## _wp08131 - References

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### I. Introduction — core question and summary conclusions
- Core question: How should India adapt monetary policy to ongoing financial globalization?
- Recent developments:
  - Surge in capital inflows leading to volatile monetary conditions, rising exchange rate volatility, exchange rate appreciation, and burgeoning domestic liquidity.
  - Policy mix includes liberalizing and tightening measures on inflows, liberalizing outflows, allowing greater exchange rate flexibility, partially sterilized intervention, hiking policy interest rates and the reserve ratio.
- Key summary conclusions:
  - The most financially globalized countries tend to experience more volatile capital flows but do not necessarily experience more volatility in monetary conditions, monetary aggregates, or exchange rates.
  - As capital account restrictions are lifted, countries appear to shift to more flexible exchange rate regimes.
  - No clear association between broad policy regime type and stability in monetary conditions measured broadly.
  - Subtler elements—operations and communications—may be critical for managing monetary effects of financial globalization.

### II. How financially globalized is India?
- International comparison — stock and flow measures:
  - India is not very financially globalized in stock terms; total foreign assets and liabilities are the lowest in the sample.
  - Capital outflows in India have averaged less than 0.4 percent of GDP since the beginning of the decade (the lowest value in the sample).
  - Capital inflows are now close to 5 percent of GDP, comparable to Brazil and China, but well below major financial centers.
  - Abiad-Detragiache-Tressel index: India more open than China, Thailand, or Brazil, but less so than Korea, Turkey, or Mexico.
  - Chinn-Ito index: India is one of the least open in the sample, along with China, Turkey, and South Africa.
  - De-facto openness evidence (Kramer and Kohli, 2007; Pasricha, 2007) indicates India may be more open de-facto than de jure measures suggest.
  - Less open countries, including India, tend to experience relatively low volatility in capital flows; financial centers (Hong Kong, United Kingdom, Singapore) have high and volatile capital flows.

- India’s globalization over time — market depth and volatility:
  - Total net capital flows have risen about sixfold since Q1 2004.
  - Foreign institutional investment (FII) inflows picked up since 2003/04; since 2004/05 the 12-month moving standard deviation of monthly FII inflows has risen notably.
  - External commercial borrowings (ECBs) accelerated after liberalization of ECB restrictions; more recently FDI inflows have also surged.
  - Foreign exchange turnover: daily turnover rose from $7 billion to $34 billion since 2004 (BIS Triennial Survey, including forwards and swaps).
  - Volatility of daily rupee–U.S. dollar movements has increased; exchange rate volatility is now almost at par with Mexico, but lower than South Africa.
  - Exchange market pressure (EMP), defined as the sum of rupee appreciation and change in foreign exchange reserves normalized by reserve money, has increased.
  - A broader market pressure index (weighted sum of foreign exchange purchases and RBI sterilization via overnight repos and market sterilization bonds, normalized by reserve money) rose sharply in H2 2007, coinciding with the surge in inflows since July and more volatile monetary conditions (12‑month standard deviation of a broad MCI with weights 0.8 and 0.2).

