Thai scare

Interference in currency markets is usually a bad idea. That is the cardinal message from Thailand8217;s recent policies intended to prevent currency appreciation. Even though the Thai central bank chose one of the least harmful ways of impacting the Thai baht 8212; a Chilean style tax on short-term capital flows 8212; it caused so much damage that it had to be substantively withdrawn. One of the lessons from the East Asian crisis of 1997 was that when capital accounts are open, fixing or manipulating exchange rates can create huge macroeconomic problems. Countries emerging from the crisis responded not by closing capital accounts, something that is not a realistic option in today8217;s world, but by letting their currencies float.

India has important lessons to learn from the Thai experience. One, if capital controls have to be imposed, they should be non-distorting and not a control on one or other kind of capital. This is very different from the way things are done in India. The system is so oriented towards administrative controls that, rather than market-based mechanisms, they are the first choice. The second, and increasingly significant lesson to be learnt from this, is that government and central bank interference in currency markets does not work today as it might have, perhaps, in the past, because the size of capital flows is too big. The broader lesson to be learnt is that when a country has a large trade and capital account, capital flows are a force that cannot be easily reversed. The best thing to do then is to create markets, structures and incentives so that firms are strong and resilient, hedge their currency exposures and are able to minimise the damage of currency movements due to capital inflows or outflows.

It should also be pointed out that with more flexible exchange rates, today8217;s Asia is far more resilient than it was in 1997, and there is no reason to worry that the Thai crisis would turn into a worldwide crisis.