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Liberalisation of the Capital Account: Perils and Possible Safeguards

Capital account liberalisation is an example of "orchestrated harmonisation" of policy advice emanating from academic institutions, think tanks and multilateral institutions in the developed world, which seek to push the doctrines of new classical economies. Capital account liberalisation is one such policy advice. This paper examines the theoretical case for CAL and finds that it is subject to important caveats relating to moral hazard, asymmetric information and agency problems. CAL has proved occasionally beneficial but only for relatively developed countries and only if accompanied by appropriate prudential measures. The line taken by several apologists for CAL that the risks of financial instability are negligible and hence more than compensated by the benefits, ignores the magnitude of the potential costs of a crisis.

Special articles

Liberalisation of the Capital Account: Perils and Possible Safeguards

Capital account liberalisation is an example of “orchestrated harmonisation” of policy advice emanating from academic institutions, think tanks and multilateral institutions in the developed world, which seek to push the doctrines of new classical economies. Capital account liberalisation is one such policy advice. This paper examines the theoretical case for CAL and finds that it is subject to important caveats relating to moral hazard, asymmetric information and agency problems. CAL has proved occasionally beneficial but only for relatively developed countries and only if accompanied by appropriate prudential measures. The line taken by several apologists for CAL that the risks of financial instability are negligible and hence more than compensated by the benefits, ignores the magnitude of the potential costs of a crisis.


t is undeniable that in the last three decades, cataclysmic changes have been underway in the functioning and organisation of the world economy. Following Went (2003), three changes may be singled out for special attention:

  • (i) A phenomenal increase in the number of global markets for products and services (especially financial services).
  • (ii) A growing role for “footloose” multinationals (a term owing to Reich (1992)) in the global economy.
  • (iii) An enhanced role for supranational organisations (the Group of Eight, International Monetary Fund, Bank of International Settlements, World Trade Organisation, etc) and regional associations (the European Union, North American Free Trade Agreement, etc), with a commensurate emasculation of the role of nation states.

    While these developments are well recognised, a related pheno menon seems to have attracted relatively little attention, viz, the unchallenged sway that the doctrines of new-classical economics1 have acquired over the policy advice emanating from academic institutions, international “think tanks” and multilateral bodies. This mould of thinking translates into blanket policy recipes, often of an extremely drastic character, which are religiously followed by many emerging market economies (EMEs) and least developed countries (LDCs), – under “persuasion” from international organisations – with no attention to local conditions. A vocal body of self-proclaimed liberals acts as the cheerleader for these policies. Their one-sided views are upgraded to the status of representative public opinion by a conniving financial press. The actual results of such policies are often mixed, and though the rare success stories are inevitably highlighted, failures tend to get under-reported and attributed to faulty implementation rather than the flawed advice in the first place.

    Capital account convertibility (henceforth CAC for short) seems to be one such instance of “orchestrated harmonisation”, and will form the subject matter of this paper.2

    CAC and Financial Instability

    Short-term and Long-term Capital Flows

    Many advocates of the reforms process in India tend to view CAC as the last bastion to overcome in India’s triumphal march towards globalisation. To all such it may come as a surprise that much of the post-second world war period (the so-called “golden age of capitalism”) was an era of heavily regulated capital flows in the western economies. Indeed the founding fathers of the Bretton Woods system recognised the incompatibility of a free trade and stable exchange rate regime with free capital mobility. Keynes, at his most acerbic, described proposals “to stabilise exchange rates and promote free trade without limiting international capital mobility” as “exercises in squaring the circle” [Felix 1995]. Reflecting the Keynesian orthodoxy then prevalent, the IMF executive board in 1956 reaffirmed the right of member countries to impose capital controls. With the breakdown of the Bretton Woods system in the 1970s and under the powerful impact of Milton Friedman’s writings (and later the emergence of the New Classical Economics School), the intellectual climate became less propitious towards capital controls, with the general policy sentiment veering to the view that “no country can share in the benefits of international trade unless it allows capital to move freely enough to finance that trade, and modern financial markets are sophisticated and open enough that capital transactions can no longer be compartmentalised as trade-related or speculative” [Boughton 1997]. Reflecting the new thinking, the IMF’s Interim Committee in April 1997

    Economic and Political Weekly September 8, 2007 decided in favour of amending the articles of the IMF to allow capital controls only as emergency measures in exceptional situations.

    To avoid a possible confusion, it is best at the outset to clarify that there are two levels of debates about the desirability of capital flows and for analytical convenience, it is best to keep them separate. The more prominent debate currently is about shortterm capital flows and this is what we will be focusing on here. This is not pronouncedly ideological, with opponents of capital inflows being on both sides of the political spectrum (one irritating stratagem commonly employed by CAC advocates is to dub all opponents of CAC as “Leftists” if not “Marxists”). There is also, however, an older debate about the desirability of long-term capital flows with distinct ideological overtones. The intellectual advocacy of long-term capital flows is normally based on some variant of the IMF’s Financial Programming model [Khan and Haque 1990], with capital inflows into EMEs viewed as raising domestic investment rates over the domestic savings rate, dampening the effects of exogenous shocks and promoting efficiency via transfer of technology and financial skills [see also Eichengreen 1996 for a more nuanced expression of this viewpoint]. This view has been challenged in predominantly leftist intellectual circles [see Plender 1997, Robinson 1996, Chesnais 1994, Went 2000] as imperialism masquerading in the guise of neoliberalism. Recently, Singh (2002) in a detailed empirical study found that unregulated foreign direct investment (FDI) may do more harm than good, and where FDI has been least regulated it has also been least beneficial, while Rakshit (2001) argues that the theoretical conditions for the postulated benefits of FDI to be realised are rather restrictive. While CAC connotes liberalisation of both long-term and short-term capital flows, it is important to bear in mind that the issues raised for the two types of flows are fundamentally different. Stiglitz (2000), for example, while emphatically regarding short-term capital flows as disruptive, finds “the argument for foreign direct investment...compelling”. The issues raised by long-term capital flows, though important, are too vast to be encompassed within the scope of a single article and are therefore not dealt with here. Our focus for the purposes of this paper remains the various issues raised by the inflows/ outflows of short-term capital.

