A V Rajwade: Full convertibility - II

The greater the economic mess, the more the incentive to take money abroad — that, in turn, deepens the crisis.

As argued in the last article, there is no empirical evidence suggesting that a liberal capital account enhances growth; on the other hand, there are risks of destabilisation of the economy in an open capital account. The draft report of the UN Commission on Reforms of the International Monetary and Financial System, chaired by Nobel Laureate Joseph Stiglitz, of which former RBI Governor Y V Reddy, is a member, also emphasises that: “There is no evidence that capital account liberalisation has contributed significantly to economic growth. …Capital account liberalisation may contribute to economic volatility as these flows tend to be pro-cyclical. This implies high costs for the economy. Also, there are doubts whether new and increased regulation alone would be enough to curb explosive speculation on financial markets.” (Chapter 4, paragraph 46).

 

Dr Jagdish Bhagwati has often made the point that capital account liberalisation for developing countries was a product of the Wall Street/Treasury Complex, using the Bretton Woods twins to push its agenda. The U N Commission Report says: “Clearly, past policy advice by the Bretton Woods Institutions in this area was often misguided. These institutions should pro-actively assist their shareholders (in)... the area of capital account management (involving) … price and/or quantitative instruments.”

Arvind Subramanian of the Peterson Institute for International Economics has argued that, after the collapse of Lehman, “Deleveraging led to non-resident flight from rupee assets while tightening credit markets abroad forced Indian companies to turn to the Indian banking system for credit and for rolling over their foreign funding. In the ultimate analysis, this sharply increased demand for foreign exchange (and)... for credit from the Indian banking system — (and) placed considerable pressure on the rupee…” (Economic and Political Weekly, January 10, 2009, ‘Preventing and Responding to the Crisis of 2018’). He goes on to argue that, before the recent crisis, “the orthodoxy (Mark I) was to aim for capital account liberalisation. After that crisis, the revised orthodoxy (Mark II) was that countries that had already opened up to capital flows should not reverse policies but … should proceed cautiously on the path of capital account opening. But one can detect the emergence of a new view that has not yet attained the status of orthodoxy (Mark III) but is garnering more adherents. On this view, not only should those not already open be cautious but even countries that are open should think of careful and prudent ways of managing, even dampening inflows through policy actions.”

“Sudden stops create large costs and that there is need for substantial self-insurance. This requires preventing the exchange rate from sharp swings, especially appreciation. The essential logic of this view is that self-insurance requires managing the exchange rate which becomes progressively difficult the greater the capital flows. Put more starkly, this view sees full capital account openness as both increasing the vulnerability to crises (the more the capital that comes in, the more that can exit) and also reducing the ability to respond to crises because openness limits the ability to maintain competitive exchange rates and hence build up reserves through current account surpluses. China is very much the model for this option.” But enough about inflows.

As for capital liberalisation for resident individuals in developing countries, no literature on the subject claims that this confers any benefits, direct or indirect, to the domestic economy in terms of growth, investment and employment. It does benefit the individual saver, through diversifying his investments: At the macro level the problem is that such benefits are negatively correlated to the fortunes of the domestic economy. The greater the mess in the domestic economy, the higher the benefits of taking money abroad! In a way, freedom for residents to move capital abroad is perhaps the most regressive form of taxation: It benefits the rich and, should a crisis occur as in East Asia in 1997-98, hurts the poor most! Overall, in my view, the case for freedom for residents to transfer savings abroad, is extremely weak as far as the developing world is concerned. Just consider what would have happened if residents would have joined non-residents in the last quarter of 2008, in transferring capital abroad.

To summarise, when the trinity of liberal capital flows, an independent monetary policy and a desired exchange rate become impossible to manage, the most expendable is a liberal capital account. This, incidentally, is also the area where there occurred the most public disagreement between the previous RBI Governor and the finance ministry when the former suggested that, at some stage, consideration may have to be given to limit inflows.

Not surprisingly, John Maynard Keynes articulated the case better than anybody else can: “We are determined that, in future, the external value of the sterling shall conform to its internal value,… Secondly, we intend to retain control of our domestic rate of interest, so that we can keep it as low as suits our own purposes, without interference from the ebb and flow of the international capital movements, or flights of hot money. Thirdly,… we will not accept deflation at the dictate of influences from outside.”

avrajwade@gmail.com  
The author blogs at avrajwade.blogspot.com