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Risks and Rewards of Capital Account Convertibility

This article discusses whether capital account convertibility can or should be an objective or a means towards achieving more fundamental macroeconomic goals. It presents an overview of the risks and rewards of convertibility and debates the issue of freely floating versus managed exchange rates and their implications for a developing economy.


Risks and Rewards of CapitalAccount Convertibility

This article discusses whether capital account convertibility can or should be an objective or a means towards achieving more fundamental macroeconomic goals. It presents an overview of the risks and rewards of convertibility and debates the issue of freely floating versus managed exchange rates and their implications for

a developing economy.


have had the privilege of having been a member of both the committees appointed by the Reserve Bank of India on the subject of capital account convertibility (CAC). The report of the second committee was submitted in July 2006 and there has since been a spate of media reports and commentaries on various issues related to the subject. While some have criticised the gradualist approach, others have agreed with it. One point which probably attracted more comment and indeed criticism is regarding exchange rate policy. This article summarises my personal views on some of the issues.

I first discuss whether capital account convertibility can be, or should be, an objective, or a means towards achieving more fundamental macroeconomic goals. The article then presents an overview of the risks and rewards, followed by a discussion of equity and debt flows. A discussion of the desirability of the distinction between non-resident Indians and other non-residents follows, and then of capital liberalisation for resident individuals. Finally, a debate of the issue of freely floating versus managed exchange rates and their implications for a developing economy.

CAC: An Objective?

A lot of media comment assumes that a liberal capital account is, by itself, a desirable objective of economic policy. The question that needs to be considered is whether CAC is, or can be, an objective or rather a policy for achieving other macroeconomic goals. To my mind, at this stage of the country’s economic development, CAC cannot be an objective per se but should be considered as a means to achieving more fundamental objectives of economic policy. The committee has agreed with this view and has spelt out the objectives as follows:

2.7 FCAC is not an end in itself, but should be treated only as a means to realise the potential of the economy to the maximum possible extent at the least cost. Given the huge investment needs of the country and that domestic savings alone will not be adequate to meet this aim, inflows of foreign capital become imperative.

2.8 …The objectives of FCAC in this context are: (i) to facilitate economic growth through higher investment by minimising the cost of both equity and debt capital; (ii) to improve the efficiency of the financial sector through greater competition, thereby minimising intermediation costs; and (iii) to provide opportunities for diversification of investments by residents.

One major advantage of clearly articulating the objectives is that it gives a framework within which each measure can be looked at. As for growth, there is no conclusive empirical evidence to suggest that a liberal capital account leads to faster economic growth. To quote from a recent paper ‘Financial Globalisation: A Reappraisal’ by M Ayhan Kose, Eswar Prasad, Kenneth Rogoff and Shang-Jin Wei (August 2006), “The majority of empirical studies are unable to find robust evidence in support of the growth benefits of capital account liberalisation”. Jagdish Bhagwati, in his recent book, In Defence of Globalisation, is highly sceptical of financial globalisation, as distinct from free trade in goods and services, arguing that, “the claims of enormous benefits from free capital mobility are not persuasive”.

It is worth emphasising this point if only because there are risks in liberalising the capital account. And, while risks have to be taken, they also need to be justified by the expected rewards. To elaborate with an analogy from a different segment, clearly investments in equities are riskier than investments in say government securities. There would be little point in investing in equities unless there is evidence that there are extra rewards justifying the risks. While this is so for individual investors, even in terms of macroeconomic policies, the risk-reward relationships will need to be weighed and considered. As for risks, in the paper above cited on financial globalisation, the authors argue that “There is little formal empirical evidence to support the oft-cited claims that financial globalisation in and of itself is responsible for the spate of financial crises that the world has seen over the last three decades”. To my mind, the keywords are “in and of itself”. While there is little to quarrel with the point made, with that proviso, the fact remains that a liberal capital account can amplify and prolong a crisis. One experience from the east Asian crises of 1997-98 is worth noting: Malaysia imposed capital controls and escaped the crisis which engulfed and imposed countless costs and hardships on the economies of Thailand, Indonesia and South Korea.