    New Classical versus Keynesian View of Financial Markets

    The new classical case for free (short-term) capital mobility rests on the so-called “efficient markets doctrine”. As is well known this hypothesis posits that current market prices of financial assets embody rationally all the known information about prospective returns from the asset. Future uncertainty is of the “white noise” kind and “noise traders” (speculators) may succeed in pushing the markets temporarily away from equilibrium. But with markets clearing continuously, “rational traders” will bring the system back to equilibrium, by taking countervailing positions, and imposing heavy losses on those speculators who bet against the fundamentals. Equilibrium asset prices will therefore be altered only when there are “shocks” to the fundamentals, and while supply shocks are inevitable, the severity of demand shocks can be tempered by policy aimed at giving more access to information about fundamentals to market participants, and avoiding “policy surprises” or attempts to control asset prices. Such a view underpins the “tough love” approach of the IMF to dealing with currency crises, so much in evidence during the Latin American crises of the 1980s and the late 1990s Asian financial crisis. This approach is fundamentally skewed in that international credit banks who usually precipitate such crises by their indiscriminate lending, rolling over of credit and tax avoidance strategies are seen in the role of victims, whereas the major blame is apportioned to the crisis-affected countries for their bungled macroeconomic management (current account deficits, overvalued exchange rates, loose monetary policy, etc) and for “misleading” investors by withholding key information about fundamentals. Such governments are then administered “bail out” packages with strong attached conditionalities as part of the “tough love” treatment. The post-crisis sternness contrasts markedly with the pre-crisis exhortations of top IMF officials as well as treasury representatives of the US and European powers, to EME and LDC governments about the desirability of private capital inflows. For example, the “Robichek-Lawson Doctrine” (so called after Walter Robichek, director of Western Hemisphere operations of the IMF in the 1980s and Tony Lawson, chancellor of the exchequer under Margaret Thatcher) regarded the financing of rising current account deficits with increasing private foreign liabilities as a matter of little concern, maintaining that countries that pursued free market policies and fiscal restraint, could always cover current account deficits with capital account inflows from global financial markets. Diaz-Alexandro (1985), Devlin (1989) and Felix (1998) attribute the Latin American crises of the 1980s to the uncritical acceptance of this advice by several countries in that region.

    The new classical orthodoxy about free capital mobility is crucially contingent on the efficient market hypothesis (EMH). Actual trading strategies of forex traders, however, more often than not, are in systematic violation of rational market behaviour. “I’d be a bum in the street with a tin cup if the markets were efficient” is a famous remark by none other than Warren Buffet. Theories of human decision-making [Kahneman and Tversky 1984 and Rabin and Thaler 2001] argue that in the face of complex un certain situations, individuals do not proceed via maximising expected utility but using “cognitive heuristics”. Such heuristics is an aid to reducing a complex task to a manageable proportion but often introduces systematic biases. The bulk of the econometric evidence on financial markets is also contra the EMH [Shiller 1981, LeRoy and Porter 1981, Shleifer and Summers 1990].

    Increasingly, economists are realising that the 1930s Keynesian description of financial markets as being “casinos” guided by “herd instincts” is nearer the mark (than the EMH) as a description of how real world forex markets operate today [Russel and Torbey 2002 and Huberman and Regev 2001]. In the Keynesian view, investors in financial assets are not interested in a longterm perspective, but rather in speculating on short-run price behaviour. This is specially true in forex markets where day trading is the rule rather than the exception. Far from basing their expectations on prospective behaviour of the underlying fundamentals, such investors are more likely to base their opinions on market sentiments (i e, the opinion of the other members of their group). This lends a dangerous edge of volatility to financial markets as any “news” if it affects market sentiment strongly (in either direction) is likely to produce mood swings in market senti ment, even if the “news” in question is unlikely to alter long-term fundamentals. If one accepts the Keynesian view of asset price behaviour, then the case for CAC virtually collapses as the damage that unregulated capital flows can impose on an economy become apparent. Volatile capital flows can produce violent swings in important asset prices such as real estate, equities and of course the exchange rate itself, especially if they are pro-cyclical as noted by Williamson and Drabek (1999) and Singh (2002). The fragility of the financial system is also enhanced by freer capital mobility. In two important recent studies, viz, Kaminsky and Reinhart (1999) and Demirguc-Kunt and Detragiache (1998) the link between financial liberalisation, exchange rate crises and banking crises is clearly brought out. Demirguc-Kunt and Detragiache (1998), for example, argue that financial liberalisation intensifies competition among banks, who in their eagerness to preserve market shares could indulge in indiscriminate and risky credit operations (a moral hazard problem). During bullish periods, debt leveraging can augment the expected return from financial position-taking by corporate borrowers. Wider asset price movements also erode the ability of banks and other financial institutions to adequately collateralise their loans, while competition restrains them from raising the risk premia on loans. Thus in a regime of capital account liberalisation, with adequate prudential banking norms not in place, currency crises can easily translate into more general financial crises.

    Thus the theoretical case for CAC seems on rather weak grounds. The position is aptly summed up by Stiglitz (2000).

    it is certainly clear now that the position (of the IMF) was maintained either as a matter of ideology or of special interests, and not on the basis of careful analysis of theory, historical experience or a wealth of econometric studies. Indeed, it has become increasingly clear that there is not only no case for capital market (account?) liberalisation but that there is a fairly compelling case against full liberalisation.

