Management of Capital Flows in India: 1990-2011

Sen Gupta, Abhijit and Sengupta, Rajeswari (2013): Management of Capital Flows in India: 1990-2011.

Abstract

Increased integration with global financial markets has amplified the complexity of macroeconomic management in India. The diverse objectives of a robust growth rate, healthy current account deficit, competitive exchange rate, adequate external capital to finance investment, moderate inflation, targeted monetary and credit growth rate, minimizing financial fragilities and maintaining adequate reserves need to be balanced in an era of volatile capital flows. In this paper we analyze India’s experience in negotiating the trade-offs between these varied objectives. We find that to minimize risks associated with financial fragilities India has adopted a calibrated and gradual approach towards opening of the capital account, prioritizing the liberalization of certain flows. Using empirical methods we find that instead of adopting corner solutions, India has embraced an intermediate approach in managing the conflicting objectives of the well-known Impossible Trinity – monetary autonomy, exchange rate stability and an open capital account. Our results indicate that the intermediate approach has been associated with an asymmetric intervention in the foreign exchange market, with the objective of resisting pressures of appreciation, and resulted in large accumulation of reserves. We also show that sterilization of this intervention has been incomplete at times leading to rapid increase in monetary aggregates and fueling inflation. Finally, we conclude that while the greater flexibility in exchange rate since 2007, has allowed pursuit of a more independent monetary policy and the exchange rate to act as a shock absorber, the hands-off approach has resulted in reserves remaining virtually stagnant since 2007, leading to a significant deterioration in the reserve adequacy measures.

• Item Type: MPRA Paper
• Language: English
• Keywords: Capital controls, Macroeconomic trilemma, Financial integration, Foreign exchange intervention, Sterilization, Exchange market pressure, Reserve adequacy.
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit; F - International Economics > F3 - International Finance; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance

References

Aghion, P., Bacchetta, P., Rancière, R., and Rogoff, K., (2009) “Exchange Rate Volatility and Productivity Growth: The Role of Financial Development," Journal of Monetary Economics, Vol. 56(4), p. 494-513

Aizenman, J. and Sengupta, R. (2012) “The Financial Trilemma in China and a Comparative Analysis with India”, UCSC Department Working Paper (July).

Aizenman, J., Chinn, M., and Ito, H. (2010a) The Financial Crisis, Rethinking of the Global Financial Architecture, and the Trilemma," Asian Development Bank Institute Working Paper #213 (April).

Aizenman, J., Chinn, M., and Ito, H. (2010b). "The Emerging Global Financial Architecture: Tracing and Evaluating the New Patterns of the Trilemma's Configurations", Journal of International Money and Finance, Vol. 29, No. 4, p. 615–641.

Aizenman, J. Lee, J. and Sushko, V. (2012), "From the Great Moderation to the Global Crisis: Exchange Market Pressure in the 2000s," Open Economies Review, Vol. 23(4), p. 597-621

Chinn, M., and Ito, H. (2008), “A New Measure of Financial Openness", Journal of Comparative Policy Analysis, Vol 10 No. 3, pp. 307-320.

Edwards, S. (2007), “Capital Controls, Sudden Stops, and Current Account Reversals” in S. Edwards edited Capital Controls and Capital Flows in Emerging Economies: Policies, Practices and Consequences, University of Chicago Press p. 73-120

Forbes, K. (2012) “The ‘Big C’: Identifying and Mitigating Contagion”, MIT Sloan School Working Paper 4970-12

Frankel, J. A., and Wei, S. J. (1994), “Yen Bloc or Dollar Bloc? Exchange Rate Policies of the East Asian Economies”. in T. Ito and A.O. Krueger edited Macroeconomic Linkages: Savings, Exchange Rates, and Capital Flows, University of Chicago Press, p. 295-333

Frankel, J. (2009), “New Estimation of China’s Exchange Rate Regime.” Pacific Economic Review, Vol. 14 No.3, p. 346-360

Girton, L., and Roper, D. (1977) “A Monetary Model of Exchange Market Pressure Applied to the Postwar Canadian Experience”, American Economic Review Vol 67, No. 4, p. 537–48.

