FX International Payments
By Frances Coppola
Some background is helpful in understanding India’s approach to capital controls. Liberalizing the movement of capital around the world has indeed helped to bring about a very large expansion of international trade in the last 30 years. But this has come with a cost: there has also been a very large financial crisis from which the world has not yet fully recovered. Economists now acknowledge that under some circumstances, unrestricted capital flows can be a serious threat to financial stability.2
For example, the feared “sudden stop” that has damaged some developing economies is caused by very large outflows of capital.3 In the aftermath of the 2008 financial crisis, many developing countries suffered sudden stops as investors fled to traditional safe haven investments such as gold and U.S. Treasuries.4 Very large inflows of capital can also be destructive, since the credit and asset booms they create often end in a financial crisis and a sudden stop, leaving the country poorer than it was before.5
Our previous capital controls article explained how capital controls have been used as a short-term expedient to help manage severe financial crises. However, some developing countries – including India – routinely use capital controls to stabilize their exchange rates, prevent damaging capital flight and promote long-term investment. .
It’s also necessary to understand the “current account.” A country’s current account is its balance of trade (imports minus exports), plus net investment returns (returns on overseas investment minus foreigners’ returns on holdings of domestic assets), plus remittances (money sent back to their families by people working outside the country) and remuneration of overseas employees. The current account is the mirror image of the “capital account,” which records short and long-term financial flows into the country.
When a country runs a current account deficit, the capital account will be in surplus – i.e. more money comes into the country in the form of investment than it does in the form of earnings. When a country runs a current account surplus, the opposite is true. We can say that a country with a current account deficit is a net importer of capital, while a country with a current account surplus is a net exporter of capital.
Large inflows of capital tend to be associated with high and rising current account deficits: in a sudden stop, when capital inflows abruptly reverse, the current account balance also reverses, switching rapidly from deficit to surplus as the external finance needed to pay for imports evaporates.
India’s long-established institutional framework for capital controls was originally built around managing its current account to maintain it roughly in balance.6 To that end, it has controls on both inflows and outflows.
Inflow controls include caps on foreign direct investment in some sectors and outright bans in others (notably defense); restrictions on foreign holdings of Indian government bonds; import controls on gold; restrictions on foreign currency borrowing by businesses; and limits on the interest rates banks can pay on foreign deposits.7 All these controls may influence international trade with India.
India may use ad-hoc inflow controls too: in 2013, after the U.S. Federal Reserve announced its intention to end quantitative easing (QE), the Reserve Bank of India (RBI) discouraged capital flow instability by requiring foreign investors to invest for at least three years.8 Institutional inflow controls of this kind can be fine-tuned in response to particular events: for example, after that Fed announcement, the RBI also lifted the interest rate cap on foreign deposits by 1 percent and exempted deposits by overseas Indians from bank reserve requirements, thus encouraging capital to flow into the country.9
As the rupee tumbled following the Fed announcement, India imposed controls on outflows, including strict limits on overseas investments by Indian businesses, limits on the amount of money that Indians could send out of the country, and complete prohibition of foreign real estate investment. Some saw this as a backwards step, reversing years of liberalization of capital movements.10 However, they were only in place for a few weeks before being gradually relaxed. Currently, there are limits on the amount of money that Indian residents can send out of the country, but few restrictions for businesses.
According to a study by the International Monetary Fund (IMF), outflow controls are now significantly less binding than inflow controls.11 This is consistent with a view that managing capital inflows can prevent dangerous current account imbalances developing and thus significantly reduce the likelihood of a sudden stop.12 However, Raghuram Rajan, former governor of the RBI, warns that too many capital controls can trap money inside the economy and distort pricing mechanisms, making doing business in, and international trade with, India more difficult.13
India’s institutional capital control framework helps it to respond effectively to capital flow instability, such as happened after the “taper tantrum” in 2013. The challenge for India is to maintain the “goldilocks” level of capital control – not so tight that business is discouraged, but not so loose that the country is exposed to unstable capital flows and the risk of a sudden stop.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1.“Capital controversies,” The Economist; http://www.economist.com/node/372519
2.The Liberalization and Management of Capital Flows: An Institutional View, International Monetary Fund; http://www.imf.org/external/np/pp/eng/2012/111412.pdf
3.“Capital flows and capital-market crises: the simple economics of sudden stops,” Journal of Applied Economics; http://www.columbia.edu/~gc2286/documents/ciecpp5.pdf
4.What’s In a Name? That Which We Call Capital Controls, International Monetary Fund; https://www.imf.org/external/pubs/ft/wp/2016/wp1625.pdf
5.Large Capital Inflows, Sectoral Allocation, and Economic Performance, Board of Governors of the Federal Reserve System; https://www.federalreserve.gov/econresdata/ifdp/2015/files/ifdp1132.pdf
6.“Policy Corner: Did the Indian Capital Controls Work as a Tool of Macroeconomic Policy?,” IMF Economic Review (subscription required); https://www.jstor.org/stable/23279077?seq=1#page_scan_tab_contents
7.“2015 Article IV Consultation—Staff Report; Press Release; And Statement By The Executive Director For India,” International Monetary Fund Country Report No. 15/61; http://www.imf.org/~/media/Websites/IMF/Imported/external/pubs/ft/scr/2015/_cr1561pdf.ashx
8.Raghuram Rajan, former governor of the Reserve Bank of India, speaking at the launch of the Global Policy Lab (G-POL) on May 16, 2017.
9.“India goes back two decades as RBI imposes capital controls to stabilise the rupee,” Economic Times of India; http://economictimes.indiatimes.com/news/economy/policy/india-goes-back-two-decades-as-rbi-imposes-capital-curbs-to-stabilise-rupee/articleshow/21832913.cms
11.“How Open is India’s Capital Account? An Arbitrage-Based Approach,” Chapter 5 of International Monetary Fund Country Report No. 16/76; https://www.imf.org/external/pubs/ft/scr/2016/cr1676.pdf
12.What’s In a Name? That Which We Call Capital Controls, International Monetary Fund; https://www.imf.org/external/pubs/ft/wp/2016/wp1625.pdf
13.Raghuram Rajan, former governor of the Reserve Bank of India, speaking at the launch of the Global Policy Lab (G-POL) on May 16th 2017.