    Risks of Capital Account Liberalisation

    Let us now examine more closely the types of risks attendant on a capital account liberalisation programme. Broadly speaking, these risks may be classified into five categories: (i) currency risk, (ii) capital flight risk, (iii) fragility risk, (iv) contagion risk, and (v) sovereignty risk. Currency risk: This refers to the possibility of a sudden precipitous devaluation of a country’s currency. The risk is particularly pronounced for EMEs embarking on an ambitious programme of capital account liberalisation without adequate safeguards in place. In such countries reserves may be insufficient to cover significant episodes of investor exit, and additionally, their ability to manage “multilateral currency rescue operations” might be limited. Capital flight risk: This occurs when non-resident holders of liquid financial assets sell off their holdings en masse. The reasons for the herd-like behaviour of foreign investors run along the lines discussed earlier. But two factors act as further aggravating factors. Firstly, investor herd behaviour is very frequently an outcome of the “safety in numbers” syndrome brought on by a shared lack of trust in the reliability of macroeconomic information emerging from EMEs. Secondly, foreign investors often tend to assess the risks in terms of a region as a whole, failing to distinguish between different EMEs within the same region. This makes EMEs vulnerable to bouts of general capital flight. Fragility risk: Fragility refers to the vulnerability of the borrowers (corporates, and banks) to internal or external shocks.

    Table 2: Countrywise Share of Average Daily Forex Market Turnover (as of 2004)

    Country Share (Per Cent)

    UK 31.3 US 19.2 Japan 8.3 Singapore 5.2 Germany 4.9 Hong Kong 4.2 Australia 3.4 Switzerland 3.3 France 2.7 Canada 2.2 Others 15.3 Total 100

    Source : BIS : Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, 2005.

    Table 1: Capital Account Liberalisation and Growth

    Study Number of Openness Results Countries Measure in Sample Used

    Quinn 1997 58 Δ (CAL2) CAC beneficial for per capita income growth

    Klein & Olivei 1999 67 CAL1 CAC beneficial for per capita income growth if accompanied by financial deepening

    Edwards 2001 55 CAL2 and Δ (CAL2) CAC beneficial for high-income countries but not for low income countries (in terms of per capita income growth)

    Arteta, Eichengreen and Wyplosz 2001 51 CAL2 and Δ (CAL2) CAC beneficial if CAL2 is used as liberalisation measure

    Bekaert, Harvey and Lundblad 2001 30 EMEs Official dates of stock market CAC beneficial with this measure of liberalisation, though

    liberalisation most of the benefits are concentrated in the early years O’Donnell 2001 94 CAL1 and Volume CAC beneficial if volume is used as liberalisation measure, but not with CAL1 Grilli & Milesi-Ferretti 1995 61 CAL1 No evidence for CAC being beneficial for per capita economic growth Rodrik 1998 100 CAL1 No evidence for CAC being beneficial for per capita economic growth Kraay 1998 117 CAL1, Volume and CAL2 CAC beneficial if volume is used as liberalisation measure, but not with CAL1 or CAL2 Edison et al 2002 89 CAL1, CAL2 and Dates of stock CAC beneficial for high-income countries and east Asian market liberalisation economies but not for developing economies.

    Notes: Δ (CAL2) represents changes in CAL2 , Volume refers to the volume of capital inflows.

    Economic and Political Weekly September 8, 2007 Basically such fragility can be traced to three sources: (i) maturity mismatch (i e, financing long-term obligations with shortterm credit), (ii) foreign currency denominated debts which are subject to changes in value under a freely floating exchange rate, and (iii) non-transparent overborrowing/overinvesting made possible by the growing derivates and futures markets. Sovereignty risk: This type of risk pertains to the constraints that a domestic government may face in its ability to pursue independent national policies in the event of a crisis. Such constraints could arise on various counts.

  • (i) Foreign governments and multilateral institutions may force contractionary policies on the domestic government to stem capital flight.
  • (ii) Investors may also be reluctant to return (following a crisis) unless explicit government guarantees are available on monetary, trade or fiscal policy (or sometimes even on policies specific to certain sectors such as telecommunications, oil extraction, etc).
  • (iii) Global financial integration also implies that in general the ability of small open economies to pursue counter-cyclical policies may be impaired if their business cycles are out of sync with the business cycles of the major economies. In particular, the difficulties confronting monetary policy formulation are compounded manifold (see below). Contagion risk: Finally contagion risk refers to the possibility of a country coming under a crisis threat following a crisis in another economy, with which its trade, investment and finance are closely interlinked.

    Capital Flows and Monetary Policy

    Capital inflows create several special problems for the conduct of monetary policy. As a matter of fact, a famous “trilemma” succinctly sums up the various issues involved. The trilemma in question [Bernanke (2005) for a recent exposition] refers to the impossibility of maintaining in simultaneous operation (for a given country) all three of the following policy regimes: (i) an open capital account, (ii) a fixed exchange rate, and (iii) an independent domestic monetary policy. Of course, in practice, concepts like “openness”, “fixity” or “independence” are not absolute, but relative or even fuzzy. Hence the trilemma needs to be interpreted as a move in one direction having to be compensated by a countervailing move along another dimension.3

    The EU is a standard illustration where countries have opted for a substantial degree of fixity of their exchange rates4 (vis-a-vis each other) with free capital mobility in place but monetary policy independence sacrificed. This is partly attributable to the EU constituting an optimum currency area in Mundell’s (1961) sense and also to their being subject to similar “shocks” [Bayoumi and Eichengreen 1993]. But this must be regarded as an exceptional case. Typically countries would be reluctant to sacrifice monetary policy autonomy, for reasons of national sovereignty and national pride, and the effective choice thus narrows down to that between capital mobility and a fixed exchange rate regime.

    For the advanced economies the choice seems to be clear (at least to most academics and policymakers) viz, the benefits of capital mobility and independent monetary policy exceed whatever costs may be associated with a system of freely floating exchange rates. For the LDCs and EMEs, the picture becomes more hazy. One view [see Vegh 1992, Dornbusch and Warner 1994, Bernanke 2005] maintains that the best course for such economies is to overcome their deeply ingrained “fear of floating” and let the exchange rate float freely. A firm central bank commitment to gear monetary policy exclusively to maintaining a low and stable inflation rate, would then provide the much needed “nominal anchor” for the macroeconomic system. There are two major arguments against a “free float” for such economies.

    Firstly, as Sargent (1982) has noted, a fixed (or heavily managed) exchanged rate can be a suitable guard against high inflation, and can even act as a strong brake on persistent hyperinflations.5 A fixed exchange rate commands visibility and is more credible than a direct inflation target (both because the former is observable instantaneously unlike the inflation rate which suffers from a lag of at least a few weeks and also because its measurement is non-controversial in contrast to the several competing measures suggested for the inflation rate in the literature).

