There has been a fair amount of discussion in the media on whether India needs to control, tax or otherwise discourage excessive foreign capital inflows. The policy dilemmas on whether such flows need to be reduced and, if so, how to do so without affecting growth have become more intense in view of high inflation. If the Reserve Bank of India (RBI) intervenes in the market to buy excess dollars, rupee liquidity increases, which, in turn, contributes to inflationary pressures. If the RBI does not intervene, the rupee appreciates making exports uncompetitive.
There is no easy answer to what has come to be known as the impossible trinity, i.e. it is simply not feasible to have capital mobility, exchange rate stability, and an independent monetary policy to check liquidity or reduce credit growth.
So far as India is concerned, different views have been expressed by experts and policy makers on the policy objective that should be given priority. Some assign the highest priority to growth and capital inflows, some to inflation and liquidity control, and some to a competitive exchange rate to promote exports.
Interestingly, the government’s policy for capital flows also came up for discussion in the media’s “in-flight” interaction with the prime minister when he was returning from Toronto after the last G20 meeting. As reported by this newspaper on June 30, the prime minister then pointed out, “As far as India is concerned, we have not reached a stage where capital flows have become a problem.”
Whether capital flows into India are “excessive” or not is, of course, a matter of judgement. And so is the choice of instruments to control capital flows even if they are considered excessive. However, what is beyond dispute is that India was saved from the full impact of the global financial and economic crisis in 2008 because it did not make its capital account fully convertible or its exchange rate fully flexible.
The relative insulation of India, China and some other emerging markets from the global crisis has also had a profound effect on academic thinking as well as the policy stance of international financial institutions, particularly the International Monetary Fund (IMF). As is well known, over the past several decades, the IMF was strongly in favour of full capital account convertibility. However, in a well-publicised Staff Position Note on February 10, 2010, the IMF declared that there are “circumstances in which capital controls can be a legitimate component of the policy response to surges in capital flows”.
So far as capital flows into India are concerned, we certainly do not need additional quantitative controls or taxes on inflows. India already has far-reaching controls on certain types of inflows, particularly foreign direct investment, short-term debt and external commercial borrowings. India also has a substantial current account deficit in its balance of payments, and capital inflows are important sources of bridging this deficit.
At the same time, from a policy point of view, it needs to be recognised that certain types of capital flows, particularly portfolio or foreign institutional investments in financial markets, can be highly volatile and reversible. When times are good and the country is growing fast with high rates of return on investments, such inflows can multiply within a short period. However, these can also be reversed sharply if the global environment and country’s prospects change or if an “asset bubble” emerges in the capital markets. Sudden reversals like this can lead to a crisis of confidence and destabilise the economy.
This is precisely what happened in a number of emerging market countries in recent years — Malaysia in 1997, Thailand in 2006, Columbia in 2007 and Brazil in 2009. Faced with a financial crisis, these countries had to reverse their policies and introduce either direct controls or impose taxes on transactions. The impact of such measures on financial stability and growth was highly adverse, and could have been prevented if “over-exuberance” was avoided and timely measures taken.
India, too, has faced volatility in capital flows in the past three years. Total capital flows were $108 billion in 2007-08, falling to a mere $8 billion in 2008-09 and increasing to $54 billion in 2009-10. It is also significant that the sharpest volatility was recorded in portfolio investments. These were +$27 billion in 2007-08, -$14 billion in 2008-09 and rising to +$25 billion in 2009-10. Foreign direct investment (FDI) inflows, on the other hand, were generally stable and fluctuated in the range of $15 billion to $20 billion during this period. High volatility in portfolio flows was also reflected in India’s stock market indices. The Nifty recorded a sharp increase of 55 per cent in 2007; fell to -52 per cent in 2008 and again increased to +76 per cent in 2009.
Paradoxically, at present India’s policy for foreign direct investment. which contributes to manufacturing or services output, is subject to widespread and diversified controls. It varies from sector to sector and there are as many as five overlapping — and sometimes confusing — press notes on the subject. However, portfolio investments are entirely free, fully reversible, and also relatively tax free.
I leave it to readers to judge, and our policy makers to decide, whether something should be done to regulate tax-free portfolio investments and at the same time, simplify rules for foreign direct investment when economy is doing well and aggregate capital flows are not considered “excessive”. Or should we wait until these become excessive and unmanageable, resulting in financial instability or, worse, a crisis?
Bimal Jalan is former RBI Governor and author of The Future of India — Politics, Economics and Governance
