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Handling volatile capital flows--the Indian experience

Poonam Gupta's picture
Capital flows to emerging economies are considered to be volatile. Influenced as much by global liquidity and risk aversion as by economic conditions in receiving countries, capital flows move in a synchronous fashion across emerging economies. There are periods of rapid capital inflows, fueling credit booms and asset price inflation; followed by reversals when exchange rates depreciate, equity prices decline, financial volatility increases, and GDP growth and investment slows down. These periods of extreme flows have unintended financial and real implications for the recipient countries. Central banks typically react with a mix of policies to cushion their impacts, ranging from managing the exchange rate and liquidity, to using reserves, monetary policy and macroprudential tools, and calibrating the pace of capital account openness. Overtime, along with the underlying characteristics of the emerging market economies and their available policy space, this policy mix has evolved too.

Wary of excessive exchange rate volatility emerging market economies have traditionally tended to either peg their exchange rates or maintain defacto managed floats. Unable to raise external debt in domestic currency, emerging markets have typically held debts denominated in foreign currency, with exchange rate depreciation resulting in adverse balance sheet effects. A customary response to capital flows has been to manage the impact on exchange rate through procyclical monetary policy-- loosening the monetary policy during periods of rapid capital inflows and high economic growth (to resist exchange rates appreciation) and tightening it during the reversals of flows and economic slowdowns (to moderate the extent of exchange rate depreciation).

However much has changed in emerging countries policy landscape in the last one and a half decade. After a series of high profile currency crises in the mid-1990s-early 2000s, many countries have moved from pegged exchange rate regimes to floating ones. They maintain less negative foreign currency positions, and have built a larger stock of reserves. An increasing number of central banks now operate under an inflation targeting framework, affording them a more definitive mandate to pursue monetary policy geared toward domestic policy imperatives. As a result countries now tolerate greater exchange rate volatility, while using their reserves when warranted; monetary policy is more countercyclical than before; and the use of macroprudential tools has become a more pervasive element of their policy mix.

My recent paper Capital flows and Central Banking-The Indian experience reviews India’s experience with handling capital flows, putting it in context with the experience of other emerging markets. It establishes three stylized facts.
  • First, India has increasingly become more financially integrated with the rest of the world. The pattern of capital flows it receives mirrors those in other emerging economies, pointing to the importance of common factors in driving capital flows to India. In the post liberalization period since the early 1990s, capital flows to India have evolved in three phases—a first phase from the early 1990s-early 2000s, during which capital flows increased steadily but remained modest compared to the size of the economy or monetary aggregates; a second phase of “surge” from the early 2000s-2007, when inflows increased rapidly, outpacing GDP and monetary aggregates; and a third period of volatility, starting in 2008 when capital flows reversed in the post Lehman Brother collapse period and again in 2013 during the taper tantrum and remained volatile. [1]  
  • The policy mix that India has deployed has evolved in sync with the capital flow cycle and is consistent with the trends observed in other large emerging economies. Its exchange rate, which was largely pegged to the US dollar until the early 1990s, is increasingly more market determined. Just like in other emerging countries, India has built a large buffer of external reserves, and for the most part has used it to modulate excessive fluctuations in the exchange rate. While monetary policy focused on price stability during the first phase, it was also conditioned by the pace of capital inflows in later phases--money supply increased during the capital flow surge and was tightened during the stop episodes. Additionally macro prudential measures have been used countercyclically, e.g. they were strengthened during the surge to limit excessive risk taking and deter asset price inflation.
  • Particularly interesting is the countercyclical liberalization of capital account. Contrary to a common perception, India has steadily liberalized its capital account since 1991; while the pace of incremental liberalization has been conditioned by the capital flow cycle. The pace of liberalization of inflows slowed during the capital surge episode of 2003-2007, while outflows were liberalized rapidly. Inflows were then liberalized vigorously during the reversal of capital in 2008-09 and in 2013.
 
