may not go out but it will add to the inflows.
Are capital controls a solution to deal with the situation? Today, reflecting on the new reality, even IMF seems to be okay with it.The intellectual position of IMF, though not formal, is that capital controls may be required to handle temporary flows. It is said that these are only temporary solutions that will be ineffective in the long run. One has to accept that capital controls are not effective given trade integration, technology and the movement of people. Second, the idea is that temporary flows require to be dealt with. The issue is how do you know what is temporary and what is not. But there will always be a question of degree of effectiveness, and it is contextual. When income tax was introduced, many people said it will not be effective as people will not disclose. So, not being effective by itself is not the answer. More important, countries which have done very well during the crisis are countries that had a combination of macro-economic balance and certain controls. So, the theology against capital controls is out.
There is an overlap between capital account and prudential norms over the financial sector, particularly banking. So, if you introduce prudential norms in the banking sector with regard to cross-country exposure and cross-currency exposure, they will be fairly effective, and that’s what Korea has finally adopted. That’s what we have been adopting for a long time. In the final analysis, the effectiveness of capital controls depends on two things. One is the nature of integration and the second is the will of the public policy. If public policy is itself scared of the financial markets, the financial markets will know that it can pressure them against controls. If public policy is determined to manage, it can be managed better.
Will Tobin Tax work in checking inflows?
It is an issue that was considered a sacrilege a few years ago. I don’t want to remind you about it but in Europe there was a very strong case for Tobin Tax. It is likely to be very effective in the context of currency trade. I don’t agree with the view that if you have Tobin Tax, there will be diversion of money or intermediation. If that was the case, the financial sector management should have ensured that no money comes to China or India. The issue is that financial markets look at a number of things and not just taking advantage of tax arbitrage. Public policy should keep the option of imposing a Tobin Tax open. It should insist that it has the option and that itself will make the financial markets conduct (business) with a certain caution.
The debate on managing the exchange rate is back, something that the west frowned upon. Given our experience, does it make sense to continue the policy we have followed all these years?
Globally there is better appreciation of intermediation, which India has been following. Now, there is increasing consensus that some sort of management is required. So, the question is how much you manage, when you manage and how you manage.
Banks are floating private equity funds and other such businesses. Is there a case for increasing the capital requirement for banks?
I don’t know but Paul Volker is pressing and the whole reform is that now they don’t want banks to do certain things. One lesson we learnt now is that what Paul Volker is saying is the wisest thing, though it may be inconvenient for the financial sector. But it should be taken seriously by everyone.
There are multiple regulators in the financial sector and it is resulting in regulatory overlap. How do you deal with this kind of a situation?
Globally, a single regulator (Financial Services Authority) has been virtually disbanded. Second, in some countries, such as the United States, where there were no formal or informal mechanisms for coordination, they are trying to put in place some mechanism. The trend all over the world is to give central banks a central role in regulation.
There are a number of reasons for this. Ultimately, an apolitical view has to be taken, which the central bank takes. You have to take a longer-term view, which a central bank takes. When there is any issue of stability, liquidity has to be provided by the central bank. Finally, there is huge professional expertise with central banks. I will be surprised if any government agency can command that type of expertise. One way is they (government agencies) can outsource to players in the financial markets.
But that will result in the players setting the agenda. In fact, one of the big problems in the last five to 10 years has been that the agenda for regulatory reforms was set by the regulated. So, the whole reform was in the favour of the regulated.
