CAPITAL CONTROLS (IN INDIA)

In the recent years, there has been a fresh wave of interest in capital controls. Post the 2008 recession,
only countries with adequate capital controls have been able to survive the hit. Therefore even IMF now
has come out and supported the use of capital controls. Hence, capital controls are back on the global
economic discussion.

To understand Capital controls, we first need to have a sound knowledge about balance of payment.
Thus in brief, Balance of payments (BOP) is the record of the economic and financial flows that take
place over a specified time period between residents and non-residents of a given country. It is a type of
balance sheet that records all monetary transactions between a country and the rest of the world.
The Balance of Payment is divided into 2 major accounts: -
1. Current Account and 2. Capital Account

In the current account, transactions related to goods, services, income and current transfers are
recorded. Current Account deals with the all transactions that are related to the current period. It
measures the country’s foreign trade i.e. any inflow and outflow other than capital flow. In simple
words, current account can be defined as: -
Current Account = Net Balance of Trade + Net Factor Income + Net Transfer Payment

Capital Account refers to that part of the Balance of Payment that deals with the buying and selling of
assets. Capital Account is the result of net inflows and outflows due to international investment. In
simple words, capital account can be defined as: -
Capital Account = FDI + Portfolio Investment + Other Investment + Reserve Account

Now, coming to Capital Controls. These are measures taken by the government or the Central Bank of
the country in order to limit / restrict or completely prohibit the flow of capital investment. It is used to
restrict the volatile movement of foreign capital flows. Restrictions can be levied on inflows and
outflows. Inflows are usually restricted to avoid short term and speculative flows which would affect
macroeconomic factors such as inflation and money supply; whereas outflows are restricted to maintain
the currency value and the foreign exchange reserves. When there are no restrictions on the flow of
foreign capital investment in the country, it a called a Fully Capital Convertible where as if there are
restrictions prevailing in the country it is called Partial Capital Convertibility.

Capital flows provide emerging market economies with invaluable benefits in pursuing economic
development and growth by enabling them to finance needed investment, smooth consumption,
diversify risks, and expanded economic opportunities. However, large capital inflows, if not managed
properly, can expose countries a few types of risks. Macroeconomic aspects that could be affected are
that capital inflows can accelerate economic growth, increase inflation, appreciation of exchange rates
along with financial instability with respect to private sector and stock markets. Also there is a fear of
hot money. Capital inflows could reverse within a short period resulting in depleting assets and sharp
currency depreciation. An example of such a situation is the Asian crisis in 1997-98.

Capital Controls can be either direct or indirect. Direct Control refers to the outright prohibition of
capital flow whereas Indirect Control refers to the penalizing of undesirable capital flows. For example, a
cap on the FDI in a particular sector is an Indirect Control whereas high tax on short term capital flow is
an indirect control.
Capital Controls in India

India was primarily a closed economy, however, in the early 1990’s, India faced a BOP crisis i.e. India’s
BOP was in huge deficit which was followed by an IMF structural adjustment program, economic
reforms and liberalization of current and capital accounts. Nonetheless, policymakers in India were very
cautious about opening up the economy. Thus, the economy was opened up to foreign capital in a
gradual and systematic approach. In other words, capital controls existed.

India has had significant controls on both inflows and outflows. These controls are applied to a broad
spectrum of assets and liabilities such as debt, equity and currency and also include strict regulation of
financial institutions. Indian capital controls consist of an intricate web of large number of quantitative
restrictions, operated by a substantial bureaucratic system. Liberalization of FDI and portfolio flows was
done in a gradual manner, with a large number of incremental changes. While a few major decisions
were taken in 1992, the process of liberalizing still continues.

India opened to FDI only in 1990’s after a major BOP crisis. The limits of FDI was also very restricted but
was gradually eased in every sector. Today, most of the sectors have 100% FDI permissible, barring a
few such as retailing, atomic energy, etc. While inbound FDI in 1990 was a mere $128m, today the FDI
has increased to more than $40,000m. Portfolio Investment opened up through FII’s also have faced lot
of restrictions such as registration with SEBI, limits on ownership or holding, heavy taxation, etc. Even
though some key controls remain especially on derivative products, FII’s have seen a growth from just
$4m in 91-92 to $32,375m in 2009-10. Corporates are also allowed to borrow through External
Commercial Borrowings (ECB) albeit with restrictions; such as 3 year maturity for amount below $20m
and 5 years for any amount above beyond and amount beyond $500m would require approval from the
RBI. All these factors have acted as an impetus to the economic growth in India.

However as we all famously know, there’s no free lunch, these controls too are not appreciated by all.
Economists and financial wizards are of the opinion that capital controls are not really effective and
should be done away with. They opined that in some cases capital controls have not delivered the
desired results and in other cases they have come with huge costs to the GDP. The effectiveness of
capital controls have been questioned by many economists and have been a question of debate for
years. It has been found that only countries like China, India and Brazil has been effective in
implementing capital controls. These countries have had a partial success in evading financial crisis
situations by implementing capital controls. As in the case of India, conservatism can say that we were
not hugely affected by the Asian Crisis of 1997-98 and the Global recession of 2008. However, as we say
no pain, no gain; India did not benefit of the high growth rate as most of the South East Asian countries.

Thus, India needs to weigh the gains and losses of capital controls closely and decide whether it can
afford to sacrifice growth for stability.

This article has been inspired by NBER reports by Mr. Ajay Shah and Ms. Ila Patnaik.