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Tuesday, May 29, 2007

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.


    Posted by on Tuesday, May 29, 2007 at 02:34 AM in Economics, India | Permalink  TrackBack (0)  Comments (16)


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