The Hindu Business Line : Rakesh Mohan conducts the Basel symphony orchestra

The report of a Working Group of the Bank of International Settlements on Capital Flows and Emerging Economies provides deep insights into not only the global issue of capital flows but also inter-country experiences that are crucial in policy formulation, says S. S. TARAPORE

In India, we have scant interest in economic history and thereby are unable to learn from the mistakes of the past. We go hyper about the ephemeral, such as the recent half a percentage point reduction by the Reserve Bank of India in policy interest rates, and often fail to focus on enduring work which provides vital lessons for the future.

A year ago, capital inflows into ‘emerging market economies’ (EMEs) was a red-hot subject. Not any longer though, as these flows are now considered a one-off phenomenon.

It is no surprise that a report of a Working Group of the Bank of International Settlements on Capital Flows and Emerging Economies (chaired by Dr Rakesh Mohan, RBI Deputy Governor), which was released in early February 2009, got scant attention from the Indian financial sector as also the media. With some element of confidence, it is possible to assert that most Indian economists would be unaware of this important report. This is most unfortunate as the report provides deep insights into not only the global issue of capital flows but also inter-country experiences which are invaluable for future policy formulationin the EMEs.

The report is eclectic and is presented without predilections. However, readers, including this writer, would absorb only what they would like to hear!

Capital account liberalisation

The perceptions on the relationship between capital account liberalisation and economic performance have undergone a change, from the unequivocal view that free flow of capital would lead to more efficient allocation of resources, to that if there are distortions in the system, there may not necessarily be welfare gains.

Malfunctioning domestic financial markets in recipient countries and poor risk management in capital-exporting countries can undermine the beneficial effects of capital account liberalisation.

Various studies have pointed out that capital liberalisation enhances growth in high income countries but decreases it in low income countries.

Further, a proper sequencing of reforms (elimination of macro-economic imbalances and openness of the economy) appear to be preconditions for attaining the benefits of capital account liberalisation. Although theory predicts a positive effect of capital account liberalisation on growth in EMEs, empirical studies have been unable to unequivocally establish this.

The benefits of capital account liberalisation, however, do not merely flow through reducing the cost of capital and investment; there are collateral benefits such as development of financial markets, improvements in local institutions and better macro-economic management.

An unusual feature in the recent period was that capital flows were far in excess of the needs of the EMEs to finance the current account deficits, resulting in a pile up of forex reserves and a pressure for the local currency to appreciate.

The report recognises that many of the recent trends are too new to permit definitive conclusions as the links between openness to international capital flows and economic activity are complex. The Working Group viewed capital account liberalisation as a process to be managed and this poses challenges to policymakers. The repeated crises in EMEs reinforce the view that capital flows into countries with weak banking systems and underdeveloped capital markets create huge risks.

There is in-depth analysis in the Report and insightful leads provided and a short column, like the present one, can just not do justice to the excellence of the Report. The purpose of this column would be achieved if Indian economists, policy and opinion-makers, and key participants in the financial sector would be provoked to study the report.

Sterilisation, intervention

The report has an interesting chapter on intervention, sterilisation and domestic financial intermediation. The experiences of Australia, Chile, China and India provide useful inter-country comparisons. It is gratifying that India did not follow the Chinese in issuing central bank bonds and payment of interest on reserve requirement balances. There is reference to concerns about rising interest costs of sterilisation bonds. The Indian approach of spreading the costs among the RBI, the Government and banks has probably minimised the adverse effects of heavy sterilisation costs.

The report lists out a number of useful conclusions which would be of relevance during future episodes of large capital inflows into EMEs.

Excessive haste in liberalising the capital account and inadequate prudential buffers can compromise financial and monetary stability. Sharp swings in capital inflows, without offsetting changes in current account balances, can lead to large and disruptive changes in real exchange rates.

The capital inflows, in a number of countries, have been as large as 10 per cent of GDP which inevitably drive up prices of assets and policy makers have to keep in mind the risks of asset price bubbles. Reliance on short-term foreign currency denominated inflows can increase a country’s vulnerability.

Many of the insights in the report implicitly reinforce the virtue of India’s gradualist approach to capital account liberalisation. Since this is a report on the EMEs as a group, Dr Rakesh Mohan has, skilfully, avoided hoisting one’s own petard. The report recognises that price stability focus of monetary policy can be undermined by paying too much attention to exchange rate objectives.

The report reiterates that a currency cannot permanently deviate from its real long-term equilibrium exchange rate as, sooner or later, inflation differentials would bring about adjustments of the nominal exchange rate consistent with the sustainable real exchange rate.

One size doesn’t fit all

Countries with open capital accounts need to brace up for shocks from financial systems abroad. Countries with flexibility in exchange rates and substantial forex reserves are better able to cushion the downward pressure on the exchange rate brought about by sudden and large capital outflows.

Countries which raised reserve requirements during the period of heavy capital inflows were better able to alleviate liquidity pressures by relaxing these restrictions. The large forex reserves were a first line of defence when there was a reversal of capital flows.

The report stresses that a combination of sound macro-economic policies, prudent debt management, exchange rate flexibility, effective management of the capital account, accumulation of appropriate levels of forex reserves and development of resilient domestic financial markets provide the optimal policy response to large and volatile two-way capital flows. The report rightly emphasises that the best combination will be country-specific and there cannot be a ‘one size fits all’.

A Working Group with 37 members and a back-up support of 61 persons would surely have generated a cacophony, but what has emerged is an enduring report which is sure to become the locus classicus on the subject of capital flows. Kudos to Maestro Rakesh Mohan for wielding the baton so deftly while conducting the Basel Symphony Orchestra to produce such a monumental piece of work.

(The author is an economist. blfeedback@thehindu.co.in)

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