Friday, April 15, 2011

Did the Indian capital controls work as a tool of macroeconomic policy?

Ila Patnaik and I wrote a paper titled Did the Indian capital controls work as a tool of macroeconomic policy?

The abstract of this paper reads: In 2010 and 2011, there has been a fresh wave of interest in capital controls. India is one of the few large countries with a complex system of capital controls, and hence offers an opportunity to assess the extent to which these help achieve goals of macroeconomic and financial policy. We find that the capital controls were associated with poor governance, were unable to sustain the erstwhile exchange rate regime, and did not support financial stability. India's experience is thus inconsistent with the revisionist view of capital controls. Macroeconomic policy in India has moved away from the erstwhile strategies, towards greater exchange rate flexibility combined with capital account liberalisation.

This is interesting in the discussion on Indian economic policy. But this has also become surprisingly interesting on an international scale.

Many years ago, policy makers and academics had figured out capital controls. The old orthodoxy ran as follows. Capital account liberalisation was an integral part of the package of policies that made up a modern nation. Plugging into globalisation meant shedding autarkic policies, and being open to ideas, trade, services, capital, etc. All good countries had an open capital account. One by one, emerging markets started figuring out how to remove capital controls. This led to many blow ups along the way: A certain coherent apparatus is required, of fiscal, financial and monetary policy in order to play this correctly. So the path has been a turbulent one, where emerging markets have had to figure out this package, but the destination has been clear.

Policy makers and academics did not come to this conclusion from deductive reasoning. They came to this conclusion by getting bloodied over and over. The capital controls that were attempted did not deliver the desired results, and the capital controls that could deliver the desired results imposed too high a cost on GDP growth. The working consensus of practical people shifted away from capital controls.

In recent years, these questions have been reopened, most notably by the IMF. These questions are, hence, back in the global economic discussion.

But in the world today, most countries have opened up.  Among the G-20 countries, only India and China have a large and complex system of capital controls. In most places, practical experience with capital controls is actually hard to find. Many of the lessons of international experience from the 1970s and 1980s have been forgotten. It is, hence, particularly interesting to study the contemporary experience of India and China with capital controls. This makes our paper a useful component of this global debate.

And, on these issues, also see The IMF needs to find its voice again, by Sebastian Mallaby in the Financial Times. The Frank Warnock paper that he talks about is also worth reading.


  1. If money wants to come it will find a way, controls or no controls. Hence instead of focusing on capital controls, policy makers should focus on sound governance and as you rightly put it, sound fiscal and monetary policies. However, sound governance is not possible in India with its political dynamics. Hence, capital controls are used to hide deficiencies and that proves ineffective in times of stress.

    The clearest example is the events leading up to the 2008 credit crisis. Money flooded in as returns were good. There was an active fixed income market outside India trading on rates and credits. There was an active convertible market which corporates used to the fullest extent. All Indian asset purchases was funded by leverage, using USD and JPY as funding currencies.
    The bubble burst revealed the shallowness of the market and money went out in a hurry taking the INR down by 10% and equities down by 50%. It all came back again when things stabilised.
    Now, with debt limits opened up with USD 40 billion in corporate bonds including infra bonds, the limits have not been used yet. There is relectuance to buy Indian bonds in times of inflation. If the RBI succeeds in sending out right signals on price stability, the limits will get utilised.

    The bottomline here is even if controls are removed there is no guarantee that things will go the way policy makers want it to go. The choice is controls stay or policy makers reform and it does seem as if the latter will hold for a while. The relectuance of China to become more transparent is the reason for their controls. India will continue to follow China in this regard.

  2. Do curbs on hot money count as "capital controls". How about tax on financial transactions like Brazil.
    How much of the failure is due to "bad governance" instead of bad policy.



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