Perhaps it is as well to clarify one other issue. A lot of media comment seems to confuse “floatation” of the currency with its convertibility. These two are entirely different issues and neither implies the other, let alone being synonymous. “Full float” means the exchange rate is left to be determined by the demand and supply in the market, with no intervention by the central bank to influence the exchange rate in a particular direction or to a particular level. Just as, for example, the price of a share in the market is determined purely by demand and supply, so would the exchange rate be, under a full float regime.

On the other hand, full convertibility implies the unfettered right of residents and non-residents, to convert the domestic

Economic and Political Weekly January 6, 2007 currency into foreign currency and vice versa, for capital account transactions involving changes in assets and liabilities in domestic and foreign currencies. Therefore, an economy could have a fully floating exchange rate without convertibility on capital account; similarly, full convertibility is not entirely incompatible with administered exchange rates. For example, for all practical purposes, the US dollar has been fully convertible right since the second world war, but for a period of 25 years the exchange rate was administered by the IMF. Hong Kong is another example today

– a fully convertible currency, but a fixed exchange rate.

There are also those who believe that since effective implementation of capital controls becomes more and more difficult in a globalised economy, this de facto situation should be recognised de jure by lifting controls on capital account transactions. One does not quite agree with the argument. To give an analogy, once again from a different area, we all know that despite all laws against it, corruption is an ever present and growing cancer in the Indian economy. It is equally true that despite all laws against it, corruption may well continue, as do thefts and robberies and other crimes in violation of the laws. Can this be an argument for legalising corruption or theft? The answer is obvious. One of the beliefs of democratic governance and justice is that, firstly, most of the people are law abiding; secondly, that even if some violators are caught and punished, this deters many others, who may not have too many moral objections, from accepting bribes or stealing. In short, to my mind, less than fully effective capital controls is not a definitive argument in favour of capital account convertibility.

Some others argue that full capital account convertibility is also useful from another perspective: it will force governments to behave more responsibly on fiscal balances. Unsustainable deficits would frighten investors, leading to capital flight and/or shorting of the currency and bonds by traders/investors – and this prospect would deter governments who may otherwise be populist and irresponsible. Firstly, such optimism is not borne out by empirical evidence. Secondly, in a democracy, it is for us, the citizens, to discipline our political masters – we should not be depending on a hundred odd currency and bond dealers, focused on short-term trading profits, to do so at an enormous cost to the real economy.

It also needs to be noted that the rupee is already convertible for capital which has come in from abroad, in the sense that the investor has the full freedom to take out his money by selling the investment. And, the fact is that we do need foreign capital

– and not just to bridge the gap between domestic savings and investments. There is no denying the collateral, i e, qualitative, non-financial, benefits from foreign capital. These include financial market development, institutional development, better governance and macroeconomic discipline, etc, as the paper on financial globalisation cited above argues. Will capital inflows be encouraged through a fuller convertibility on capital account, particularly for residents? I do not see a linkage between the two – China attracts huge capital inflows without the currency being convertible even on current account.

I therefore proceed on the assumption that a liberal capital account and measures in that direction, will have to be justified in terms of: (i) the extent to which they can help achieve the macroeconomic

Economic and Political Weekly January 6, 2007

objectives spelt out above; and (ii) the risk:reward relationship in relation to specific steps and measures.

As stated earlier, there is little empirical evidence to suggest a positive correlation between a liberal capital account and faster economic growth. On the other hand, there are several cases of premature liberalisation of the capital account leading, or at least contributing, to balance of payments crises and consequential, prolonged, social misery. In our case, to my mind, these risks need to be weighed particularly carefully as too many of our political masters have little conviction in economic liberalisation. The closure of even a few industries because of their inability to compete with imports, let alone a major crisis, is quite capable of reversing the process of liberalisation. In fact, economic liberalisation and reforms have virtually come to a halt for the last several years.

