A capital idea

In mid-2007, there were two competing views about India’s capital flows “problem”. According to the first view, India is able to calibrate capital flows, to be able to selectively switch off or on certain components of capital flows and thus achieve a judicious mix and quantity of capital flows.

Going by the alternative view, India is too open today for this central planning mentality to work. If one door is closed, money will move through other doors, as long as the basic reason for money to move is unchanged. In this view, small changes to capital controls are ineffective and not worth the political cost. The only thing that would work in affecting capital flows is far-reaching and draconian capital controls.

In 2007, the traditional view supporting capital controls won the policy debate. In August, restrictions were brought in against external commercial borrowing and in October, restrictions were brought in against portfolio flows. The world economy took a turn for the worse, which normally reduces capital flows into emerging markets. But US interest rates have dropped, and even though India pegs the rupee to the dollar, Indian interest rates have not dropped. This interest rate differential has been pulling money into India.

It is now time to look at the evidence, to take stock of the impact. Did events work out as the policy makers hoped?

In Q2 USD 33.5 billion net capital inflows came to India. In Q3, net capital inflows were USD 31.5 billion. This was despite the turmoil in global financial markets in which capital was moving away from risky assets and emerging economies like India are seen as more risky.

Q1 2007 (April-June) is the old, undistorted environment. By Q2, capital controls against ECB were in place. In most of Q3, controls against portfolio flows were also in place. The evidence shows that these did not work. In Q2 and Q3, net capital inflow was roughly twice that seen in Q1. It rose from an average inflow of about USD 3 billion per month in the quarters preceding July 2007, to USD 10 billion per month after July.

The restriction on Participatory Notes (PNs) imposed in October 2007 does not appeared to have reduced portfolio flows into India. Portfolio flows grew from USD 10.89 billion in the second quarter to USD 14.56 billion in the third quarter.

Despite various restrictions on External Commercial Borrowings (ECBs) inflows on account of ECB went up from USD 4.7 billion in the second quarter to USD 5.26 billion in the third quarter. Short-term loans remained high. They were USD 4.79 billion in the second quarter, and USD 4.25 billion in the third quarter.

... contd.

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