dealing with the capital surge

Capital Management Techniques for Financial Stability and Growth

D M Nachane

By refraining from imposing capital controls, India is today paying a high price in the form of a loss of autonomy in monetary policy, a reduction in the available fiscal space, and bouts of volatility in the foreign exchange and equity markets. These volatility episodes have often created a penumbra of uncertainty around investment decisions. Surprisingly, the pronounced swing of opinion globally against unfettered capital account liberalisation in the light of the recent financial upheavals seems to have completely bypassed Indian policy circles. This article discusses various options for capital management that would contribute to growth with stability. These techniques comprise two complementary (and sometimes overlapping) sets of policies, viz, capital controls on inflows/outflows and prudential financial regulation.

1 Introduction
s the developed world struggles with a tepid industrial recovery, weak financial systems, burgeoning fiscal deficits and unsustainable debtGDP ratios, it is becoming increasingly clear that part of the burden of the painful adjustment to global imbalances is likely to fall upon emerging market economies (EME s). The low interest rates, quantitative easing of credit and frequent bailouts in the United States (US) and Europe are all injecting massive amounts of global l iquidity which is winding its way i nexorably to EMEs, driven by the search for g reater returns and the relatively sound macroeconomic fundamentals of the l atter. India seems to be a particularly favourite destination as between April and October of this year, about $80.0 billion has flown in (of which foreign direct investment (FDI) flows accounted for $13.5 billion, foreign institutional investment (FIIs) for $51.0 billion and external commercial borrowings (ECBs) for $10.6 billion) (RBI 2010). Confronted with capital flow upsurges, several EMEs have imposed some form of capital restrictions (most notably Brazil, Venezuela, Thailand, Indonesia, South Korea and Taiwan). India remains a notable exception, with official pronounce ments repeatedly reaffirming commitments to further capital account liberalisation. It is argued in this article that such a stance is completely unwarranted by the current circumstances, and that the time is propitious for supplementing the central bank armoury with the powerful tools of capital management (which is a comprehensive term embracing both capital c on trols as well as certain prudential measures for domestic financial institutions). Advocacy of open capital accounts is based on the neoliberal view that free global capital markets enable EMEs and the less developed countries (LDCs) to get cheaper access to international credit,

thereby promoting growth and stability. This view, always of dubious theoretical merit (see Arteta et al 2003; Nachane 2007; De Long 2009, etc) has been further discredited with the recent experience of currency crises (Ocampo, Spiegel and Stiglitz 2008). The received theoretical literature, as well as empirical evidence (BIS 2009) broadly point to a consensus on three issues: (i) the benefits of capital a ccount liberalisation are vastly overstated by their advocates, (ii) they (benefits) are circumscribed by too many conditionalities which are unlikely of fulfilment in many EMEs and LDCs, and (iii) controls over capital inflows can effectively reduce the vulnerability of economies to financial crises. As a result, full capital account liberalisation need not be some kind of an ultimate goal for all developing economies a conclusion quite at variance, incidentally, with the official Indian thinking on the subject.

2 What Can Capital Management Achieve?

As mentioned above, we are employing the term capital management to include controls on capital flows complemented with certain prudential regulatory measures (on the domestic financial sector). Before we spell these out in detail, we briefly list what a country can hope to achieve by deploying such measures. (1) Capital inflows typically confront an economy with a dilemma on the exchange rate front. As complete sterilisation of large inflows usually raises domestic interest rates (and thereby stimulates further inflows) and entails a fiscal burden, central banks have either to resort to incomplete sterilisation and risk inflation or allow the real exchange rate to appreciate. Most central banks, whether inflation targeters or not, are inclined to favour the latter alternative. As a matter of fact, the RBI has of late been following a hands off policy on the exchange rate front (see EPW 2010) with the result that the 36-country real effective exchange rate (REER) has appreciated by 13.2% over 2009-10, topped up with a further rise of 0.4% over April-October 20101 (RBI 2010). A steep rise in REER is fraught with serious consequences for the economy. First, it dampens exports and hence growth. Second, it raises the prices of non-tradables (especially real estate and labour) versus

The views expressed in this article are personal and do not represent those of the institution that the author works for. D M Nachane (nachane@hotmail.com) is at the Indira Gandhi Institute of Development Research, Mumbai.

