WSJ on Indian capital controls and monetary policy

Eswar Prasad has an article Cracking open India's capital account in The Wall Street Journal Asia where he says:

Capital account liberalization is back on the table in India. In 1996, with spectacularly bad timing, the government-appointed Tarapore committee recommended rapid opening of the capital account. The Asian crisis that erupted in 1997 halted that policy dead in its tracks. In 2006, with the Asian crisis a distant memory, the Reserve Bank of India revived the Tarapore committee. This time, the group's report was more cautious, endorsing a gradual move towards a more open capital account. Another government committee's work, dubbed the "Mistry Committee" report, has ratcheted up the debate this year by arguing that to give Mumbai a fighting chance of becoming an international financial center, the capital account must be fully opened by the end of 2008.

Would India be putting the cart before the horse by plunging headlong into capital account liberalization? The financial system is still underdeveloped, the fiscal deficit remains high (around 7% of GDP) and the exchange rate is still managed (although in recent weeks the rupee has been allowed to appreciate significantly). Under such circumstances, when the economy is not equipped to handle a gusher of capital flowing in or out, unbridled capital account opening in some emerging market economies has ended in tears.

Despite the risks, capital account liberalization could indeed prove to be a boon for India, but for a completely different set of reasons than the traditional ones associated with pulling in capital inflows. And, notwithstanding the recent complications with managing inflows, it is important to keep the big picture in mind, and reforms moving forward.

The traditional view is that opening up to inflows allows capital-poor developing countries to import capital, increase domestic investment and grow faster. The problem for proponents of this view is that economists analyzing macroeconomic data have found it difficult to detect the direct growth-enhancing benefits of foreign capital.

But a new paradigm has recently emerged in the academic literature on this issue. The real benefits of financial globalization to an emerging market economy have less to do with the raw financing provided by foreign capital. Instead, the indirect "collateral" benefits associated with such capital are far more important. These indirect benefits may be crucial for India's development.

One of the key benefits is that openness to foreign capital catalyzes financial market development. Foreign investment in the financial sector tends to enhance competition, raise efficiency, improve corporate governance standards and stimulate the development of new financial products. For instance, in India, even the limited entry of foreign banks has already given domestic banks a much-needed kick in the rearside and forced them to improve their efficiency in order to compete and stay viable.

Liberalizing outflows has the salutary effect of giving domestic investors an opportunity to diversify their portfolios internationally. This means greater competition for domestic financial institutions but also an opportunity for them to cultivate the financial savvy to offer products that would help their customers invest abroad.

Other indirect benefits associated with foreign capital include transfers of expertise - technological and managerial - from more advanced economies. When supported by liberal trade policies, foreign investment can help boost export growth. Foreign-invested firms also tend to have spillover effects in generating efficiency gains among domestic firms.

Notwithstanding these potential benefits, there is strident opposition in India to capital account opening. Some of it is based just on ideological opposition to foreign involvement in the economy. Dig deeper, though, and it turns out that much of the opposition comes from entrenched interests that view foreign-financed competition as an unwelcome intrusion that erodes the protection and privileges they have enjoyed for many years. Indeed, a "shock" like capital account opening is just the tonic to shake up the system and thwart coalitions that try to block reforms in this and other dimensions.

So why the rush towards a fully open capital account? What is so special about the end-of-2008 date or, for that matter, any specific date? In short, nothing.

But deadlines do have a way of focusing the mind. A policy commitment to fully open the capital account in a couple of years would give domestic firms time to adjust to the new landscape but force them to get to work immediately on restructuring themselves. It would give less room for reactionary forces to coalesce and block the reforms. It would also force policy makers to push forward with reforms such as deficit reduction and increased currency flexibility. Moreover, the historically high level of foreign exchange reserves (about $200 billion) and the benign international environment provide a window of opportunity to undertake capital account liberalization with fewer risks.

