Duvvuri Subbarao: Volatility in capital flows - some perspectives
Comments by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the High-level
Conference on "The International Monetary System", jointly organised by the Swiss National
Bank and the International Monetary Fund, Zurich, 11 May 2010.
* * *
As the crisis is ebbing, capital inflows into emerging market economies (EMEs) have
resumed - a consequence of a global system awash with liquidity, the assurance of low
interest rates ruling in advanced economies over "an extended period" and the prospects of
robust growth in EMEs. According to the IMF, net private financial flows to emerging and
developing economies increased from US$ 254 billion in 2006 to US$ 689 billion in 2007 and
then declined, at the height of the global financial crisis, to US$ 179 billion in 2008 and
US$ 180 billion in 2009. The resumption of capital flows has triggered familiar concerns in
EMEs about macroeconomic and financial stability. This has also sparked off a vigorous
debate internationally on the policy approach to capital flows at the country level and at the
international level. My comments as chairman of this session will cover the theoretical
arguments for and against capital flows, the collective experience to date in managing capital
flows and issues on the way forward. I will also allude to India's approach to capital account
management.
Arguments for and against capital flows
2. The theoretical arguments in support of capital flows are quite persuasive. Capital
flows aid growth by providing external capital to sustain an excess of investment over
domestic savings. By affording the opportunity of using the world market, an open capital
account permits both savers and investors to diversify their portfolios to maximize returns
and minimize risks. Capital flows could also potentially develop nascent financial markets,
promote financial discipline and reduce the borrowing costs both for the government and the
corporates.
3. On the flip side, however, capital flows are known to be procyclical and they
complicate macroeconomic management. An open capital account interferes with the
simultaneous management of a fixed/managed exchange rate peg and an independent
monetary policy - a phenomenon familiarly known as the "Impossible Trinity".
4. Large and persistent capital flows can potentially jeopardize financial stability. Large
speculative flows in "search for yield" typically go into investment in assets leading to rapid
and destabilizing build up of asset prices. Since such speculative flows are volatile by nature,
they can impair the orderly functioning of the financial markets. When investors exit from
securities markets abruptly in a herd, stock and bond prices get affected, and when investors
take the redemption proceeds out of the country, the exchange rate gets affected. Should the
central bank intervene to stabilize the forex market, the resultant tightened liquidity can affect
the money markets. Thus, speculative flows affect all financial markets - the securities
markets, the forex market, the money market and the credit market, with contagion spreading
from one market to another rapidly. If not contained, these swift developments can threaten
financial stability and lead to output and employment losses.
Managing capital flows
5. Surely, capital flows are important to meet the investment needs of EMEs. Problems
arise when the flows are largely in excess of the economy's absorptive capacity and also
when they are highly speculative in nature. EMEs have responded to managing the adverse
macro impact of volatile capital flows through a variety of policy actions. Stylistically, these
can be categorized into three options. The first option is to do nothing (exchange rate option)
in which case the exchange rate will appreciate. The second is to allow the flows to come in
but intervene in the forex market (reserve accumulation option). The third option is to deploy
capital controls. Typically, EMEs have adopted a mix of all the options. Let me briefly discuss
the implication of these options.
The option of exchange rate adjustment
6. The most straight forward option for the central bank is to allow flows to come in
without any intervention. However, when capital inflows are large, this can lead to currency
appreciation unrelated to fundamentals and trigger a "Dutch Disease" syndrome. Experience
has shown that a flexible exchange rate system is prone to overshooting, and this has
engendered the "fear of floating" among many countries.
The option of reserve accumulation
7. The second option for a central bank, confronted with a surge of capital flows, is to
intervene in the foreign exchange market to dampen disorderly movements of the exchange
rate. This will result in accumulation of foreign exchange reserves and release of additional
liquidity into the system. If left unsterilized, the additional liquidity so generated in the system
will have potential inflationary implications. Typically central banks have sterilized the flows,
either partly or fully, using a variety of tools including open market operations, tightening the
access of banks to the discount window, adjusting reserve requirements, using a foreign
exchange swap facility, easing restrictions on capital outflows and pre-payment of external
debt. In theory, each of these tools holds out the prospect of achieving the same effect as
open market operations. However, one should be mindful of the law of unintentional
consequences. Such intervention would prevent the domestic money market interest rates
from falling which would attract more inflows and thus actually accentuate appreciation
pressure, the problem that was sought to be contained in the first place. In the case of EMEs,
intervention may also entail large quasi-fiscal costs if the domestic assets yield higher returns
than the foreign exchange reserves.
