IMF has recently changed its stance on capital controls. How sincere is the change and how relevant is it for India? The impact of controls on the magnitude and composition of capital flows, the cost of transaction and monetary policy has been a subject of enormous debate.

The International Monetary Fund, or IMF, has historically been hawkish on capital controls. For three decades, it has been preaching great virtues of a liberal capital account and market-determined exchange rates and cautioning that countries that control capital flows wind up artificially undervaluing their currencies.

But the trans-Atlantic financial crisis has forced the fund to rethink some of its past shibboleths. The extremely loose monetary policy in the West post-crisis has caused an enormous amount of money to slosh around the international financial system, raising commodity prices worldwide. Much of that has headed off in search of higher returns to the emerging economies, creating inflation, asset bubbles and currency volatility in these countries. In response, many of them, such as Brazil, have imposed controls, like special tariffs on monetary inflows.

Challenged by this new environment, IMF has now admitted that under some circumstances, capital controls might be the right thing to introduce, especially to counter influx of money caused by “temporary or cyclical” factors. A recent research paper from the fund concludes that “if the economy is operating near potential, if the level of reserves is adequate, if the exchange rate is not undervalued, and if the flows are likely to be transitory, then use of capital controls – in addition to both prudential and macroeconomic policy – is justified as part of the policy toolkit to manage inflows.” (Capital Inflows: the Role of Controls, February 2011).

The series of ‘ifs’ testifies to the reluctance to let go of a cherished doctrine. Like Vatican II of the Roman Catholic Church, IMF wants to be seen conceding something, without actually doing so.  

India’s monetary authorities naturally feel vindicated. For decades, India rigidly controlled inflows of foreign capital. Although it has opened up a great deal since mid-1990s, yet even now it retains the massive legal and administrative structure that can support the imposition or tightening of a comprehensive array of controls. And it is a fact that India fared relatively well during the global crisis. Its economy did slow down in tandem with the global economy, but growth remained positive in the downturn, and no large financial firm went bankrupt. This juxtaposition of extensive controls and favourable economic performance suggests to some that the two were causally linked. It has been argued, for example, that controls made India more resilient, by isolating it from shocks that occurred elsewhere and preventing a build-up of foreign debt.

India’s stance on capital inflows has hardened over the years. In recent years, faced with a surge in capital flows, India tightened restrictions within the existing elaborate system of capital controls. The measures included tighter controls on cost and end-use of foreign currency borrowing, tax and administrative changes for venture capital regime, registration provisions for non-resident Indians who were foreign portfolio investors and ban on offshore derivative products.

India continues to attract massive capital inflows. Typically, the short-term volatile funds brought in by FIIs outweigh by far the foreign direct investment in plants and factories. These inflows have contributed to high inflation and soaring prices of real estate, shares and bullion. The rupee has appreciated although the country has a large current account deficit, indicating that the exchange does not reflect the intrinsic strength of the economy.

Recent statements from the Reserve Bank of India (RBI) have been more direct in expressing concern on the deleterious impact of such flows. This is understandable. 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.

However, India cannot afford to go back to the bad old days of socialism when all foreign capital was regarded as an evil. The large deficit on the current account means that the country spends more dollars than it earns and needs foreign capital to bridge the gap. Moreover, at the current stage of its development, India cannot allow concerns over portfolio inflows to derail the effort to attract foreign direct investment (FDI). FDI is more stable, and brings with it benefits such as advanced technology, access to export markets and exposure to international best practices. An indiscriminate assault on foreign capital would be as unwise as an open door policy.

A critical variable about which IMF is silent is the exchange rate. IMF continues to believe that “the benefits from a free flow of capital across borders are similar to the benefits from free trade.” It sees nothing wrong in highly volatile market-determined exchange rate, which is a natural corollary of free capital flows.

What is presented as a statement of fact is in fact a highly questionable assumption. As noted columnist A.V. Rajwade has pointed out, market-determined exchange rates convert a currency (say dollar) from “a unit of account, a store for value, a medium of exchange” into a commodity, with its price changing minute to minute. This benefits the currency trader or speculator, often at the cost of the real economy. As it happens, we are yet to study the impact of a 25 per cent appreciation (in real terms) of the Indian rupee in dollar terms of the last two fiscal years on the competitiveness of India’s tradeables sector, particularly vis-a-vis China.

The accepted wisdom of 1920s (free capital flows, fixed-exchange rates, but no control on money supply) resulted in a global depression. Today’s accepted wisdom – free capital flows, an independent monetary policy, and floating exchange rates – can be as risky for countries like India.

What India needs is an enlightened regime of capital account controls which encourages foreign direct investment in areas of national priority while punishing the coming and going of loose money. It also needs sustained market intervention by the central bank to maintain a competitive exchange rate that reflects the internal strength (or weakness) of the domestic economy.

The author is Executive Editor, Corporate India, and lives in Mumbai