Should India Liberalize its Capital Account?

Eswar Prasad of Cornell says it's time to liberalize India's capital account:

Cracking Open India's Capital Account, by Eswar S. Prasad, Commentary, WSJ: Capital account liberalization is back on the table in India. ... [A] government committee ... has ratcheted up the debate this year by arguing that to give Mumbai a fighting chance of becoming an international financial center, the capital account must be fully opened by the end of 2008.

Would India be putting the cart before the horse by plunging headlong into capital account liberalization? The financial system is still underdeveloped, the fiscal deficit remains high ... and the exchange rate is still managed... Under such circumstances, when the economy is not equipped to handle a gusher of capital flowing in or out, unbridled capital account opening in some emerging market economies has ended in tears.

Despite the risks, capital account liberalization could indeed prove to be a boon for India, but for a completely different set of reasons than the traditional ones...

The traditional view is that opening up to inflows allows capital-poor developing countries to import capital, increase domestic investment and grow faster. The problem for ... this view is that economists ... have found it difficult to detect the direct growth-enhancing benefits of foreign capital.

But a new paradigm has recently emerged in the academic literature... The real benefits of financial globalization to an emerging market economy ...[come from] the indirect "collateral" benefits associated with such capital... These indirect benefits may be crucial for India's development.

One of the key benefits is that openness to foreign capital catalyzes financial market development. Foreign investment in the financial sector tends to enhance competition, raise efficiency, improve corporate governance standards and stimulate the development of new financial products. ...

Liberalizing outflows has the salutary effect of giving domestic investors an opportunity to diversify their portfolios internationally. This means greater competition for domestic financial institutions...

Other indirect benefits associated with foreign capital include transfers of expertise -- technological and managerial -- from more advanced economies. When supported by liberal trade policies, foreign investment can help boost export growth. Foreign-invested firms also tend to have spillover effects in generating efficiency gains among domestic firms.

Notwithstanding these potential benefits, there is strident opposition in India to capital account opening. Some of it is based just on ideological opposition to foreign involvement in the economy. Dig deeper, though, and it turns out that much of the opposition comes from entrenched interests that view foreign-financed competition as an unwelcome intrusion that erodes the protection and privileges they have enjoyed... Indeed, a "shock" like capital account opening is just the tonic to shake up the system...

So why the rush towards a fully open capital account? What is so special about the end-of-2008 date...? In short, nothing. But deadlines do have a way of focusing the mind. ... It would give less room for reactionary forces to coalesce and block the reforms. ...

For an emerging market economy, the process of opening the capital account comes down to a delicate balance between the benefits it affords and the risks of disruptions to growth if things go wrong. For the Indian economy, which has made great strides in recent years, ... the risks are now smaller and well worth taking...

Update: Dani Rodrik offers a different perspective.

 

Comments

[DRR]

Capital liberalization should be one of the last, if not THEE last stages in development. Methinks India should at least be as economically large & stable as Mexico before even considering it.

[Bruce Wilder]

Some Western investors and banks like capital liberalization, because it helps them rape developing countries, so they hire unscrupulous economists to argue for it. Now, these unscrupulous economists have a new rationale for this self-destructive set of policies. Whoop-de-do.

[notsneaky]

I agree with DRR and Dani Rodrik - the particular corner of the Trilemma that is currently best for India does not involve a fixed exchange rate and free capital flows. But Bruce, no one's hired Eswar Presad for anything. I believe he is arguing in good faith and that he believes in what he says. He is not unscrupulous, as far as I know. It's rude, not to mention stupid, to impugn people's motives just because they happen to have a different opinion.

And the problem with free capital flows comes basically from the exchange rate movements that they generate, not from Western investors raping and looting anything. If the exchange rate movements weren't a problem, foreign capital flows into India would be a beneficial phenomenon. So drop the hyperbole. And the insults.

[Bruce Wilder]

notspeaky: "If the exchange rate movements weren't a problem, foreign capital flows into India would be a beneficial phenomenon."

Other than that, did you enjoy the play, Mrs. Lincoln?

What disturbs me is not that he has a "different" opinion, it is that this former IMF official has the same destructive opinion that has been pushed in bad faith for 40 years; he's just dressed it up in a new frock. As a former IMF official he is intimately familiar with that history, as well as what will curry favor in that club and with the editors and readers of the Wall Street Journal and the Financial Times. So, don't tell me no one is paying him. Someone butters his bread, and he knows that, very well.

It is insulting to imply that people are corrupt. We will be in much deeper trouble still, when it is isn't considered to be insulting. But, it is not stupid to recognize that people have the opinions they have, for a variety of reasons only tangentially related to the logical coherance or factual basis of their opinions.

Just on its face, to come out and gleefully proclaim that you have a new rationalization for a failed and destructive policy is provocative of scorn, or it ought to be. And, scorn I will.

[reason]

I'm suspicious of the argument, because it is the same argument that has been made for hostile leveraged takeovers, which I think are really indefensible (because they privilege arrogance over acchievement). Yes, allow some sort of joint ventures (for technology transfer) and persue active anti-trust policies or regional integration to shake up local monopolies/oligopolies but open the door to casino international capitalism which will treat your economy as a new toy.