To summarise, we need to carefully weigh the risks and rewards of capital account convertibility rather than considering it as a desirable objective by itself, at this stage of economic growth.

Capital Flows: Equity

Given India’s investment needs, there is obviously a case for encouraging capital inflows, for both financial and non-financial reasons. There has been a sharp rise in the inflows of private capital in India, particularly after portfolio investments were liberalised. In fact, we now have become practically independent of external capital in the form of official flows, bilateral aid, World Bank and International Development Agency (IDA) loans, which constituted a significant proportion of the capital inflows pre-1991. (In fact, we have actually prepaid, in my view foolishly, some concessional external aid from friendly countries.)

It is the capital inflows and not surpluses on current account that have allowed the reserves to go up from negligible levels at the time of the balance of payments crisis to the current level of $ 160 bn or more. However, much of these capital inflows has been in the form of portfolio investments by foreign institutional investors (FIIs), rather than foreign direct investment (FDI). While portfolio flows are also valuable, dollar for dollar, direct investment contributes more to the economy in terms of growth and job creation than foreign portfolio investments. They are also more stable. Again, direct investments lead to inflows of technology and also a number of “soft” benefits like management practices, training policies, supply chain management practices, distribution systems, etc, which help introduce global best practices in the economy: in other words, Coca Cola is not just coloured water but it brings in a lot of other practices from which the rest of the economy can also benefit. While it will be difficult to establish a direct cause and effect relationship, the competitiveness of a lot of Indian manufacturing industry has been achieved by adopting global best practices – it seems difficult to imagine, for example, that our automobile component industry, which is growing so rapidly and is today world competitive, would have done so in the absence of foreign automobile manufacturers’ entry into India. In another sector, many Indian business houses are entering into contract farming and other agrorelated businesses after learning from what Pepsico did for the farmer in Punjab, while gaining benefits itself. This has the potential of proving to be a win-win situation for both agriculture and industry.

Clearly, there are great benefits to foreign direct investments. In my view, therefore, in terms of capital account liberalisation, the highest priority needs to be given to removing all sectoral and other restrictions on FDI. On the other hand, this is one issue on which there are too many ideological and other barriers.

The result is that FDI flows in India are much smaller compared to most Asian economies, and but a fraction of the flows China attracts. (Incidentally, China’s success in exports owes a lot to foreign direct investment in special economic zones: almost 60 per cent of exports of manufactured goods are accounted for by foreign companies). Indeed, in the year that has just ended, outflows of FDI could well turn out to have exceeded inflows! Again, a significant proportion of FDI seems to be coming in the form of private equity investments, which are rarely accompanied by technology or management, but we do not seem to have hard data on the numbers. There is a need for collecting private equity inflow data separately from traditional FDI, and reporting them at least by way of a footnote.

As for portfolio flows, while opening the door to them has helped India considerably, as of now, perhaps 50 per cent of the inflows come in the form of participatory notes. As may be recalled, the Committee has recommended banning the use of participatory notes, an issue on which I have dissented. My rationale for recommending continuation of the existing system is because there are a number of genuine investors who either cannot qualify to register as FIIs for some technical reasons, or otherwise prefer the less cumbersome and more cost effective P-note route. There are apprehensions, and some evidence, that the P-note route was used for “roundtripping” resident Indians’ money – going out by questionable means, coming back through the P-note route. While this may be so, I have seen no evidence suggesting that the scale of such misuse of P-notes is significant. Again, to my mind, the correct solution is to catch the outflows, rather than shutting the barn door after the horse has fled, to debar it (and many genuine investors), from coming in! Surely, it cannot be argued that outflows through questionable means may continue so long as the moneys do not come back in.

While, in theory, portfolio flows can reverse at short notice, worldwide – and our own – experience is that FII flows are a source of long-term capital, and should therefore be welcome – they also help improvement of market practices, corporate governance, etc.

