This collection of essays analyses in great detail the phenomenon of capital flows in emerging market economies and makes suggestions on what should be done to tackle them
Managing Capital Flows
Subir Gokarn, Bruno Carrasco
& Hiranya Mukhopadhyay
MANAGING CAPITAL Flows is a collection of academic papers that were presented at a conference held jointly by the Asian Development Bank (ADB) and Reserve Bank of India (RBI) in Mumbai in 2012. Therefore, the reader can expect detailed technical papers on the subject, as the authors deep-dive into the issue of capital flows and their effects on various economies. The authors of the papers analyse capital flows in different countries as case studies to make suggestions on what should be done to tackle them. We get to learn what various countries did when faced with these challenges, and these responses could serve as possible templates in the future for others. But there are different views on this possibility too.
The three important messages, which the authors highlight based on the conclusions of various authors of the papers presented in this volume, are the following: the first is that countries can gain a lot from these inflows if they come more in the form of equity, that is, FDI and are channelled in the right direction, that is, investment. This means that FII investment in the secondary market would not have the same positive impact on economies. Second, price stability does not guarantee financial stability, as large inflows can be inflationary and can lead to misalignment in exchange rates. Therefore, macro prudential regulation has to necessarily be the first line of defence against the building up of asset prices. Third, a proactive policy is needed to avoid a constant exchange rate and interest rate realignments, which put central banks under constant pressure, as they have to tune monetary policy to these twin developments.
A paper by Michael Klein argues that there is little evidence to prove that controls of any nature on capital flows tempered exchange rate appreciation. His take is that while countries like China and India did witness lower appreciation, there is less evidence for other countries, which had capital controls. Therefore, the conclusion is that capital controls could tend to be less potent in controlling exchange rate appreciation in several cases.
Another paper by Jonathan Ostry recommends that there is no ‘certain magic formula’ for dealing with short-term volatile capital flows. The usual policies of stabilisation may not be effective and one will also have to examine the implications on other macro indicators to gauge whether or not these measures work. Capital controls can be impactful if the distortion is temporary. However, persistent inflows would require a different set of policies, and capital controls will not be feasible.
Subir Gokarn’s paper relating to India focuses on policy flexibility rather than adherence to theoretical rules. The recommendation is to pursue a flexible rate policy with selective exchange rate intervention, which is what was done during the period 2007-12 when the economy went through both varieties of flows: large inflows and sudden outflows. The controls on inflows were on both quantity and price, while those on outflows were essentially quantitative in nature. The effectiveness of such policies is more important and tends to be time-specific, which reinforces the belief that there is no size that fits all. But such actions have an impact on expectations, development of the market and various stakeholders.
The experience of Brazil is elaborated in another paper, where inflation and financial stability goals were jointly pursued. Regulations introduced were more to deal with financial stability. Brazil tackled forex inflows by contractionary fiscal and monetary policies, and allowed for substantial currency appreciation, while sterilising the incremental reserves simultaneously. In the case of Indonesia, traditional policies did not quite work in the form of open market operations. Here, the central bank pursued a blend of keeping a flexible rate, conducting capital flow management, as well as invoked macro prudential measures.
This collection of papers is interesting, as it analyses in great detail the stories of tackling capital flows in emerging markets. But ultimately, one would go with Gokarn’s view that it may not be possible to always go by the textbook, as the macroeconomic conditions prevailing within the specific country would determine to a large extent the available policy responses. Though at a generalised level, the solutions offered here would hold. Therefore, internal introspection is called for and countries do need to monitor all these flows and be prepared with responses to ensure that the distortions caused are minimised.
Madan Sabnavis is chief economist, CARE Ratings