Batting for controls on capital flows, the Reserve Bank of India (RBI) on Thursday said capital inflows much above a country's absorptive capacity can pose problems other than currency appreciation.
Speculative flows on the look-out for quick returns can potentially lead to asset price build up. In the current juncture, one of the driving forces behind hardening commodity prices is the excess liquidity in the global system, said RBI Governor D Subbarao. In the K R Narayanan Oration at the Australian National University, Canberra, Subbarao said India's approach to capital account management was strategic. India had explicitly said it preferred long-term flows over short-term flows and equity over debt flows. He said India had used both price-based, as well as quantity-based controls to operationalise this policy.
Even with relatively large swings in capital flows during the crisis, the pressure to use tactical controls did not build up, since strategic controls provided automatic buffers, the RBI governor said. Referring to the period after the global financial crisis, he said emerging economies started recovering from the crisis before advanced economies. These also began exiting from the crisis-driven accommodative monetary stance ahead of the advanced economies.
The multi-speed recovery and the consequent differential exit have triggered speculative capital flows into emerging market economies, resulting in currency appreciations which are not related to economic fundamentals. Currency appreciation erodes export competitiveness and intervention in the foreign exchange market to prevent appreciation entails costs. If the resultant liquidity was left unsterilised, it could potentially fuel inflationary pressures, he said. On the other hand, if it is sterilised, it puts upward pressure on interest rates, which not only hurts competitiveness, but also encourages further flows.
Critics say capital controls create distortions and are largely ineffective. They are also difficult to implement, but easy to evade. Those supporting capital controls argue such restrictions preserve monetary policy autonomy and save sterilisation costs. They also tilt the composition of foreign liabilities toward long-term maturities and ensure macroeconomic and financial stability, Subbarao said.
The recent crisis was a clear turning point in views on capital controls. The International Monetary Fund (IMF) had, in February 2010, issued a policy note that reversed its long-held orthodoxy of capital controls being inadvisable, always and everywhere. The IMF note referred to certain 'circumstances in which capital controls can be a legitimate component of the policy response to surges in capital flows'. The World Bank and the Asian Development Bank Outlook-2010 too, echoed these views.