Are capital controls the right way to manage an economy? This column looks at what we can learn from India’s experience, where capital controls have never been fully dismantled.
Among the questions that divide macroeconomists is whether capital controls are an effective tool for managing an economy. Can restrictions on foreign direct investment (FDI) help to reduce inflation? Can restrictions on how much money can be taken out of the economy help to protect against speculation? Several studies have found that temporary (or transitory) capital controls can be effective but they only appear to work for a short time. Often, people can find ways to get around the controls (see Magud et al. 2011). In recent research we see what evidence India experience has to offer to the global debate.
The efficacy of capital controls?
The current debate on the effectiveness of capital controls emphasises their potential role as a tool for macroeconomic policy. While some remain sceptical about capital controls (Warnock 2011, Mallaby 2010), others have suggested that the effectiveness of capital controls may depend on whether a country has comprehensive and permanent capital controls, or temporary controls (Klein 2012, Ostry et al. 2011, Wagstyl 2012). This disagreement represents somewhat of a reopening of the policy debate about capital controls in recent years, largely created by a shift in the IMF’s position.
All or nothing
There is the possibility that in countries with full-blown legal and administrative machinery for capital controls, the goals of macroeconomic policy could be usefully pursued by dynamically varying capital controls. This emerging literature implies a bipolar hypothesis; countries should choose between a fully open capital account on one hand, versus comprehensive and permanent controls on the other. Relatively few countries have comprehensive and permanent controls, other than China and India. This has motivated researchers to carry out careful country studies focusing on China and India, analysing their experiences on the extent to which capital controls have been useful in achieving the goals of macroeconomic policy.
India and China's experiences
In a recent paper (Patnaik and Shah 2012), we analyse the costs and benefits of capital controls by studying the experience of India, where a comprehensive system of capital controls has never been fully dismantled. We find significant costs to the financial system imposed by comprehensive and permanent controls. To be effective – even in the limited sense in which they are – such as the capping of foreign debt flows, long-standing controls require a regulatory framework that gives discretionary and broad powers to regulators. This brings about costs in three ways:
- Price differences between foreign and domestic capital markets arise
- Higher domestic cost of capital and inferior risk sharing
- Implications for growth and welfare
Economic agents change their behaviour in response to controls, giving distortions in resource allocation. We thus identify important problems in the realm of governance and the rule of law.
Can these costs be justified?
These costs might be justified on the grounds that when a capital surge arises in either direction, the system of comprehensive and permanent controls will assist the goals of macro policy. The welfare analysis of comprehensive and permanent controls thus requires a comparison of the costs to society (which are paid at all times) versus the gains to society (in episodes of a capital surge or flight). Hence, we examine the effectiveness of the Indian capital controls framework in the period of a surge. We find that when used as tools of macroeconomic policy, during a capital surge, the Indian experience is similar to that of other countries where the system of control had been dismantled.
A systematic approach to costs and benefits
We analyse the Indian experience by using a classification scheme that distinguishes between different costs:
- Reduced financial integration
- Micro-economic distortions in the decisions of economic agents
- Problems of governance and the rule of law
And different benefits:
- Reduced capital inflow surges
- Monetary policy autonomy
- Avoiding real exchange-rate appreciation
- Avoiding boom-and-bust of asset prices; avoiding a credit boom
- Avoiding balance sheet exposures
Arriving at a judgment about the usefulness of a system of capital controls involves assessing the extent to which these kinds of costs were present, and assessing the extent to which these goals of macroeconomic policy were achieved.
After the turn of the millennium, when emerging markets worldwide got a surge in capital flows, India also experienced a surge. This peaked at $100 billion, or 8% of its GDP. And yet the capital controls did not avert a big surge in inflows. This surge induced stress for the prevailing exchange rate regime and monetary policy framework. In the biggest ever business cycle expansion in Indian history, the policy rate (expressed in real terms) dropped from 3% to -4%. The erstwhile exchange-rate regime, which had a low volatility against the US dollar, gave way to much higher flexibility. The capital controls were not able to provide monetary policy autonomy.
Further, from 2000 to 2007, the index of the real effective exchange rate went from 85 to 110, showing a significant real appreciation. The capital controls did not avert a real appreciation.
In the boom, bank credit was growing at over 30% per year. A measure of the boom-to-bust ratio of stock prices shows that India was one of the worst emerging markets in terms of the boom-and-bust of stock prices. The capital controls did not avoid the problems of a credit boom or a boom-and-bust in asset prices.
The system of capital controls did deliver on reduced foreign borrowing. There was a quantitative restriction on the dollar value of outstanding foreign borrowing. The stock of foreign borrowing was thus prevented from growing, while GDP grew, so the foreign borrowing-to-GDP ratio fell sharply. At the same time, firms appear to have circumvented the controls, and obtained currency exposure through other methods. Balance sheet effects were not avoided.
These are, broadly speaking, the areas where capital controls are expected to achieve the goals of macroeconomic policy. The Indian experience was not different from that of countries that had opened up their economies and then imposed transitory controls.
Several studies in recent years have demonstrated that the Indian capital controls are effective in reducing financial integration. As such, the law of one price is violated, covered interest parity is violated, and American Depositary Receipts are priced differently from the shares on the local market. India paid a higher cost of capital as a consequence of the introduction of a wedge between foreign and domestic markets. This cost was constant, even when there was no surge of capital.
The capital controls introduced unintended microeconomic distortions. As an example, the authorities introduced a rule in August 2007 where foreign borrowing was permitted only for the purpose of importing capital goods. This appears to have led to a substitution away from domestic capital goods in favour of imported capital goods. In any country, the operation of a permanent and comprehensive system of capital controls would pose a challenge for public administration. These problems are exacerbated in countries with weak governance. It is difficult for a bureaucracy to obtain sound information, process it correctly, resist political pressures, and come up with sound decisions. We document many examples where poor policy decisions were taken in the operations of the Indian capital controls. We also document many situations where there was a breakdown of the rule of law. These difficulties of governance need to be viewed as one element of the costs associated with capital controls.
Under a permanent system of capital controls, costs are borne by the country at all times, whether there is a surge or capital flight or not. These costs may be justified if the capital controls are able to deliver on the goals of macroeconomic policy. The Indian experience, however, does not suggest that these goals were met.
- Klein, Michael W (2012), "Capital controls: Gates and walls", Brookings working paper, September.
- Mallaby, S (2011), "The IMF needs to find its voice again", Financial Times, April.
- Patnaik, I and A Shah (2012), "Did the Indian capital controls work as a tool of macroeconomic policy?", IMF Economic Review, September.
- Ostry, JD, AR Ghosh, M Chamon, and MS Qureshi (2011), "Capital Controls: When and Why?", IMF Economic Review, August.
- Magud, N, C Reinhart and K Rogoff (2011), "Capital Controls: Myth and Reality - A Portfolio Balance Approach", NBER Working Paper, 16805, February.
- Wagsty, S (2012), “Currency wars: Brazil-style capital controls have 'zero' effect", FT blog, September.
- Warnock, FE (2011), “Doubts about capital controls”, report, Council on Foreign Relations, April.