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tradables. The implied relative rise in wages is likely to affect labour intensity adversely. Thus employment faces a double jeopardy from an appreciating REER, viz, reduced labour intensity and falling aggregate demand. Capital management techniques can resolve this dilemma by moderating inflows and thereby controlling REER appreciation. (2) One of the import and beneficial fallouts of (1) above is that capital management techniques can strengthen financial stability. This occurs because the stabilisation of REER via capital controls can considerably dampen carry trade in the concerned currency by setting at rest speculation centred around expected oneway movements in that currency. Simultaneously the other component of capital management, viz, prudential domestic regulation can (to a large extent) prevent the emergence of banking crises. (3) Capital controls by cutting the Gordian knot of the impossible trinity can provide additional space for domestic monetary policy (see Epstein 2009; Reinhart and Rogoff 2008, etc). (4) There are other, more general, advantages to capital management techniques. They lead to an overall reduction in the political power of the financial community, especially foreign investors and multilateral institutions. This creates v itally needed space for the interests of other groups (such as the peasantry, u rban poor, SMEs) to play a role in the design of economic and social policy.2 At the risk of sounding grandiose, one may even assert that capital management techniques can improve the quality of democracy by making policy more pluralistic.

tech ni ques need not be static (i e, once for all types) but can be dynamic, responding to changes in circumstances.3 There is a considerable literature which shows that these two arms of capital management can be deployed in combination to ensure both macroeconomic stability and socially beneficial growth (see Grabel 2004; E pstein 2009; Palley 2003; Ocampo 2003, etc). We now turn to a discussion of capital management techniques. It is important to emphasise that the focus of these measures is on preventing banking and currency crises. They are not designed to address the issue of the salvage measures that need to be taken once a country is actually overcome by a crisis.4 In a discussion of any preventive measure two considerations become paramount, viz, (i) the a ctual content of these measures, and (ii) a mechanism to decide when these should be activated. We begin by discussing the types of measures subsumed under capital controls and prudential financial regulation.

3.2 Prudential Financial Regulation Measures

But capital controls are only half the story. They need to be supplemented with various prudential measures, many of which have not yet been adopted by central banks. One such crucial measure could be a sset based reserve requirements (ABRR). Large capital inflows, driven by the search for high returns, inevitably end up fuelling stock and real estate markets. This confronts central bankers in host countries with an unpleasant dilemma whether to risk pricking a bubble and be accused of choking off a healthy growing economy, or to allow the asset bubbles to pop off themselves and to insulate the rest of the economy from the consequences by a massive injection of liquidity. One (and perhaps standard philosophy of central bankers) is to leave asset prices alone rather than run the risks of smothering an incipient recovery. In this standard framework (Bernanke 2005) asset prices, rather than being an explicit target, have only informational value to the central bankers as one (albeit important) component of aggregate demand. Under such a set-up, an inflation-targeting central bank has no reason to actively intervene when asset prices are on the upturn, but may be forced to intervene when asset prices start falling, for fear of setting in a prolonged debt-based deflation. Hence asset prices can only move upwards and investors knowing this fully well, keep on prolonging the asset bubble unduly. Even though India is not explicitly targeting inflation, this scenario applies very aptly here. Fortunately, ABRRs suggest a way out of the dilemma. The full details of this system are worked out in Palley (2000) and basically revolve around two elements, viz, (i) all financial institutions (not only banks) would be required to hold reserve requirements against assets, with weights varying according to the social desirability of the asset, and (ii) these reserve requirements could be adjusted at the discretion of the central bank. Thus ABRRs are exactly like the cash reserve requirements against deposits, except that whereas the cash reserve requirements operate on the liability side of the financial institution, the ABRRs operate on the assets side. At least five advantages can be claimed for

3.1 Types of Capital Controls

A variety of capital controls have been suggested in the theoretical literature and many of these have been invoked by different countries at various periods in the post-second world war period (see Epstein et al 2005 for details). Perhaps the oldest such proposal is the Tobin tax on capital inflows, suggested by Tobin (1978) in an influential article. O ther types of capital controls (on inflows) include (i) unremunerated reserve requirements (URR) which require a certain percentage of inflows to be d eposited with the domestic central bank for a lockin period (usually not less than a year), (ii) taxes on external commercial loans, (iii) sectoral regulation of FDI, (iv) interest equalisation taxes, and (v) restriction on domestic spending of NRI deposits, etc. Controls on outflows are less common but have nevertheless been resorted to under times of duress by countries such as Malaysia, Taiwan and Singapore. They could include (i) exchange controls, (ii) restri ctions on domestic institutions from extending credit (denominated in domestic currency) to non-residents, (iii) graduated exit levies proportional to length of stay of the investment in the country, and (iv) repatriation waiting periods, etc.

