Capital flows in general are welcome in developing economies. They all add to the productive capacity of the country. They also lead to the development of financial markets. Such flows are also viewed as vehicles for the transfer of technology and management skills.
In effect, international capital markets try to distribute the available world savings among countries, with countries showing high productivity growth attracting more capital.
However, the problem with capital flows is their size and volatility. When capital flows are large and that too with a high degree of fluctuation, they have a bearing on macro economic stability. If capital flows are volatile or temporary, the economy will have to go through a whole adjustment process, in both the real and financial markets which later will have to be reversed. This reversal will not be without cost.
Even when capital flows are not ‘hot' or volatile, several consequences follow.
Some of these concerns include excessive money supply and the consequent pressure on prices, impact on nominal and real exchange rate, increase in consumption and possible deterioration in the current account.
Prior to 1990-91, our major concern was to mobilise enough capital flows to finance the current account deficit.
The crisis of 1991 exploded because of our inability to finance a current account deficit of the order of 3.1 per cent of the GDP. That position has changed.
Thanks to the development of the international capital markets, today emerging economies including India are able to attract large capital inflows.
Policy Options
When the inflows are large, there are three options open to the policymakers.
The first option is to let the capital flows pass through the foreign exchange markets fully. This will have the effect of making the domestic currency appreciate, with possible adverse consequences on the country's exports.
This will be particularly uncomfortable, if the country was experiencing already a current account deficit. The second option is to absorb the inflows into reserves.
If unsterilised, these inflows will lead to an expansion of money supply causing prices to rise. Domestic inflation has its own implications. Apart from this, with prices rising, the real effective exchange rate will rise, even when nominal exchange rate remains unchanged.
If sterilised, some of the consequences of the reserve accumulation can be moderated but this will imply a cost which will depend on the return on foreign exchange reserves and the cost of borrowing. One has to balance the ‘self insurance' benefit of reserves with the cost.
The third option is to use capital controls to restrict the inflows and to stimulate the outflows. Capital controls are not that easy to monitor.
However, as a temporary measure, restrictions on some forms of capital inflows have been attempted by several countries. In fact, the response to large capital inflows is always in the form of a mixture of the three options.
The policy makers may let the domestic currency appreciate to some extent, absorb some part of the flows into reserves and impose some controls on capital inflows.
It is impossible to maintain simultaneously free capital flows, fixed exchange rate and autonomy in domestic monetary policy.
Tobin Tax
Capital controls to check inflows take a variety of forms. One generalised instrument to check particularly short-term flows has been the Tobin tax.
Under this system, a small tax is levied on all foreign exchange transactions. In some ways this is a blunt instrument which makes no discrimination between one type of flow and another type.
More importantly, it will clutter the foreign exchange market. It may also make the collection of tax itself very cumbersome. However, several countries have imposed restrictions, both price-based and quantitative, on specific types of transactions. These may not be characterised as Tobin tax.
Apart from direct quantitative controls, reserve requirements have been used as tools for curbing capital inflows. IMF has recently recognised that in certain specific circumstances capital controls can be imposed and these may even be deemed as advisable. However, IMF's advice was directed to countries which have more or less adopted full capital account convertibility. Countries such as India do not fall in this category.
Even with respect to foreign direct investment, we have sector-specific restrictions. While external commercial borrowing has been made easier, prior sanction from the central bank is required beyond specified limit. FII investment in debt has also limits. The Indian scenario is thus different.
Current account deficit
There has been a dramatic change in the quantum and composition of capital flows to India. In 1990-91, total capital flows amounted to $ 7.1 billion. Almost all of this was in the form of debt.
Much of it was also official. Total capital flows increased from $10.8 billion in 2002-03 to $45.2 billion in 2006-07 and further to $106.6 billion in 2007-08. In 2009-10, the total capital flows are estimated at $53.6 billion. The composition has definitely shifted towards non-debt creating private flows.
India's balance of payment position in the post-liberalisation period has been strong. India's current account deficit remained low till 2008-09. Since then, it has started climbing and the current account deficit stood at 2.8 per cent of GDP in 2009-10. In the first half of 2010-11, the current account deficit remained very high at 3.7 per cent of the GDP.
However, in the second half, exports picked up strongly while import growth was weaker. It is now estimated that the current account deficit for the year as a whole was 2.6 per cent of GDP. So far we have had no problems in financing the current account deficit. Even in 2010-11, capital flows were adequate to cover current account deficit and add to the reserves $15 billion.
Given the current trends in the world economy and the behaviour of international capital markets, efforts must be made to keep the CAD around the manageable level of 2.5 per cent of the GDP. This itself will mean a larger inflow of capital in absolute amount, as our GDP keeps increasing.
For this reason, we need to be proactive in attracting capital flows. So long as our economy grows at a rate exceeding 8 per cent and our inflation and fiscal deficit remain at modest levels, we should not face any problem in financing the current account deficit. However, over a longer time horizon of a decade or more we should try to achieve a balance in our current account.
(Extracts from the First Convocation Address of the National Institute of Securities Markets, Mumbai delivered on September 9.)
(The author is Chairman, Economic Advisory Council to the Prime Minister.)