Archive for February 25th, 2009

India’s capital account liberalization – What is the real issue?

February 25, 2009

Eswar Prasad of Cornell University has written a new paper (free version here) on India’s capital account liberalisation. The abstract says:

In this paper, I analyze India’s approach to capital account liberalization through the lens of the new literature on financial globalization. India’s authorities have taken a cautious and calibrated path to capital account opening, which has served the economy well in terms of reducing its vulnerability to crises. By now, the capital account has become quite open and reversing this is not a viable option. Moreover, the remaining capital controls are rapidly becoming ineffective, making the debate about capital controls rather moot. Managing de facto financial integration into international capital markets and aligning domestic macroeconomic policies in a manner that maximizes the indirect benefits and reduces the risks is the key challenge now facing India’s policymakers on this front.

On reading the abstract casually, I thought the paper would be a typical one – criticising India’s approach towards capital account liberalisation and ask policymakers to open it further.

However on reading the paper carefully, I get an opposite message. The paper actually says India has liberalised its capital account and is quite open. (One could also see this paper which measures financial globalisation by comparing spreads between offshore and onshore markets. India does not fare very badly either.)

One area where India has not opened up is opening its debt market to foreigners. As a result when we look at comprehensive measure of capital account liberalisation, India is ranked low compared to its peers. However, when we disaggregate see only equity markets (FII and FDI), India ranks with the peers. The author points that the ideal way to liberalise capital account with beginning with equity markets and debt markets coming later.

He also praises RBI:

The outcome of the RBI’s calibrated approach to capital account opening appears to have resulted in a preponderance of FDI and portfolio liabilities in India’s stock of gross external liabilities. All elements of the literature point to this as being a favorable outcome in terms of improving the benefit-risk tradeoff of financial openness.

What is also interesting is that author reviews literature on whether capital flows matter. He looks at three ways:

  • On growth: no evidence whether capital flows matter (this is well known as pointed by Obstfeld and Rogoffin different studies). He also points to his own study which says non-industrial economies that rely less on capital flows have betterlong run growth. He says capital flows seem to have more indirect effects than direct ones. However, proving this empirically is very difficult.
  • On risk sharing: Ideally more integrated economies should be better off as their risks are diversified across other economies. However, only developed econs have been able to manage their risks (this has also been thrashed in this crisis). Integrated emerging econs have only seen risks rise in a crisis (see figure 2 in the paper). The author then points to research which says risk sharing works better in case of equity markets and not in debt markets. Which is what India has done exactly.
  • Productivity: Again the same result…equity market integration shows higher productivity, debt does not. If we add indirect benefits of capital flows, impact on productivity is more.
  • Hence, research points what is more important is composition of foreign capital inflows and not overall benefits.

And despite all this knowhow, author says:

Given the cushion provided by India’s high level of reserves, there is now an opportunity to push forward more aggressively with capital account opening in order to gain some of the indirect benefits of financial integration. For instance, a specific recommendation of Rajan Committee (2008) is that allowing foreign investors to invest in government bonds could improve the liquidity and depth of this market. This would have numerous ancillary benefits.

A deep and well-functioning government bond market is a prerequisite for serving as a benchmark for pricing corporate bonds, which could allow that market to develop. By providing an additional source of debt financing, it would create some room for the government to reduce the financing burden it currently imposes on banks through the statutory liquidity ratio—the requirement that banks hold a certain portion of their deposits in government bonds. And it might even have the beneficial effect of imposing some discipline on fiscal policy since foreign investors could pull out and raise the cost of debt financing if the government budget deficit were to start rising again.

I mean why would you recommend this? The benefits of a deep bond market are well known but costs could be much higher especially in times of this crisis (it will be interesting to do a cost benefit analysis). With record high government deficit the least Indian government would want is a foreign investor pull out. It would be a disaster of all sorts.

I don’t think sequence of events should be open govt debt markets and then use it as a signal to impose lower fiscal deficit. It is ideal but never works. A better sequence is to lower fiscal deficit (actual fiscal deficit including off-balance sheet liabilities) and let govt show commitment towards the lower deficit. Only then liberalise govt bond markets.

Anyways an interesting paper. Highly readable.

UK’s new banking act gives BoE more powers

February 25, 2009

UK has passed a new banking act:

The Banking Act provides a permanent and appropriate regime for the resolution of failing banks. It is a major step forward in the Government’s ongoing programme to strengthen stability and confidence in the UK banking system, in the wake of the global instability experienced by financial markets in the last eighteen months. I am particularly grateful to the contribution of the expert liaison group of industry participants in developing these proposals.”

The documents related to the Act are here.

Interestingly, they have also placed a report which analyses cost-benefit analysis of the new bill.

Costs of the Bill: GBP 2.2 mn – 4.5 mn
Benefits: GBP 3.6 mn – 5.1 mn

I am still going through the document. The media helps explain the act. BBCIHT. Telegraph has a neat explanation by outgoing BoE Deputy Governor John Gieve:

On Saturday the first provisions of the new Banking Act brought into force a new and permanent Special Resolution Regime (SRR) under which the Bank of England has been given a central role. The Act also gives the Bank of England for the first time a statutory objective to promote financial stability, working in cooperation with the FSA and the Treasury.

The SRR is a last resort. It will be triggered only if the FSA decides that a bank is failing or is likely to fail its threshold conditions and has no reasonable prospect of remedying that position. At that point, the Bank of England will choose between a range of options including the transfer of the whole or part of the business to a commercial purchaser directly or through a bridge bank, which would be a subsidiary of the Bank of England.

Assorted Links

February 25, 2009

1. Krugman on bank aid plans

2. IDB points to small change education can make

3. WSJ Blog points to Bernanke’s new speech, Econbrowser points as well

4. Mankiw on confused messages from US policymakers

5. FCB points to finance formula that killed wall street

6. Roth points market design is coming of age

7. CTB points Taleb goes short on markets each time he sees Bernanke speaking on TV.

8. ICLB compares bank nationalisations in India with US

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