3 Capital Management Techniques

As mentioned above, capital management techniques comprise two complementary (and sometimes overlapping) sets of p olicies, viz, capital controls on inflows/ outflows (aimed at influencing directly or indirectly, the volume or composition of international capital flows) and prudential financial regulation (generally desig ned to guide the ability of domestic financial institutions to provide credit or capital for consumption or investment projects and the prices at which such capital or credit is made available). Capital manage ment

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dealing with the capital surge

ABRRs (i) they can be used to change the relative costs of holding different asset categories without changing the general levels of interest rates, (ii) they could be used to divert funds to socially desirable areas of investment (e g, low-cost housing), (iii) unlike capital reserve requirements which are pro-cyclical, ABRRs are countercyclical, (iv) ABRRs can yield attractive seignorage benefits to the central bank, and (v) finally, by rebuilding the demand for reserves they will contribute to making monetary policy more relevant.5 Apart from ABRRs, there are several other prudential measures which we now briefly introduce. (i) In many LDCs and EMEs (including India), the deposit insurance system is one based on a flat premium. This poses a moral hazard problem, with banks likely to indulge in excessive risky lending and investment activities. A switchover to a system of risk-based deposit insurance relying on a system of Fair Value Accounting6 can thus be a step towards more prudent regulation. Simultaneously, there is a need to raise the deposit insurance coverage,7 with a view to providing a much needed safety net for the savings of the middle classes. (ii) The role of rating agencies in the perpetration of the current crisis has come under heavy scrutiny from economists like Buiter (2008), Portes (2008), Giovanni and Spaventa (2008), etc. Such criticism has prompted the Financial Stability Forum (now Financial Stability Board), through the Inter national Organisation of Securities Commissions (IOSCO) to offer a code of conduct for credit rating agencies. The RBI should see that this code of conduct is accepted and adhered to, by major credit rating agencies in their Indian operations. (iii) A strict monitoring of off-balance sheet items and structured product vehicles (SPVs) of banks and financial institutions.

rediction and then use probit/logit modp els or signal extraction methods to recognise particular patterns associated with banking/currency crises. Thus EWS methods can in principle be used by central banks (or financial stability authorities) to identify situations that can lead up to a crisis. However, there are several problems with the use of an EWS. First, at the conceptual level, it is not clear whether these should be used exclusively by the central bank or whether the signals emanating from an EWS should be made public. Several proponents seem to believe that making the signals public could avert impending crises by inducing market stabilising behaviour by rational investors. But given the herd mentality and proclivity to panic behaviour noted famously by Keynes, the reverse possibility seems equally if not more likely, especially in LDCs. Second, as pointed out by Grabel (2004) the presence of an EWS (whether exclusive or public) might prompt investors to assume a more than normal risky behaviour as long as the EWS does not indicate a looming crisis. To the extent that EWS can often miss crises or send out false alarms, such risky behaviour can precipitate crises. Finally, the actual prediction performance of EWS seems to be quite unsatisfactory (see, e g, Sharma 1999 and Edison 2003).

eveloping into full-blown crises. Instead, d it assumes that the actions of private sector agents in response to evident financial vulnerabilities can actually trigger instability. It therefore assigns to regulators the task of activating regulatory measures as signs of financial vulnerability start to emerge.

5 Conclusions
One of the major planks of the reforms process initiated in India in 1991 was a high level of trade and financial integration with the rest of the world. To this end, subscription to Article VIII of the IMF was taken as the first priority and effective current account convertibility was achieved in August 1994. The government then directed its attention to the attainment of full capital account convertibility. To this date four high level official committees have examined this issue (using the chairmans name to refer to the committees), viz, Tarapore I 1997; Tarapore II 2006; Percy Mistry 2007 and Raghuram Rajan 2009.10 The first two of these were specifically addressed to capital account l iberal isation, while the remaining two dealt with wider issues of financial sector reforms. While the committees differed widely in their scope, style and depth of analysis, they shared a common faith in the theory of efficient markets and were steadfast in maintaining full capital a ccount convertibility as the ultimate goal of Indias external sector policy. As our above discussion should make clear, such a focus was totally unnecessary even in the early days of the reforms, but is p ositively pernicious at the current j uncture, in the aftermath of the global crisis.11 India today is paying a high price for refraining from capital controls in the loss of autonomy of monetary policy, a reduction in available fiscal space, and bouts of volatility in foreign exchange and equity markets. These volatility episodes have often created a penumbra of uncertainty around investment decisions, especially in the tradables sector. Sterilisation operations have imposed heavy quasi-fiscal costs, while undue real appreciation of currency (REER) has not only put severe strains on exporting units (especially the small and medium enterprises) but has in all likelihood had an adverse impact on unemployment (it is a pity that paucity of data on labour statistics prevents a reliable

4.2 Trip Wires-Speed Bumps

The essence of the Trip Wires-Speed Bumps (TW-SB) approach is simple. It rests on the idea that specific changes in policy ought to be activated to curtail particular financial risks as soon as the vulnerabilities are evident. The approach has been exciting i ncreasing interest among economists in recent years (see Ariyoshi et al 2000; Grabel 2003, etc). The TWs are usually simple indicators that are designed to warn policymakers of impending risks.8 Under the approach, whenever TWs cross predetermined critical thresholds, various regulatory actions called speed-bumps (SBs) are called into play.9 The idea has parallels in the typical circuit breakers employed routinely in several stock exchanges around the world (including the BSE and NSE in India), to stabilise excess market volatility. In contrast to the EWS, this approach does not presume that the self-correcting actions of market agents will prevent financial risks from

