Regulating Capital Flows Jayati Ghosh

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 province of 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.