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The recent troubles with emerging market (EM) currencies have been accompanied by the usual recriminations. The affected governments have accused the US Federal Reserve of being insensitive to them, whereas commentators in developed countries blame the EMs for economic mismanagement and political instability. This glosses over the fundamental risks from liberalised cross-border capital flows.
Conventional wisdom has pushed developing countries to liberalise their capital account to supplement local capital and to deepen and broaden domestic financial markets. In India too, multiple committees on financial sector reforms have recommended a phased progress towards full capital account liberalisation (CAL). In recent years, India has progressively loosened capital controls, mainly to help corporates access low-interest foreign capital and to attract capital to shore up a declining rupee.
But the global financial crisis has unsettled several macroeconomic policy orthodoxies, including the consensus on capital flows. In late 2012, the IMF acknowledged the significant risks posed by cross-border capital flows, “magnified by gaps in countries’ financial and institutional infrastructure”. Arguing that full liberalisation need not be an “appropriate goal for all countries at all times”, it supported context-specific “capital flow management measures”. The recent currency market turmoil lends credence to the long list of arguments against liberalising capital flows.
To start with, episodes of capital inflows, sudden stops and outflows, triggering sharp currency devaluations, have become very frequent. Further, once the tide of capital flows is reversed, most often due to global factors beyond the control of the host country, the potential downside pressures on the currency can be disproportionately greater than the fundamentals of the economy would warrant. As economists Barry Eichengreen and Poonam Gupta show, at such times, economic fundamentals do not provide any insulation and countries with large and liquid financial markets suffer the most. If the markets perceive any political instability or macroeconomic weakness, both always likely even in the better governed countries, the downside risks get amplified.
For example, despite a temporary worsening of the current account deficit, India’s export receipts and foreign exchange cover for external debt service are among the lowest for EMs. Among 18 large EMs, only China and Russia have a lower external debt to GDP ratio than India, and this has been low and stable for a decade. Nevertheless, driven mostly by market perceptions, the rupee has experienced relentless pressure.
Two, several studies, including those by IMF economists, have shown that after controlling for various factors, there is little to suggest any causal relationship between CAL and economic growth. It also has no correlation with lower inflation or higher investment rates.
Three, there is a fundamental risk management problem with external debt financed investments by corporates in infrastructure and non-tradeable sectors. It leaves borrowers exposed to currency risk due to the mismatch between the rupee cash-flow and dollar repayments. Accordingly, in the aftermath of the recent decline in the rupee, many continued…