    Secondly, Calvo and Reinhart (2000) have drawn attention to the low credibility of policymakers in several LDCs, which could mean that a flexible exchange rate could exhibit high volatility (both short-term and long-term). The latter is usually recognised as exports-inhibiting and could also lead to volatility in capital inflows and domestic interest rates (if these are unregulated) via the covered interest parity [Calvo 1996, Kwack 2003, Cavoli and Rajan 2006, etc].

    In the Indian context, the problems confronting monetary policy in the wake of capital inflows (and financial liberalisation generally) have been discussed extensively in Rangarajan (2000), Reddy (2005), Mohan (2007), Nachane and Raje (2007), etc. There has been in evidence a general movement away from a heavily managed exchange rate system of the 1980s and early 1990s towards a more flexible policy of letting the exchange rate gravitate towards its equilibrium value (as determined by market fundamentals). Today the concerns over exchange rate management are limited to short-term considerations such as the need to smoothen out excessive volatility and foreclose the emergence of destabilising speculative activities and are usually subsumed under the rubric of “overall financial stability”. Even though the RBI does not have a target exchange rate band in mind, it has not hesitated from proactive intervention to prevent undue nominal exchange rate intervention.

    Table 3: Cross-Currency Share of Trade (as of 2004)

    US $ (per cent) Euro (per cent) Japanese Yen British Sterling Swiss Franc Australian $ Canadian $ New Zealand $ Source: Same as Table 2. US $ – Euro 28 – Japanese Yen 17 3 – British Sterling 14 2 – – Swiss Franc 4 1 – – – Australian $ 5 – – – – – Canadian $ 4 – – – – – – New Zealand $ – – – – – – – –
    3636 Economic and Political Weekly September 8, 2007

    However such episodes of “leaning against the wind” are becoming increasingly less frequent now as the economy is showing signs of a robust growth and successful integration with the international economy. But, as the following quotation from Mohan (2007) illustrates, India’s exchange rate policy is in a state of evolution and may undergo a substantial transformation in the foreseeable future.

    ... the Dutch disease syndrome has so far been managed by way of reserves build-up and sterilisation, the former preventing excessive nominal appreciation and the latter preventing higher inflation. However the issue remains how long and to what extent such an exchange rate management strategy would work given the fact that we are faced with large and continuing capital flows apart from strengthening current receipts on account of remittances and software exports.6

    CAC: Macroeconomic Effects on the Real Economy

    IMF’s Financial Programming Model

    The transmission mechanism through which short-term capital flows impinge on the real economy are at best imperfectly understood. The so-called IMF Financial Programming Model (henceforth FP for short) and various extensions of the framework (see Rao and Nallari (2001) for a detailed overview) have been used to justify the IMF case for freer capital movements.

    A persuasive critique of the IMF model derives from the asymmetric information, moral hazard and agency literature [see Stiglitz and Weiss 1992 and Grandmont 1998]. This critique comprises three key components:

  • (1) Domestic capital markets in several LDCs and EMEs lack “efficiency”, plagued as they are by “agency” and “asymmetric information” problems.
  • (2) Secondly, financial liberalisation involves in its wake, a largescale conversion of liquid into illiquid assets, and the associated risks are not reflected in interest rates due to the adverse selection phenomenon. In the face of incomplete financial markets, large imbalances tend to be thrown onto the most liquid market (viz that for foreign securities).
  • (3) Interest rates in small open economies (under CAC) are not determined by the marginal productivity of capital or the intersection of the savings and investment schedules. Instead they are
  • more likely to be determined by an interest parity condition of the form

    ⎛ fe − f ⎞

    id = iw + ⎜⎜ ⎟⎟ + θ (i)



    where id, iw are respectively domestic and world interest rates, f e, f are the expected and actual values of the exchange rate and θ is a country risk factor.

    By virtue of (i), it is clear that the domestic rate of interest does not act as a market-clearing mechanism, but depends on several of the same factors that determine short-term capital flows, lending a dimension of instability to the exchange rate and the balance of payments generally.

    Effects on Output and Growth

    The relationship between capital account liberalisation and economic growth has been debated at great length, both theoretically and empirically. Summers (2000), Fischer (1998), Kaminsky and Schmukler (2002) etc, make out the standard new classical case for financial liberalisation in general and capital account liberalisation in particular. But this view ignores several key features of the ground reality in a majority of LDCs and EMEs. In these countries, security markets are not the major source of long-term industrial finance. Instead, most firms are bank-dependent for their working capital funds, whereas their long-term funding comes from either internal funds (i e, retained funds) or external borrowing (including foreign borrowing). Because equity markets are narrow and shallow, they exhibit wide fluctuations in response to changes in foreign flows. Such fluctuations in turn affect the availability of bank credit (unless fully sterilised), real exchange rate movements, and interest rates (via monetary policy responses). As shown in Fitzgerald and Mavratos (1997) such oscillations tend to magnify the effects of financial frictions originating abroad on the domestic economy, without having any compensatory positive effect on private sector fixed capital formation. Aghion et al (2000) qualify such conclusions by noting that capital account liberalisation is deleterious only when it is premature (i e, when undertaken without adequate financial development).