### III. How does financial globalization affect the monetary environment?
- Empirical measures used: exchange rate volatility, exchange market pressure (EMP), volatility in monetary conditions index (MCI), volatility in reserve money.
- Key empirical findings:
  - Currency market volatility in India is moderate compared to more financially open countries; average EMP over 2000–06 is lower in India compared to more financially open emerging countries with managed floats like Malaysia or Russia.
  - Exchange rate volatility has risen but remains among the lowest in the sample, suggesting capital account restrictions help insulate India somewhat from exchange rate pressures.
  - Correlation between financial openness and exchange rate volatility is weak (and negative in the sample); some highly globalized countries have modest exchange rate volatility, possibly due to deep and liquid currency markets.
  - Correlation between financial openness and EMP is also weak.
  - Volatility in monetary conditions (MCI):
    - India’s MCI volatility tends to be lower than some more financially open emerging countries (South Africa, Chile, Russia).
    - Other financially globalized emerging countries (Thailand, Malaysia) and most advanced countries exhibit low MCI volatility.
    - Correlation of MCI volatility with financial openness in the sample is negative.
    - Volatility of reserve money (normalized by GDP) yields similar results.
  - Comovement with U.S. monetary conditions:
    - More financially open countries tend to have higher correlation of their MCI with the U.S. MCI, but the relationship is statistically weak with significant outliers.
    - India’s MCI has a coefficient of correlation of 0.7 with the U.S. MCI—comparable to Thailand, Malaysia, and Singapore despite India’s relatively closed capital account.
  - Policy regime choice and openness:
    - De jure measures show an association between capital account liberalization and adoption of flexible exchange rate regimes.
    - No evidence that more financially open countries prefer a particular type of monetary policy framework.
    - Broad monetary policy framework seems to have little influence on MCI volatility over 2000–06; low MCI volatility across inflation targeters, exchange-rate-anchored, and multiple-objective frameworks.
    - EMP-based (narrower) measures reveal that inflation-targeting regimes have sometimes higher-than-average exchange rate volatility but intervened less and generally experienced below-average EMP; flexible exchange rate countries show similar patterns to IT countries.
    - Correlations remain weak; several non-IT and managed-float (and fixed-rate Hong Kong SAR) countries have experienced low EMP.

### IV. Possible policy responses — operations, instruments, and controls
- Operational focus: liquidity forecasting and proactive liquidity management.
  - Liquidity forecasting:
    - Financial globalization increases volatility in capital flows (measured by the standard deviation), complicating forecasting.
    - Under strong exchange rate pressure, accurate prediction of future FX purchases or sales becomes impossible, which can increase exchange rate volatility and short-term liquidity volatility.
    - Implication: central banks may need to upgrade their ability to forecast foreign exchange flows.
  - Proactive liquidity management:
    - Central bank intervention to mitigate volatility and appreciation pressures can undermine monetary policy if surplus liquidity is not actively managed.
    - Most central banks have shifted to market-based instruments or a mix of quantitative and market-based instruments for sterilization objectives.
    - OMOs and deposit facilities can be calibrated against liquidity forecasts to support operating targets (short-term interest rate or bank reserves target).
    - Key operational constraint under large inflows: availability of domestic sterilization debt instruments with a broad range of maturities for fine-tuning and sterilizing durable inflows.
    - Foreign currency swaps can be used for sterilization but do not promote capital market development like participation in bond/money markets.
  - Case for an "active" open market approach:
    - Predominantly open market or “Fed”/“hands on” style assigns a smaller role to reserve requirement changes and SFs and involves frequent market operations.
    - In well developed money markets, standing facilities support OMOs and limit overnight interbank rate volatility.
    - The open market approach sets the policy rate below marginal lending facility and above deposit facility (reverse repo) rate to more clearly signal policy stance, especially with structural liquidity surplus.
    - Required instruments: wide range of maturities (short-term—1–2 weeks—and longer-term—91-day to 1 year); frequent/flexible OMOs determine effectiveness.
    - India example: three consecutive 25 bps hikes in the repo and four increases in the cash reserve ratio totaling 200 bps, yet yields on government securities only went up by 30–40 bps over the past year.
    - Operational suggestion for India: complement longer-term instruments (MSBs) and reserve requirements with short-term instruments (regular deposit auctions or government securities with 1–2 week maturities) for fine-tuning and regular issuance of long-term OMOs.
- Other measures: capital controls and liberalization of outflows
  - FX interventions are costly and only effective short-term; non-standard instruments are used in practice to manage inflows or moderate reserve accumulation.
  - Examples of measures and sequencing:
    - India: restrictions on ECBs and issuance of offshore equity derivatives; increased limits on individual, corporate, and institutional investments abroad.
    - Malaysia: temporary controls on short-term inflows (1994); later liberalized outflows and provided greater flexibility to onshore banks.
    - Thailand: unremunerated reserve requirement in late 2006 to fend off speculative inflows.
  - European experience (selected countries) 1994–2005:
    - Gross flows averaged about 9.6 percent of GDP.
    - Common responses: sterilized intervention and exchange rate changes (widened bands or switch to floating).
    - Capital controls on short-term inflows were used in Bulgaria, Hungary, Poland; Bulgaria and Czech Republic liberalized outflows.
  - Conclusion: as countries integrate further, effective regulation of capital flows becomes harder; most effective responses include deepening financial markets, strengthening supervision and regulation, and improving capacity to design and implement sound macroeconomic and financial sector policies.

