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Copyright © The Author 2007. Published by Oxford University Press.
This article appears in the following Oxford Review of Economic Policy issue: INDIA [View the issue table of contents]
Capital inflows, financial repression, and macroeconomic policy in India since the reforms
* Delhi School of Economics, e-mail: partha{at}econdse.org
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Abstract |
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Since the early 1990s the Indian economy has seen a considerable relaxation of controls, as a consequence of which it has witnessed unprecedented growth. This is especially remarkable in the external sector. In this paper I evaluate the progress made on the macroeconomic front and address the possibility of opening up the capital account of the balance of payments. I show that given the weakness in the financial sector and the government finances, it may be dangerous to speed up the process of opening up the capital account further.
Key Words: economic liberalization • financial repression • capital account convertibility
I am grateful to the Centre for Development Economics for providing research support and to Vineeta Sharma for research assistance. I have benefited from discussion on these issues with Partha Chatterjee, Errol D'Souza, Nira Goyal, Vijay Joshi, Kenneth Kletzer, and Urjit Patel. The comments by a referee and Andrew Glyn have, I hope, improved the quality of the paper.
1 Mishkin (2004, p. 5). Of these, we shall see below that only the first and the second fit the Indian policy stance to date. Its monetary authority never resorted to monetization in a big way, so the third feature does not apply. And its capital account, so far, has not been sufficiently open for the fourth and the fifth points to apply.
2 Broner and Rigobon (2004) look at 23 developed and 35 emerging market economies and find that capital flows to the emerging market countries are 1.79 times more volatile than those to the developed countries, while the (left) skewness (that is, proneness to crises) is 1.5 times as high. In addition to ‘fundamentals’, emerging market economies experience more contagion and persistence. Since their (annual) data go back to 1965, they probably understate the volatility.
4 Kletzer (2005, pp. 21–2) calculates implicit interest subsidy on public debt and seignorage at an average of 8.2 per cent of GDP over the period 1980–93.
5 See Sen (2002) for a further discussion of this period.
6 See Joshi and Little (1994, ch. 7) for an account of the macroeconomic developments in this period.
7 The government-owned banks still continue to be in a pre-eminent position, accounting for over 80 per cent of bank deposits and over 60 per cent of all assets of the financial sector.
8 India signed Article VIII of the IMF's Articles of Agreement in 1994.
9 Restrictions on the flow of capital have used two broad types of control mechanisms: (a) which distinguishes between transactions—implemented, for example, in Chile and Argentina, and (b) which differentiates between domestic residents and others—the strategy followed in India and South Africa—with domestic residents being forbidden from participating in certain transactions. This almost inevitably translates into liberalizing inflows first, and then outflows.
10 As a measure of government's fiscal health, it is far from perfect—for example, because it includes privatization proceeds as revenue rather than their being ‘below the line’.
11 The largest of these are losses of the State Electricity Boards.
12 Regulatory forbearance and state ownership of the banking sector imply hidden contingent liabilities for the public sector.
13 See, for example, Joshi and Little (1994), Sen (2002), Kletzer (2005), and Buiter and Patel (2006)
14 It is interesting to note, however, that following the collapse of a private bank, the depositors were compensated, but not the owners.
15 A distinction is made between Indians resident in India and non-resident Indians (NRIs). See Joshi and Sanyal (2005) and Sen (2002) for details.
16 With a fully open capital account, the domestic interest rate for a small open economy would be given by the foreign one. Sterilization becomes impossible in such a scenario.
17 This is true of all capital flows insofar as they lead to added demand for non-traded goods.
18 Joshi and Sanyal (2005) discuss this at length.
19 In a crisis, as in a bank run, only 100 per cent reserves would be adequate!
20 The current account deficit changes a country's claims against the rest of the world.
21 The RBI and World Bank give different figures for the FDI/GDP ratio. According to the World Bank's figures the peak is later (in 2002).
22 The rise in the domestic interest rate may generate further flows, but would probably have a dampening effect on stock prices.
