Capital controls as a means of minimising speculative bubbles in real exchange rates: key features of the literature and its application to China and India

Economic Papers (Economic Society of Australia), Sept, 2003 by Craig Applegate

In the case of India, the effectiveness of the controls on capital flows was probably assisted by a flexible exchange rate, ample foreign exchange reserves and limited international trade and financial linkages (Habermeier 2000). Joshi (2001) argued that India looked quite similar the crisis countries in terms of its ratios of non-concessional debt to exports, but not as ratios to G.D.P. The ratio of non-performing loans in the banking system also was similar to that found in the crisis countries. Joshi noted that the consolidated public sector fiscal deficit of India which amounted to 9% of G.N.P. 1996 compared very unfavourably with the South East Asian countries which were roughly in fiscal balance. What stood out about India in Joshi's mind is that it had relatively very low levels of short-term foreign debt.

A brief chronology of India's moves so far to partially liberalise its capital account follows. India has signalled its intention to continue to gradually liberalise its capital account in line with the recommendations of the Tarapore committee. Since 1991, foreign direct investment of up to 51% in 35 industries listed as being a national priority are subject to automatic approval. Direct foreign investment flows into India were further liberalised in 1996 and firms have been permitted to repatriate any profits earned back overseas. The foreign ownership limit varies according to the industry.

India has been open to foreign portfolio equity investment flows from authorised foreign institutional investors since 1997. A majority of the equity investment flows into India have been in the form of portfolio investment flows (Singh 1998). For example in 1996/97 foreign direct investment into India equalled $ U.S. 2609 million, while portfolio flows equalled $U.S. 2775 million.

Since 1998, India has not had any restrictions on the issuing of overseas debt with maturities of over 10 years, in 1997, Offshore borrowing for shorter terms has been permitted in some sectors with permission but subject to quantitative limits (Habermeier 2000). Oil and Telecommunications sectors have been allowed to borrow for 5 year terms. Firms that export 100% of their output have been allowed to accrue debts of 3 years maturity (Singh 1998).

India basically has a total prohibition on the export of capital by residents (Joshi 2001).

The real depreciation experienced by India was trivial in scope when compared with the real depreciations experienced by Korea, Malaysia and Thailand, the real value of whose currencies initially halved. Indonesia experienced an even greater initial real depreciation. The real value of Indonesia's currency suddenly plummeted to less than a third of its initial value (Hamada and Takeda (2001)).

The above graph illustrates the relatively mild nature of the real depreciation experienced by India.

While Habermeier 2000 states that India's controls on capital flows appear to offer very few opportunities for circumvention or evasion, it appears as though India's opening to portfolio equity investments has meant that this now provides a mechanism through which currency speculation may now occur.