Even before the global financial crisis of 2008 precipitated, there was a widening view among policy analysts that the issue of cross-border capital movements needed to be re-examined. It was all very well for the International Monetary Fund (IMF), which was closely identified with the full-convertibility view, to argue that this was the best way to give comfort to foreign investors and also ensure that currencies and country risk were priced correctly. The reality was far more ambiguous. The experience of many emerging markets that opened up to foreign investors indicated great vulnerability to massive swings in the direction of capital flows. Even the IMF became somewhat more guarded in its advocacy of full convertibility after the East Asian crisis of 1997-98, emphasising the need for certain conditions to be fulfilled before it was viable or desirable. Fast-forwarding to the most recent crisis, emerging economies, which had experienced huge inflows of capital in the form of portfolio investment over the preceding two or three years, suddenly saw it flying back to home base in a matter of days and weeks. As in previous crises, this caused significant disruptions in asset prices and the exchange rate, but this time, many countries had enough foreign exchange reserves to withstand the shock of capital outflows, so no emerging economy experienced a serious balance of payments problem. This episode has clearly highlighted the need for re-assessing the benefits of accumulating large foreign exchange reserves. Once viewed as inefficient by the orthodoxy, “self-insurance” is now being seen as a legitimate crisis-management strategy.
Alongside this, the orthodoxy about the desirability of capital inflows is also being questioned. Brazil is a prominent example of having recently imposed a tax on short-term portfolio inflows, a variant of the class of instruments generally known as Tobin taxes. The rationale, very simply, is that as beneficial as capital inflows are, they also bring with them the risk of disruption in both financial and real sectors following sudden and massive outflows. The standard argument in favour of imposing any tax is based on externalities — the actions of a few having consequences for many. If disruption constitutes a negative externality, then the source of that disruption, viz., short-term portfolio investment inflows, is a legitimate target of taxation. Contrary to the orthodox view that Tobin taxes will queer the pitch for foreign capital, a clear delineation of the transactions on which they are to be levied may actually incentivise more desirable long-term portfolio and direct investment inflows because they promise a more stable balance-of-payments and exchange-rate environment. The issue is not yet one of great urgency as far as India is concerned, but a strong economic recovery next year in the midst of still abundant global liquidity could very quickly cause a repeat of the 2007 flood of inflows, with its attendant risks. It would be prudent to have a plan in place to deal with such a situation.