Duvvuri Subbarao: Capital account management Remarks by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the “Rethinking macro policy II,” a conference sponsored by the International Monetary Fund, Washington DC, 17 April 2013. * 1. * * Capital account management Intellectual shift on capital controls • The change in our world view on capital account management is by far one of the most remarkable intellectual shifts brought on by the crisis. • In her opening remarks yesterday, the Managing Director said that the crisis shattered the consensus on many macroeconomic issues and shibboleths. Nowhere is this more true than in the broad policy area of capital account management. • In my view, the three big issues on which the pre-crisis consensus has dissolved are the following: Three issues where consensus is broken (i) Movement towards a fully open capital account (ii) The use of capital controls as short-run stabilization tools (iii) The desirability of foreign exchange intervention. I want to comment briefly on each of these. I. Movement towards a fully open capital account • On the first issue, open capital account, before the crisis, the consensus was that every country should eventually move towards a fully open capital account. The debate was only about the appropriate strategy – sequencing and timing, in particular – for transitioning to full capital account convertibility. China and India • Let me invoke the example of India. Moving towards full capital account convertibility has always been our policy goal. The only variable was the road map for getting there which, it was agreed, should be redefined from time to time, consistent with the evolving situation. There was also general agreement that we should start with floating the exchange rate and decontrolling interest rates, and finish with the capital account, on the rationale that this strategy will best preserve macro stability. • There has been a long and vigorous debate in China too on opening up the capital account, with a roughly similar consensus as in India about sequencing. Over the last few years though, China has apparently changed its strategy, as is evident from their policy direction. If you accept that measures to internationalize the RMB are a big step towards capital account convertibility, then this initiative by China has been much bolder than its actions on freeing up exchange and interest rates. Controls and financial stability • The crisis has, however, changed all this. It shifted the debate, from the strategy and timing for capital account convertibility, to questioning the very imperative for capital account convertibility. BIS central bankers’ speeches • In other words, the consensus that every country should eventually move towards a fully free capital account is now broken. • The main argument in support of the new view – that full capital account convertibility need not be an eventual goal – is that controls prevented emerging markets from adopting some of the financial products that proved toxic in advanced countries. So, there is merit, it is argued, in retaining capital controls. • Against this is the old argument, which is still quite persuasive, that as countries become more integrated economically, they will need to become more integrated financially. In that backdrop, the questions on this sub-topic of movement towards a fully free capital account are the following: (i) While there is virtual consensus that free trade in goods is welfare enhancing, opinion is divided on the virtues of financial openness. What explains this difference? In what ways is financial liberalization different from trade liberalization? (ii) Is full capital account convertibility still an appropriate objective for every country? (iii) If so, what is the best strategy for achieving it? Should it be Festina Lente, which I believe, is Latin for making haste slowly. II. Capital controls as a stabilization tool • The second issue on which the pre-crisis consensus is broken is the use of capital controls as a stabilization tool. • Before the crisis, the consensus was that capital controls are bad, always and everywhere. • That consensus no longer holds. • Received wisdom today is that capital controls are not only appropriate, but even desirable, in certain circumstances. • Even so, there are many unsettled debates. Effectiveness of capital controls • The first big debate is about the effectiveness of capital controls. People have questioned effectiveness on the basis of mainly two arguments: – First, that capital controls do not alter the volume of flows, but alter only their tenor. – and second that, capital controls can easily be circumvented by disguising short term flows as long term flows Price vs quantity controls • Then, there is a debate about what type of controls are effective. • Countries have used both price based controls such as taxes, as well as quantity based controls. Evidence on which of them has been effective, and under what circumstances, is not conclusive. India’s experience • In India, for example, we deploy both price based and quantity based controls. [For example, deposits from Non-Resident Indians, which are an important source of capital flows into India, are controlled through the interest rates banks can offer, a price variable. External borrowing by Indian corporates is controlled through both quantity and price variables.] BIS central bankers’ speeches • Our experience has been that while quantity controls are more effective in the shortterm, they can also be distorting, inefficient and inequitable. Capital controls vs prudential measures • There is also an argument about whether capital controls can be substituted by prudential measures. • It is not clear that they are always exact substitutes. If capital inflows are intermediated through the banking system, then prudential measures can be applied directly on domestic banks, circumventing the need for controls. • But what if the inflows are direct, that is to say, loans directly from foreign entities to domestic companies? In that case, the only mechanism to prevent excessive