23 See the Lahiri Committee (Government of India, 2005, para. 40).
24 See RBI (2006, Table 81) for figures.
25 The Southern Cone (Chile, Argentina, and Uruguay) liberalization in the early 1980s was the first of these.
26 For example, the Basle prudential norms set some internationally comparable standards in the banking sector.
27 See, for instance, Caballero and Krishnamurthy (2001) who model a developing economy as having two constraints—one for domestic assets and the other for foreign assets. A developed economy has only an aggregate constraint on borrowing.
28 See Caballero (2000) for how in Chile's case, most macroeconomic series follow the international price of copper, its main export—this, in spite of Chile being a market-oriented economy with fairly good regulatory institutions in place. See also his discussion on the volatility of the various stock-market indices in Argentina.
29 See the discussion on the recent Latin American crisis below.
30 See Williamson (2001) and Schneider (2001).
31 In the Lahiri Committee Report (Government of India, 2005), this episode does not find a mention in section 3.V, entitled ‘Episodes of Vulnerability’ [sic], whereas the Soros attack on sterling does.
32 See the references to Tarapore Committee II (RBI, 2006) and Lahiri Committee (Government of India, 2005) elsewhere in this paper.
33 That the distinction between FDI and FII flows from a macroeconomic management is not appreciated in Indian policy circles can also be seen in the Tarapore Committee II Report (see RBI, 2006, para. 2.8). The Lahiri Committee has the following to say on this: ‘Foreign investment—both portfolio and direct varieties—can supplement domestic savings and augment domestic investment without increasing the foreign debt of the country. Such investment constitutes non-debt creating financing instruments for the current account deficits in the external balance of payments.’(Government of India, 2005, para. 40).
34 I emphasize the distinction between an open (to financial flows) capital account and a closed one rather than a demand-constrained versus a supply-constrained setting. The latter distinction, while crucial in the short run, becomes blurred over time—e.g. investment creates demand in the short run but augments supply in the next period.
35 In any case, as mentioned earlier, we do not see much action in the Indian data that points to private primary issues having received a shot in the arm when the stock market was booming.
36 In an earlier version of this paper, a Keynesian-type model was sketched out in an Appendix—this was deleted because to integrate that analysis with the rest of the paper would have made this paper very long. The semi-reduced form of that model is estimated in my paper with P. Dua (Dua and Sen, 2006).
37 Malaysia and Thailand, for example, had an open capital account for decades prior to the Asian crisis, but they received no inflows, so there was no problem.
38 See Caballero (2000) for examples casting doubts on the ability of inflows to generate positive effects.
39 But as Calvo and Talvi (2005) point out, a country's economic structure and policies can determine how hard it is hit when a reversal takes place. They show that the Chilean meltdown was much more severe than that in Argentina. Thus Chile was hit harder in the crisis than Argentina, but since recovery requires a country to run current-account surpluses, this was something that Chile—being more open to trade—was able to do at a lower cost than Argentina.
40 Against this there is some evidence elsewhere in the developing world, where lending was undertaken indiscriminately—e.g. with consumption growth in Chile growing at over 40 per cent (surely a harbinger of trouble) before the crisis in the early 1980s. Similarly, there is the much-quoted example of a currency-mismatch where a taxi-cab company in Indonesia borrowed huge amounts in US dollars. These episodes of indiscriminate lending were a good predictor of crises, rather than sustained growth.
41 In a supply-constrained full-employment set-up, keeping one's real exchange rate undervalued is inflicting a terms-of-trade deterioration on oneself. Clearly it does not make sense in such a framework.
42 In a typical short-run macroeconomic model and in growth models (e.g. the decentralized version of the Ramsey model), saving and investment are done by different agents and equality between these is brought about by price and/or quantity adjustments. In models with credit constraints, investment depends on net worth (and in simpler versions on savings)—see, for example, Obstfeld and Rogoff (1996, ch. 6).
43 The real appreciation does help the import of capital goods, which raises productivity. But capital-goods importation was part of an ongoing process of liberalization that started in the 1980s, and hence did not require the real appreciation to jump start it.
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