    Given the conflicting theoretical picture, it is of interest to turn to the empirical evidence. Here one immediately runs into the problem of developing a suitable measure of capital account

    Table 4: Capital Inflows into India (US $ million)

    2001-02 2002-03 2003-04 2004-05 2005-06 (P) 2006-07 (P) April-May 2007-08 (P)
    A Foreign direct investment (I+II+III) 6130 5035 4322 6051 7752 19531 3671
    I Equity (a+b+c+d+e) 4095 2764 2229 3778 5820 16065 3671
    a Government (SIA/FIPB) 2221 919 928 1062 1126 2156 923
    b RBI 767 739 534 1258 2233 7151 1657
    c NRI 35
    d Acquisition of shares 881 916 735 930 2181 6278 1091
    e Equity capital of unincorporated bodies 191 190 32 528 280 480
    II Reinvested Earnings 1645 1833 1460 1904 1676 2936
    III Other capital 390 438 633 369 256 530
    B Foreign portfolio investment (a+b+c) 2021 979 11377 9315 12492 7003 3826
    a GDRs/ADRs 477 600 459 613 2552 3776 16
    b FIIs 1505 377 10918 8686 9926 3225 3810
    c Offshore funds and others 39 2 16 14 2
    Total investment (A+B) 8151 6014 15699 15366 20244 26534 7497
    Source: RBI Monthly Bulletin (August 2007).
    Economic and Political Weekly September 8, 2007 3637

    liberalisation. At least four measures have been suggested in the literature which we simply list below (their computation is explained in the references cited.

  • (i) IMF measure (CAL1).
  • (ii) Quinn’s (1997) measure (CAL2).
  • (iii) Montiel-Reinhart (1999) measure (CAL3).

    (iv) Uncovered interest parity measure [Reisen and Yeches 1993] (CAL4).

    Table 1 presents the main features of some selective empirical studies designed to explain the growth implications of capital account liberalisation. Most of the studies employ panel data on sets of countries in the post Bretton Woods era. While Table 1 lays no claim to exhaustiveness, it does indicate that the case for capital account openness being growth enhancing is far from convincing and that whatever benefits may be involved are confined to high-income countries, though even the latter conclusion is challenged by empirical investigations such as those of Eatwell (1996) and Singh (1997).

    Other Important Distortions

    Capital account liberalisation introduces several other potential sources of distortion, of which we note the following:

    (i) One of the most important distortions is the steep rise in asset prices as foreign capital pours into important asset markets such as equities and real estate.The problem becomes particularly sensitive with the real estate market. In countries experiencing demographic as well as urbanisation pressures, there is a chronic shortage of urban housing. Hence it is a safe bet that real estate prices have a strong upward trend. Foreign capital on the lookout for capital gains finds housing investment an attractive option. The investment is both on the demand and supply side. That foreign purchases of property push up prices would be obvious. Equally obvious is the fact that the poor and middle class domestic buyers (whose salaries would be indexed, if at all, to a price index which does not incorporate housing prices) would find themselves rapidly priced out of the housing market. What is not so obvious is the fact that even foreign investment in real estate development does not really relieve this distress but actually aggravates it as this estate development essentially involves constructing condominiums that cater to tastes (and budgets) of the upper segments of the society (and of course non-residents). As a matter of fact, such estate development very often blocks off any increase in the supply of effective housing space for the poor and the middle-class. This phenomenon is rampant in most LDCs and EMEs and India constitutes a prime example.

    Table 5: Preconditions for Capital Account Liberalisation (Tarapore I)

    Item Precondition Position (2005-06)
    Gross fiscal deficit (as per cent of GDP) <3.5 4.1
    Inflation (per cent) 3 to 5 4.6
    (3-year average) (3-year average)
    Gross NPAs
    (as per cent of total advances) <5 5.2 (as of 2004-05)
    Average effective CRR (per cent) 3.0 5.0
    Current A/c deficit (as per cent of GDP) <2.0 >3.0
    Debt servicing ratio (per cent) <20 10.2
    Forex reserves >6 months 11.6 months
    imports cover imports cover

    Source: Tarapore Committee I.

    (ii) A real exchange rate appreciation could result from an upward pressure on the asset prices. This could act as an important retardant of exports and undermine the progress of trade reforms.

    (iii) As discussed in Fernandez-Arias and Montiel (1996), distortions to the perceived cost of foreign capital may arise because of externalities associated with aggregate country risk and credit rationing arising from limited cross-border contract enforceability.

    (iv) Distortions in the financial sector could give rise to improper financial intermediation [Calvo et al 1993] and result in excessive foreign borrowing.

    Several further instances of macroeconomic and microeconomic distortions that can result from capital flows are discussed in Corbo and Hernandez (1996).

    Capital Account Liberalisation in India: A Status Report

    First CAC Committee (Tarapore I)

    To put our discussion in perspective, let us commence by reviewing a few empirical facts about capital flows and forex markets. The global forex market had an average daily turnover of $ 1.88 trillion (as of 2004) according to the latest Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity by the BIS (2005). This makes the forex market the largest financial market in the world.7 The main participants in this forex market are central, commercial and investment banks, hedge funds, pension funds, corporations and individuals, with more than 75 per cent of the transactions being routed through banks. The UK, US and Japan account for the largest shares in the daily turnover (see Table 2). Table 3 shows that the major trade occurs in four currencies, viz, the US dollar, euro, sterling, and the Japanese yen, accounting between themselves for 78 per cent of the total cross-currency trade with the Euro-US$ share the highest (at 28 per cent). The spot market accounts for about one-third of the daily turnover ($ 621 billion), with foreign exchange swaps being the largest component (at $ 944 billion), followed by outright forwards (at $ 208 billion).

    Capital inflows into India have been increasing ever since the reforms were initiated, but there has been a marked acceleration in these inflows – both of the foreign direct investment (FDI) and foreign portfolio investment (FPI) variety. As indicated in Table 4, total foreign investment during the year 2005-06 stood at approximately $ 20 billion with FPI accounting for nearly 62 per cent of this total. The rate of growth of FDI is considerably lower than that of FPI, though (as expected) the latter shows greater volatility. Shortly before the onset of the Asian crisis in June 1997, a committee to lay down a road map for moving to full capital account convertibility was appointed under the chairmanship of S S Tarapore. (We will refer to this committee as Tarapore I.) The committee adopted a threefold approach.

    Firstly, it enumerated the major kinds of restrictions that were in force in India for capital account transactions. Secondly, it stipulated a framework for the progressive dismantling of each of these restrictions over a short span of three years (i e, by April 2000). Thirdly, it laid down a series of macroeconomic conditions that needed to be fulfilled before CAC was finally attained. These conditions are listed in Table 5 (together with the position obtaining on each of them as at end of 2005-06, i e, six years after CAC was supposed to be in place).

