Some New Perspectives on India’s

Approach to Capital Account LiberalizationEswar Prasad

Cornell University

Benefits of Financial Integration:

Theory Efficient international allocation of capital

Consumption smoothing via international risk sharing

Large welfare effects for developing economies

Growth Benefits of Financial Integration: Evidence

About 25 studies of growth effects

No effect 4Mixed: 18Positive: 3

No robust macroeconomic evidence of growth benefits

Correlation between Growth and Current A/c Balance

Non-industrial Countries, 1970-2004

DZA

ARG

BGD

BOL

BRA

CMR

CHL

CHN

COLCRI

CYP

CIV

DOM

ECU

EGY

SLV

ETH

GHA

GTM HTIHND

IND

IDN

IRN

ISR

JAM

JORKEN

KOR

MDG

MWI

MYS

MLI

MUS

MEXMAR

NGA

PAKPAN

PRY

PER

PHLRWA

SEN

SLE

ZAF

LKA

TZA

THA

TTO

TUN

TUR

UGA

URY

VENZMBZWE

-20

24

68

Pe

r ca

pita

GD

P g

row

th

-10 -5 0 5Average current account balance to gdp

Above Median

Below Median

Below Median

Above Median

0.00

1.00

2.00

3.00

Ave

rage

Per

Cap

ita

GD

P G

row

th

Investment/GDP

Current Account/GDP

Figure 6. Current Accounts, Investment and Growth in Developing Countries

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

Financial Integration and Risk Sharing(Industrial Countries)

0.2

0.3

0.4

0.5

1987 1989 1991 1993 1995 1997 1999 2001 2003

Ris

k Sh

arin

g (1

-BE

TA

)

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

Fin

anci

al O

penn

ess,

Sto

ck

Risk sharing

Financial Openness, stock

Financial Integration and Risk Sharing(Emerging Markets)

0

0.1

0.2

0.3

0.4

1987 1989 1991 1993 1995 1997 1999 2001 2003

Ris

k Sh

arin

g (1

-BE

TA

)

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

0.4

Fin

anci

al O

penn

ess,

Sto

ck

Risk Sharing

Financial Openness, Stock

New Evidence: A Summary

Equity market liberalization seems to work

FDI benefits becoming more apparent

Benefits more evident in micro data

The Traditional View

Financial Globalization

More efficient international allocation of capital

Capital deepening

International risk-sharing

GDP growth

Consumption volatility

A Different Perspective

Traditional Channels

Potential Collateral Benefits

Financial market developmentInstitutional development

Better governanceMacroeconomic discipline

Financial Globalization

GDP / TFP Growth

Consumption volatility

Complication: Threshold Effects

Threshold ConditionsFinancial market development

Institutional Quality, GovernanceMacroeconomic policies

Trade integration

Financial Globalization

GDP / TFP growth

Risks of Crises

GDP / TFP growth

Risks of Crises

Above Thresholds

Below Thresholds

X

?

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

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

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

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

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

De Jure Capital Account Openness

Full Sample India ChinaMedian Minimum Median Maximum

Chinn Ito1985 -1.13 -1.80 -1.13 2.54 -1.13 -1.131995 -0.09 -1.80 -0.09 2.54 -1.13 -1.132006 0.14 -1.13 0.03 2.54 -1.13 -1.13

Edwards1985 50.00 12.50 37.50 75.00 25.00 37.501995 75.00 25.00 50.00 100.00 25.00 37.502000 81.25 37.50 62.50 100.00 75.00 37.50

Miniane1985 0.86 0.83 0.86 1.00 0.831995 0.43 0.71 0.86 1.00 0.832000 0.36 0.71 0.86 0.86 0.86

Emerging Markets

De Facto Financial Integration

0

10

20

30

40

50

60

70

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

External Liabilities (ratio to GDP)

External Assets (ratio to GDP)

External Assets + Liabilities (ratio to GDP)

De Facto Financial Integration:

Emerging Markets (2006)

0

50

100

150

200

250

300

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

2004-05 2005-06 2006-07 2007-08

Gross international reserves 141.5 151.6 199.2 309.7(in percent of GDP) 20.3 18.8 21.6 27.2

Change in international reserves 28.5 10.1 47.6 110.5

A. Current account balance -2.5 -9.2 -9.6 -17.4 (in percent of GDP) -0.4 -1.1 -1.0 -1.5

Merchandise trade balance -33.7 -51.8 -64.9 -90.1 (in percent of GDP) -4.8 -6.4 -7.0 -7.9 B. Capital account balance 28.0 23.4 44.9 108.0 FDI, net 3.7 4.7 8.4 15.5 portfolio flows, net 9.3 12.5 7.1 29.3 C. Errors and omissions, net 0.6 0.8 1.3 1.5

D. Valuation change 2.4 -4.9 11.0 18.4

Nominal GDP 696.0 806.0 922.7 1140.0

Foreign Exchange Reserves: Flows and Stocks

(in billions of U.S. dollars)

