The Hindu Business Line : Complex issue of capital controls

Brazil’s move to impose a tax on capital flows has triggered a debate on the merits of imposing such curbs. Heavy inflows have led to currency appreciation, affecting the ability of local producers to compete. However, capital flows into India have helped finance its trade deficit. Hence, controls may not have a desirable impact, says S. VENKITARAMANAN.

There have been discussions in the international media on the need to restrict capital inflows. This follows the decision by Brazil on October 20, 2009, to impose a 2 per cent tax on capital inflows. It is recognised that unrestricted capital inflows lead to increased liquidity and appreciation of the local currency. As a result, local industries become uncompetitive. Brazil’s action of imposing a tax on capital flows was, therefore, a reasonable one. The questio n that has, however, arisen is whether such taxes on capital inflows are in keeping with the ideology of economic reforms.

Leading economists Dr Arvind Subramaniam and Dr John Williamson of the Peterson Institute of International Economics have, in a recent article in Financial Times, pointed out that prejudice against controls on capital flows is a reflection of intellectual arrogance.

FAVOURING CURBS

Critics of such curbs say that taxes on capital inflows can be easily evaded by investment firms. But that is more a matter of design of the tax and not an argument against imposing controls on capital surges which can destabilise macroeconomic fundamentals.

Market fundamentalists argue that instead of a tax on capital inflows, countries should endeavour to make their corporate governance effective and their own financial structures efficient so as to reduce dependence on foreign capital. Such reforms will take time. It is inevitable, therefore, that countries pressed by the reality of appreciating currencies and increasing liquidity will try to stem flow of capital through unconventional methods.

Brazil’s experiment with a 2 per cent tax on capital inflows is not the only instance of capital inflows being taxed. Chile had earlier endeavoured to impose restrictions on capital inflows by asking the capital exporting firm to place a deposit with the Chilean Central Bank. Dr Subramaniam and Dr Williamson point out that though the effectiveness of Chilean measure was not clearly established, it was a necessary step. What is interesting is that Dr Williamson was one of the originators of the Washington Consensus in the 1990s, which had argued in favour of free capital flows . His current position illustrates the distance the world has travelled since the 90s.

The Asian crisis had demonstrated the need for economies to protect themselves against a flood of foreign capital and its potentially chaotic consequences. The former Prime Minister of Malaysia, Mr Mahathir Mohamed, argued in favour of restrictions on capital inflows as an effective means of protecting the Malaysian economy.

In the recent G-20 deliberations there were discussions to how the destabilising effects of capital movements can be controlled and monitored. A kind of Tobin tax was commended at the instance of the Brazilian Finance Minister to control the volatility of markets.

India has reason to analyse the adverse impact of large inflows. The appreciation of the Indian rupee since the start of this fiscal year has hurt exports.

Various analysts have asked whether India should resort to a Brazilian type of tax on capital inflows. In a recent interview, the RBI Governor, Dr D. Subbarao, disposed of a related query saying that India’s situation was not analogous to that of Brazil.

IMPACT ON BoP

There has been a debate on whether other measures can do the job of controlling capital inflows more effectively than a tax. The Economist has made a suggestion in a recent issue that the present restrictions on foreign direct inflows (FDI) and portfolio investments themselves amount to a tax on foreign inflows.

The Economist argues that there is need for substituting this regulatory requirement by more efficient measures. Can tax be a substitute?

Is total freedom of capital flows desirable in a world in which there are too many resources seeking opportunities in emerging markets, like India, which offer better returns than the advanced economies? However, in recent times capital flows from advanced economies have dried up as a result of the financial crisis. A crisis of abundance has arisen in certain emerging market economies.

The appropriateness of such measures to control capital inflows has to be judged on the basis of their impact on exchange rates and the importance of capital flows in maintaining stability in a country’s balance of payments.

In the case of India, capital inflows, both portfolio and FII, play an important part in maintaining stability in the BoP. They help to finance in large part the looming trade deficit. It is questionable whether India should think of resorting to market-unfriendly measures, like the capital inflow tax.

CAPITAL ACCOUNT CONVERTIBILITY

The debate on capital account convertibility has to be viewed along with this question. Outflows of capital from local citizens and corporates are to be more liberally permitted under convertibility. It follows from this that there has to be a similar treatment for capital inflows from abroad. These related issues deserve to be further explored in the debate on whether India should impose a Brazilian type of tax or Chilean type of deposit requirement.

Dr Subramaniam and Dr Williamson point out that the global financial crisis stemmed from the IMF’s belief system that unduly elevated the status of finance. This contributed to sanctifying, implicitly or explicitly, foreign finance. IMF should, therefore, revise its attitude and favour measures to contra-cyclically restrict surging capital inflows from abroad.

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