    Second CAC Committee (Tarapore II)

    The Asian crisis cast the entire issue of capital account liberalisation in a fresh perspective. As Goldstein (1998), Singh (2002), Bhalla and Nachane (2001) etc have noted, the extent of capital account liberalisation made a big difference to the incidence of the crisis on individual countries, and countries like India and China managed to avoid the worst consequences of the crisis mainly because their capital accounts still had a number of restrictions in place. The sobering effects of the crisis meant that the recommendations of Tarapore I had to be shelved for a few years subsequent to the crisis.

    However, following the high growth phase of the last few years, Indian policymakers once again began flirting with the CAC idea. A new committee was hastily set up once again under the chairmanship of S S Tarapore, with many notable “champions” of CAC on board.8 We will refer to this committee as Tarapore II. This committee once again followed an approach much similar in spirit to that of the earlier committee. It began by reviewing the extent to which the earlier committee’s recommendations had been actually implemented. It then laid down a detailed time frame for achieving full convertibility and also drew out a new set of safety guidelines. Let us turn briefly to each of these aspects in turn.

    Table 6 is an “action taken report” on the major recommendations of Tarapore I. It shows that most of the recommendations have been either followed or even exceeded. So one may say that there has already been a “creeping movement” in the direction of CAC. However, Tarapore II is far more ambitious in the scope of its recommendations, and intends to take India quite a bit further along the road to full (or almost full) capital account convertibility. This it proposes to do progressively in three phases: Phase I (2006-07), Phase II (2007-09) and Phase III (2009-11). The major recommendations of Tarapore II are set out below:

  • (1) Removal of overall external commercial borrowings (ECBs) ceiling of $ 22 billion and removal of restrictions on end-use of ECBs.
  • (2) Limits on corporate investments abroad be doubled from the current limit of 200 per cent of net worth.
  • (3) Banks be allowed to borrow overseas up to 50 per cent of paid-up capital and reseves in Phase I, which amount can be raised to 75 per cent in Phase II and 100 per cent in Phase III.
  • (4) As against the current limit of $ 25,000, individuals be allowed to remit abroad (annually) up to $ 50,000 in Phase I, $ 1,00,000 in Phase II and $ 2,00,000 in Phase III.
  • (5) Currently only NRIs are allowed to invest in companies listed
  • on Indian stock exchanges. The committee recommends extension of this facility to all non-residents (through SEBI registered entities such as mutual funds and other portfolio management schemes).

    (6) FIIs be prohibited from raising money through Participatory Notes (PNs).

    The Issue of Participatory Notes

    As noted above, Tarapore II has explicitly demanded a ban on PNs. However, this was not a unanimous decision of the committee. As a matter of fact, two members had submitted notes of dissent. The issue is a rather controversial one, especially as the RBI and the finance ministry view it from radically different perspectives. PNs are instruments similar to contract notes issued by registered FIIs to overseas clients, who are not directly eligible to invest in Indian securities markets. The PNs are issued against an underlying security, thereby helping the holder to benefit from dividends and capital gains on that security. The RBI stand on PNs was first articulated when the RBI member entered a note of dissent to the Lahiri Committee report on Liberalisation of Foreign Institutional Investment (2004). The RBI’s case for banning PNs is based on the fact that the nature of the beneficiary or the identity of the investor is unknown, unlike in the case of FIIs registered with a financial regulator. Most of the PNs are issued to hedge funds, with opaque ownership and shifting location, which are not registered in any country or with any regulator.9 The Lahiri Committee on the contrary, felt that the current regulations for PNs are adequate, as (with effect from February 3, 2004) PNs can be issued only to regulated entities, and the FIIs issuing PNs are bound by know your customer (KYC) norms. In my opinion there are two major considerations which weigh the argument in favour of the RBI’s point of view. Firstly, the enforcement of KYC norms is difficult, because several hedge funds operate in unregulated countries behind a veil of confidentiality provisions. Even reputed institutions operate through subsidiaries in Mauritius and often stonewall on provision of information. Secondly, and even more importantly, as pointed out by M K Narayanan (national security advisor, government of India) in a speech at the 43rd Munich Conference on Security Policy (2007) terrorist organisations have been increasingly resorting to legitimate business enterprises and routine banking channels to fund their outfits. PNs could be thus providing a safe conduit for the movement of terrorist funding.

    Safety Guidelines

    One welcome feature of Tarapore II is the recognition that the bold recommendations it has made, would need an extensive

    Table 6: Implementation of Recommendations of Tarapore Committee I

    Recommendations Action Taken

    1 Direct investment in foreign ventures by Indian corporates be allowed up to $ 50 million at level of authorised dealer (anything above this limit to be routed through a special committee) This limit currently stands at $ 100 million

    2 Corporates be permitted to open offices abroad Implemented

    3 Restrictions on end-use of external commercial borrowings (ECBs) for rupee expenditures be removed Implemented

    4 Exporters be allowed to retain 100 per cent of forex earnings in foreign currency accounts Implemented

    5 Direct portfolio investment by non-residents be allowed (on the same footing as FIIs and NRIs) Disallowed

    6 Banks be allowed to borrow in overseas markets and to deploy funds outside India Largely implemented

    7 Individuals be allowed to invest in markets abroad to the extent of $ 25,000 Implemented

    8 Residents be allowed to have foreign currency denominated deposits with corporates and banks Allowed but subject to some restrictions

    Source: Tarapore Committee II.

    Economic and Political Weekly September 8, 2007 safety network in place. It thus goes to great lengths towards suggesting several measures in the money market, corporate bond market, government securities market and forex market. What is worrisome, however, is that most of these measures, while supposedly masquerading as “safety guidelines” seem specifically designed to weaken regulatory mechanisms in important segments of these markets. They thus seem more in the nature of “accompaniments” to CAC rather than “prudential” measures. The committee has virtually nothing to say on instruments designed to insulate financial markets and the macroeconomy from the destabilising consequences of capital inflows.

