The IMF is in the process of endorsing this policy approach. In this context India’s experience is worth examining.
India’s strategy for managing the capital account was developed initially to deal with the capital inflows boom that preceded the GFC (2006-7). India’s macro-monetary framework allowed policymakers to steer within the intermediate zone of the open-economy trilemma and to achieve domestic price objectives while addressing exchange rate concerns even in the face of a prolonged and heavy surge in capital inflows.
The first element in India’s strategy was to increase the stock of foreign exchange reserves by US$ 57 billion in 2006-07 — this level is well above the average in the preceding five years. The main reason for the accelerated pace of reserve accumulation was the increase in the capital account surplus, driven by a sharp rise in net non-FDI capital flows.
However, the heavy capital inflow severely strained the monetary base. Reserve money growth ran above 17 percent year-on-year in 2006, accelerating further to 30 percent for most part of 2007 and money supply was running close to 25 per cent. The increased liquidity allowed banks to increase the pace of lending — beyond that justified by strong economic growth and other fundamentals — by rapidly running down their stock of investments in government bonds and loaning close to three-fourths of their deposits by 2006-07. To limit the monetary impact of intervention and restrain the growth of reserve money, the central bank sterilised the foreign exchange inflows. Between March-December 2007, the RBI sterilised almost 43 per cent of its net foreign exchange purchases on average, allowing partial feedback into money supply.
The second element in India’s strategy was greater exchange rate flexibility. The degree of exchange rate flexibility can be shown through an index measure derived from the relationship between the nominal exchange rate and foreign exchange reserves, or the idea of exchange market pressure. The index of exchange rate flexibility increased from 0.85 in April 2006 to 0.91 from May 2007 onwards, reflecting a rise in flexibility relative to historical levels and in comparison to both advanced (Japan) and emerging economies (Mexico). Real appreciation averaged over 2 per cent each month from May to August 2007. The domestic currency appreciated vis-à-vis the US dollar in nominal terms too — by over 9 per cent in 2007, relative to 2006 levels. As capital inflows intensified from May 2007, nominal appreciation exceeded 11 percent annually for ten successive months.
Another element in the strategy to manage capital inflows was interest rate control that was possible due to existing restrictions on debt inflows by foreigners. India also had to manage the exploitation of carry-trade arbitrage by market agents and residents converting cheaper borrowings in foreign currencies into rupee deposits placed with the central bank’s overnight liquidity adjustment facility (LAF). In response, the width of the corridor was widened steadily from the end of 2006 from 100 bps to 175 bps by April 2007 to deter one-way bets by foreign investors. The central bank also addressed the arbitrage trade by capping absorption through the reverse repo window at Rs 30 billion daily in March 2007. Finally, as the prolonged surge in capital inflow persisted and currency appreciation pressures remained unabated, policymakers capped residents’ access to foreign currency borrowings and prohibited conversion of foreign currency loans into rupees in August 2007. Specifically, outright caps were imposed upon foreign loans above US$ 20 million for domestic expenditures. Also restricted were participatory notes (PNs), an offshore derivative product allowing overseas retail investors exposure to the Indian stock market.
The Indian authorities used these various techniques strategically to manage capital inflows and navigate the monetary policy trilemma. One advantage of having a number of components to the strategy was that it allowed the authorities to avoid the undesirable consequences associated with overuse of one or another instrument for a prolonged period. This was an effective strategy that — in conjunction with a restricted debt market — assisted in preserving monetary independence amidst an environment of strong growth and overheating pressures. Based on this experience and evidence, it appears that the Indian central bank was able to retain monetary control. In other words, capital controls were effective in maintaining the wedge between domestic and foreign interest rates, an essential condition for pursuing an independent monetary policy. This conclusion is in line with other empirical work on the efficacy of capital controls, which demonstrates that the area where capital controls have been most successful is in providing more autonomy for monetary policy.
R Kohli is Consultant Professor at the Indian Council for Research in International Economic Relations, New Delhi and a former staff member of the IMF and RBI. The full report can be found here.