Do capital controls work?

billion dollars has been unprecedented in India’s history. This figure was nearly four times that of the rather meek USD 8.7 billion that came into India in the same quarter last year. The flows in July-Sept 2007 were more than double the USD 16.5 billion, the amount that came into India in the previous quarter, April-June 2007. What is equally striking is that this surge in capital was not caused by a sudden change in policy to open up to inflows. Indeed, it was the opposite. It was witnessed when India had started moving towards restricting capital inflows such as the restrictions on external commercial borrowing (ECB) flows.

As the data presented in the Balance of Payments table shows, net inflows on account of loans fell from USD 9.4 billion in the first quarter to USD 7.6 billion in the second. The biggest component of loans — ECBs — witnessed a decline of USD 3.4 billion (From USD 7 billion in the first quarter to USD 3.6 billion in the second). However, short term loans went up.

If restrictions on loans reduced capital inflows, where did the increase of USD 17.4 in net inflows come from? The biggest chunk of the increase came from a category known as ‘other capital flows’. This increased by USD 8.2 billion compared to the previous quarter. ‘Other capital flows’ comprises leads and lags in exports, funds held abroad, advances received pending issue of shares under FDI and other capital receipts not included elsewhere. The category ‘other’ is mainly capital that comes through channels that cannot be accounted for properly.

The second biggest chunk of the increase came from net banking capital. This amounted to an increase of USD 7.1 billion over the previous quarter. According to the RBI, this mainly reflects a draw down of assets held by the banking system abroad. NRI deposits fell in this category. The RBI controls the interest rate on NRI deposits and this had been lowered to reduce inflows to India. So while the growth in NRI deposits was very small at less than USD 1 billion, that in banking assets and liabilities, which the RBI does not control, saw a sharp increase.

FII flows accounted for USD 3.5 billion of the total increase. Net foreign investment into India the second quarter was USD 2.7 less than in the first quarter.

The most striking fact about the sources of increase in capital flows is that the bulk of the increase, of USD 15.3 billion out of USD 17.4 billion, came from categories such as ‘other capital flows’. This is a lot of flows that cannot be accounted for properly, and net banking capital where capital flows take place on the balance sheets of banks and are not directly controlled by RBI.

This evidence about the effectiveness of capital controls is not surprising. Internationally, when capital controls are imposed it has often been seen that the category for which the specific control is imposed shows a reduction in inflows, but the total continues to rise through an increase in some other form.

Part of the capital that households and firms want to bring into the country will show up on the current account; capital account transactions will be disguised as current account activities. For this reason, the problem that is faced in trying to manage the exchange rate is even bigger than that seen on the capital account. The sharp growth in remittances is part of the story being enacted on the current account.

Balance of Payment data for the third quarter, October-December 2007-08, is not available yet. But reserves data gives us an indication that the capital surge continued. In the second quarter, the RBI’s foreign exchange reserves increased by USD 29 billion. In the following months, RBI data shows that from Oct 1, 2007 to Dec 28, 2007, RBI’s foreign exchange reserves increased by USD 27 billion, similar to the USD 29 billion added in the quarter of the capital surge. The restrictions on participatory notes in October might have led to a reduction in FII flows. The continuing restrictions on ECBs might mean that debt flows are smaller. However, total inflows may be nearly the same, or even bigger.

The lesson is obvious. As long as there are incentives for people to bring money into India, they will find ways to do so. If the government wishes to go after FIIs, it can do so. If it wishes to go after exporters to reduce leads and lags, it can do so. If it wishes to restrict FDI, it can do so. The component that is targeted for reversal of reforms might show smaller numbers, thus allowing RBI to claim victory. But the money that is blocked through one path will show up in other paths.

The writer is senior fellow, National Institute of Public Finance and Policy