    Measures for Coping with Capital Inflows

    Irrespective of whether India decides to go for full CAC or otherwise, management of capital inflows will remain an important issue. One rational policy response would then be to examine a minimal set of capital account restrictions that will mitigate the probability of financial crises of the order of the Asian crisis (1997-98), the LTCM crisis (1998) or the Russian crisis (1998). We examine a few such proposals below.

    Tobin Taxes

    Perhaps the oldest such proposal is the Tobin tax, suggested by Tobin (1978) in an influential article, though the idea itself can be traced back even further, viz, to the following specific passage occurring in Keynes’s General Theory (1936), p 160.

    The introduction of a substantial government transfer tax on all

    transactions might prove the most serviceable reform available,

    with a view to mitigating the dominance of speculation over enter

    prise in the United States.

    The transactions tax rate usually proposed [Tobin 1978, Summers and Summers 1990, Spahn 1996, etc] typically ranges from

    0.05 per cent to 0.25 per cent of the transaction principal. The burden of the tax is inversely related to the length of the holding period.10 Although the rate is small, as shown by Dodd (2002), it amounts to a substantial proportional increase in current transactions costs, as the typical bid-ask spreads in inter-dealer markets are between 0.01 per cent and 0.04 per cent (of the principal). The tax can thus be expected to reduce the returns to short-term speculation. This would be a double-edged weapon, as it would simultaneously reduce the volume of speculative hot money and reduce forex volatility. Additionally, it could generate substantial revenue which could be available for development purposes.11

    In spite of its intellectual appeal, however, as a practical proposal it has not really got off the ground. There could be several reasons for this. Firstly, the proposal would require worldwide agreement and coordination. Otherwise funds will simply migrate to countries which opt out of the tax agreement.12 There is also a distribution problem, for most of the revenue will accrue to the developed western economies. Finally, unless the tax is applied to both the spot capital flows as well as the derivative instruments (forwards, futures, options and swaps), there may be substitution from the former to the latter.

    Trip Wires-Speed Bumps Approach

    The essence of this approach is simple. Certain basic indicators (trip wires or TWs) are defined and as and when these indicators deteriorate (below a threshold) certain safety measures (relating to capital account transactions) are “triggered off”. The approach has been exciting increasing interest among economists in recent years [Ariyoshi et al 2000, Grabel 2003] . The TWs are usually simple indicators that are designed to warn policymakers of impending risks. Among suggested TWs13 we may prominently mention:

  • (i) Ratio of official reserves to total short-term external obligations (foreign portfolio investment and total – i e, private plus public – short-term hard-currency denominated foreign debt),
  • (ii) ratio of foreign currency denominated debt to domestic currency denominated debt (appropriately weighted by maturity),
  • (iii) ratio of short-term debt to long-term debt, and (iv) ratio of total cumulative foreign portfolio investment to gross equity market capitalisation.

    Under the approach, whenever TWs cross predetermined critical thresholds, various speed bumps (SBs) are called into play. The latter could take several forms including

    (i) requirements on borrowers to unwind positions involving locational/maturity mismatches, (ii) curbs on foreign borrowings, (iii) restrictions on certain types of FPI, and (iv) import curbs (in exceptional circumstances).

    The Chilean Model

    Chile is widely touted as a successful example of a financial liberalisation programme, but it has to be remembered that a large role in the Chilean success story is attributable to an extremely cautious approach to capital inflows that was followed from May 1992 to October 1998, and which represented an ingenious combination of the Tobin and TW-SB approaches.

    Central to the Chilean approach was an extremely flexible model of capital flows regulation, which incorporated five main features. (i) A tax of 1.2 per cent per annum on external commercial loans, (ii) a one-year residence requirement for FDI,

    (iii) a non-interest bearing reserve requirement of 30 per cent on all types of external credits and all foreign financial investment in the country, (iv) an exchange rate band with occasional movements permitted in the central parity rate (similar to the snake in the tunnel arrangement prevailing in western Europe prior to the formation of the EMU), and (v) a restriction on outflows of Pension Funds to a maximum of 12 per cent of their assets abroad.

    The Chilean model may be regarded as a highly effective means for managing the various types of risks associated with capital account liberalisation.

    Currency risk was managed via a crawling peg arrangement complemented by inflows management. As a result the Chilean currency appreciation and current account deficit were smaller than in other Latin American countries. Hence, the currency never came under attack following the Asian and Mexican crises. Flight risk was mitigated by discouraging those inflows that carried the maximum risk, with the reserve requirements acting as a type of Tobin tax on these investments. The minimum resident requirement on FDI reinforced long-term investments, while barricading the entry of short-term flows disguised as FDI. This effective bias against short-term capital inflows went quite some way towards containing fragility and contagion risks.

    In sum, these controls played a major role in insulating the Chilean economy from the global financial turbulence of the 1990s. The most notable feature of this win-win situation is that Chile received a larger proportion of external finance (relative to GDP) as compared to other countries in the region, with FDI constituting a larger portion of the inflows than in many EMEs.

    These controls had to be abandoned in 1998 in the wake of the pronounced decline in foreign inflows brought about by the combination of the Asian, Russian and LTCM crises, but there is no doubt that the Chilean model deserves careful consideration from other EMEs too.


    In recent years EMEs are facing increasing pressures from multilateral institutions and developed countries to liberalise their capital accounts. This case essentially rests on five claims made on behalf of capital account liberalisation.

  • (i) Such liberalisation achieves the optimum allocation of global financial resources, letting capital flow to those regions where its marginal productivity is highest. It thus helps EMEs to raise the rate of capital formation above their domestic savings rate.
  • (ii) Capital inflows promote long-term growth in EMEs by contributing to transfer of technology, financial know-how and management skills.
  • (iii) Capital inflows have a disciplining effect on domestic fiscal and monetary policy.