Hansen, Lars Peter, (1982), “Large Sample Properties of Generalized Method of Moments Estimators”, Econometrica, 50, issue 4, p. 1029-54.

Hutchison, M., Sengupta, R., and Singh, N. (2011) “India’s Trilemma: Financial Liberalization, Exchange Rates and Monetary Policy”, The World Economy, Vol. 35, No. 1, p. 3-18.

IMF (2012) “Liberalizing Capital Flows and Managing Outflows”, International Monetary Fund, Washington D.C. Available at http://www.imf.org/external/np/pp/eng/2012/031312.pdf

Johnson, S., Ostry, J. D., and Subramanian, A. (2007), “The Prospects for Sustained Growth in Africa: Benchmarking the Constraints", IMF Working Paper 07/52.

Kohli, R. (2011) “India’s Experience in Navigating the Trilemma: Do Capital Controls Help?” ICRIER Working Paper 257, June.

Kose, M. A., Prasad, E. Rogoff, K. and Wei, S.J (2009), "Financial Globalization: A Reappraisal," IMF Staff Papers, Palgrave Macmillan, Vol. 56(1), p. 8-62.

Lane, P., and Milessi-Ferreti, G.M. (2007), “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities: 1970-2004", Journal of International Economics, Vol. 73 No. 2, p.223-250.

Mohan, R., and Kapur, M. (2009), “Managing the Impossible Trinity: Volatile Capital Flows and Indian Monetary Policy”, Stanford Center for International Development Working Paper No. 401

Obstfeld, M., Shambaugh, J. C. and Taylor, A. M. (2010), “Financial Stability, the Trilemma, and International Reserves”, American Economic Journal: Macroeconomics, Vol. 2 No. 2, p. 57-94.

Patnaik, I., Shah, A., Sethy, A., and Balasubramaniam, V. (2011), “The Exchange Rate Regime in Asia: From Crisis to Crisis”, International Review of Economics and Finance, Vol. 20 Issue 3, p.32-43.

Patnaik, I., and Shah, A. (2011), “Did the Indian Capital Controls Work as a Tool of Macroeconomic Policy? NIPFP Working Paper # 87.

Planning Commission (2009), A Hundred Small Steps: Committee on Financial Sector Reforms. SAGE Publications India.

Pontines, V. and Rajan, R. (2011), “Foreign Exchange Intervention and Reserve Accumulation in Emerging Asia: Is there Evidence of Fear of Appreciation?”, Economic Letters, Vol. 111 No. 2 p. 252-255

Prasad, E. S., and Rajan, R.G. (2008), "A Pragmatic Approach to Capital Account Liberalization", IZA Discussion Paper No. 3475.

Prasad, E. S., Rajan, R.,and Subramanian, A. (2007), “Foreign Capital and Economic Growth", Brookings Papers on Economic Activity, Vol. 1, pp. 153-230.

Rajan, R. G., and Subramanian, A. (2005), “What Undermines Aids Impact on Growth?", IMF Working Paper 05/126.

RBI (2006), “Report of the Committee on Fuller Capital Account Convertibility” Reserve Bank of India.

Reddy, Y.V. (2008), “Management of the Capital Account in India: Some Perspectives”, Reserve Bank of India Bulletin, February.

Sen Gupta, A. and Manjhi, G. (2012), “Negotiating the Trilemma: The Indian Experience”, Global Economy Journal, Vol. 12, No. 1 p. 1-20

Srinivasan, N., Mahambare, V. and Ramachandran, M. (2008), “Preference Asymmetry and International Reserve Accretion in India”. Applied Economics Letters Vol. 16, No. 15, p.1543–1546.

Zeileis, A., Shah, A., and Patnaik, I. (2010) “Testing, monitoring, and dating structural changes in exchange rate regimes” Computational Statistics & Data Analysis, Vol. 54, No. 6, p.1696-1706.