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Indira Rajaraman: Regulating capital flows

Going into the New Year, there is something well worth celebrating

Indira Rajaraman 

The year 2010 marked a dramatic change in the stance of the international policy establishment towards capital controls in emerging markets, where I use the term not in the sense of differences between countries in levels of restriction, but in the sense of imposition of (renewed) controls in countries which had previously liberalised their capital account regimes. The term “regulation” is more appropriate for these reversals, but I will continue with the term capital controls, since it is still used, and since much of the emotion surrounding it happened when it had that name. So the term capital controls is used here for going into reverse gear on capital account liberalisation.

The change in the international stance on capital controls in 2010 was marked by the G20 communique after the Seoul Summit in November 2010, and in the statement by Dominique Strauss Kahn at the Shanghai meeting of the International Monetary Fund in October, both of which endorsed capital account management among permissible “carefully designed macro-prudential measures”. These are big signals, even if they merely mark recognition of what countries facing the newest round of capital surge that started in mid-2009 have been doing anyway, starting with Brazil.

Prior to 2010, for a period of twelve long years, capital controls met with outright hostility and condemnation, dating back to September 1, 1998, when Malaysia imposed capital controls in what had been the most famously free capital account regime in the developing world. Malaysia gained current account convertibility status under Article Eight of the International Monetary Fund as far back as November 1968, a brazen display of export confidence. Then, in 1973, the Malaysian ringgit went into a full float, along with the dollar, pound and yen. It was a status no other developing country currency had attained, or even dared aspire to attain.

That record of early commitment to borderless capital flows was abruptly reversed in 1998. Capital controls had been imposed before. Colombia had unremunerated reserve requirements on capital inflows from 1993 to 2000, and even Malaysia temporarily restricted an inflow surge in 1994. The difference was that those were controls on entry, but the 1998 Malaysian move controlled exit. This was immediately condemned as an egregious abuse of sovereign power, and a violation of international trust. But what Malaysia did was not extreme. It was a carefully calibrated move designed to give Malaysia the space within which to lower interest rates without precipitating an outward stampede of capital. For non-resident capital, there was no ban on taking out profits and interest. It was only the principal that was incarcerated within the country. After six months, the ban was converted to an exit levy, and after another six months the levy was reduced to 10 per cent on capital gains alone, later further reduced to a levy on capital gains only on capital that had been in the country less than a year. By May 2001, all controls had been fully lifted (controls on exit of resident capital were, however, retained for a longer period).

This was not a story of irresponsible monetary policy at all. It enabled Malaysia to recover from the East Asian crisis with far less macroeconomic pain than other countries in the region. And it was clear that Bank Negara was continually calibrating controls to the need of the hour, removing them when no longer required.

The international reaction was swift and broadbanded to condemn all controls of any kind on foreign capital, at the point of entry or exit. To the basic lesson for developing countries that capital account liberalisation gave access to capital at lower cost and was, therefore, good for them, a corollary was appended, that such liberalisation must be monotonic at all times. The only permissible direction in which the capital account regime could go was towards liberalisation, without reversals of even a temporary kind along the way. There was no formal justification for this monotonicity requirement, and no empirical support. On the contrary, Malaysia offered a clear case of a country that had worked its way out of the East Asian crisis by disregarding monotonicity.

Any country worried about its international reputation was compelled to abide by these rules. Thus it was that when capital inflows into India quadrupled over the period 2004-08, regulating the inflow of capital was not seen as an option. The Reserve Bank of India (RBI) had to use such instruments as were available, to hold the exchange rate from appreciating wildly as it would have done if the dollars surging in had not been added to official reserves, and to sterilise the rupee inflow from the continued dollar purchase. This task was managed well, albeit at huge fiscal cost. What also helped was use by RBI of its role as a banking regulator to prick a potential asset bubble in its infancy.

Two countries did dare to flout the rules even then. Colombia reimposed unremunerated reserve requirements on inflows during 2006-08, and Thailand did too. In a recent paper, Kevin Gallagher and David Coelho assess these actions for their effectiveness, set against the background of a panel of neighbouring countries in each case. The results of all such empirics are necessarily context-specific, since the kinds of capital control used, their timing and duration, all matter critically for the success of the initiative. But the results of this and other studies show that temporary restrictions do help monetary policy autonomy, can control the composition of inflows in desired directions, do help stabilise the exchange rate, and do help regulate the pace of inflows.

The 2010 official benediction means that countries facing a capital surge can now consider capital controls without fear of blotting their good conduct book. This augurs well for the poor in these countries, who face the brunt of macroeconomic volatility. May we all have a Happy New Year.

The author is honorary visiting professor, ISI Delhi

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First Published: Sat, January 01 2011. 00:53 IST