I am thankful to Bank of England for the excellent
arrangements and well thought out agenda for the 2004 Central Bank Governors'
Symposium.
As desired by Governor Mervyn King, I will give
a brief introduction in this session on capital account liberalisation and capital
controls.
Professor Kenneth Rogoff's well-researched messages
on effects of financial globalisation on developing countries are appropriate
as governing thoughts for this session. There is evidence of a threshold effect
in the relationship between financial globalisation and economic growth, and
the heightened risks of volatility in capital flows to developing countries
gets reduced only after a particular level of integration. In contrast, empirical
evidence shows that trade liberalisation has had beneficial impact. A review
of evidence provides no road map for the optimal pace and sequencing of financial
integration. Many questions in this regard are best addressed only in the context
of country-specific circumstances and institutional features.
In this background, based on the Indian experience,
I will present some issues relating to managing capital account.
First, capital account liberalisation
is a process and it has to be managed keeping in view elasticities in the economy,
and vulnerabilities or potential for shocks. These include fiscal, financial,
external, and even real sector – say, oil prices and monsoon conditions for
India. Professor Rogoff's presentation places special emphasis on government
borrowings as a vulnerability.
Second, caution is needed in moving forward
with each step in capital account liberalisation, recognising that reversal
of any step in liberalisation is very difficult since markets tend to react
very negatively to reversals, unless there is already a crisis situation.
Third, the capital account itself needs
to be managed during the process of capital account liberalisation. There is
a hierarchy in the nature of different types of capital flows in real life.
For example, foreign direct investment is preferred for stability, and quantum
of short-term external debt, by residual maturity, should not be excessive.
Furthermore, adequate reserves, keeping in view the national balance sheet considerations,
which include public and private sectors, provide comfort. Public policy can
achieve these desirable conditions only through some sort of management of capital
account.
Fourth, the management of capital account
will be effective under enabling conditions, such as, reasonable confidence
in macro policies, in particular tax regimes, and safeguards against misuse
of liberalised current account regime to effect capital transfers. Sound management
will also avoid dollarisation of the domestic economy and internationalisation
of domestic currency.
Fifth, operationally, management of capital
account involves a distinction not only between residents and non residents
or between inflows and outflows but also between individuals, corporates and
financial intermediaries. The financial intermediaries are usually a greater
source of volatility amongst these. If such financial intermediaries operating
in the developing countries are owned or controlled by foreign entities / investors,
there is perhaps greater tendency to volatility in the flows. It is noticed
that such foreign owned / controlled intermediaries are often influenced by
considerations other than domestic economy and have less appreciation of local
conditions – apart from the issues relating to cross-border supervision of financial
intermediaries by the host country supervisor.
Sixth, the prudential regulations over
financial intermediaries, especially over banks, in respect of their forex exposures
and forex transactions must be effective and a dynamic component of management
of capital account as well as financial supervision. Such prudential regulations
should not be treated as capital controls.
Seventh, capital controls should be treated
as only one of the components of management of capital account. As liberalisation
advances, the control-regime would contract, and thus, it is the changing mix
of controls that charecterises the process of liberalisation in management of
capital account.
Eighth, capital controls may be price
based, including tax-regimes, or administrative measures. Depending on the legal
framework and governance structures, the mix between the two would vary. As
liberalisation advances, the administrative measures would get reduced and price-based
increased, but the freedom to change the mix and reimpose controls should always
be demonstrably available. Such freedom to exercise the policy of controls adds
comfort to the markets at times of grave uncertainity.
Finally, as mentioned by Professor Kenneth
Rogoff, a distinction needs to be made between de jure and de facto
financial integration in general and hence, in the context of capital account
in particular. In practice, there are difficulties in measuring the degree of
financial integration. However, the institutional structures, both of public
policy and markets, need to be evolved to meet the imperatives of liberalised
capital account. In the final analysis, the basic issue in any policy context
is whether capital controls lead to distortions in exchange rate or the liberalised
capital flows that lead to distortions in exchange rate. In respect of emerging
economies, the conduct of market participants shows that automatic self-correcting
mechanisms do not operate in the forex markets. Hence, the need to manage capital
account – which may or may not include special prudential regulations and capital
controls. There are many subtleties and nuances in such a management of capital
account which encompasses several macro issues and micro structures.
Thank you for your patience.
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