The International Monetary Fund (IMF) recently released a series of policy papers titled ‘Review of the Institutional View on the Liberalization and Management of Capital Flows’. This mouthful of a title for IMF’s Institutional View (IV) is daunting for sure, but it has deeper policy implications. What is more interesting is how this IV is becoming closer to the Indian policy view on capital flows.
In this article, we analyse IMF’s IV, its policy implications, and the Indian connection.
Macroeconomic textbooks cite three purposes of capital flows. First, some economies may have a lower savings rate than the rate of investment. In such savings deficit countries, foreign capital inflows can be used to increase investments.
Second, some of the economies have trade deficits (imports are more than the exports). Such economies will need foreign inflows to pay the extra import bill. Is there a relation between the first and the second purposes? Yes, countries which have savings deficits are trade deficit countries, and need capital inflows. The countries which have savings surplus are trade surplus countries which export capital to the deficit countries. Investment-savings and trade deficit- trade surplus are two sides of the same coin.
Third, apart from meeting the deficits, capital flows also bring world class technology. The foreign capital flows are mainly of two kinds: Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). While FDI is foreigners establishing businesses in India, the FPI is investment in companies, both debt and equity. The foreign flows, especially FDI, also brings the latest technology to the countries. We have seen this in India. Following the 1991 reforms, as India welcomed foreign investment, several companies established joint ventures and collaborations. Apart from capital, the inflows also brought the latest technology which changed the Indian economy.
However, as we move from textbook to policy and implementation, the reasonably sounding ideas go for a toss! As some of the deficit countries opened up to capital inflows, they faced many problems. The capital inflows which were expected to help the economy instead created the ‘Dutch disease’. In the late 1950s, the Netherlands economy discovered new oil basins which led to a surge of capital inflows. The high inflows in turn led to appreciation of the local currency which in turn made the export-driven economy uncompetitive. Since then, Dutch disease is used for all such cases when the economy receives capital inflows and makes the economy uncompetitive.
Another problem with capital inflows is when it rains, it pours, and vice versa. The capital flows, especially of the FPI variety, comes in quickly following positive news, and then goes quickly following a shock. When it goes out, the currency suddenly depreciates. In case the locals have borrowed in foreign currency (typically US dollar), depreciation makes the borrowing costlier, and difficult to pay the lenders back. The capital flow crisis also spills over to other countries with similar size and macroeconomic indicators as seen in the 1997 South East Asian crisis.
Given the above positives and negatives, how do policymakers maximise the benefits of capital flows while minimising the impact of the adverse loop? The first response of the policymakers is to sequence capital flows. The typical sequence is to prioritise FDI inflows over FPI inflows. Within FPI flows, the preference is for equity flows. The second response is to put controls on capital inflows and outflows which involve taxes and regulation to control the amount of capital inflows.
The IMF plays a central role in capital management policies as it provides financial help to countries which face crisis in honouring external liabilities. Despite the above highlighted problems, the IMF took a highly liberal approach towards capital flows and shunned any kind of capital controls. The IMF’s IV says that in case a country faced an external liability crisis, the problem was not capital flows but lack of markets, institutions, and governance. It actually asked countries to liberalise capital flows after a crisis.
After the 2008 crisis, the IMF’s IV changed dramatically. In a policy note released in 2012, IMF said ‘rapid capital inflow surges or disruptive outflows can create policy challenges’. The IV mentioned that both countries which are recipients and originators of capital flows need appropriate policy responses. It reiterated its stance that macroeconomic policy adjustments should take priority before resorting to capital flow measures.
Within capital flow measures, capital controls were included which was seen as a major policy change. In the 2022 IV, the IMF has continued with the 2012 stance saying countries should reap the benefits of capital flows, while managing the associated risks in a way that preserves macroeconomic and financial stability.
This change in IMF view on capital flows and controls brings it closer to the view held by Indian policymakers. Before the 2008 crisis, Indian policymakers were criticised for not opening up the capital account. However, the policymakers resisted the pressure and adopted a judicious mix of sequencing and controls. The impact of the 2008 global financial crisis on the Indian economy was at best limited and the criticisms suddenly became praises. Even after 2008, India has continued to open its capital account albeit gradually.
Economists Anton Korinek, Prakash Loungani, and Jonathan D Ostry have termed these changes in the IMF view as ‘a welcome evolution’. They point that we have seen large capital outflows from China in the Ukraine war serving a reminder on the volatility of capital flows. They add that the ‘framework should continue to evolve to provide countries with policy space when capital flows impinge on domestic objectives (e.g. reducing inequality) or generate international spillovers’. The IMF should closely study the Indian policy on capital flows, and hopefully draw some lessons.
Amol Agrawal is faculty at Ahmedabad University.
Views are personal and do not represent the stand of this publication.
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