While the capital flows to emerging markets are expected to remain volatile in the years ahead, their policy mix is likely to evolve further. Specifically for India, the move to an inflation targeting framework will likely reinforce the domestic orientation in monetary policy; whereas due to a progressively liberalized capital account over the last two and a half decades, further scope to manage the pace of capital account liberalization seems limited. Going forward, reserve management and macroprudential measures are likely to play a larger role in responding to capital flow cycles; even as the markets, economy and policy makers develop greater tolerance for inevitable market determined adjustments in exchange rate.
 
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[1] See Basu, Eichengreen and Gupta (2015) “From Tapering to Tightening: The impact of the Fed’s Exit on India” for a discussion of the policy response in India during the tapering talk episode in May 2013.

Comments

Submitted by Rajeev Gopal on

Volatile capital flows are a tragedy of the developing world.
When they flow in, the recipients love it and become careless. The beneficiaries are only a few among the recipient country's elites. When they flow out, and currencies decline and inflation goes up and prices rise, the victims are usually the poor and the salaried class.

When capital flows out, and prices rise, countries usually respond with the wrong policy instrument - monetary policy and inflation targeting. What is needed instead is moderation of capital inflows and outflows.

Why does capital flow in? It is usually an overseas investor seeking high and easy returns. Very often it is 'hot' money which is unproductive. How can a financial investor possibly help an emerging market by bringing in capital to invest in the stock market. The share prices inflate without adding any value. People celebrate the higher value of their share holdings not realizing that these values will dive when the overseas investor leaves (think recent activity in China). No benefit is achieved in the economy. FIIs rarely fill a funding gap. It is very few countries which need overseas capital for subscribing to equity, except perhaps where underfunded sectors need a huge investment which rivals the country's GDP, e.g. hydropower in Nepal. Nepal can never fund its hydropower on its own. It needs foreign capital. But this foreign capital cannot be allowed to come unchecked. It has to be strategically negotiated and brought in after careful planning. e.g. Bhutan has funded its hydropower sector with Indian money on a govt. to govt. negotiated basis. Hence the resulting prosperity is substantial whereas the negative impacts are few. Maldives is another country which successfully grew its tourism sector by carefully controlling capacity addition. Most of the investment was foreign capital.

Similarly overseas debt should not be encouraged (think China, Japan and India). A country loses control when it has to agree to creditor terms whether from multilaterals or from commercial banks. The first comes in with conditions which have long term consequences (e.g. Jamaica and Zambia) and the second has a high interest rate which usually leads to debt traps (e.g. Belize and Nigeria).

Central Banks should be the last institutions to handle long term policy and action. They should limit themselves to short term tactical action and corrective action. Inflation is a result of imbalance in demand and supply. How can a central bank influence either consumer behavior or supplier behavior. That has to be left to the government of the day. Long term inflation targeting is an anamoly. Not that many central banks can claim success in inflation control (think negative interest rates).

India has been relatively fortunate because its imports have been largely for productive purposes and not for consumption. This is changing. As the Indian economy consumes more and more imported goods, and gradually becomes dollarized, it will start becoming vulnerable like many smaller countries such as Jamaica, Zambia and Nigeria. India is managing foreign flows well but as noted by the author, India is integrating more with the external world. This is a risk and India, like any other country in a similar situation, needs to be alert.

The above is neither an agreement or a deviation from what the author says, it is simply my take on capital flows.

Submitted by Rob Webb on

Repeated your statement, but in the context of "called artificially low interest rates requiring printing large amounts of money" - interesting!

There are periods of rapid capital inflows in to the economy (called artificially low interest rates requiring printing large amounts of money), fueling credit booms and asset price inflation; followed by reversals when exchange rates depreciate, equity prices decline, financial volatility increases, and GDP growth and investment slows down. These periods of extreme flows have unintended financial and real implications for the countries with artificially low interest rates requiring printing large amounts of money. Central banks typically react with a mix of policies to cushion their impacts, ranging from managing the exchange rate and liquidity, to using reserves, monetary policy and macroprudential tools, and calibrating the pace of capital account openness.

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