Dont cap it

The government and the Reserve Bank of India say that India can take in 150 billion of capital inflows every year without capital controls. To the extent that this indicates increased confidence in the Indian economy to absorb tens of billions of dollars more in its trillion-dollar economy,it is good. However,the framework in which India operates is inadequate for a growing and maturing economy. Comparable countries like Brazil,South Africa,Turkey and South Korea have moved away from capital controls to a much greater extent. The framework that has guided Indias opening up has been to first think of an acceptable figure for the amount of capital inflows that,given the GDP and size of trade,the RBI feels the country can absorb and then to think of a hierarchy of capital flows. In this hierarchy India has treated FDI as better than portfolio investment,with debt coming third. Within debt,long-term debt is preferred to short-term debt. These preferences are implemented with a framework for capital controls set up through the Foreign Exchange Management Act and circulars from the RBI.

Experience suggests that opening up rapidly when financial markets are underdeveloped carries the danger of firms and households acquiring high levels of foreign financial liabilities. There could be currency mismatches exposing agents to movements in currency.

If incomes are in the domestic currency,then sharp movements of the exchange rate can make firms and citizens go bankrupt as they could then be unable to pay back the loans whose value has increased. The danger,in other words,is not the size of the debt but the denomination of the debt. Indian policy-makers still see things differently. If anything,the position is the opposite. Foreign purchase of rupee-denominated bonds is more restricted than external commercial borrowing in dollars.

Another important issue is the implementation of the limit of 150 billion of capital inflows. Capital controls are distortionary and people find ways around them but incur a cost in doing so. Unless the government stops thinking of an acceptable figure and gives up trying to implement it,we will be hampering growth and investment.