There is one area however where FIIs need to be given freer access – this is in the equity derivatives market which today they can access only for hedging their exposures. One result of the restrictive approach has been that there is an active market in the futures contract on Indian equity indices, traded on Singapore and Hong Kong exchanges. In a way, by restricting access to the derivatives market, we have “exported” some trading activity in the Indian derivatives market.

Nor has a less than fully convertible rupee for residents curbed the ability of Indian businesses to make foreign investments, whether in greenfield projects or takeovers. The spate of takeovers in recent years bears ample testimony to the fact that Indian business has enough flexibility for converting rupees into foreign currency for investments abroad. In fact, there has been little demand on the part of business for a more liberal capital account to overcome specific difficulties in growth or investment abroad.

Capital Flows: Debt

The issue of debt flows has three different elements: Indian businesses raising loans in the international market;

Economic and Political Weekly January 6, 2007 non-residents investing in the Indian rupee (INR) debt market; and non-residents raising rupee debt in the Indian market. Considering the first issue, namely, access to international bank and debt markets for Indian businesses, given the current ceilings on external commercial borrowings, it does not seem as if Indian companies are facing regulatory restrictions in accessing foreign markets. In fact, there have been few demands in the media for liberalising the flow of foreign currency debt, nor have many representations been made for such a policy change. An increasingly larger number of companies are accessing international markets for syndicated loans, convertible bonds and equity issues. Interestingly, over the last five years external commercial borrowings were actually negative in the first three years but positive in the last two years (2004-05 and 2005-06); the figure in 2005-06 was just about $ 1.6 bn. All the evidence suggests that there are few hurdles in the access to markets for Indian businesses which are accepted as good credit risk by international lenders. The access has been further liberalised in the last monetary policy.

As for the access to INR debt/bond markets for non-resident entities, there are certain ceilings. Indeed, not much FII investments seem to have taken place in the INR bond market. The other side is that, firstly liquidity in the G-Sec market is limited to just about half a dozen issues. Secondly, there is very little liquidity or trading in corporate bonds in the secondary market. Again, in the absence of contrarian players in the market, it often behaves in a unidirectional way. Considering the huge funding needs of the corporate sector in general, and the infrastructure sector in particular, there is obviously a need for a deepening and lengthening of the bond market – the infrastructure sector for example would need bond maturities of 10 years or longer, while the appetite of the existing investors limits the maturity to barely half of this. This apart, it is the investor, and not the borrower, in the INR bond market who is taking the currency and interest rate risk. Induction of more players is clearly needed for the growth of a more efficient bond market.

Recognising this perspective, the Committee has recommended a gradual increase in the ceilings. I have dissented with the Committee’s view on this issue and believe that the INR bond market should be thrown open to foreign investors without any quantitative ceilings or restrictions on use of derivatives. If necessary, this could be done with the imposition of a minimum holding period. (See ‘Notes of Dissent’,

Report of the Committee on Fuller Capital Account Convertibility, p 146.)

On the subject of debt flows, the third issue is allowing foreign issuers to access the rupee debt market. Only a couple of such issues have taken place, by multilateral agencies. There is a case for more liberal access to be permitted, on the basis of a case by case approval of the central bank. This would also help Mumbai becoming an international financial centre in course of time.

Non-resident Indians and Non-residents

Our regulatory regime has always made a distinction between non-resident Indians (NRIs) and other non-residents (NRs). While most of the differences provide more liberal access to the Indian market for NRIs, in a few cases – investment in stock market by overseas corporate bodies (OCBs) controlled by NRIs – the opposite is also true.

The question that needs to be considered is whether the distinction between NRIs and NRs needs to be continued, or that all non-residents should be treated on an identical basis. In other words, should we treat dollars from NRIs as being more acceptable and virtuous, than those from other NRs? While, historically, NRIs’ foreign currency deposits have been of great use in managing the balance of payments, we have also seen that such deposits tended to be withdrawn, or not renewed, when there was the possibility of crisis, as for example occurred in 1991. Secondly, in contrast with his Chinese counterpart, the NRI has not played a large role in direct investment in the country. It is also worth noting that few countries in the world make the kind of distinction we make between NRIs and NRs: most treat all non-residents on the same footing.

