Abhijit Sen Gupta: Does convertibility lower inflation?

The fear of capital outflows acts as a big check on loose monetary policies in full convertibility regimes.

The last year witnessed a fresh stimulus being administered to the issue of greater capital account convertibility with the prime minister floating the idea of revisiting the issue and the immediate setting up of Tarapore II. The committee pointed out that there is already an ongoing process of capital account liberalisation and its report was aimed at deepening this process.

Interestingly, at a time when India is thinking of aggressively pursuing greater capital account convertibility, globally there is a great deal of debate about the benefits of such convertibility. At one time a strong pursuer of greater convertibility, the IMF research department has shown considerable change in its position over the last ten years. In the mid 1990s, the IMF strongly believed that free movement of capital allowed portfolio diversification, consumption smoothing, risk sharing and intertemporal trade, thereby leading to greater allocative efficiency. However, recent research at the IMF shows that major benefits of successful financial liberalisation are primarily indirect. Successful financial liberalisation acts as a catalyst for growth by imposing discipline on macroeconomic policies, promoting development of the financial sector and exposing domestic firms to competition from foreign competitors. Thus now it is widely believed that freer movement of capital flows tends to generate a number of "potential collateral benefits".

One such benefit has been the lowering of inflation across a number of countries that have opened up their capital account. The opening up of the capital account imposes a "discipline effect" on the central bank. In a country with a completely closed capital account, the only bonds the private sector can hold are domestically issued by the government or the domestic private sector, and whose returns are denominated in the national currency. In such a situation, the central bank will have an incentive to undertake a loose monetary policy to raise inflation with the view to reduce the burden of the debt for the government. On the other hand, if the economy has an open capital account, the private sector has the choice of investing in foreign assets also, whose returns are denominated in foreign currency. Now if the private sector anticipates that the central bank is going to undertake a loose monetary policy which will raise the inflation rate, it has the choice of simply shifting away from holding domestic assets to holding foreign assets, whose returns are not affected by domestic inflation. Thus any loose monetary policy is penalised by a surge of capital outflow from the host country. This reduces the central bank's incentive to undertake a loose monetary policy.

Moreover, by opening up the capital account, the central bank also imparts a signal to the private sector that it is willing to suffer the punishment of a loose monetary policy in the form of capital outflow. This alters the private sector expectations about the future monetary policy, which in itself can be inflation-reducing.

In India also, capital account liberalisation has exercised some degree of "discipline effect" on the RBI and has helped reduce inflation. Since the mid '90s, India has slowly but steadily moved towards greater capital account convertibility. The RBI has undertaken several steps to ease the flow of capital once the initial problems related to the Asian crises were overcome. During this time, the policy endeavor of the RBI has been to keep year-on-year inflation at a low level. Though India does not follow a specific inflation target, the RBI keeps a strict vigilance on inflation and especially inflation expectations. Through several speeches, notifications and press releases, the RBI has made its preference for anchoring inflation expectations clear. The recent hike of 50 basis points in the CRR was aimed at reducing excess liquidity and curbing inflation expectations. One major reason for this concern about inflation expectation is the threat of capital outflow in the face of a loose monetary policy and high inflation.

The writer is Fellow, Indian Council for Research on International Economic Relations