How India managed pre-crisis capital flows

Managing capital flows has been a key policy challenge for emerging economies like India in the aftermath of the global financial crisis. Regulation of capital flows has certainly moved to the centre-stage. It was earlier confined to the margin of the mainstream policy discourse. Although fresh lessons were learnt from the 2008 crisis and capital controls now form part of the policy toolkit of emerging markets, it would always be useful to study India's approach to capital account management in 2006-07, when there was a capital inflows boom.

Providing an understanding of the strategy adopted by India in management of capital account in that period is a paper – “ India's experience in navigating the trilemma: Do capital controls help ”, authored by Mr R. Kohli, a consultant at ICRIER. It offers useful policy insights on managing capital inflows through the illustration of India's experience.

It demonstrates the possibility of reconciling growth-promoting national priorities such as exchange rate competitiveness, encouraging foreign direct investments, and containing asset price spillovers in an extraordinarily difficult global environment through deft management of capital account.

THE INDIAN WAY

In contrast to other emerging markets that are levying capital controls, the paper noted that India's macro-monetary framework was distinguished by significant restrictions that helped in managing the inflows.

The paper shows how the capital controls (restrictions) that were in existence at that time allowed sufficient policy latitude to the authorities to straddle the open-economy trilemma and balance the exchange rate and price stability objectives.

Features like a restricted foreign presence in the domestic debt market and a current account deficit had enabled India to manage pressures upon the capital account in the recent past, says the paper.

Such a strategy of capital account management was deployed to manage the capital inflows boom in 2006-07 in the build-up to the global financial crisis. The approach allowed the central bank to delicately navigate the ‘trilemma' by keeping an intermediate exchange rate regime but managing to retain its monetary autonomy at the same time.

The paper highlights the role of capital controls in enabling monetary independence. It offers relevant evidence on the effectiveness of India's capital controls in retaining monetary autonomy. The paper also examined the case for retention of monetary control by the Indian central bank during this episode with the help of simple, price-based tests of uncovered interest parity. It finds that capital controls were effective in maintaining the wedge between domestic and foreign interest rates, an essential condition for pursuing an independent monetary policy.

SURGE IN INFLOWS

The paper notes that the pace of capital inflow into the country accelerated significantly from 2005. As a share of GDP, gross capital flows more than doubled from 32.4 per cent in 2005 to 66.4 per cent in 2007, representing a ten-fold increase over 2000 levels to $ 758 billion in 2007.

The main source of the foreign capital inflows was non-FDI flows. They were driven by a combination of excess liquidity –low interest rates abroad and strong growth within the country.

There were two main contributors to the $ 51 billion increase in non-FDI net inflows in 2006 and 2007 over the average 2001-05 levels.

1) Higher purchase of debt and equity securities by foreign investors. These nearly trebled from $12 billion to $35 billion in the two years to 2007.

2) Higher borrowings offshore by domestic companies. Their loans more than trebled to an average 2.7 per cent of GDP ($ 42 billion in 2007).

These surpluses were managed by a combination of policy responses that attempted to balance both exchange rate and price stability goals. The strategy comprised a combination of reserve accumulation-cum-sterilisation, part feedback into money supply, exchange rate flexibility, liberalisation of outflows and controls upon overseas borrowings by residents as a last resort in August 2007.

For most part of the surge, the RBI pursued a strategy of dynamic shuttling between one and another response to achieve consistency in macroeconomic management and to avoid adverse outcomes associated with prolonged use of one response and/or instrument, the paper has highlighted.

At the peak of the boom in mid-2007, by which time the pressures on the capital account had intensified significantly, further liberalisation of foreign debt inflows were temporarily paused, to resume when the macroeconomic cycle turned in 2008, says the paper.

NATURE OF CONTROLS

Finally, as the prolonged surge in capital inflows persisted and currency appreciation pressures remained unabated, policymakers capped Indian companies' access to foreign currency borrowings and prohibited conversion of foreign currency loans into rupees in August 2007.

Specifically, outright caps were imposed upon foreign loans above $20 million for domestic expenditures; loans above these limits for domestic use had to be specifically approved by the central bank; and loans in excess of the cap had to be parked overseas.

Also restricted were participatory notes (PNs), an offshore derivative instrument allowing overseas investors exposure to the Indian stock market. Besides these monetary and exchange rate management measures, certain macro prudential measures were also taken at a fairly early stage of the boom to cool down asset prices and prevent build-up of financial vulnerabilities.

These initiatives succeeded with varying degrees.

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