India’s policies on international capital flows are extremely complex, in part due to the absence of a consensus on the value of capital account controls. This column argues that the tools for measuring the implementation of the policy need to be revisited, and presents new evidence to suggest that India’s capital account has been liberalised – without leading to economic disaster.
One of the most obvious features of India’s policy regime with respect to controls on international capital flows has been its complexity. This has reflected, to some extent, the complexities and uncertainties of the global economy, as well as policymakers’ attempts to grope their way forward in the absence of a clear academic consensus on the value of capital account controls. Two expert committees (Tarapore Committee 1997, 2006) failed to provide a clear roadmap for removing or rationalising capital controls, and global events have tended to lead to reactive or ad hoc policy adjustments with respect to the capital account. Narendra Jadhav (2003) gave an early narrative on India’s experience with capital controls, while he was at the Reserve Bank of India. Soon after, Ajay Shah and Ila Patnaik (2005) provided a systematic, but still descriptive treatment of Indian capital controls. The recent report of the Working Group on Foreign Investment (Sinha, 2010) only re-emphasised the intricacies of India’s capital control regime.
Meanwhile, Menzie Chinn and Hiro Ito (2008) had been constructing a widely-used index of capital openness for a large set of countries and the value of this index for India has stayed constant, at a level that indicates a high degree of restrictions on the capital account. The Chinn-Ito index is constructed using data on various regulations and legal restrictions, so it is what is known as a de jure index. This would have seemed fine, except that the evidence was that India was becoming more open to international capital flows. This showed up in an innovative analysis of arbitrage possibilities by Gurnain Pasricha (2008), and in simple measures of the level of capital flows relative to the size of the economy (Patnaik and Shah 2011; Hutchison, Sengupta and Singh 2012). Thus, de facto capital account openness has not seemed to match the de jure situation, as measured by the Chinn-Ito index.
Capital account liberalisation has not led to economic disaster
Policymakers need to know whether their policies are working, and having some measures of effectiveness is critical. Patnaik and Shah (2011) argue that India’s capital control regime has not served the country’s macroeconomic policy goals very effectively. A much more basic issue is the disjuncture between de jure and de facto views of the actual bite of India’s capital controls. As noted, the complexity of these controls in practice has made measurement difficult. In my recent work with Gurnain Pasricha and Michael Hutchison (Hutchison, Pasricha and Singh 2012), we have made significant progress in resolving the puzzles of the data, and providing useful tools for policymakers. These tools are a new index for measuring India’s de jure capital controls, and the technique of using measured arbitrage possibilities to assess the de facto bite of the de jure controls.
We find that our index (really two separate indices, one for inflows, one for outflows) shows a gradual liberalisation of capital inflows as well as capital outflows. The progression is sporadic, and occasionally reversed, but the trend is demonstrably there, and thus our results differ significantly from the Chinn-Ito measurement. We also find that there is an increase in arbitrage possibilities over the period of our analysis (1998–2011) that indicates de facto liberalisation. This de facto liberalisation squares up quite well with the trends in de jure capital controls, allowing for the separate impacts of changes in global economic conditions to the extent possible.
In a nutshell, India has effectively been liberalising its capital control regime, and the result has been greater financial integration as revealed in the working of certain financial markets. And this liberalisation has not led to economic disaster. Conversely, India’s relative insulation from the recent global crisis does not seem to be attributable to a severely closed capital account regime.
We need better tools for measuring policy effectiveness
We do not think our analysis is the last word on the matter, but it shows that careful empirical analysis can provide deeper understanding of the links between policymaking and outcomes. This is a general desideratum, but seems to be particularly needed in the Indian context, for many different kinds of policies. Good measurement does not automatically lead to good objectives or good decision making, but it is hard to see how one can make good policy without the best measurement possible.
- Chinn, Menzie and Ito, Hiro (2008) “A New Measure of Financial Openness”, Journal of Comparative Policy Analysis 10(3), 309-322 (September).
- Hutchison, M., Pasricha, G., Singh, N., (2012), Indian Capital Control Liberalization: Estimates from NDF Markets, forthcoming International Monetary Fund Economic Review.
- Hutchison, M., Sengupta, R., Singh, N., (2012), India’s Trilemma: Financial Liberalisation, Exchange Rates and Monetary Policy, The World Economy 35(1), January.
- Jadhav, Narendra (2003). “Capital Account Liberalisation: The Indian Experience,” available at http://www.imf.org/external/np/apd/seminars/2003/newdelhi/jadhav.pdf.
- Patnaik, I. and A. Shah. (2005) “India’s Experience with Capital Flows: The Elusive Quest for a Sustainable Current Account Deficit,” Working Paper 11387, National Bureau of Economic Research, Cambridge, MA.
- Patnaik, I., and A. Shah (2011): Did the Indian capital controls work as a tool of macroeconomic policy?, NIPFP Working Paper 2011-87
- Sinha, U. K. (2010): Working Group on Foreign Investment, Committee report, New Delhi: Department of Economic Affairs, Ministry of Finance
- Tarapore Committee (1997)), Report of the Committee on Capital Account Convertibility, Mumbai: Reserve Bank of India, May 30.
- Tarapore Committee (2006), Report of the Committee on Fuller Capital Account Convertibility, Mumbai: Reserve Bank of India, July 31.