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Friday, May 27, 2011

Dum Spiro Spero!

Forex reserves of over $290 bn, low rate of inflation, and the lowest ever interest rates till a couple of months back, are certainly reasons good enough to believe that “all is well” with us. But the all-intriguing issues of what to do with the surging forex reserves, with not much happening in the domestic investment market persists. Such a mismatch between inflow of dollars and demand for dollars from the domestic market either in terms of rising imports or additional industrial investments has become a macroeconomic issue. And this is revealing in rupee breaking almost a record a day.

Unwittingly, this prompted, some pundits to question the sanity of continuing with the near autarkic capital controls that were imposed “when restrictions on cross-border trade and investment kept us in a permanent state of forex-depletion paranoia” under the plea that such restrictions on capital movement is blocking domestic residents from investing overseas, while inflows are freely flowing in. Hence the advocacy is that India should phase out capital controls.

It is true that with the opening up of the economy, mounting reserves and appreciating rupee, it is no more logical to live in “forex-depletion paranoia”. At the same time, one cannot be ignorant of the fact that economic profession knows a great deal about current account liberalization but very little or almost nothing about capital account liberalization. This school of thought is therefore asking for order both in thinking about and policy framing on capital account. It is also argued in many quarters that capital account liberalization has got many costs embedded in it, the shocks of which are beyond the capacity of developing economies to absorb. It is being increasingly felt that capital account liberalization makes administration of the monetary policy more complex by constraining the feel of the domestic interest rate. It throws exchange rate management out of control besides reducing the already poor tax base of a developing country. Cumulatively, capital account liberalization subjects the developing countries to avoidable additional risks. Nor is there any econometric evidence to suggest that elimination of capital controls, affects growth and hence the question—“why capital account liberalization?”

In one of his presentations, Professor Jagdish Bhagwati, the noted Economist of Colombia University forcefully but persuasively warned the world not to equate the benefits that are likely to flow out of free mobility of capital with that of benefits emanating from free trade, for, they are not analogous. Obviously, all those benefits that flow to society from the principle of “comparative advantage” in production and exchange of goods do not readily translate into similar benefits from the exchange of currencies. He drew the world’s attention to the fact of availability of enormous quantum of historical database to establish the flow of benefits from   free trade while it is abysmally low with regard to free flow of capital. Not only is there enormous data to support the beneficial effect of free trade but also many economists of repute have in the past examined the whole gamut of free trade and framed rules in a way that no one participant can take unfair advantage from the system. There being no such accumulated knowledge with regard to free movement of capital, he warned that the weight of evidence and the force of logic point towards a policy that restraining capital flows rather than allowing its free flow.

It is increasingly being realized that capital account liberalization makes a developing country’s economy highly vulnerable i.e., when some thing goes wrong, then suddenly a lot goes wrong, as it had happened during the Asian crisis. Free flow of capital from international markets into a developing economy is usually guided by a “feel good or bad-equilibrium” of an economy. The “good-equilibrium” created by the high confidence and growth in economy acts as a ‘pull-factor’ for capital inflows while a reverse of it results in outflow of capital. Indeed, this is what happened in South-East Asian countries during 1997. Once the equilibrium is shifted from good to bad owing to lowering of confidence in their pegged-rate currency system and fall in exports growth, nothing could stall the flight of capital from these countries. Despite there being no change in their “fundamentals”, the shock waves generated by the sudden shift from good to bad equilibrium and the resulting flight of capital from these countries could not be checked even by   the huge reserves owned by central banks. It simply resulted in a contagion.

Dum spiro spero!—“While there is life, there is hope”. Leon Trotsky in his path-breaking essay observed this, on optimism and pessimism. Forex reserves cannot be an exception to these remarks of the greatest revolutionaries of the 20th century. When there are reserves there is always a hope to manage them well. And that could be the prime reason why China is sitting pretty cool on a stunning forex reserves of US $2.85 trillion which are incidentally rising fast that too mostly, unlike in India, fed by exports; ignoring global demands for letting its currency float. Any lessons to learn?

GRK Murty


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