Handling volatile capital flows--the Indian experience

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.