In all this background, the committee thought that access to the deposit and equity markets should be available to all nonresidents, including NRIs, on an identical basis, and has recommended accordingly.

Questions have been raised whether such a liberalisation may not throw the doors open to undesirable elements, who may not qualify under the “know your client” (KYC) norms. At least initially, it would be difficult for intermediaries to fulfil the KYC norms in relation to all non-residents.

The question is whether this is a ground for a regulatory distinction between NRIs and NRs. The view is that regulations should treat both identically; if banks cannot satisfy themselves about the KYC requirements, it is up to them to open or not to open accounts.

Liberalisation for Residents

No literature on the subject claims that capital liberalisation for resident individuals confers any benefits, direct or indirect, to the domestic economy in terms of growth, investment and employment. It does benefit the individual saver, through diversifying his investments: at the macro level the problem is that such benefits are negatively correlated to the fortunes of the domestic economy. The greater the mess in the domestic economy, the higher the benefits from investing money abroad! One key issue is the priority that should be given to this factor in the current state of the economy. As it is, there is a question mark about the ability of the domestic economy to finance the investments in manufacturing and infrastructure, needed to generate 8 per cent + GDP growth.

The amounts are huge, and may well stretch the capacity of the financial markets to meet them. It also needs to be noted that capital outflows by residents means reducing the resources available with the banking industry. Our monetary aggregates – bank deposits, bank credit or money supply – as a percentage of nominal GDP, are well below those in most Asian countries. The question is whether we should be promoting capital outflows at the current stage of our development, merely because the reserves are comfortable enough to permit them. It can also be argued that such capital outflows would reduce the problems and cost to the central bank, in sterilising the effects of capital inflows on money supply. But more on the latter issue while discussing the exchange rate policy.

There is of course a philosophical/ ideological argument on the subject. In a democratic society, does the government have any right to place restrictions on how an individual can, or should, invest his money? But, I do not wish to go into this issue beyond saying the obvious: there is general acceptance of the government having the power, and indeed duty, to limit individual freedom if it harms the interests of the rest of society.

To come back to a more mundane level, the issue of capital outflows by resident

Economic and Political Weekly January 6, 2007

individuals should not be looked at merely from the angle of foreign exchange reserves. As I have argued above, the benefits of such outflows are negatively correlated to the health of the domestic economy. At the present time, given the rewards available in the domestic market, there are few incentives for residents to transfer savings outside – this is also manifest in the negligible amount of money transferred outside under the $ 25,000 limit (recently increased to $ 50,000). The attractions of doing so increase dramatically at the hint of problems, let alone a crisis, in the domestic economy. It will take a very bold man to believe that there are no circumstances in which the Indian economy could face problems on the external or domestic sectors of the economy: even miracle economies like those in east Asia have suffered crises. (Incidentally, in one conversation I had with an economist who was working in Indonesia before the BoP crisis of 1997-98, he told me how huge amounts were being transferred in the months preceding the crisis by the entire Indonesian political and business establishment. When I questioned as to why the central bank did not act earlier, his answer was that the elite and decision-makers were themselves very interested in transferring money.)

As a consultant in risk management, one definition of the subject I like is that it asks the uncomfortable question: “what happens the other 1 per cent of the time?” in short, to me the risk:reward relationship of liberal outflows by residents is not acceptable as it will benefit only the few, and that too when the many, if not most, are in misery. This is the reason I have dissented with the Committee’s recommendations on the subject (see Convertibility Committee, op cit, pp 147-48).

