Handling the dollar rush

India witnessed a dollar deluge in the last few months. This had more to do with a compression of the values of imports than with a large inflow of capital of different kinds. And, the Reserve Bank of India (RBI) managed exchange rate stability by increasing its foreign exchange reserves (hereafter, reserves) by a whopping $56.8 billion in five months. Should that be the policy more generally? 

More often than not a dollar deluge is primarily due to a sudden and large capital inflow, and not a compression of imports. If the RBI increases its reserves, the country incurs an opportunity cost (the funds could fetch a higher return elsewhere). Furthermore, though the RBI has the mandate to target 4 per cent inflation, it is expected to be flexible. There it faces a difficulty in resolving its trade-off between various objectives when it has to deal with capital flows. But what is the alternative, given the limited instruments with the RBI? 

We need to think beyond the RBI. There can be instruments with the Ministry of Finance (MoF)! This may sound surprising but research over the last decade has shown the way. The 2006 RBI report on capital account convertibility and even chapter 5 of the 2014 report on inflation targeting need a revision at this stage. Here, I will focus on the economics and abstract from the operational details. 

To see the basic idea of the proposed policy, let us, in what may seem a digression, revisit some public economics before I come to the point. Consider an example. A factory may emit smoke and harm others in the neighbourhood; this is an externality that has a social cost that can get ignored. The accepted policy is to impose a tax on the business to correct for the externality. 

Anton Korinek at the University of Virginia, and others including Olivier Jeanne, Viral Acharya and Arvind Krishnamurthy have extended the above analysis from externalities in public economics to externalities in macroeconomics. This author has carried the argument further. 

In case of externalities, market prices exclude relevant information — the costs associated with an externality. In contrast, in case of many transitory macroeconomic shocks, market prices tend to include somewhat irrelevant information. In either case, we can have false prices that can be corrected through a tax policy. 

A good example of a transitory macroeconomic shock is a sudden and large capital inflow or outflow. Ideally, this transitory event should not affect, say, exports and imports. But it does as the market exchange rates get affected. The way out can be to impose a tax on sudden and large capital flows (and not on capital flows in general). No restriction is proposed on dealing in assets by foreigners within the economy, given whatever resources they already have in the country. The idea is only to discourage bulk international flows in a short span of time. Of course, there is a need to announce the policy change in advance to avoid any surprise for the markets. 

The proposed tax policy by the MoF reduces, if not obviates, the need for intervention by the RBI. With an additional policy instrument, while the MoF takes care of sharp capital mobility, the RBI is less constrained in resolving its trade-off between various objectives. Observe that under the prevailing policy, the public authorities incur the large opportunity cost of holding reserves. In contrast, under the proposed policy there is a gain due to the proposed tax. 

The proposed tax is different from the more familiar Tobin tax. This is typically a very small tax but an ongoing tax to curb excessive trading. In contrast, the proposed tax here is occasional and its size can be calibrated in line with how big the capital flows are. Interestingly, it can be rule-based where the rule encompasses pre-specified contingencies. Of course, the specific rules need not be permanent. 

Hedge funds often impose penalties or even restrictions on investors if there are large withdrawals under some circumstances. It is interesting that the investors are aware of and are agreeable to such rules. The proposed policy is mutatis mutandis, basically an adaptation of that very basic principle in a different setting. 

The virtues of the proposed change in policy raise a question. How did the central bank intervention come into being in the first place in dealing with capital mobility and exchange rate stability? This is an interesting question but it will take us far into the domain of much earlier policy regimes that included gold standard, fixed exchange rates, and so on. That is a separate thesis in itself. The point here is to gradually move towards using more of MoF policy and less of RBI policy in handling sudden capital flows.  

The writer is visiting faculty, Indian Statistical Institute, Delhi Centre