The art of managing capital flow volatility

The volatility of capital flows has increased significantly in recent years, particularly since the global financial crisis of 2008, making their management one of the biggest challenges facing emerging market economies (EMEs). The two broad strands of analysis in the book try to answer the following questions: (i) how successful were countries in managing their capital account in the face of volatile global capital flows during 2003-12? (ii) how effective were policymakers in stemming the fallout on the economies of these countries? The essays collected in the volume compare and contrast the theoretical paradigm and empirical evidence on the merits of capital account liberalisation and the role of capital account management, the latter with a focus on ways to attract larger capital flows to finance investment while safeguarding macro-management and averting sudden stops, flight to quality and the resultant destabilising forces to the economy.

The publication brings together the perspectives of economists and those of hard-nosed central bankers on a central problem in modern international finance, which was discussed in an international conference held on November 19-20, 2012, in Mumbai and sponsored by the Reserve Bank of India and the Asian Development Bank. The scope of the conference covered developments until 2012. However, the delayed publication of the volume provided an opportunity to bring the story up to date by incorporating the currency turbulence during May-October 2013. Section I deals with compositional shift and volatility of capital flows, section II on challenges of capital account management and section III on the experiences of select countries. This review highlights some common strands of thought. Summaries of discussions would have helped us to know whether there was any consensus.

The "Overview" chapter contains a good summary of the contents and conclusions of the various papers besides highlighting the rise and fall of capital flows. As Kristin Forbes argues, the best approach involves attention to the form of the capital flows (equity preferred over debt) and strengthening the domestic financial system rather than directly controlling the total flows by reducing leverage in the banking system. Michael L Klein's paper claims that there is little evidence that either long-standing or episodic controls on capital inflows tempered real exchange rate appreciations. Jonathan Ostry's paper argues that capital controls should only be imposed in response to macroeconomic concerns when the flows are expected to be temporary. Persistent flows require policy interventions.

The practitioner's approach is captured by three central bankers from India (Subir Gokarn and Bhupal Singh), Brazil (Luiz Awazu Pereira da Silva and Ricardo Eyer Harris) and Indonesia (Hartadi Sarwono) and a related paper on India. A common thesis is that flexibility and pragmatism are required in episodes of high volatility rather than adherence to strict theoretical rules. Messrs Gokarn and Singh show how the measures recognised the costs and benefits in management of the capital account relating to market expectations, development of markets and the impact on categories of the stakeholders. Abhijit Sengupta and Rajeswari Sengupta point out that faced with the "Impossible Trinity" (open capital account, fixed exchange rate and independent monetary policy), India decided to opt for a middle ground - an intermediate regime avoiding corner solutions - that sought to juggle various policy measures according to the macroeconomic context.

Brazil managed capital inflows in the standard textbook fashion with aggregate demand contraction through fiscal and monetary policies allowing for sufficient currency appreciation while smoothing movements through sterilised reserve accumulation, which reduced volatility of the exchange rate without aiming at distorting the structural trend. The paper by Mr Sarwono on Indonesia deals with the inadequacy of purely macroeconomic policy response and/or conventional open market operations to address volatile capital flows. Capital flow management and macro-prudential policies are equally important to limit the roles of short-term volatile flows, but they cannot substitute for basic monetary policies.

The volume is a good addition to the ongoing debate on the recent international financial crisis. In the context of India, I would like to point out, as I have argued in the past, that the liberalisation measures taken by the authorities were a panicky overreaction to the Lehman crisis. Although some measures were justified to insulate the country from the fallout, the extent of fiscal and monetary liberalisation adding up to nine per cent of gross domestic product in September 2008 was not warranted by the circumstances pertaining to India. In the first place, the exposure of Indian banks to the damage caused to the international system was small. Secondly, the Indian markets functioned normally unlike those in the West where they had become dysfunctional due to the heightened fear of risk. The inflationary trend since then only shows that the chickens have come home to roost.

On the exchange rate side, the persistent steep appreciation of the rupee for more than a year despite market intervention proved the Mishkin thesis that a sterilised intervention has almost no effect on the exchange rate. It leaves the money supply unchanged and so has no direct way of affecting interest rates or the expected future exchange rate. Unsterilised intervention can, however, bring about a change in the exchange rate.

The reviewer is an economic consultant and a former officer-in-charge in the department of economic analysis and policy at RBI

MANAGING CAPITAL FLOWS
Issues in Selected Emerging Market Economies
Bruno Garrasco, Subir Gokarn and Hiranya Mukhopadhyay (editors)

ADB and Oxford University Press; Rs 995