If the growth rates of emerging markets continue to be substantially higher than those of developed world economies, then the former must be ready for higher capital flows, and its consequences such as appreciating currencies and overheated capital markets. The developing economies will have to bear the onus of this round of global rebalancing.
As for India, it may have to tighten some of the already existing controls on capital flows. A tax on capital flows will only be a measure of last resort, says Abheek Barua, chief economist, HDFC Bank, in a wide-ranging interview with Sanjay Kumar Singh.
Given the heavy capital inflows that are taking place - about $22 billion of FII money has already come in - and this could possibly increase after the second round of quantitative easing by the Fed (QE2), what are the options before policymakers for moderating the rupee's appreciation and preventing asset price bubbles from building up within the country?
I think the only thing is to impose some kind of capital control. Capital controls are considered now even in the larger global policy community as an acceptable tool. That is the ultimate tool against this kind of flows. But what has happened in the recent past is that those economies, particularly Brazil, which have experimented with capital controls really haven't had much success.
The huge momentum in capital flows continues. It is likely that this will abate a little or even reverse if some of the risks that global investors were pricing in just a couple of months are back on the table. But consider the worst-case scenario in which capital flows continue and risks don't come back, then some form of capital controls will have to be considered.
In our case, we do have some controls in place which can be tightened. A large part of the commercial borrowing mechanism is fairly heavily controlled. You have restrictions on end use and interest-rate caps. The first option that the RBI can exercise is to tweak some of the existing regulations pertaining to commercial borrowings and NRI deposit rates (which are still controlled by RBI).
Perhaps the Securities and Exchange Board of India (SEBI) could step in and impose some controls on equity portfolio flows. A lot of the money, as I understand, is coming through the exchange traded fund (ETF) route. In future issues can be raised about the identity of investors using the ETF route.
Something similar to the curbs imposed on participatory notes could be tried, which, according to my understanding, were really used as a capital control tool but came in the guise of a market hygiene kind of regulation. This can be experimented with again .
Ultimately, I think that if flows still don't abate then you may have to go for an across-the-board tax. I don't think either the Finance Ministry or the RBI is interested in taking these extreme measures at this stage. And compared to the likes of Thailand and Brazil, which are far more active bond markets, our flows have been okay. So these are the options that are open. I'm sure that if things continue to get worse in terms of flows continuing, then these options will have to be considered.
So no policy option is off the board anymore?
Nothing is off the board. These measures have also got some kind of international legitimacy now, including with the likes of the IMF (International Monetary Fund), which doesn't consider these measures as retrograde. They are a legitimate response to a problem that emerging markets encounter, given the US's stance on monetary policy.
But from my understanding, these controls work only in the short term. Over the longer term they don't really work if inflows continue.
Absolutely. The history of controls has been very patchy. Yes, it can provide temporary breathing space, but over a slightly longer horizon we will have to think of other measures. If the principal problem is one of loss of competitiveness owing to an overvalued rupee, then productivity enhancing measures for the export sectors will have to be brought in. On the other hand, if you think that asset market overheating is a concern, then the use of both micro and macro prudential norms to curb the froth in asset markets will have to be considered. For instance, I understand that once again some pressure is building up in the housing market. Some kind of risk weightages and capital requirements for the sector can easily be introduced by the RBI.
Similarly, one can think of margin requirements and so on that could be tightened in the case of equity markets to curb the fervour.
But all this is part of the larger process of global rebalancing, and we will just have to get used to the idea of sustained long-term flows into our markets which would naturally have an impact both on the currency and on asset markets.
Our current account deficit has gone up substantially over the last couple of years. That in itself has worked as some kind of a capital control because you are using up more capital. Perhaps it's a blessing in disguise although there are legitimate questions about financing it over the long term. But if capital flows continue and we have some assurance, or there is a perception, that capital flows will be stable and strong, then perhaps working with a much higher current account deficit, which policymakers have actively discouraged in the past, is one option of dealing with this.