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.