  • (iv) Capital inflows dampen the effects of exogenous shocks on the domestic economy.
  • (v) Free mobility of financial capital is essential for stimulating global trade.
  • Several of these claims are sustained in terms of the IMF’s Financial Programming model. However, as we have noted in this paper, the IMF model is subject to important caveats stemming from moral hazard, asymmetric information and agency problems. Admitting these caveats casts serious doubts on several of the above claims. Besides, there are the special problems created by short-term capital mobility in terms of financial market instability, asset bubbles and other microeconomic distortions. These problems are not a new discovery, and as a matter of fact were noted by Keynes in his General Theory 70 years ago, as stemming from the special nature of asset markets such as “animal spirits” and “herd behaviour”. The efficient markets theory, advanced as an alternative to Keynes’ somber view of financial markets, fails to address the issue of the destabilising effects on financial markets of speculative behaviour by “noisy traders”. There is thus sufficient ground to cast doubts on the theoretical case for capital account liberalisation.

    The empirical evidence is not very reassuring either. Capital account liberalisation has occasionally proved beneficial, but only for relatively developed countries, and only if accompanied by appropriate prudential measures in the financial system. In the Indian context the government has shown a keenness for accelerating capital account liberalisation and going all out for full CAC. The two committees appointed to examine the issue (Tarapore I and II) have laid out a detailed roadmap for CAC, along with the necessary safeguards. To this author, it is not very evident that these committees (especially Tarapore II) have really gone into a detailed examination of all the risks attached to CAC, and devoted sufficient attention to measures such as TW-SBs which have recently been experimented with in several countries. It is important to stress that the line taken by several apologists for CAC that the risks of financial instability are negligible and hence more than compensated for by the benefits ignores the magnitude of the potential costs of a crisis.14

    The TW-SB measures have three special features:

  • (i) They can prove highly effective in insulating economies from financial crises, without impinging seriously on the volume of FDI (though it will act as a curb on short-term capital flows).
  • (ii) They would be more effective in checking real currency appreciation and prove cheaper than the conventional sterilisation measures usually invoked to deal with capital inflows.
  • (iii) Contrary to fears expressed in certain quarters, such controls need not necessarily increase the cost of foreign capital to EMEs. As a matter of fact, with effective controls in place (and the corresponding reduced vulnerability to crises), the risk premium on foreign capital is likely to decrease.

    The overwhelming evidence against CAC, however, may not necessarily convince some of the die-hard reformers among India’s current economic policymakers. Since this group has conveniently decided to regard all advice emanating from resident (as opposed to non-resident) Indian academics as otiose and almost worthless, I can do no better in conclusion, than to quote similar advice, but emanating from a source which carries far greater weight with the current Indian government, viz, from one of the leading architects of the erstwhile Washington Consensus “At this stage full capital account liberalisation promises no large benefits, while it increases the risk of things going badly wrong” John Williamson (2006).

    Interestingly in a recent letter published in the Financial Times, August 1, 2007, Williamson reaffirms this earlier stance but with a new spin on the role of the IMF,

    I at one time shared the impression that the IMF had pushed capital account liberalisation in the years prior to the east Asian crisis and in that way was culpable of contributing to the cause of the crisis. When this view was challenged (by an IMF official). I conducted a small survey of critical policymakers in emerging market countries at that time. The results are hardly statistically robust, but to my surprise displayed no inclination to blame the IMF for having pushed them into opening their capital accounts. The rhetoric of IMF officials was just rhetoric and was not translated into policy at the individual country level.




    [I am grateful to S Narayan, Biswajit Chatterjee, Smriti Mukherjee, R Acharya, Errol D’Souza, and M Matthai for helpful comments. Responsibility for any errors and shortcomings rests solely with the author.]

    1 The most common assumptions underpinning new classical economics are (i) rational expectations, (ii) market clearing, and (iii) a unique full employment equilibrium.

    2 Considering the accumulated writing on CAC in India, an additional article on the subject seems almost redundant. But like the proverbial bad penny, CAC refuses to drop out of circulation!

    3 Obstfeld et al (2004) present several historical instances of the trilemma. 4 The euro is however floating against the other major currencies such as the US dollar and the Japanese yen. 5 He cites the role of exchange rate stabilisation in ending the 1920s European hyperinflation.

    6 The introduction of the Market Stabilisation Scheme (MSS) in April 2004 assumes significance in this context as an important tool for short-term liquidity management.

    Economic and Political Weekly September 8, 2007

    7 This forex turnover is more than 10 times the daily turnover of global equity markets (at $167 billion), 40 times the daily turnover of the NYSE (at $ 46 billion) and on an annual basis the forex turnover is more than 10 times the value of the combined world GDP (estimated at $ 36 trillion).

    8 As a matter of fact, notwithstanding the fact that the committee chairman was a highly respected senior central banker, well known for his independent views, the general feeling was that the composition of the committee was loaded heavily in favour of the officially desired result – a stratagem increasingly resorted to by Indian governments in the past two decades.

    9 PNs currently constitute about 25 per cent of net portfolio investment.

    10 For example, a tax of 0.10 per cent implies that a twice daily round trip carries an annual rate of interest of 146 per cent, whereas the same figure for a a twice weekly round trip reduces sharply to about 21 per cent.

    11 D’Orville and Najman (1995) estimate that a Tobin tax of 0.25 per cent would globally fetch a revenue of $ 140 billion, whereas Felix and Sau (1996) predict the revenue generation at over twice this amount (for the same rate).

    12 The phenomenal rise of the Eurodollar market in the 1970s and 1980s should serve to remind us of the scale of transactions that can occur outside a system of central bank clearing.

    13 There are also special types of TWs called “contagion TWs” which are activated in a given country (say A) whenever SBs are invoked in another country (say B). Such TWs become especially important for groups of countries with interdependent financial systems in general and interlocked funds in particular.

    14 As given in Mohan (2007), recapitalisation of banks (subsequent to the financial crises of the 1990s) cost 55 per cent of GDP in Argentina, 42 per cent in Thailand, 35 per cent in Korea and 10 per cent in Turkey. The total welfare costs would be substantially higher.


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    Williamson, J and Z Drabek (1999): ‘Whether and When to Liberalise Capital Account and Financial Services’, Economic Research and Analysis Division, WTO, Staff Working Paper No ERAD-99-03.

    For the Attention of Subscribers and Subscription Agencies Outside India

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    Economic and Political Weekly September 8, 2007

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