The
possibility of volatile movements of capital has become
one of the most significant issues in developing countries
today. Of course it is a problem in itself, since rapid
movements in and out of the country create instability
in exchange rates and consequent problems within the
economy. But even more than that, the fear of capital
flight has posed substantial constraints upon domestic
economic policies across the developing world.
Governments
now worry before engaging in the most basic of fiscal
and monetary policies that would be targeted towards
improving the welfare of their citizens, simply because
they are concerned that international finance may express
its displeasure at anything that curtails its profits,
by causing a currency crisis.
For this reason, it is extremely important for governments
to continue to maintain some measures that will allow
them to regulate capital flows. It is important to note
that controls on the inflows of capital are as important
as controls on outflows, since sudden large inflows
can be as destabilising for an economy as outflows.
Indeed, the history of currency crises in the past decade
proves that it is those countries that were suddenly
''favoured'' by international finance and received large
inflows, that subsequently also faced financial crises
because of sudden outflows.
Partly, this is because large inflows which are coming
in for speculative purposes put upward pressure on the
exchange rate, causing the currency to appreciate. This
then creates tendencies whereby the current account
deficit increases, and over time, this leads to a ''loss
of confidence'' on the part of international investors.
The countries that have avoided such financial crises
even when all around them other countries in the same
region have fallen victim to them, are precisely those
countries that have continued to maintain some degree
of controls on the movements of capital in and out of
the country.
Even in India, the large inflows of capital over the
past two years, while not yet precipitating a crisis,
have been unnecessary and expensive for the government.
These inflows did not involve increases in investment
but were largely been directed towards speculative activity
in the stock market, and also led to large increases
in the foreign exchange reserves held by the RBI. Since
these reserves are held in safe areas which provide
very low return, especially in relation to the rate
of interest on external commercial borrowing, holding
them has actually been quite costly for the Indian economy.
Some people argue that holding these huge reserves is
necessary to prevent possible currency crises, but the
experience of other countries shows that even very large
reserves are rarely proof against determined speculators.
In any case, a much simpler method of avoiding such
crises is to provide for regulation that will smoothen
both inflows and outflows.
This issue is of special concern in India today because
the current government has already declared its intention
to undertake a number of policies which fly in the face
of the market-determined strategy. These include an
emphasis on public investment especially in the rural
areas, a rural employment guarantee scheme, an increase
in the tax-GDP ratio. None of these are likely to find
much favour with speculative capital, which is why it
is quite possible that some measures which result from
these aims will lead to pressure for capital flight.
For this reason, it is important to have an array of
instruments available to control the movement of capital,
prevent crises and ensure that capital inflows are directed
towards the best uses within the economy. There is already
a large set of controls which have been used quite recently
(and continue to be used in some countries) which provide
good examples. It is not only the more well-known example
of China, or India's own past, which provides such instances.
Capital controls of varying sorts have been used to
effect in recent times by countries ranging from Chile
and Colombia to Taiwan China and Singapore. Some possibilities
are briefly mentioned here.
To begin with, of course, there are the more obvious
direct controls which regulate the actual volume of
inflow or outflow in quantitative terms. These can relate
to Foreign Direct Investment and to external borrowing
by residents as well as to portfolio capital flows.
In addition, these can be directed within the economy
towards particular sectors or recipients through positive
or negative lists.
But there are also more indirect or market-based methods
which have been increasingly used to regulate capital
movements. Several countries have specified a minimum
residence requirement (of 1-3 years) on portfolio capital
inflows and also on FDI. Chile and Colombia had provided
for a non-interest bearing reserve requirement (of between
33 per cent and as much as 48 per cent of the total
inflow) to be held for one year with the central bank,
to ensure that the inflows were not of a speculative
nature.
For portfolio capital, other specific measures are possible.
In some countries foreigners are prevented from purchasing
domestic debt instruments and corporate equity. The
extent of FPI penetration in the domestic stock market
can be regulated, with a limit on the proportion of
stocks held by such foreign investors. There can be
exit levies which are inversely proportional to the
length of the stay, such that capital which leaves the
country sooner has to pay a higher tax. In any case,
differential rates of taxation provide an important
means of regulating capital flows.
In the case of external commercial borrowing, some countries
have imposed a tax on foreign loans. Others have provided
fiscal incentives for domestic borrowing and investment.
Domestic banking regulations can also play an important
role in ensuring that private external debt does not
reach undesirable proportions and to direct resources
towards particular sectors.
The financial press tends to portray such controls as
rigid and acting as disincentives to investment. But
the reality is very different – experience shows that
these controls can be and have been used flexibly and
changed in response to changing circumstances. Furthermore,
they have typically not acted as disincentive to continued
capital inflows of the desired variety; instead, they
have ensured that such inflows actually contribute to
increasing investment in socially effective ways. It
is worth noting that China, which still retains the
largest number and most comprehensive of controls over
all forms of capital flow among all countries, has also
been the largest recipient of capital inflows in the
developing world.
So
the new government must recognise that capital controls
have to form a basic part of the overall economic strategy.
Such controls must be over both inflows and outflows,
and be flexible and responsive to change. But without
them, it is difficult to see how other aspects of the
planned economic programme can be implemented effectively.
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