leverage, and foreign exchange exposure, may be by imposing controls. Against that backdrop, the questions on Capital Controls as a short-run Stabilization Tool are the following: (i) Can we define the distortion that capital controls are meant to correct? For example, how do we determine if capital flows are excessive or dangerous? (ii) What have we learnt about the effectiveness of capital controls as a stabilization tool? (iii) When can prudential measures be substituted for capital controls? (iv) What criteria should we adopt to choose between price based and quantity based controls? (v) Are capital controls symmetric as between inflows and outflows? In other words, should we use one type of controls to control inflows and another type to limit outflows? III. Foreign exchange intervention • The third important issue on which the pre-crisis consensus has dissolved is foreign exchange intervention. • The pre-crisis consensus, at any rate among advanced economies, was that intervention in the forex market is sub-optimal. • That consensus no longer holds, with even some advanced economies defending their currencies from the safe haven impact. • Emerging markets, for their part, have had long and varied experience of struggling with forex intervention. The policy dilemma in the event of receiving capital flows, beyond the country’s absorptive capacity, can be quite complex. • If you didn’t intervene in the forex market, then you would have currency appreciation quite unrelated to fundamentals. • – If you intervened, but did not sterilize the resultant liquidity, you become vulnerable to inflation pressures and asset price bubbles. – If you intervened in the forex market and sterilized the resultant liquidity, you may find interest rates firming up – which attracts even more flows – a classic case of Dutch disease. – What all this says is that there is really no benign option for dealing with volatile capital flows. There is one other important issue relating to forex intervention. Both currency appreciation and currency depreciation, quite unrelated to fundamentals, are BIS central bankers’ speeches complex problems. But there is a significant asymmetry between intervention for fighting appreciation and intervention for fighting depreciation. • When you are fighting currency appreciation, you are intervening in your own currency. Your capacity to do so is, at least in theory, unlimited, quite simply because you can print your own currency. • But when you are fighting currency depreciation, you are intervening in a hard currency. Your capacity to intervene is, therefore, limited by the size of your forex reserves. What complicates the dilemma is that the market is aware of this. • So, there is the real danger that by intervening in the forex market, you could end up losing forex reserves, and not gaining on the currency. The lower your reserves dip, the more vulnerable you become. And the vulnerability can become quite serious if your reserves go below the level markets perceive as necessary to regain market access. • It should also be clear that a failed defence of the exchange rate is worse than no defence. So, when you are intervening in the forex market, it is important to make sure that your intervention is successful. In that context, the questions on this topic of forex intervention are the following: (i) Under what conditions is it appropriate for countries to intervene in the forex market? (ii) Under what conditions is forex intervention preferable to capital controls? (iii) In most cases, countries claim that they are intervening in the forex market, not to target any particular rate, but only to manage the volatility in the exchange rate. Is it necessary then to define upfront your measure of volatility that will trigger intervention? 2. Reserves • The optimal level of reserves that countries may hold has been one of the important policy issues post-crisis. • An argument in support of countries holding sizeable foreign exchange reserves has been their role as a war chest, as a source of liquidity, and as an instrument for inspiring market confidence. • The argument against holding reserves has centred on the opportunity cost of holding them, and also that the comfort they provide may encourage excessive risk taking and therefore become detrimental to macro stability. Questions 1. How do we measure the costs and benefits of holding reserves? 2. How realistic are the alternatives to self-insurance by way of reserves? Are the alternatives to self-insurance, the IMF’s new instruments, Flexible Credit Line (FCL) and Precautionary and Liquidity Line (PLL), bilateral and multilateral swap lines, really effective alternatives to having an own war chest of reserves? Are the alternatives flexible enough to accommodate country circumstances? Are they quick enough to provide relief in a crisis situation? Do they still carry the stigma usually associated with IMF assistance? 3. How do you measure the adequacy of reserves? And how do you build in country circumstances into that measurement? BIS central bankers’ speeches 3. International provision of liquidity • The global financial crisis has revived the familiar concerns about the global reserve currency and the availability of liquidity in times of stress. • The crisis has illustrated the threat to global stability because of a single reserve currency. Questions 1. Are the risks of a single reserve currency being exaggerated? After all the world weathered the global financial crisis quite well even with a single reserve currency? 2. If not, how do we reduce those risks? How do alternate reserve currencies emerge? 3. To what extent is increase in SDR issuance a solution to the liquidity problem given that the SDR is essentially a liability on member countries’ freely usable resources, and not of the IMF? 4. Till alternatives to the single reserve currency emerge, what are the obligations of the US as the issuer of the sole reserve currency? In particular, what are its obligations to EMEs whose currencies are not yet fully convertible on the capital account? BIS central bankers’ speeches