The Reserve Bank of India (RBI) and the Asian Development Bank (ADB) co-hosted an international conference on “Managing Capital Flows” in Mumbai during November 19-20, 2012. Central bankers, international institutions, academics and analysts from Asia, Europe, Latin America and the US participated in the conference and deliberated on key issues relating to ‘Managing Capital Flows’. Views broadly converged around the opinion that management of capital flows should be a concern for both source as well as recipient countries, and to maximise welfare there is merit in acting in concert and in a coordinated manner in the event of excess capital flow volatility.

Shri Deepak Mohanty, Executive Director, Reserve Bank of India welcomed the participants and underscored the relevance of the topic particularly in the present context of uncertain global economic and financial conditions. He drew an interesting anecdotal parallel between Mundell’s impossible trinity and the Hindu belief of impossible co-existence of deities of Brahama, Vishnu and Mahesh under the same roof and indicated that these conflicts are better managed in the country specific situation.

Mr. Iwan Azis, ADB in his opening remarks underscored the importance of capital account management and the need to learn from country experiences in this regard. He noted that Asia had gone through a dramatic turn-around from excess investment during pre-1997 to excess savings during post-1997 even though the region has huge deficit in social and physical infrastructure.

Dr. Subir Gokarn, Deputy Governor, Reserve Bank of India in his keynote address set the tone for the conference. He underscored the importance of multilateral coordination, complementarity between capital controls and macroeconomic policy options and need to distinguish strategic and tactical controls for managing capital flows.

The conference deliberated on the subject in three technical sessions: (i) compositional shift and volatility of capital flows, (ii) challenges of capital account management, and (iii) select country experiences – objectives of capital flows management, instruments and their effectiveness. This was followed by two panel discussions comprising senior officials of central banks. The discussions revolved around: (i) capital controls and instruments of capital flow management, and (ii) adequacy of reserves, volatility in capital flows and international financial architecture. In the summing up, Mr. Bruno Carrasco captured the essence of the proceedings of the conference.

Apart from Dr. Subir Gokarn, Deputy Governor of the Reserve Bank of India and Mr. Iwan Azis, Head, Office of Regional Economic Integration, Asian Development Bank, several eminent central bankers, academicians, policy makers, financial regulators and supervisors participated in the conference to share their experience and thoughts. Some of the eminent participants included Deputy Governors/Deputy Head/Senior officials of central banks/monetary authorities of Brazil (Mr. Luiz Awazu Pereira), Chile (Mr. Manuel Marfan), India (Shri H.R. Khan) Indonesia (Mr. Hartadi A Sarwono), Korea (Mr. Sangdai Ryoo), Maldives (Mr. Aishath Zahira), Philippines (Ms Wilhelmina Manalac), Singapore (Mr. Choy K. Meng), Switzerland (Mr. Thomas Moser), Sri Lanka (BDWA Silva); Professors such as Kristin Forbes, Massachusetts Institute of Technology, Joseph E Gagnon, Peterson Institute for International Economics, Michael Klein, Fletcher School, Tufts University; and Mr. Jonathan Ostry, International Monetary Fund, Mr. Hun Kim, ADB, Mr. Ashok Lahiri, Executive Director for India, ADB. Apart from these, representatives of major commercial banks, financial and research institutions from India also participated. Professor Shankar N. Acharya, Indian Council for Research on International Economic Relations (ICRIER) moderated the panel discussions.

Major takeaways from the conference were:

• With more open capital account and financial innovations, growth of hedge funds and mushrooming of new breed of financial institutions and investors, cross-border capital flows have become highly volatile particularly after the 2008 crisis.

• Capital flows are seldom consistent with the precise needs of the individual economies and therefore have implications for exchange rate management, domestic monetary and liquidity conditions and overall macroeconomic and financial stability.

• Capital flows are driven by both pull (economic fundamentals of recipients) and push (policy stance of source countries) factors. Monetary and prudential regulation policies in source countries may exacerbate the level and riskiness of capital flows in recipient countries. Thus, adjustment in the wake of volatile capital flows should not be the exclusive responsibility of receiving country. Both recipient and source economies need to act in coordination and the burden of adjustment should be shared between them.

• Free flow of capital may not always ensure efficient global outcome as individuals fail to recognise the domestic economy’s collateral constraint. Thus, the importance of capital controls as legitimate tool for protecting the domestic financial markets under certain circumstances is well recognised. However, use of capital controls to keep the currency undervalued to gain competitive advantage need to be avoided.

• It is important that controls should not be perceived as a substitute to prudent macroeconomic policies and well regulated financial system. A sound and well developed financial system makes absorption and intermediation of foreign flows smoother for Emerging Market Economies. Macro-prudential instruments supplemented to monetary policy may help in achieving control over inflation and ensure financial stability in the wake of excess global liquidity.

• Capital account management needs to be viewed in terms of a distinction between "strategic" and "tactical" controls. Strategic controls spell out the pecking order and accompanying controls and assure the stake holders that no further restrictions will be imposed. Tactical controls, on the contrary, are essentially emergency responses to intense pressure and will largely depend on the country circumstances and appetite for risk.

• Within the ambit of prevailing international financial architecture, reserves are first line of defense against the backdrop of volatile capital flows. This is particularly true for current account deficit economies. While assessing adequacy of reserves, a distinction needs to be made between surplus and deficit economies. Deficit economies are far more vulnerable and need to build sufficiently large reserves to maintain confidence of the investors.

• There is a need to discourage excessive reliance on only few reserve currencies as the main reserve asset. Development of SDR bond market may reduce the need to borrow in foreign currencies thereby decreasing the currency mismatches and exposure to developments in the US and euro-area economies. Development of local currency bond market can also help in this direction.

• The country experiences presented in the conference showed that countries have generally tried to balance the benefits and costs associated with capital flows using a mix of capital controls (CFMs) and macro-prudential measures. These inter alia include: flexibility in exchange rate, sterilised foreign exchange intervention and careful articulation of macroeconomic policies. Apart from managing volatility in exchange rate and the systemic liquidity, these measures are generally intended to direct the flows towards long-term investments, equity instruments, and growth promoting sectors.Apart from various capital controls used across countries, Brazil, in particular, also used tax on certain categories of capital inflows to deal with their implications for economy.

• Finally, an important message that emerged from country experiences has been that in the face of volatile capital flows, flexibility and pragmatism are needed in exchange rate policy rather than adherence to strict theoretical rules. Central banks need to strike a fine balance between alternative and often conflicting objectives while ensuring that negative externalities of capital flows are minimized on the society at large.

Alpana Killawala
Chief General Manager

Press Release : 2012-2013/840