How financially open is India?

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: In my August 30 column, I examined India’s inflation growth record, and compared it to four other large developing countries: Brazil, Indonesia, Mexico and Russia (BIMR). India has recently done better than all of them. Its good performance on the inflation front goes with an apparent lack of capital account openness. This would make India an exception to the general pattern of a negative correlation between inflation rates and openness, the explanation being that its governance institutions perform better than those of the BIMR quartet.

But there is another wrinkle to this tale. The comparison of capital account openness used the popular Chinn-Ito index, which combines various measures of legal restrictions on cross-border capital movements, using a purely statistical technique to determine how to achieve the “best” combination. By this index, India has the lowest score (least capital openness), which is -1.1. A score of 2.6 is the best possible, achieved by several developed countries. The BIMR quartet’s scores are, respectively, 0.2, 1.2, 1.2, and -0.1. The comprehensiveness of the exercise undertaken by Chinn and Ito, and their use of the index in various analyses of the links between financial development and growth, have together contributed to its popularity. However, it tells only part of the story. Ultimately, de facto financial openness and financial integration are best indicated by relationships in asset prices. The idea is as follows.

The condition known as covered interest parity (CIP) states that, in the absence of market imperfections or transaction costs, the interest differential between financial assets of the same term denominated in different currencies will equal the cost of covering in the forward market the currency risk from arbitrage between the two assets (arising from possible movements of the exchange rate before the assets mature). If there are frictions, then there will be a no-arbitrage band (defined by two inequalities), rather than a single equality condition. This observation essentially goes all the way back to John Maynard Keynes, writing in the 1920s, but recently, better data and new empirical techniques have allowed the idea to be applied systematically. In the current context, capital controls contribute to market frictions, and so the nature of the arbitrage thresholds gives insight into de facto openness, consequent on legal restrictions as well as market imperfections.