India has seen a sharp increase in capital flows over the last three months. From March to May 2020, there was a coronavirus-related sell-off, which resulted in an outflow of foreign capital from India.
This reversed since June — net portfolio investments increased to US$ 6.7 billion in August from US$ 3.4 billion in June. After recording a modest outflow in September, net portfolio flows have rebounded in October.
A key reason for the inflow of capital into India is the quantitative easing measures adopted by the central banks in advanced economies to address the economic fallout of the Covid-19 pandemic. Another reason, particularly for the surge in inflows in August, was the raising of capital through quantitative institutional placement (QIP) by large commercial banks such as ICICI Bank and HDFC Bank that resulted in large inflows.
RBI is pursuing free capital mobility
Till the third week of August, RBI purchased dollars to prevent the rupee from appreciating. Consequently, the rupee was hovering at a little less than Rs 75 per dollar. Since the last week of August, the pace of intervention has slowed. This was reflected in the appreciation of the rupee that touched Rs 73 to a dollar during this time. On the first day of September, the rupee surged past the 73 per dollar mark, ending at 72.87. The data on foreign exchange intervention shows that the scale of net purchases of US dollars by RBI slowed in August to US$ 5.3 billion from US$ 15.97 billion in the previous month.
Over the last few weeks, the RBI appears to be following a strategy of allowing the rupee to appreciate to keep inflation under check. In a note on fostering orderly market conditions, the RBI noted that “the recent appreciation of the rupee is working towards containing imported inflationary pressures”. Given the constraints on monetary policy at the moment, the RBI seems to be using its currency policy to keep inflation under check.
An important tenet of open economy macroeconomics is the ‘impossible trinity’ — which states that a country cannot simultaneously maintain a fixed exchange rate, an independent monetary policy and an open capital account. The RBI currently seems to have given up on managing the exchange rate to pursue an independent monetary policy along with free capital mobility. In the past, it has used capital controls to manage the ‘impossible trinity’. During the taper tantrum episode, the RBI had imposed restrictions on the outflow of capital, along with monetary policy tightening, to prevent the rupee from depreciating.
The case IMF evaluators are making
A recent article by Prakash Loungani and Sriram Balasubaramanian of the IMF’s Independent Evaluation Office (IEO) has presented a case for pre-emptive capital controls in a country’s policy toolkit.
In India’s case, the article points out that while open capital account is beneficial for its growth prospects, it could use pre-emptive capital controls to address financial stability concerns emerging from a surge in capital flows. The authors argue that the IMF should take this into consideration when it reviews its official position on capital controls next year.
The annual Article IV consultation by the IMF reviews the recent developments, outlooks and risks in member countries and provides advice on macroeconomic policies. An important part of the Article IV report is the advice by the IMF on capital controls.
A recent report by the IEO provides an assessment on how useful IMF advice has proven to Indian policymakers as they make decisions about how to deal with capital flows.
India has a complicated framework of long-standing capital controls. This needs to be taken into account while framing views on capital controls. The Indian officials who were interviewed for the study raised concerns about the IMF’s advice on capital controls. They were of the view that the system of administrative controls was cumbersome and not transparent. It imposed large costs by hindering the development of liquid markets and hampering growth. These costs were not taken into consideration by the IMF while welcoming the capital control measures solely through the lens of financial stability.
The article by the IEO gives the example of Korea and Peru, who have used capital controls pre-emptively and judiciously to maintain financial stability. For such countries, relying on episodic controls could prove useful. But in a country like India, where we have multiple regulators, laws, instruments, and bureaucratic hurdles, the case for pre-emptive controls needs to be made with caution.
Literature on capital controls has distinguished between ‘gates’ (episodic controls) versus ‘walls’ (long-standing controls). These are fundamentally different, and the debate around their effectiveness must take these differences into account.
The IEO review of capital controls as an instrument in the policy tool-kit recommended by the IMF is a useful exercise. The right policy framework for capital controls for a country may be based on initial conditions. While capital controls may be useful in maintaining financial stability, the Indian experience suggests that in its review next year, the IMF would do well to focus on the yardsticks of transparency and rule of law in addition.
Ila Patnaik is an economist and a professor at National Institute of Public Finance and Policy.
Radhika Pandey is a consultant at NIPFP.
Views are personal.