8. Notwithstanding the costs of accumulating and holding reserves, reserves so built
up come handy in preserving financial stability in the face of outflows. In fact, besides being
an intrinsic good, foreign exchange reserves confer several other important advantages such
as automaticity, fungibility and usage in both crisis prevention and crisis resolution. Because
of the potential for rapid outflows and the associated liquidity risks, EMEs have tended to
build up reserves as a means of self-insurance. During the recent crisis, EMEs which had
built up reserves as self-insurance found that they could weather the crisis more effectively.
The very possession of an ample level of reserves helped to maintain market confidence as
measured by lower spreads on credit default swaps and also blunted the penetration of the
crisis in these economies.
9. Such self insurance has, however, faced intellectual inclement. It has been criticized
as being costly and inefficient and also as contributing to global imbalances. To wean EMEs
away from self insurance, international financial institutions like the IMF have recently come
up with revised instruments such as a flexible credit line and high access precautionary
arrangements. There were also cases of regional swap arrangements during the recent
crisis. It is not yet clear if such external safety-nets can fully substitute for national level
selfinsurance in terms of speed, effectiveness and autonomy.
The option of capital controls
10. The third standard option for EMEs is to impose controls on capital flows.
Experience in this regard has been mixed. Protagonists of controls have argued that capital
controls are distortionary, difficult to implement, easy to evade, and that they become
ineffective fairly quickly and entail negative externalities. On the other hand, proponents of
capital controls contend that controls are desirable because they preserve monetary policy
autonomy, save sterilization costs, tilt the composition of foreign liabilities toward long-term
maturities, and ensure macroeconomic and financial stability. The challenge for policy
makers is to design and implement controls where the cost of compliance is lower than the
cost of evasion.
11. Capital controls were a central issue during the Asian crisis, but the orthodox view
that "controls are not desirable" largely survived the crisis. Capital controls are now once
again a central issue, as the recent crisis witnessed, across emerging economies, a rough
correlation between the extent of openness of the capital account and the extent of adverse
impact of the crisis. Surely, this should not be read as the denouncement of open capital
account, but a powerful demonstration of the tenet that premature capital account opening
hurts more than it helps.
12. The advisability of a Tobin tax has figured prominently in the discussion on capital
controls in the post crisis period. Several countries have used variants of Tobin tax to
discourage heavy, short-term capital inflows. It has been argued that the tax helps reduce
exchange rate volatility and consequently curtails the intensity of "boom-bust" cycles
engendered by international capital flows. However, Tobin tax has been criticized on many
counts: the tax can be evaded easily through modern financial instruments like derivatives; it
reduces liquidity in the markets; and to be effective, the scope of the tax needs to be
continuously widened which may lead to inefficiencies. The efficacy of a Tobin type tax
remains a debatable issue.
13. Refreshingly, the IMF has shed its long held orthodoxy against capital controls. The
policy note of the IMF published in February 20101 has referred to certain "circumstances in
which capital controls can be a legitimate component of the policy response to surges in
capital
flows". The IMF's Global Financial Stability Report (April 2010) has gone further into
this issue and observes that capital controls are reasonable instruments in the "toolkit" of
developing/EME economies facing volatile capital flows. The World Bank and the Asian
Development Bank too have echoed the view that capital controls may be advisable, indeed
inevitable, in certain circumstances.
India's approach
14.
India has experienced both "floods" and "sudden stops" of capital flows. Net capital
flows to India increased from as low as US$ 7 billion in 1990-91 to US$ 45 billion in
2006-07, and further to US$ 107 billion during 2007-08, the year just before the crisis. They
dropped to as low as US$ 7 billion in 2008-09 at the height of the crisis. Capital flows are
estimated to have recovered to around US$ 50 billion in 2009-10.
15. India has followed a consistent policy on allowing capital inflows in general and on
capital account management in particular. Our position is that capital account convertibility is
not a stand alone objective but a means for higher and stable growth. We believe our
economy should traverse towards capital convertibility along a gradual path - the path itself
being recalibrated on a dynamic basis in response to domestic and global developments. We
will continue to move towards liberalizing our capital account, but we will revisit the road map
to reflect the lessons of the crisis. As regards a Tobin type tax, we have not so far imposed
nor are we contemplating one. However, it needs reiterating that no policy instrument is
clearly off the table and our choice of instruments will be determined by the context.
16. Among the components of capital flows, we prefer long term flows to short-term
flows and non-debt flows to debt flows. The logic for that is self-evident. Our policy on equity
flows has been quite liberal, and in sharp contrast to other EMEs which liberalized and then
reversed the liberalization when flows became volatile, our policy has been quite stable.
17. Historically, we have used policy levers on the debt side of the flows to manage
volatility. Contrary to popular perception, we have used both quantity and price based
variables to moderate debt flows. There is a ceiling on the extent of FII investment in
sovereign and corporate debt (quantity variable) and there is also a withholding tax (price
variable). External commercial borrowings (ECB) by corporates come in through both an
automatic route and an approval route. ECB flows under both the automatic and approval
routes are moderated by interest rate ceilings (a price variable) and those under the
automatic route through an additional ceiling on total quantity (a quantity variable).