[notsneaky]

Other than that, did you enjoy the play, Mrs. Lincoln?

Don't be a weasel. The argument is not over whether free capital flows to developed countries are good or bad. The argument is over why they are potentially bad. Your position is that they help western investors "rape" developing countries and that Presad is a paid (evidence?) hack (evidence?) of these rapists. This is WWWWAAAYYYY different than saying that free capital flows may be undesirable because of exchange rate effects, which would be present even if investors had nothing but altruistic intentions in their hearts.

As far as the rest goes, in general free capital flows from the Western countries to less developed ones are good thing - they provide much needed financing, savings and physical investment, and raise incomes. They do come with the potential costs however - exchange rate appreciation and possibility of financial crisis. But it is perfectly possible a priori, that the assesment of the costs and benefits - even of the last 40 years (or maybe especially) can come out positive.

[billy]

in general free capital flows from the Western countries to less developed ones are good thing - they provide much needed financing, savings and physical investment, and raise incomes.

FREE Capital flows is what is being talked about. So let's keep the discussion there.

FDI has been allowed in India for quite long now. So there's nothing that that stops "Western countries from providing much needed financing, savings and physical investment, and raise incomes" in India.

The talk about FREE is really code for talk about making a fast buck, the consequences be damned.

[Bruce Wilder]

notsneaky: "The argument is not over whether free capital flows to developed countries are good or bad. The argument is over why they are potentially bad."

No, and no. See billy, above.

[notsneaky]

I'm sorry but neither you nor billy have a clue of what you're talking about. This is the point where I give up.

[calmo]

Well, FDI is supposed to benefit both the developing country and the investing developed country (such an orthodox view applied universally, but to particular countries or worse, particular sectors...not so much)--some cause for concern among the likes of Setser (And Roach's imbalanced world view too) who were worried at one time that the massive FDI into the US would inhibit global development. [Meanwhile Africa continues to smolder.]
notsneaky, (and notnaive either) would you say that Eswar Prasad of Cornell made his case ("For the Indian economy, which has made great strides in recent years, ... the risks are now smaller and well worth taking...") for opening up India's capital markets by detailing those great strides that make the risks smaller or was he turning out the lines bw and possibly dr say he is that come from a deep trough of armchair (academic) enlightenment that doesn't dwell on the recent experiences of FDI in emerging economies?
For instance:Foreign investment in the financial sector tends to enhance competition, raise efficiency, improve corporate governance standards and stimulate the development of new financial products. does this "trickle sideways" theme distinguish India's performance from say China's or other developing countries or is he merely marketing Free Capital flows...for that WSJ audience? Is that audience unable to handle R's summary of possible currency responses to this influx of FDI?

[notsneaky]

Calmo, he was writing an opinion column for a newspaper. So he's limited to quickly presenting his views and giving some very general reasons for them. He doesn't have space to go into all the nuances. At least that's what people always say about Krugman.

Like I said, I disagree with him but I'm not gonna impugn his character.

[calmo]

Thanks notsneaky, for that fair (somewhat nuanced but not rushed wazzit?) reply, but if you were writing for the WSJ (no ordinary paper according to Murdoch) would you be writing "quickly" (sans nuances) or with some specific intent?
I even like your inclusion of Krugman here --in much less space than Eswar Prasad had, as a punchy nuance.

In an effort to cross thread, allow me to suggest this article is an illustration of orthodoxy (Free Capital Flows are intrinsically Good)[But possibly more pragmatically, and remuneratively (for Prasad) and cynically (for non and not just anti-Prasadians): India: a place for your dough.] compared to his colleague's trenchant criticism which may be an instance of the non-complacent orthodoxy that kharris identifies in her post.
So Bruce, more familiar with Prasad's history than myself, is not impugning his character gratuitously: it does appear to be a plug for WSJ investors considering India. And this says something about the WSJ and Prasad and little about India.
So why should we put up with this schtick? (Murdoch would amplify these kind of articles and ruin what's left of this prestigious newspaper IMO.)

[notsneaky]

"quickly" was meant in terms of space, not time. As in get ideas across quickly because there isn't much space.

As to the second paragraph, huh? Too many parentheses or something. And I don't think Bruce is familiar with Prasad's past. He just thinks anyone who holds different views must be a paid lackey since his own views are so obviously right. I think Prasad thinks that capital account liberalization is good for India. There's probably a number of state officials who pay attention to WSJ. Prasad is a well published, respected, Indian born economist who probably wants his home country to do good economically and that's why he wrote what he wrote. He may be wrong, but crap like Bruce's is just way out of line.

[reason]

Me thinks that international financial flows are way to big, and asset prices way too volatile at the moment (even if the day to day movements are not so much - look at the year to year movements and think about them). I'm still pretty spooked by all those comparisons with with the 1920s (and 1980s Japan). If I was India and things were going pretty well, I would want to be convinced that I wasn't volunteering for a roller coaster ride with an empty stomach.

[jonfernquest]

Thanks for this article. This is also one of the dilemmas that Thailand currently faces.

[anon]

Related:? Brad Setser's most recent post about the likelihood of Russia revaluing the ruble. Due to massive inflow of funds for investment and from exports.