Exchange Rate Policy

The Committee’s recommendations envisage an exchange rate policy aimed at maintaining the real effective exchange rate broadly within a +/- 5 per cent band around a neutral level. Indeed, it is this recommendation which probably has attracted more comment and criticism than any other. Some of the criticism flows from a belief in the markets being more reliable than the central bank, in terms of arriving at a proper exchange rate. While on this point, it has to be conceded that, over the 20th century as a whole, the record of central banks in managing monetary and exchange rate policies has been less than impeccable. To quote a few instances, the US Federal Reserve perversely tightened money which worsened the stock market crash and the following worldwide depression in the 1930s. The Bank of England’s decision to restore the gold parity of the pound, some years after the end of the first world war, was equally disastrous. The German central bank too made a total mess of German monetary policy in the years immediately following the first war, leading to hyperinflation which helped the advent of Hitler.

More recently, one of the proximate causes of most of the balance of payments crises in the 1990s has been the foolish efforts by central banks to maintain overvalued exchange rates (Mexico 1994, east Asia 1997-98, etc). While our own central bank’s management has been far more prudent, many analysts believe that the economic slowdown in India for about three years until 2001, was directly attributable to the monetary policy of 1995 and 1996. Again, in the 1970s, the central bank allowed the exchange rate to appreciate. On the other hand, its record on the exchange rate policy since the mid-1980s has been commendable and has facilitated the adjustment of a highly protected domestic industry to free trade and much lower import duties, without any major disruptions. Clearly, central banks are capable of learning!

While on the point, one should also look at the impossible trinity of managed exchange rates, an independent monetary policy and a liberal capital account. While, in theory, the three cannot coexist, at least in their extreme form, this does not preclude freedom in managing monetary and exchange rate policy for most of the time, even with a reasonably liberal capital account.

On first principles, there are three economic agents who have important stakes in the exchange rate: the traders in the exchange market; the central bank; and, to my mind, by far the most important, the real economy. Of this, the first, namely, the currency traders, play an important role in the financial markets by providing liquidity and readily quoting prices. On the other hand, trading can be profitable only in volatile markets and, therefore, currency traders have a lot of stake in, and benefit from, a volatile market. Again, too many currency traders are trend followers. As is said, “the trend is your friend” – and there is a great deal of safety in numbers. Their time horizons are also often short. And, both the trend following mentality and the short-term outlook do not lead to efficiency in the market’s ability to find the correct prices, as the efficient market theory suggests.

The central bank also has a major stake in the exchange rate. A rapid fall of the currency can lead to inflation; on the other hand, an appreciating currency is deflationary. Neither is a desirable outcome from the perspective of a central bank. It could be argued that the central bank should merely look at monetary aggregates allowing the exchange rate to move where it will, and relying on money supply to control inflation. This is a logical proposition, provided the objectives of growth or employment are to be considered completely superfluous. Else, it is difficult to see how a central bank can follow a policy of benign neglect of the exchange rate – unless of course it is the US Federal Reserve and its currency is the world’s reserve currency.

The third and the most important stakeholder in the exchange rate is the real economy producing goods, services, employment, growth etc. Unfortunately, it seems to me as if the real economy does not get too much of a voice in the media and in the debate on issues of exchange rate and monetary policy. The financial economy needs to serve the interest of, and be subservient to, the much larger real economy, rather than the other way round. The financial cost of a reasonable exchange rate, reasonable for the real economy, is far less than the cost for the real economy to adjust to any prices that the financial market produces. While markets are better in many respects than administrators, there is general consensus that the value of money is too important a variable to be left purely to markets. While this is accepted as a matter of course in relation to the domestic value of the currency, as determined by the inflation rate, I do not see why the same logic should not apply to the external value as determined by the exchange rate.

While considering the standard arguments on the subject, two issues strike me. Firstly, today’s developed economies have never grown in their history as fast as several of the Asian economies have done, the largest example of course being China over the last quarter century. There is no comparable record of hundreds of millions of people coming above the poverty line in just one generation. And, the exchange rate policies have been an important element of the macroeconomic policy spectrum which facilitated this.

