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. * * * 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. first, capital account liberalisation is a process and it has to be managed keeping in view elasticities 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

is of the essence in order to ensure that credit expansion also takes place in a sustainable manner. finally, it is evident that national fiscal policy has a crucial stabilisation role to play after euro area entry, when monetary policy is no longer available. iv. concluding remarks to sum up, the new eu member states have made considerable – and, in a number of cases, impressive – progress on the road to the euro. the adoption of the single currency will bring many benefits and opportunities to these countries. at the same time, it involves responsibilities and may pose new policy challenges. the adoption of the single european currency implies a permanent commitment. it is, therefore, of paramount importance that the economic policies pursued by the euro area member countries are conducive to price stability and consistent with the constraints imposed by the single currency. the successful participation of a country in the euro area and the smooth functioning of monetary union itself requires that prospective euro area members achieve the necessary high degree of convergence in a sustained manner and prepare their economies – market structures and institutions – so that they can effectively address potential policy challenges that may arise both before and after joining monetary union. good preparation and the attainment of sustainable long - term convergence are crucial before joining monetary union. this is why the ecb – as well as the european commission – take great care to examine the sustainability of convergence and make sure that member states adopting the euro are ready for this momentous historical step. finally, let me stress that to ensure continuity and equal treatment, the ecb will, in its examination of the degree of convergence achieved, employ the same framework of analysis as in the past and will build on the same definitions and principles as set out in the previous convergence reports. thank you very much for your attention.