Go with the flow

Official worries over PNs follow other capital controls imposed in recent months: restrictions on real estate investment and on external commercial borrowings ECBs. If restrictions on fund flows to equity markets are implemented, there may be a temporary fall in capital flows. But consider: one trillion dollars flow in and out of this high-growth trillion-dollar economy annually, so it is going to be very difficult, to put it mildly, for the government to plug all the holes through which money moves in and out of India. As long as India is a fast growing globalising economy and remains an attractive investment destination, tinkering with capital controls will remain largely ineffective.

One example: earlier this week, a Lehman Brothers report suggested that India, already one of the fastest growing economies in the world, could see sustained GDP growth of 10 per cent. That report will engender increased investor interest in India. If the government tries to restrict PNs, people will find other ways of bringing money in.

This is why the question is not whether the government will be able to effectively impose capital controls. The question is whether it is trying to do the right thing in bringing capital controls. Is closing the capital account the way forward for India? The years since 1991 saw India make a successful transition to an open trade account.

Fear-mongering about how Indian industry would shut down and millions would lose jobs in response to lower tariff barriers seems quaint today. The trade account was opened up incrementally. Year after year, custom duties were brought down. In 2001 all quantitative restrictions were removed. Yashwant Sinha8217;s policy of cutting rates, year after year, until India reached Asean levels, was a source of policy stability where businesses learnt what to expect from trade policy. An essential element of India moving towards an open trade account was policy clarity.

Unfortunately, the same clarity does not exist in capital account policies. So we haven8217;t strengthened our markets, regulatory institutions and banking procedures, modernised our monetary and exchange rate policies and laid out a clear path towards removing capital controls. This is despite two Tarapore committee reports and the more recent Percy Mistry committee report. All the excellent work in these reports haven8217;t reduced the opacity about how India wants to prepare for convertibility. Therefore, it is not surprising that a sharp inflow of capital causes great discomfort 8212; there isn8217;t enough preparation. And since at the bottom of it is a lack of conviction about moving towards a globalised economy, policymakers respond by moving back to controls.

The experience of other countries suggests that those which carefully prepared for capital account openness 8212; Chile and Israel are the best examples 8212; were able to harness the benefits of globalisation much better than those which went it unprepared. The latter typically lived from crisis to crisis in attempting to cope with a globalised economy.

So why is India choosing a suboptimal path to capital account openness? Part of the answer lies in the institution which implements capital controls and therefore has a vested interest in their retention: RBI. Most of the responsibility for preparing for an open capital account also lie with RBI. Bluntly put, if RBI were serious about capital account convertibility, the last 10 years should have seen the central bank allowing foreign exchange derivative markets, building up a flourishing bond market and moving towards a modern monetary policy framework. Since most of these things were not done, the infrastructure for handling big surges in capital flows isn8217;t in place, so it becomes 8216;natural8217; for RBI to say that inflows are a source of risk to India and should be curbed.

Even if RBI doesn8217;t understand this, sensible government leaders must: curbs on capital flows, or even proposals to do so, signal to the world that Indian policymakers are not ready for the big league, for integrating into the world economy. This can have serious perceptional and, eventually, real impacts.

A government/regulatory set-up that seems ready to complain about capital inflows can engender the perception that it is not willing to implement or capable of implementing a macroeconomic management programme in an open economy. This conclusion leaves an investor with two choices. He can decide that Indian policymakers should go back to the days of excessive control. Or he can decide that macroeconomic management skills are deficient. Either way, he may conclude that GDP growth will suffer, because both ineffective macroeconomic management and a less open economy are GDP-dampeners.

Then, the investor may decide against betting on India. India8217;s attractiveness as an investment destination may pall. And capital inflows may actually start falling. So the policy of control will be a success. But is that the kind of success the government wants?

The writer is senior fellow, National Institute of Public Finance and Policy, New Delhi