-6

-1

4

9

14

19

Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07

0

50

100

150

200

250

300

350

Monthly Changes

Stock of Reserves

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

dollars)1998-2001 2001-06 2006-08 2001-06 2006-08 -1998-2001 -2001-06

(1) (2) (3) (2) - (1) (3) - (2)

Increase in foreign reserves 4.4 21.7 79.1 17.3 57.3

Current account balance -3.8 2.4 -13.5 6.2 -15.9 Capital account balance 9.2 17.5 76.5 8.3 59.0 FDI, net 2.6 3.8 12.0 1.2 8.2 Errors and omissions, net 0.1 0.3 1.4 0.3 1.1

Valuation Changes -1.1 1.5 14.7 2.6 13.2

Non-FDI capital account balance (including errors and omissions) 6.7 14.1 65.9 7.3 51.8

Annual averages Changes

Has the Benefit-Cost Tradeoff Improved?

Composition of inflows, stocks of external liabilities has become more favorable

Share of FDI and Portfolio Liabilities

in Gross External Liabilities

0

10

20

30

40

50

60

70

1990 1992 1994 1996 1998 2000 2002 2004 2006

Ratio of FDI + Portfolio Liabilities to Gross External Liabilities:

Emerging Markets (1995)

0

10

20

30

40

50

60

70

Ratio of FDI + Portfolio Liabilities to Gross External Liabilities:

Emerging Markets (2006)

0

10

20

30

40

50

60

70

80

90

Has the Benefit-Cost Tradeoff Improved?

Composition of inflows, stocks of external liabilities has become more favorable

High levels of foreign exchange reserves

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

1996-97 2000-01 2006-07

Net Position -81 -76 -45

A. Assets 38 62 244

1. FDI 1 3 242. Portfolio 0 1 1 Equity 0 0 0 Debt 0 0 0

3. Other investment 10 16 20 Other assets

4. Reserve assets 27 43 199

Foreign exchange reserves 22 40 192

B. Liabilities 119 139 289

1. FDI 11 20 722. Portfolio 19 31 80 Equity 14 17 63 Debt 5 14 17

3. Other investment 89 87 136

External Debt Stocks

0

5

10

15

20

25

30

35

40Short term debt (ratio to GDP)

Long term debt (ratio to GDP)

Reserve Adequacy(ratio of reserves to relevant

variables)

Months of imports

Short- term External Debt

External Debt

Non-FDI external

liabilities M3

2005 9.5 18.0 1.1 0.7 0.22006 9.6 16.7 1.1 0.7 0.22007 12.5 16.0 1.4 0.2

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

Trade Openness Ratio

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0.50

The Savings-Investment Balance(in percent of GDP)

0

5

10

15

20

25

30

35

-3

-2

-1

0

1

2Savings (LHS)

Investment (LHS)

Current Account (RHS)

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

Nominal Exchange Rate Relative to U.S. Dollar

30

35

40

45

50

Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08

6

7

8

9

10

Rupees per $ (LHS)

Renminbi per $ (RHS)

Real and Nominal Effective Exchange Rates

80

85

90

95

100

105

110

Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

REER NEER

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

India’s Share of Gross Inflows to Emerging Markets and Other

Developing Countries

-8

-4

0

4

8

12

16

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Total

FDI

Portfolio

India’s Share of Gross Outflows from Emerging Markets and Other

Developing Countries

-1

0

1

2

3

4

5

6

7

8

9

10

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Total

FDI

Portfolio

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

Interest Rate Differentials Relative to U.S.

0

1

2

3

4

5

6

7

8

Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

Govt. Security 1-year

U.S. 3-month t-bill

U.S. 3-year t-bond

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

200

400

600

800

1000

1200

1400

1600

1800

Apr-04 Apr-05 Apr-06 Apr-07 Apr-08

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

Extra Slides

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

0

10

20

30

40

50

60

70

0

200

400

600

800

1000

1200

1400

1600

1800

Monthly Changes

Stock of Reserves

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

-0.5

0.0

0.5

1.0

1.5

2.0

Pre-Globalization Globalization

Real GDP per worker TFP contributionK/Y Contribution H Contribution

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

Real GDP per worker TFP contributionK/Y Contribution H Contribution

0.0

0.5

1.0

1.5

2.0

2.5

Pre-Globalization Globalization

Does the Composition ofExternal Liabilities Matter?

FE GMM FE GMM

CA Openness 0.03685 0.04967 0.02837 0.03830[0.03741] [0.04595] [0.04312] [0.05047]

FDI & Equity Liab. -0.00141 0.00607*** 0.00022 0.00695***[0.00190] [0.00220] [0.00246] [0.00207]

Debt Liab. -0.00229* -0.00383*** -0.00305** -0.00378***[0.00122] [0.00117] [0.00116] [0.00087]

0.00361* -0.00332[0.00196] [0.00228]

0.00033 0.00261**[0.00131] [0.00113]

0.00101 -0.00640***[0.00240] [0.00223]

0.00226* 0.00392***[0.00120] [0.00120]

Institutional Quality * Debt Liab.

Private Sector Credit * FDI & Equity Liab.

Private Sector Credit * Debt Liab.

Institutional Quality * FDI & Equity Liab.