Secondly, regard must also be had to the nature of exports from the developing

Economic and Political Weekly January 6, 2007 countries, including China. Most of these are in the nature of “manufactured commodities” and therefore extremely sensitive to cost and pricing. In their case, the classical theory of comparative advantage operates far more forcefully, than in the case of economies engaged in trade in branded products. In the latter case, it is the consumer’s desire for variety which drives trade, and not so much comparative price advantage. (For example, the classical theory cannot explain why, say, Germany both imports and exports luxury cars.) Therefore, the exchange rate is a far more important macroeconomic variable in a developing country’s economic competitiveness. Indeed, the importance of the real effective exchange rate cannot be overemphasised in an era of free trade: almost every BoP crisis in the last decade – Mexico in 1994-95, east Asia in 1997-98, Argentina in 2001, etc – has had its origin in overvalued real rates, uncompetitive economies and, hence, unsustainable deficits on the current account. On the other hand, the economic miracles in Germany and Japan after the second world war, and China over the last quarter century, have been firmly underpinned by undervalued, administered exchange rates.

Critics of managed exchange rates argue that nobody can know what the correct exchange rate is, or should be, or that central banks can enforce them. In many ways, this is misrepresentation of the arguments in favour of managed exchange rates. While nobody can know the exact “correct” exchange rate, it is not too difficult to calculate, within a reasonably narrow band, the exchange rate needed to keep the domestic economy reasonably competitive with the rest of the world. The measure does not need to be mathematically accurate to the fourth decimal – indeed, any index, including the inflation index, can be criticised on the same grounds as regards its accuracy, as an exchange rate index. What I have not understood is that, while central banks are legitimately expected to manage two measures of the value of domestic money (domestic value, i e, inflation rate, and time value, i e, interest rate), why the third measure, i e, the exchange rate, is considered too sacrosanct to be managed by the central bank.

Critics of managed exchange rates sometimes argue that coordinated monetary policies and convergence of inflation and interest rates, would lead to less volatile exchange rates. There is enough empirical evidence to refute the proposition. To quote from an article by Kenneth Rogoff (Finance and Development, June 2002):

Whereas (Dornburg’s) over-shooting model is a landmark theoretical achievement, it is an empirical bust, at least as far as it concerns exchange rates among the United States, Japan, and Europe (known as the Group of Three, or G-3). The most obvious observation is that monetary policy in the G-3 is far more stable today than it was in the mid-1970s after the first oil crisis…Yet the volatility of G-3 exchange rates has dropped only marginally since the 1970s...Where is the windfall that we were supposed to reap by restoring global monetary stability?

If monetary policy does not lead to stable exchange rates, can markets do a better job? In theory, if a currency becomes significantly undervalued or overvalued, players would step in to buy the undervalued currency and sell the overvalued one, thus bringing the exchange rates close to their intrinsic or sustainable values. In practice, as Keynes remarked, markets can remain irrational for much longer than you can remain solvent! To quote just one example, the yen-dollar rate was below 80 in April 1995, slipped to 147 at one stage three years later, and moved from 136 to 111 in less than a week in October 1998! And, all this with little change in the inflation rate! Arguably, Japan’s lost decade in terms of growth was due at least partly to the extreme volatility in the exchange rate witnessed in the 1990s.

To be sure, central bank intervention and sterilisation of money supply can have financial costs. But to my mind, the costs to the real economy of misaligned exchange rates, in terms of lost growth and jobs, can be far larger. The difficulty is that they cannot be calculated as precisely, or as simply, as the costs of sterilisation. In any case, these costs would cease to matter as our inflation and interest rates approach the levels in the industrial countries in whose currencies we hold the reserves.

To summarise, there is a strong case for managed exchange rates at least in the case of developing countries; that such rates have paid rich dividends to many economies, helping them achieve spectacular growth rates never experienced by the western world; and that, if this means some capital controls, so as to avoid the “impossible trinity”, so be it: there is, in any case, very little empirical evidence showing strong positive correlation between the degree of capital liberalisation and growth rates.



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Economic and Political Weekly January 6, 2007

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