Non-Resident Indians (NRI) deposits are monitored through an interest rate ceiling, a price
variable.
18. Our exchange rate policy is not guided by a fixed or pre-announced target or band.
Our policy has been to intervene in the market to manage excessive volatility and disruptions
to the macroeconomic situation. This "volatility centric approach" to exchange rate also
stems from the source of volatility which is capital flows. Despite not having a fully open
capital account, we have experienced large volatility in capital flows as the data for last four
years suggests (See Table below). The exchange rate of the Indian rupee vis-à-vis US dollar
appreciated when there were large capital inflows; and it depreciated when the capital
inflows thinned out. The two way movement is a clear demarcation of our flexible exchange
rate policy.
Table
Trends in India's external sector
2006/07 2007/08 2008/09 2009/10
CAD (% of GDP) 1.0 1.3 2.4 2.5
Net Capital flows
(% of GDP) 4.8 8.7 0.6 3.8
Capital flows in excess of CAD ($
billion) 37 92 (-)20 14
Rupee appreciation (+)
depreciation (-) vis-à-vis US$
during the year 2.3 9.0 (-)21.5 12.9
19. India's exchange rate policy is said to have imposed some costs. Last fiscal
(2009/10), the rupee appreciated by 13 per cent in nominal terms but by as much as 19 per
cent in real terms because of the inflation differential between us and our trading partners.
This has implications for our external competitiveness at a time when world trade is
recovering and concerns about protectionism are resurfacing. Also, if we have a flexible
exchange rate, and if other countries which are our trading partners or competitors for the
same export markets have a fixed exchange rate, we get disadvantaged.
20. Although India does not have a deliberate strategy of building up reserves for self
insurance, our reserves got built up as a result of our relatively flexible exchange rate policy.
The reserves so built up have been used to contain volatility in the event of capital flow
reversals.
21. There has been much discussion post-crisis on the cost effectiveness of
self-insurance. The main refrain has been that accumulation of reserves by EMEs as a
safety-net entails domestic costs while also leading to global imbalances. Be that as it may,
in evaluating the level of reserves and the quantum of self insurance, it is important to
distinguish between countries whose reserves are a consequence of current account
surpluses and countries with current account deficits whose reserves are a result of capital
inflows in excess of their economy's absorptive capacity. India falls in the latter category. Our
reserves comprise essentially borrowed resources, and we are therefore more vulnerable to
sudden stops and reversals as compared with countries with current account surpluses.
Way forward
22. For several decades now, EMEs have struggled with capital flows in their own ways.
The orthodox view that capital controls are inherently inefficient and should not be resorted to
has inhibited mainstream research on the topic. But that orthodoxy has now changed, and a
more flexible and open-minded approach is gaining ground. For example, the April 2010
Global Financial Stability Report of the IMF says, "there are a number of different types of
controls that can be imposed with varying degrees of success under different country
circumstances. Overall, the message is that one size does not fit all. Since the use of capital
controls is advisable only to deal with temporary inflows, in particular those generated by
external factors, they can be useful even if their effectiveness diminishes over time." There is
a need to follow up this revised world view with research. The IMF and other multilateral
bodies and research institutions must embark on researching the negative externalities
arising from large and volatile capital flows, the ways to address the negative externalities,
explore when it is appropriate to use controls, what kind of controls work best and under
what circumstances.
23. Another area where IMF research would be value adding will be in creating an
informative and exhaustive database on capital flows including cross border bank exposures.
This may include standardization of the definition of capital flows, maintaining data at higher
frequencies and collecting information on the counterparties involved in the transactions.
Such tracking would help countries determine which types of flows are potentially unstable
and need reserve backing. The IMF should undertake an independent study on capital flows
based on such data and pinpoint the vulnerabilities, if any, in the international monetary
system so as to enable countries to take preventive action against potential pressure points.
24. There has been some discussion on the role of the IMF in evaluating the capital
account stances of countries. It would be preferable for the IMF to play only an advisory (and
not jurisdictional) role on capital account issues as our collective understanding is not yet
complete and differences in views/perceptions/experiences need to be accommodated.
Within this advisory role, even-handed treatment, in the sense that sources of volatility and
potential vulnerability are given as much emphasis as the issue of capital controls, is
important.
Conclusion
The Economist
25. In its January 28, 2010 issue, said, "Capital, like water, tends to flow
around such obstacles (taxes). Try to dam its movements at one point, and slowly but
remorselessly, it will find its way around." To learn to "dam" the flows so that the benefits of
capital flows exceed their costs remains an intellectual and policy challenge for EMEs.