Arguments against completely liberalizing capital flows

India is a developing economy where maximum amount of the current account deficit is met by the inflow of foreign capital. Complete liberalization of this capital flow would allow these foreign investors to pull out their money whenever they want from the economy in case the country faces economic problems leaving the country with huge balance of payments deficit. Economic dilemma India will face on complete linearization of capital flows: India needs capital inflows since it has a current account deficit (CAD). In an ideal world, it would want capital flows just about sufficient to finance its CAD. But in the real world capital flows are either too much or too little. If capital flows are freely allowed to move in and out of the country, inflow might increase far in excess of CAD causing the exchange rate to appreciate out of line with fundamentals. And if the flows are volatile, that will be reflected in the exchange rate movement too. The Reserve Bank then has to make a judgment on whether or not to intervene in the forex market. If it intervenes to buy foreign exchange in the market, volatility may be smoothen and exchange rate appreciation contained, but systemic rupee liquidity goes up, and that could add to inflationary pressures. To contain inflationary pressures, RBI sometimes puts upward pressure on interest rates which erodes our competitiveness. Higher interest rates also attract more capital flows, thus again, accentuating the very problem that we were, in the first place, trying to resolve.
Increase interest rates Capital inflows

RBI intervenes

Capital inflows > CAD

Inflationary pressures

Exchange rate appreciates

Increase rupee liquidity

RBI may intervene

Unrestricted volatile capital outflows pose similarly complex policy choices. In this case, the exchange rate tends to depreciate, again out of line with fundamentals exacerbating inflationary pressures and also hurting the government and corporates who have external debt obligations. In an outflow situation, financing of the current account deficit could also turn into a problem. One of the most observable facts about capital controls effectiveness is to look at the global economic shocks such as the 1997-98 Asian Crisis and the Global crisis of 2008. The relative closeness of India capital account has been highlighted as one of the key factors contributing to reduce the overall vulnerability of the economy to external shocks and potential financial crisis contagion. There are only two reasons of why India has managed better than most of the East Asian countries: debt management and capital controls. Indeed, in the case of India, the country has benefited from avoiding premature capital account convertibility as exerted by the IMF. A minimum controls on inflows contributes to prevent investors from engaging in arbitrage activity, raising the cost of shifting funds across borders.