The possibility of volatile movements
of capital has become one of the most significant issues in developing
countries today. Of course it is a problem in itself, since rapid movements
in and out of the country create instability in exchange rates and consequent
problems within the economy. But even more than that, the fear of capital
flight has posed substantial constraints upon domestic economic policies
across the developing world.
Governments now worry before engaging in the most basic of fiscal and
monetary policies that would be targeted towards improving the welfare
of their citizens, simply because they are concerned that international
finance may express its displeasure at anything that curtails its profits,
by causing a currency crisis.
For this reason, it is extremely important for governments to continue
to maintain some measures that will allow them to regulate capital flows.
It is important to note that controls on the inflows of capital are as
important as controls on outflows, since sudden large inflows can be as
destabilising for an economy as outflows. Indeed, the history of currency
crises in the past decade proves that it is those countries that were
suddenly “favoured” by international finance and received
large inflows, that subsequently also faced financial crises because of
sudden outflows.
Partly, this is because large inflows which are coming in for speculative
purposes put upward pressure on the exchange rate, causing the currency
to appreciate. This then creates tendencies whereby the current account
deficit increases, and over time, this leads to a “loss of confidence”
on the part of international investors. The countries that have avoided
such financial crises even when all around them other countries in the
same region have fallen victim to them, are precisely those countries
that have continued to maintain some degree of controls on the movements
of capital in and out of the country.
Even in India, the large inflows of capital over the past two years, while
not yet precipitating a crisis, have been unnecessary and expensive for
the government. These inflows did not involve increases in investment
but were largely been directed towards speculative activity in the stock
market, and also led to large increases in the foreign exchange reserves
held by the RBI. Since these reserves are held in safe areas which provide
very low return, especially in relation to the rate of interest on external
commercial borrowing, holding them has actually been quite costly for
the Indian economy.
Some people argue that holding these huge reserves is necessary to prevent
possible currency crises, but the experience of other countries shows
that even very large reserves are rarely proof against determined speculators.
In any case, a much simpler method of avoiding such crises is to provide
for regulation that will smoothen both inflows and outflows.
This issue is of special concern in India today because the current government
has already declared its intention to undertake a number of policies which
fly in the face of the market-determined strategy. These include an emphasis
on public investment especially in the rural areas, a rural employment
guarantee scheme, an increase in the tax-GDP ratio. None of these are
likely to find much favour with speculative capital, which is why it is
quite possible that some measures which result from these aims will lead
to pressure for capital flight.
For this reason, it is important to have an array of instruments available
to control the movement of capital, prevent crises and ensure that capital
inflows are directed towards the best uses within the economy. There is
already a large set of controls which have been used quite recently (and
continue to be used in some countries) which provide good examples. It
is not only the more well-known example of China, or India’s own
past, which provides such instances. Capital controls of varying sorts
have been used to effect in recent times by countries ranging from Chile
and Colombia to Taiwan province of China and Singapore. Some possibilities
are briefly mentioned here.
To begin with, of course, there are the more obvious direct controls which
regulate the actual volume of inflow or outflow in quantitative terms.
These can relate to Foreign Direct Investment and to external borrowing
by residents as well as to portfolio capital flows. In addition, these
can be directed within the economy towards particular sectors or recipients
through positive or negative lists.
But there are also more indirect or market-based methods which have been
increasingly used to regulate capital movements. Several countries have
specified a minimum residence requirement (of 1-3 years) on portfolio
capital inflows and also on FDI. Chile and Colombia had provided for a
non-interest bearing reserve requirement (of between 33 per cent and as
much as 48 per cent of the total inflow) to be held for one year with
the central bank, to ensure that the inflows were not of a speculative
nature.
For portfolio capital, other specific measures are possible. In some countries
foreigners are prevented from purchasing domestic debt instruments and
corporate equity. The extent of FPI penetration in the domestic stock
market can be regulated, with a limit on the proportion of stocks held
by such foreign investors. There can be exit levies which are inversely
proportional to the length of the stay, such that capital which leaves
the country sooner has to pay a higher tax. In any case, differential
rates of taxation provide an important means of regulating capital flows.
In the case of external commercial borrowing, some countries have imposed
a tax on foreign loans. Others have provided fiscal incentives for domestic
borrowing and investment. Domestic banking regulations can also play an
important role in ensuring that private external debt does not reach undesirable
proportions and to direct resources towards particular sectors.
The financial press tends to portray such controls as rigid and acting
as disincentives to investment. But the reality is very different –
experience shows that these controls can be and have been used flexibly
and changed in response to changing circumstances. Furthermore, they have
typically not acted as disincentive to continued capital inflows of the
desired variety; instead, they have ensured that such inflows actually
contribute to increasing investment in socially effective ways. It is
worth noting that China, which still retains the largest number and most
comprehensive of controls over all forms of capital flow among all countries,
has also been the largest recipient of capital inflows in the developing
world.
So the new government must recognise that capital controls have to form
a basic part of the overall economic strategy. Such controls must be over
both inflows and outflows, and be flexible and responsive to change. But
without them, it is difficult to see how other aspects of the planned
economic programme can be implemented effectively.