This blog post is joint work with Jeetendra.
One important part of capital account decontrol
is commitment. If there is risk that capital controls will be
brought back in the future, this can have a variety of unpleasant
effects. If there is a fear of fresh restrictions coming in on
inflows, a surge of money will rush into the country. If there is a
fear of fresh restrictions coming in on outflows, a surge of money
will rush out of the country. A long-term commitment to openness is
required, in order to rule out such behaviour.
As a consequence, when a country moves to full convertibility, this
requires not just the removal of restrictions. It also requires the
removal of bureacratic process including reporting requirements. As
long as forms have to be filled up for `automatic approval', this
can easily swing back and become a capital control through
breakdowns of rule of law (as has happened in India). See
the MoF
Working Group on Foreign Investment on issues of rule of law in
India's capital controls. It is important to pour concrete on the
decontrol so as to give confidence that the controls are gone.
We don't have the exact facts, but in the UK, when they moved to
convertibility (back in the late 1970s) this was accompanied by
dismantling of reporting requirements.
Korea is very open; there are no restrictions on capital flows. But
Korea has kept the reporting requirements and through this, they
have retained controls in a certain sense. The reason is that people
fear that if they report transactions, then the government may come
and investigate, and ask why they are doing it. They might also ask
where the money is coming from. So, even though the rules may allow
capital transactions, people -- especially individuals, but also
small businesses -- remain very wary of these, and refrain from
wiring large amounts in and out of the country, apart from some
outward investments via mutual funds, where the government can't
actually see who is sending the money out. Through this, reporting
requirements perpetuate home bias and inhibit international
economic integration.
Today we became aware of one mechanism through which some countries
have committed themselves to an open economic system: When the US
signs free trade agreements and bilateral investment treaties, there
are provisions which limit the extent to which capital controls can
then be brought back.
A curious
letter has brought this to our notice. It says: Under
these agreements, private foreign investors have the power to
effectively sue governments in international tribunals over
alleged violations of these provisions.. How interesting. So
that locks down the possibility of a reversal of reforms in
countries
countries where the US has free trade agreements,
and quite
a few more where the US has bilateral investment treaties.
It makes sense for investment and trade treaties to mention capital
controls. Trade and finance cannot really be separated: finance
follows trade, and enhanced de facto integration in each
feeds the other.
Trade requires currency risk management. When an Indian firm signs
a long-term contract to buy/sell with invoicing in Yen, the
Indian firm needs to be sure that Japan will stay open so as to
enable INR/JPY hedging in the future.
If an MNC makes a direct investment in a country, it needs some
assurance that it can bring in funds (equity and loans) to
finance the investment, take them out when it wants to run down
its operations, and repatriate profits in the meantime. It also
needs to be able to hedge its currency exposure.
Hence, entering into trade/investment contracts today is assisted
by confidence that liberalisation put in place
today will still be there tomorrow.
More generally, there is a big difference between (a) a move today and
(b) a move today + a commitment about behaviour tomorrow. Permanent tax
cuts yield a much greater consumption response. Permanent capital
account liberalisation leads to more FDI and trade. A variety of
mechanisms need to be found through which reforms can be given
stronger commitment so as to rule out risk of reversal in the future.
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