The Hindu Business Line : CAC needs policy underpinning

The experience of the Southern Cone countries in the late 1970s/early 1980s points to the dangers of moving rapidly towards opening the capital account without a supporting policy matrix.

Convertibility is in the news. Implemented, it will mean the end of all controls on the exchange of currencies. In effect, it will mean aligning interest and exchange rates to the world demand and supply forces. And it will pave the way for freedom from quantitative controls, taxes and subsidies applicable to transactions in the capital account and financial account of the balance of payments.

This demands charting out a sequence of measures for liberalisation; what pre-conditions should be set before the capital account is made convertible, what type of controls should or can be effectively enforced in the event of a crisis, given that international financial markets are integrated on a larger scale and any bubble can precipitate a crisis. Most important is the type of macro-economic policies governments should pursue once controls are dismantled.

The experience of countries so far suggests that capital account should be made free along with other reforms undertaken on the same level — particularly, financial sector reforms, fiscal reforms to adapt or absorb rising domestic demand so as to reduce pressures on exchange rate or the celebrated catchall balance of payments.

It calls for a robust regulation, not only of the banking system but also of the depositors. The idea is to catch high-risk opportunities with a cushion of support, should things fail unknowingly.

Wrong signals

Whether it is a fixed or flexible exchange rate, a country needs to first fix it at a realistic level, followed by a series of adjustments, either in the interest rate or taxes or government expenditure. These adjustments should not be abrupt or hasty; otherwise, it may send wrong signals to investors.

Interest rate and taxes should not be changed too often; rather there should be proactive and orderly adjustments made towards a benchmark level to bring the macro-economy to an equilibrium. This will thwart speculation.

The experience of the Southern Cone countries in the late 1970s and the early 1980s points to the dangers of moving rapidly towards opening capital account convertibility without a supporting mix of policies.

Even the developed countries opened up capital account after a series of broad trade and home financial reforms.

Some countries have opened up successfully without doing the homework of correcting weaknesses in the financial sector, such as framing prudential regulations or devising financial instruments to serve global intermediation from savers to investors. There reforms have actually exposed the underlying gaps.

As a reaction, governments liberalise capital outflows first before inflows are made free. Short-term capital inflows may be regarded as potentially destabilising; so these flows may be limited. Long-term inflows — FDI, for instance — are not checked, presumably because they are more productive for the country.

It becomes difficult to fine-tune policy in the face of such twists and turns of inflows and outflows, each following its own path. Freeing one component of the capital account may create pressures for deregulation of other accounts.

Political resistance

Political resistance builds up, creating vested interests for those affected by reforms.

In such cases, it is best that the capital account is freed after weighing the pros and cons of anticipated gains and unanticipated losses, given the structure of the economy, though the exact sequence of reforms may still be experimental.

Here, India has the edge because of its proven success of controlling capital flows over the years, particularly the outflows.

Faced with prolific capital inflows and in the context of other policy adjustments, several countries have attempted to re-impose capital controls to slow inflows. Banks are controlled, market-based measures such as taxes and levies are put in place, and there are quantitative restrictions on inflows and outflows.

In Malaysia, the Philippines, and Indonesia, banks' offshore operations were tightened, while Brazil and Chile imposed non-interest-bearing reserve requirements against foreign currency borrowing by companies. Malaysia imposed quantitative restrictions in the process. Such measures may seem to be prudent but prolonged use may create distortions.

Capital controls are not, therefore, that important when it comes to controlling capital inflows. Far more important will be the pursuit of sound macroeconomic policies that are fundamental to the economy. Only this can distortions and prepare the ground for adjustments that are deeper in nature. In India, the wide fiscal deficit is always a matter of concern.

Open capital account

An open capital account (de facto or de jure) puts a premium on the right set of macroeconomic policies. For example, there will be a risk of large capital reversals. Monetary and fiscal policy should be so arranged that it is in tune with prevailing market conditions.

Where the exchange rate is managed flexibly, a sharp turn of monetary policy away from market expectations may cost dearly in that the exchange rate goes out of gear.

For example, inflationary expectations, if not handled properly, may upset the exchange rate.

In the same vein, fiscal policy should not be less potent when it comes to its efficacy. A disciplined fiscal stance can correct distortions and bring fundamental adjustments. In Spain, a major move towards liberalisation was made upon its accession to the EU in 1986.

Controls on interest rates were lifted during the reforms process, whereas key capital controls were retained until later.

Home macroeconomic imbalances at the inception of capital account reforms were large in a number of countries with inflation rates ranging from 5 per cent in Indonesia and Singapore to over 1,000 per cent in the Baltic countries before liberalisation.

Breathing space

Nevertheless, controls provide incentives or a breathing space during which time an appropriate macroeconomic policy response can be formulated and put into action. The OECD Code of Liberalisation of Capital Movement provides for introducing emergency measures subject to strict time limitations. Though, even with such time limits, the reprieve from inflows is limited.

The ability to jump controls will reduce the breathing space, and the extent of policy adjustment required over such a time-frame will be correspondingly lower.

Government's fiscal policy may not have the degree of freedom and so may not augment production and incomes despite intentions to do so. The burden in that case falls on the interest rate or on the conduct of monetary policy. Whether it will be used to keep inflation in check or for sharpening money market instruments (like private placement of debt, which SEBI is examining, that can open up FII investment in India in the debt market) depends on the policy responses or, in the Indian case, coalition politics.

(The author is Professor of International Business, Institute of Technology and Science, Ghaziabad, UP. He can be contacted at sgitsgzb@yahoo.com)