Y V Reddy: Capital account liberalisation and capital controls
Remarks by Dr Y V Reddy, Governor of the Reserve Bank of India, at the Central Bank Governors'
Symposium convened by the Bank of England in London, 25 June 2004.
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I am thankful to Bank of England for the excellent arrangements and well thought out agenda for the
2004 Central Bank Governors' Symposium.
As desired by Governor Mervyn King, I will give a brief introduction in this session on capital account
liberalisation and capital controls.
Professor Kenneth Rogoff's well-researched messages on effects of financial globalisation on
developing countries are appropriate as governing thoughts for this session. There is evidence of a
threshold effect in the relationship between financial globalisation and economic growth, and the
heightened risks of volatility in capital flows to developing countries gets reduced only after a particular
level of integration. In contrast, empirical evidence shows that trade liberalisation has had beneficial
impact. A review of evidence provides no road map for the optimal pace and sequencing of financial
integration. Many questions in this regard are best addressed only in the context of country-specific
circumstances and institutional features.
In this background, based on the Indian experience, I will present some issues relating to managing
capital account.
capital account liberalisation is a process and it has to be managed keeping in view elasticities
First,
in the economy, and vulnerabilities or potential for shocks. These include fiscal, financial, external, and
even real sector - say, oil prices and monsoon conditions for India. Professor Rogoff's presentation
places special emphasis on government borrowings as a vulnerability.
Second, caution is needed in moving forward with each step in capital account liberalisation,
recognising that reversal of any step in liberalisation is very difficult since markets tend to react very
negatively to reversals, unless there is already a crisis situation.
Third, the capital account itself needs to be managed during the process of capital account
liberalisation. There is a hierarchy in the nature of different types of capital flows in real life. For
example, foreign direct investment is preferred for stability, and quantum of short-term external debt,
by residual maturity, should not be excessive. Furthermore, adequate reserves, keeping in view the
national balance sheet considerations, which include public and private sectors, provide comfort.
Public policy can achieve these desirable conditions only through some sort of management of capital
account.
Fourth, the management of capital account will be effective under enabling conditions, such as,
reasonable confidence in macro policies, in particular tax regimes, and safeguards against misuse of
liberalised current account regime to effect capital transfers. Sound management will also avoid
dollarisation of the domestic economy and internationalisation of domestic currency.
Fifth, operationally, management of capital account involves a distinction not only between residents
and non residents or between inflows and outflows but also between individuals, corporates and
financial intermediaries. The financial intermediaries are usually a greater source of volatility amongst
these. If such financial intermediaries operating in the developing countries are owned or controlled by
foreign entities / investors, there is perhaps greater tendency to volatility in the flows. It is noticed that
such foreign owned / controlled intermediaries are often influenced by considerations other than
domestic economy and have less appreciation of local conditions - apart from the issues relating to
cross-border supervision of financial intermediaries by the host country supervisor.
Sixth, the prudential regulations over financial intermediaries, especially over banks, in respect of their
forex exposures and forex transactions must be effective and a dynamic component of management
of capital account as well as financial supervision. Such prudential regulations should not be treated
as capital controls.
Seventh, capital controls should be treated as only one of the components of management of capital
account. As liberalisation advances, the control-regime would contract, and thus, it is the changing mix
of controls that charecterises the process of liberalisation in management of capital account.
Eighth, capital controls may be price based, including tax-regimes, or administrative measures.
Depending on the legal framework and governance structures, the mix between the two would vary.
As liberalisation advances, the administrative measures would get reduced and price-based
increased, but the freedom to change the mix and reimpose controls should always be demonstrably
available. Such freedom to exercise the policy of controls adds comfort to the markets at times of
grave uncertainity.
Finally, as mentioned by Professor Kenneth Rogoff, a distinction needs to be made between de jure
and de facto financial integration in general and hence, in the context of capital account in particular.
In practice, there are difficulties in measuring the degree of financial integration. However, the
institutional structures, both of public policy and markets, need to be evolved to meet the imperatives
of liberalised capital account. In the final analysis, the basic issue in any policy context is whether
capital controls lead to distortions in exchange rate or the liberalised capital flows that lead to
distortions in exchange rate. In respect of emerging economies, the conduct of market participants
shows that automatic self-correcting mechanisms do not operate in the forex markets. Hence, the
need to manage capital account - which may or may not include special prudential regulations and
capital controls. There are many subtleties and nuances in such a management of capital account
which encompasses several macro issues and micro structures.
Thank you for your patience.