There is an old story about US President Harry Truman, tired of getting ?on the one hand?on the other hand? answers, asking for a one-handed economist. On the subject of capital flows into India, and the need for capital controls, economists seem to be only one-handed, on the side of raising the alarm about surging inflows.
Given that the Indian government (with its own economists presumably advising in the background) is taking the opposite position, this is one instance where a two-handed perspective is called for.
First, what are the arguments against allowing the surge in capital inflows to continue unchecked? The direct concerns seem to be two-fold. First, that the economy does not have the absorptive capacity for the inflows. Second, that inflows can be suddenly reversed. In the first case, the capital coming in does not get used productively, merely creating asset price bubbles, or getting wasted on low-yielding investments, or even getting stolen or perhaps diverted, as in Latin America, to offshore accounts. In the second case, the capital can be used well but a sudden reversal creates havoc with ongoing investments and the real economy.
This is not the end of the apparent dangers. India is running a large current account deficit to match the capital account surplus. In the absence of capital inflows, the exchange rate would depreciate, favouring exports and restraining imports. This equilibration is prevented by the capital inflows. When other countries are doing their best to keep their currencies relatively undervalued, India is hurting its exports even more by allowing in foreign capital and pushing up its exchange rate, in this view. Losses of export markets may not be easily reversed, even if capital flows later change course and the exchange rate then depreciates.
On top of all this, it has been suggested that some of the potential capital inflows?coming from raising ceilings on foreign holdings of government debt ?will make it easier for the government to avoid needed fiscal consolidation.
Interestingly, this argument is that foreigners will be buying long-term government bonds, along with their hot money going into Indian equities.
?On the other hand,? it is possible that foreign capital will find its way into productive investments in India, and that exporters will find ways to adjust to exchange rate appreciation. The larger ones may hedge against exchange rate movements. A higher rupee makes imports cheaper and may help to reduce inflation, by bringing down its imported component. One can even argue that opening up sovereign debt markets places more discipline on the government, rather than less?the new market that it must satisfy will be more demanding than traditional domestic purchasers of government bonds.
In my view, this is a true two-handed situation. Economic theory does not give definite predictions, only multiple possibilities, in the case of capital inflows. Which possibilities come to pass depends on expectations and the evolution of the global economy, as well as what happens in India. It seems to me that the government is confident that it can step in when it needs to, if there are signs of instability. Meanwhile, it is reasonable to take the stance that a pre-emptive strike against foreign capital is uncalled for.
This is not to say that the government cannot do more for exporters, for governance, or for more efficient financial intermediation. Microeconomic reforms can always help by improving efficiency and growth potential. But there is really no ironclad case for more controls on foreign capital, or abandoning the larger project of building a larger and more effective financial sector. Indian financial sector functioning has been so far from the frontier of craziness that led to the global crisis that one cannot argue on the basis of the crisis that India must retrench. Nor is India?s political economy like Latin America?s (at least not yet), where foreign capital often financed a narrow and corrupt elite. Again, my sense is that India?s business and government elites are not behaving in ways that involve collusion with greedy foreigners at the expense of the rest of the population.
Ultimately, which hand is holding the right cards needs to be decided through rigorous empirical analysis of the Indian economy, including its interaction with the rest of the world. The tricky part here, as the recent crisis did teach us, is that models can create a false sense of security. But, on the other hand, they can also be a guide to more efficient policymaking. On balance, one has to believe that Indian policymaking could benefit from reliable estimates of the impact of exchange rate changes on variables such as exports and inflation, and of the impact of capital flows on the exchange rate and various aspects of real economic activity. Until then, we are all making guesses, informed ones, but guesses nonetheless.
?The author is professor of economics, University of California, Santa Cruz