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Do Preemptive Capital Controls Belong In India’s Policy Toolkit?

The ability to use preemptive capital controls offers a buffer, managing the risks to financial stability that come with openness

A builder lays a brick for the exterior wall of a new home. (Photographer: Simon Dawson/Bloomberg)
A builder lays a brick for the exterior wall of a new home. (Photographer: Simon Dawson/Bloomberg)

Since the start of the Covid-19 pandemic, there has been an ebb and flow of foreign capital into emerging markets, including India, complicating the lives of policymakers.

In just one month in March 2020, the reduction in net capital flows to emerging markets was equal to what occurred in six months during the famous 2013 ‘taper tantrum’ episode. Since March, foreign capital has flooded back in, leading to familiar debates about whether to throw some sand in the wheels through capital controls.

India’s policy response in the two episodes has differed: capital controls were not used this year when the capital was leaving, a contrast to the response in 2013.

What determines whether or not capital controls should be used? And are controls more needed and useful when the country is facing a surge of inflows but futile in the face of outflows?

Policymakers reach answers to these questions largely on the basis of their knowledge of country circumstances and constraints, but they are also influenced by the experience of other countries and the views of multilateral institutions like the International Monetary Fund.

Our recent report provides an independent view on how useful IMF advice has proven to Indian policymakers as they have dealt with capital flow volatility over the past decade. The IMF’s Independent Evaluation office—set up in 2001 with Montek Singh Ahluwalia as its first Director—works at arm’s length from IMF management and executive board. Our reports draw on confidential interviews conducted by renowned experts with current and former senior policymakers and IMF staff. The interviews with Indian policymakers and IMF staff who have worked on India were conducted by Ila Patnaik.

IMF’s Advice And India

So how useful was IMF advice to India on dealing with capital flow volatility? There is much to praise but also some room to improve.

On the plus side, there is no doubt that the yearly consultation with the IMF is regarded as a useful consistency check of India’s policy settings, a judgment also reached by our report last year led by Rakesh Mohan.

There was also praise for the flexibility shown by the IMF in becoming more accepting of the use of their ‘heterodox’ policy toolkit to manage the capital account. The Indian preference has been for a mix of policies—use of capital controls and foreign exchange intervention along with standard policy tools—to manage capital flow volatility.

The late Subir Gokarn was fond of saying, drawing on a basketball analogy, that the IMF favoured man-to-man defence whereas the Indian officials preferred zone defense. Over the last decade the IMF has become more accepting of zone defense – the use of a mix of policies to meet a set of goals.

Our report also points to some shortcomings in IMF advice to India on capital flow issues.

One shortcoming was highlighted during the taper tantrum episode. India came under significant market pressure in the summer of 2013.

Debt and equity outflows both accelerated and the rupee depreciated by 15 percent in just three months as the RBI struggled to convince markets that the outflow from India was not in line with fundamentals of the Indian economy. These led to a wide-ranging and heterodox response that including a number of current and capital account measures, including restrictions on lending against gold, direct dollar sales to oil marketing companies, and subsidised forex swaps to attract inflows from non-resident Indians.

Interviews indicate that Indian officials would have welcomed a statement of IMF support for their package of measures. The IMF did not come through in time with public support, in part because each measure taken had to be assessed against the IMF’s agreed policy position on the use of capital controls.

In short, while becoming more supportive in principle of heterodoxy, the IMF did not provide concrete support when it was needed the most.

The experience of Chinese officials in 2015 when they were facing outflow pressures was somewhat similar, suggesting that the IMF’s policy position that the use of capital controls should be limited to crisis or near-crisis situations rather than preemptively is too limiting.

At the same time, the IMF is also faulted by some former officials for not making the case for longer-term capital account liberalisation as firmly as it could have.

In this view, the system of administrative controls in place in India to keep foreign capital out was cumbersome and not very transparent. While it may have helped to preserve financial stability, it imposed a large cost by hindering the development of liquid domestic markets and putting a lid on economic growth. These officials felt the Fund had been excessively cautious in its advice and looking at capital controls solely through the lens of financial stability.

The bottom line is that some fine-tuning of IMF advice is needed so that it does more to support countries in their long-term move toward capital account liberalisation while also showing greater flexibility in supporting the use of capital controls when they are really needed, including preemptively at time of severe stress.

The Case For Preemptive Controls

The preemptive use of capital controls can be of value not only in the case of outflow pressures, as was the case in India in 2013, but even more so under some circumstances in managing inflows – the circumstances include when FX markets are shallow, when economies are dollarised, or when they are large currency mismatches on balance sheets.

Our report found that a number of countries would value such flexibility: Korea and Peru are two cases where such controls have been used preemptively and judiciously to maintain financial stability.

India’s growth prospects, like those of other emerging economies, would be boosted by reaping the benefits of more open capital markets. The ability to use preemptive capital controls on occasion provides a necessary buffer to allow countries to manage better the risks to financial stability that come with greater openness.

The IMF should take this into careful consideration when it reviews its official policy position on capital controls next year.

Prakash Loungani is Assistant Director and Sriram Balasubramanian is Senior Research Officer at the IMF’s Independent Evaluation Office. The views are those of the authors and should not be attributed to any organisation.

The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.