For an emerging market economy, the process of opening the capital account comes down to a delicate balance between the benefits it affords and the risks of disruptions to growth if things go wrong. For the Indian economy, which has made great strides in recent years, the balance has shifted - the trisks are now smaller and well worth taking to embrace financial globalization and push growth higher.

Coincidentally, The Wall Street Journal Asia also had an editorial on Indian monetary policy:

Mercantilist monetary policies are popular in developing Asia, where central banks have plenty of money to intervene in foreign-exchange markets and keep their currencies cheap. But how long will the party last? At some point, intervention becomes too expensive and inflationary pressures too great.

That's the conundrum India is facing today, where waves of inbound foreign capital have led the central bank to abandon more than a decade's worth of heavy intervention in foreign-exchange markets to keep the rupee cheap. The rupee has risen by more than 8% since March, eliciting cries of pain from exporters and protests from the Commerce Ministry. But the move seems to have taken the edge off inflation, which has edged down to 5.4% at the beginning of this month, from a high of 6.5% in mid-March.

"We must learn to manage these inflows but we must not do anything that will restrict investment -- domestic and foreign, and private and public," Finance Minister Palaniappan Chidambaram told the Confederation of Indian Industry on Friday. That's exactly right -- though not always as easy a political matter.

Investment flows are an affirmation that foreigners judge India a good place to invest. They are a byproduct, too, of freer flows of trade and capital. India wouldn't be growing at 8 to 9% a year were it not for economic liberalization. But as the country opens up to trade and cracks open its capital account, it will be more exposed to global monetary policy.

Welcome to a world without stable exchange rates, in which central banks tussle with competing demands of keeping inflation under check while avoiding attacks on their currency. This year, the Reserve Bank of India found itself in a bind: It had to purchase the foreign currency to keep the rupee within its normal range, but it also had to sterilize those inflows' inflationary impact by issuing bonds. The costs of issuing the debt spiralled upwards, and in March, the RBI simply stepped back from the market, and the rupee shot up.

But will the RBI do what the Finance Minister suggests, and truly shed its old mercantilist ways? As soon as the rupee started to climb back toward its nine-year highs last week, the Reserve Bank started intervening again. Equally worrying, the central bank clamped down on real estate companies' ability to borrow abroad and repatriate the funds -- a major source of pressure on the rupee -- by setting limits on the bond yields they could offer.

Capital controls are distortionary, at best, and at worst, completely ineffective. Real estate companies aren't likely to stop raising money just because the RBI has discouraged them from selling bonds; they'll figure out other ways to do so. What's more, by capping the yields on bonds that real estate companies can raise, the RBI has tipped the scales in favor of larger companies at the expense of small and medium-size firms, which are the real drivers of India's economic growth.

New Delhi need only look to Thailand to see what broad capital controls can do to wreck a functioning economy. When the military-installed government -- pressured by the country's large exporting lobby -- clamped down on hard on incoming foreign-equity flows in December, the Bangkok Stock Exchange experienced a 15% one-day drop. In any case, the capital controls have done little to limit flows; the baht has continued to appreciate since December's action, and Bangkok has now lifted most of the controls.

India's exporters aren't happy with a rising rupee, but that's part of the price of doing business in an open economy. India could link its currency to the dollar, a la China, but that would mean abandoning its own monetary policy. It could, however, go on defense, and focus on what it can control: its domestic financial markets. It's past time India got serious about deregulating its banking sector, allowing futures and hedging markets to develop, and letting foreigners compete on an equal footing.

Unfortunately, those changes don't look likely under the current Congress-led government. There may be an economist in the Prime Minister's seat, but it's Sonia Gandhi, president of the Congress Party, who's pulling the strings, and she's no friend to free markets. The closest this administration has gotten to financial-sector reform has been to crack open the capital account a little bit to let Indian investors put more money abroad, and to issue a few reports on what else needs to be done. New Delhi can't control how much money the U.S. Federal Reserve Bank releases into the global financial system. But it can control how efficiently it receives and distributes that money. The RBI may not be able to guide the rupee in the way it used to, but there are plenty of things it can do to bolster India's competitiveness.