Some New Perspectives on India’s Approach to Capital Account Liberalization

1. Some New Perspectives on India’s Approach to Capital Account Liberalization Eswar Prasad Cornell University

2. Benefits of Financial Integration: Theory • Efficient international allocation of capital • Consumption smoothing via international risk sharing • Large welfare effects for developing economies

3. Growth Benefits of Financial Integration: Evidence About 25 studies of growth effects No effect 4 Mixed: 18 Positive: 3 No robust macroeconomic evidence of growth benefits

4. Correlation between Growth and Current A/c Balance Non-industrial Countries, 1970-2004

6. Volatility and Risk Sharing • No evidence that financial integration by itself is proximate determinant of financial crises • Developing economies, including emerging markets, have not attained better risk sharing

9. New Evidence: A Summary • Equity market liberalization seems to work • FDI benefits becoming more apparent • Benefits more evident in micro data

10. The Traditional View More efficient international allocation of capital Capital deepening International risk-sharing GDP growth Consumption volatility Financial Globalization

11. A Different Perspective Traditional Channels Potential Collateral Benefits Financial market development Institutional development Better governance Macroeconomic discipline GDP / TFP Growth Consumption volatility Financial Globalization

12. Complication: Threshold Effects GDP / TFP growth Risks of Crises Above Thresholds Threshold Conditions Financial market development Institutional Quality, Governance Macroeconomic policies Trade integration X Financial Globalization ? GDP / TFP growth Risks of Crises Below Thresholds

13. TENSION !! • Financial integration can catalyze financial development, improve governance, impose discipline on macro policies... • But, in the absence of a basic pre-existing level of these supporting conditions, financial integration can wreak havoc

14. Collateral Benefits Framework Could Help Make Progress • Unified conceptual framework • Country-specific requirements, initial conditions can be taken into account • Selective approach to liberalization based on prioritization of collateral benefits • Can manage risks during transition to thresholds, but can not eliminate them

15. Really New Evidence:Composition of External Liabilities Matters • FDI and portfolio equity liabilities improve risk sharing outcomes; Debt worsens risk sharing • FDI and portfolio equity liabilities boost TFP growth; Debt has negative impact • Negative effects of debt attenuated by deeper financial markets, better institutions • Level of financial integration itself is a threshold

16. Reality on the Ground • De facto financial openness increasing • Capital controls becoming less effective > Expansion of trade > Larger international financial flows > Rising sophistication of international investors • Trying to maintain rigid capital controls doesn’t solve inflows problem + creates distortionary costs

17. How Open is India’s Capital Account? • De jure capital account openness > Capital controls • De facto financial integration > Stocks of external assets, liabilities as ratio to GDP

18. De Jure Capital Account Openness

19. De Facto Financial Integration

20. De Facto Financial Integration: Emerging Markets (2006)

21. Balance of Payments (in billions of U.S. dollars)

22. Foreign Exchange Reserves: Flows and Stocks(in billions of U.S. dollars)

23. A Decomposition of the Recent Reserve Buildup (in billions of U.S. dollars)

24. Has the Benefit-Cost Tradeoff Improved? • Composition of inflows, stocks of external liabilities has become more favorable

25. Share of FDI and Portfolio Liabilities in Gross External Liabilities

26. Ratio of FDI + Portfolio Liabilities to Gross External Liabilities: Emerging Markets (1995)

27. Ratio of FDI + Portfolio Liabilities to Gross External Liabilities: Emerging Markets (2006)

28. Has the Benefit-Cost Tradeoff Improved? • Composition of inflows, stocks of external liabilities has become more favorable • High levels of foreign exchange reserves

29. International Investment Position (in billions of U.S. dollars)

30. External Debt Stocks

31. Reserve Adequacy(ratio of reserves to relevant variables)

32. Has the Benefit-Cost Tradeoff Improved? • Composition of inflows, stocks of external liabilities has become more favorable • High levels of foreign exchange reserves • Rising trade openness

33. Trade Openness Ratio

34. The Savings-Investment Balance(in percent of GDP)

35. Has the Benefit-Cost Tradeoff Improved? • Composition of inflows, stocks of external liabilities has become more favorable • High levels of foreign exchange reserves • Rising trade openness • Greater exchange rate flexibility

36. Nominal Exchange Rate Relative to U.S. Dollar

37. Real and Nominal Effective Exchange Rates

38. Has the Benefit-Cost Tradeoff Improved? • Composition of inflows, stocks of external liabilities has become more favorable • High levels of foreign exchange reserves • Rising trade openness • Greater exchange rate flexibility • Financial markets stronger (banking reforms) and broader (equity markets deep and liquid) • More international flows of capital, including by institutional investors who have longer-term horizons; new financial instruments

39. India’s Share of Gross Inflows to Emerging Markets and Other Developing Countries

40. India’s Share of Gross Outflows from Emerging Markets and Other Developing Countries

41. But … • May still be below threshold levels of financial, institutional development • Managed exchange rate; absence of singular focus of monetary policy on inflation objective • Surges in inflows create macro complications • Financial markets still have way to go: bond markets not working well, banking sector problems tied in with other aspects of government policy (fiscal) • Many imperfections in international financial markets: herding behavior; incomplete markets; risks in system harder to trace

42. Interest Rate Differentials Relative to U.S.

43. Outstanding Stock of Market Stabilization Bonds(in billions of INR)

44. Implications • Best to actively manage process of capital account liberalization rather than fight the inevitable • Seize windows of opportunity when benefit-risk tradeoff improves; but coast is never completely clear. • Capital account liberalization not an end in itself; needs to be put in the context of a more complete policy/reform agenda

45. Extra Slides

46. Chinas Foreign Exchange Reserves: (billions of U.S. dollars)

47. Growth Accounting for More Financially Open Economies (MFO) (1966-1985 and 1986-2005)

48. Growth Accounting for Less Financially Open Economies (LFO) (1966-1985 and 1986-2005)

49. Does the Composition ofExternal Liabilities Matter?