4 Timing and Activation of Capital Management Techniques 4.1 Early Warning System
The Early Warning System (EWS) approach was initiated in an early paper by Sachs et al (1996), and elaborated in several later papers by Goldstein et al (2000), Edison and Reinhart (2001), Abiad (2003), etc. The essential logic is simply to identify a group of variables relevant for crisis

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estimate of the incidence of REER appreciation on unemployment). Surprisingly, the pronounced swing of opinion against unfettered capital account liberalisation which has occurred among a majority of academic economists,12 as well as several foreign governments and multilateral institutions (the IMF not excepted) in the light of the recent financial upheavals seems to have completely bypassed Indian policy circles. It is important to realise that central banks in EMEs like India, with substantial segments of vulnerable population, cannot be narrowly focused on commodity inflation targeting alone (though this is an extremely important objective), but have to worry about a host of other objectives such as equitable growth, financial stability, availability of credit, etc. Today with the interest rate as the sole instrument of monetary policy, the central bank finds itself burdened with too many objectives and resembles an army with only a single corps (Friedman 1999). This problem of instrument insufficiency can be overcome to a great extent by adding to the central banks armoury the various capital management techniques discussed above (or suitable variants of the same).
Notes
1 The corresponding figures for the six country REER are even more telling at 20.0% (over 200910) and 3.1% (over April-October 2010). 2 As a notable, but by no means isolated, example of the overpowering influence exerted by the financial and corporate sector on economic and social policy in India, we may mention a recently appointed high-level committee which includes the Reliance Industries Head, the Bharti Head, ICICI Bank MD & CEO, HDFC Chairman, Infosys Chief Mentor, Chairman Emeritus RPG Group and the Bajaj Group and Motors Proprietor as members and the Finance Secretary as Member Secretary. Ironically the Committee is for Promoting Financial Inclusion. Note that the Committee does not include a single professional economist! 3 Examples of static techniques could include banning of certain types of inflows (say Participatory Notes) or certain types of activities (short-selling of currency) or instruments (currency derivatives). Examples of dynamic management techniques could be cyclically varying provisional norms, etc. 4 As an example of a salvage measure, we may refer to Prasad (2009), who has suggested an ambitious group insurance arrangement for the G-20 group. Apart from an entry fee (of between $10 billion and $20 billion), there would be a variable premium depending both on the level of insurance desired as well as the macroeconomic policies followed by a particular country. Participants would be offered a short-term credit line in the event of a crisis and the surveillance authority would be the Financial Stability Forum rather than the IMF. 5 Friedman (1999) had conjectured hat monetary p olicy could become irrelevant because of diminished demand for reserves and the evaporation of the link between demand for money and econo mic activity (through financial innovations such as e-money). 6 Such Fair Value Accounting could be on the lines

7 8

10 11

12

of the SFAS No 133 issued by the US Financial Accounting Standards Board in 1998. This currently stands at Rs 1 lakh in India. Among suggested TWs we may prominently mention (i) ratio of official reserves to total shortterm external obligations (foreign portfolio investment and total i e, private plus public short-term hard-currency denominated foreign debt), (ii) ratio of foreign currency denominated debt to domestic currency denominated debt (appropriately weighted by maturity), (iii) ratio of short-term debt to long-term debt, and (iv) ratio of total cumulative foreign portfolio investment to gross equity market capitalisation. SBs could take several forms including (i) requirements on borrowers to unwind positions involving locational/maturity mismatches, (ii) curbs on foreign borrowings, (iii) restrictions on certain types of FPI (foreign portfolio investment), and (iv) import curbs (in exceptional circumstances). I am following the common practice of referring to the various committees by their chairmen. As a matter of fact, the Raghuram Rajan Committees Report submitted in 2009, well after the global crisis had struck, was still arguing for the removal of any further vestiges of capital controls! To give one leading example, Willem Buiter in the Financial Times (18 February 2009) notes that For countries with a minor-league currency (every currency except for the US dollar, the euro and the yen) an open capital account will always be a mixed blessing. The joys of an open capital account the undoubted benefits from decoupling domestic capital formation from national saving and from unrestricted portfolio diversification and risk trading cannot be enjoyed without the pain: the risk of its domestic financial institutions, capital markets, non-financial enterprises, consumers and public finances becoming the flotsam and jetsam on massive and mindless killer waves propelled by an out-of-control global financial storm. Krugman (2009a and b) expresses similar sentiments.

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