University of California Professor Barry Eichengreen on Monday said India needs to worry about short-term debt flows, including external commercial borrowing, whose relative importance has been rising in recent years, albeit from low levels.
“It needs to keep an eye on outward FDI, which is greater than in other emerging markets and where regulation is more permissive for firms than individuals (where we know that firms as well as individuals can engage in cross-border financial arbitrage),” he said. “It has been wise to accompany that move with a more flexible exchange rate,” Eichengreen, George C Pardee and Helen N Pardee Professor of Economics and Political Science at the University of California, Berkeley, said while delivering the Exim Bank’s 32nd Commencement Day Annual Lecture.
“India has been prudent in moving gradually and incrementally when liberalising the capital account in the the last 25 years, starting with policy toward FDI inflows, followed by policy toward portfolio equity inflows and then debt inflows, and turning last toward policy toward outflows, gradually raising ceilings and increasing the range of transactions subject to automatic approval,” he said.
Eichengreen said India could also move further in the direction of price-based as opposed to quantitative restrictions on capital account transactions. “It needs to further strengthen its banking system so that the banks, especially public banks with lower asset quality and governance issues, can cope with the volatility to which larger international financial flows give rise,” he said.
“But the story… has been broadly positive. India has other pressing challenges. But fundamental reform of its capital-account-management practices, happily, is not one,” he said.
“Recent experience confirms that capital flows are volatile, so that the capital account of the balance of payments should be liberalised only gradually, as other measures are taken to strengthen domestic markets and institutions, and as policies are adapted to the more open capital account. Regulations affecting FDI should be relaxed first, since FDI remains the least volatile form of capital flow,” he said.
Eichengreen believes a limited fall in FDI can cause problems when gross FDI inflows are financing a large current account deficit. “And FDI outflows from EMs, which have become increasingly important in recent years, can constitute a vehicle for capital flight, as in China, which has been forced to reverse earlier measures…,” he said.
“Emerging markets can then follow up on measures encouraging FDI with gradual liberalisation of their policies toward international bond and equity market flows. But flows into emerging equity markets remain limited; this is what we should expect, after all, given that information asymmetries and questions about corporate governance, which are the fundamental obstacles to equity finance, are defining features of emerging markets,” he said.