The Fund recants

India must remain watchful, but not wary

The International Monetary Fund (IMF) has been recanting past doctrines ever since the trans-Atlantic financial crisis dissolved the “Washington consensus”. In a recent report, the IMF has given up an old shibboleth on cross-border capital flows. With emerging markets and developed ones worried about “hot money” flows and their impact on exchange rates, inflation and asset bubbles, the IMF’s neo-conservatism has found new converts. The document has understandably created fissures in the international community, with developing countries feeling the document has not gone far enough in attempting to control capital flows. Developed countries, on the other hand, have been hinting at the dangers of setting a precedent in curbing the free flow of capital. While the truth may lie somewhere in between, the immediate responsibility for restoring a semblance of order in the international financial system rests squarely with the developed economies. As just one example, the recently concluded quantitative easing (QE2) programme in the US lowered the domestic interest rate to virtually zero, raised commodity prices worldwide and led to outflows of capital, seeking better returns. While QE2 was an attempt to jump-start a sluggish US economy, the negative spillovers are being felt the world over. Other developed economies have also contributed to this problem, albeit not to the same extent as the US.

The IMF has been at great pains to emphasise the non-binding nature of the document. In theory, capital controls would work best for countries whose currencies are not undervalued, economies are overheating and where the scope for fiscal policy is limited. As a corollary, countries without these problems would be ill-advised to restrict the flow of capital into their respective economies. This clearly delineated advice would have limited applicability given that most countries would have some combination of these conditions, which would lead them to adopt country-specific measures. China, for example, has a starkly undervalued currency and follows tight fiscal policy, but has been recently grappling with overheating. Yet China has been arguing vociferously for curbs on capital flows, to prevent upward pressures being exerted on the renminbi. Brazil and South Korea have already put a control regime in place to deter hot money inflows.

India’s stance on capital inflows has hardened over the years. Recent statements from the Reserve Bank of India (RBI) have been more direct in expressing concern on the deleterious impact of such flows. The RBI should know. The sterilisation of hot money from 2004 to 2007 to prevent rupee appreciation led to interest payments of approximately Rs 60,000 crore a year! The furore over portfolio investments should not be allowed to derail the effort to make India an attractive destination for foreign direct investment (FDI). FDI is more stable, and brings with it a basket of benefits such as advanced technology, access to export markets and exposure to international best practices. An indiscriminate assault on “foreign” capital would result in throwing the baby out with the bathwater!