This op-ed originally appeared in the Business Standard.
By Arvind Subramanian / New Delhi November 25, 2009,
Around the peak of the global financial crisis, in late November 2008, I wrote a column which concluded: “Some time in the not-too-distant future, when the storm clouds recede, when the rupee is at, say, Rs 50 to the dollar, Indian exports will be hypercompetitive, and Indian growth prospects will be restored to pre-crisis levels of 8-9 per cent. At that stage, capital, attracted by the higher returns, will once again come pouring into India. That is almost certain (Nov. 26, 2008).”
Growth prospects have not quite been restored to the pre-crisis levels but capital is pouring in. India, along with other emerging markets, is attracting capital in part because it has suffered less than many industrial countries. Call this the pull factor. But what I had not anticipated was the strong push factor: extraordinarily loose monetary policy and the resulting close-to-zero interest rates in many industrial countries are pushing capital out to emerging markets. Brazil’s currency has appreciated by 30 per cent this year, India’s stock market soared by 70 per cent, and China is once again furiously accumulating foreign exchange reserves, $62 billion in September.
And this push factor is not going away soon. The US Federal Reserve and the Bank of England are likely to keep interest rates low for some considerable time, until there are clear signs that unemployment is headed down durably. This might take another 18 months or so.
Moreover, because the push factor is common to all emerging market countries, the policy challenge of capital inflows will be faced not only by individual countries such as India but also by emerging markets as a group.
So, what should India do? The purists’ answer, of course, will be “nothing”. But that is an increasingly untenable position. For emerging market countries, surges in capital flows can lead to a “doom loop”, which is the evocative term used by Andrew Haldane of the Bank of England to describe the vicious sequence of bubble-bust-bailout. The Latin American debt crisis of the early 1980s, the Asian financial crisis of the late 1990s, and the Eastern European crisis of 2008 are stark reminders of the downsides of excessive capital flows to emerging markets.
The Reserve Bank of India should give serious consideration to strengthening its arsenal of macroprudential measures, including sensible and targeted measures to moderate inflows. A proposal that I recently advocated is the possibility of emerging markets coordinating actions on capital controls. The rationale for coordination is less economic than political or ideological.
Despite the recent crisis, the world is still in thrall to the “foreign finance fetish”. Actions to moderate inflows carry a stigma of being imprudent and market-unfriendly. Brazil recently botched its attempt at imposing controls because the policy action was half-hearted, anxious about the reaction of markets. Because it was half-hearted, it was ineffective.
So, countries face a double whammy: they incur the market unfriendly stigma without getting any pay-offs for their (weak) actions. The obvious response, of course, would be to strengthen controls to stem the tide. But the tyranny of the foreign finance fetish rules out such strengthening.
One possible approach to overcome the fetish, and hence to make capital controls a serious policy response to surges in capital flows, would be for a number of countries to act together in imposing controls. Brazil and a few other countries (Indonesia and Taiwan) have taken modest and quiet actions. One suspects that many others would like to do so but are fearful of a first-mover disadvantage.
But there is now a good forum for coordination and that is the G-20. India should privately consult its counterparts in other emerging markets, and convene a meeting of G-20 finance and monetary officials. Coordinated actions by a group of countries that is collectively endorsed by the G-20 as an appropriate macroprudential action against capital flows could eliminate the stigma problem.
The G-20 should serve as a forum for addressing another related issue: China’s exchange rate. The magnitude of the capital flow challenge for emerging markets is strongly correlated with Chinese exchange rate policy. The more China resists currency appreciation or persists with depreciation (by pegging the yuan to a declining dollar), the less willing other emerging markets such as India will and should be to allow their own currencies to appreciate and lose further competitive ground against Chinese exports. The surge in capital flows is thus even more of a problem — and the lure of capital controls even greater — for countries competing with China.
The reality may well be that China has graduated away from being amenable to outside influence, carrots or sticks. It will change its exchange rate policy only when self-interest dictates that course. But is it completely beyond outside influence?
Outside influence cannot come from the US alone. President Obama, like his predecessor, has had little success with that approach. It cannot come from the IMF either, because it too has tried and failed. The IMF’s managing director has recently been unequivocal in characterising the yuan as significantly undervalued but with little response from China.
One possibility that remains is for a number of emerging market and developing countries — including South Korea, Indonesia, Thailand, India, Turkey and Mexico among others — to come together and highlight the impact of China’s exchange rate on their trade and competitiveness and hence on their ability to manage inflows. The G-20 could be the best forum for these countries to coordinate and articulate their concerns. This effort should, of course, be in a spirit of cooperation rather than confrontation. But the message should be conveyed from a broad cross-section of the international community, and not just the US, that China’s actions have significant externalities. China cannot give primacy to its international responsibilities over domestic imperatives. No country does that. But China cannot ignore these responsibilities altogether either.
The G-20 can thus become a forum for coordination initiatives by emerging market countries vis-à-vis industrial countries as in the case of joint actions on capital controls. It can also be a forum for emerging markets to resolve potential tensions among themselves as in the case of the Chinese exchange rate. Yes, it can be a lot of things. Will it, is the question.