### V. How could financial globalization affect monetary strategy and communication?
- Increased uncertainty:
  - Financial globalization raises uncertainty about the medium-term inflation outlook through greater exposure of asset prices to foreign shocks and long-term implications for price stability.
  - Strategies emphasizing monetary aggregates are challenged because cross-border financial flows affect net foreign assets and money and cannot simply be netted out.
  - Implication: policy may need increased emphasis on preserving price stability over a longer time horizon and factor in developments in monetary liquidity on output volatility and price stability.
- Changes in transmission mechanism:
  - Domestic asset prices and interest rates increasingly determined by global factors; co-movement of countries’ MCI with the U.S. MCI rises with financial globalization.
  - Under floating exchange rates and higher capital mobility, monetary policy becomes more effective via the exchange rate channel offsetting weakening of the interest rate channel (Mundell-Fleming).
  - Central banks can retain leverage by:
    - Active liquidity management to keep short-term nominal rates close to the policy rate or within a policy corridor.
    - Clear communication to shape market expectations about short-term nominal rates and thus influence long-term rates.
    - Anchoring inflation expectations through consistent and predictable policies to influence long-term real rates.
- Communication and transparency:
  - Increased uncertainty and transmission changes heighten the importance of effective and consistent central bank communication.
  - Stepped-up communication is important when foreign investors constitute a greater share of investors.
  - Several emerging countries have emphasized clear and frequent communication, sometimes prompted by a shift to an IT regime.
  - Example: Turkey’s central bank presents a quarterly analysis of risks to price stability and issues summary reports of the MPC’s views on the inflation outlook within 5 days of policy meetings.
- Timing and predictability:
  - More frequent, pre-announced policy reviews can enhance predictability and focus markets on domestic conditions, especially where MCI co-movement with the United States is significant.
- Transparency and openness:
  - Weak positive correlation between numerical transparency measures and financial openness in the sample.
  - High transparency has been an ingredient of successful strategies in highly integrated countries (United Kingdom, Euro Area), and many emerging IT countries have achieved comparable transparency.
  - Using IMF Standards and Codes observance measures, overall monetary policy transparency of the least financially open countries in the sample is broadly similar to that of the most open countries (on average).

### VI. Selected country experiences and operational lessons
- India — Box 1 (key capital account restrictions, as of end-September 2007):
  - FII equity: restricted to approved FIIs, up to 30 percent of capital; investment in government and corporate debt capped at US$2.6 billion and US$1.5 billion; FIIs restricted from buying unlisted corporate debt.
  - FDI limits: 74 percent in private banks, telecoms, satellites and atomic minerals; 51 percent in single-brand retailing; 49 percent in air transport services and investing companies in infrastructure/services; 26 percent in defense, insurance, oil refining and publishing news and current affairs; 20 percent in radio; prohibited in retail trading, atomic energy, lottery, gambling, real estate business, and agricultural businesses such as tea plantations.
  - ECBs: minimum average maturity of 3 years (up to US$20 million) and 5 years (US$20–500 million); additional loans up to US$250 million if average maturity 10 years; funding cost caps linked to Libor plus basis points; prepayment of ECBs subject to a $500 million annual limit.
  - Short-term external borrowing: subject to a US$20 million ceiling per transaction for permissible imports; funding cost ceilings tied to Libor plus basis points.
  - Domestic banks’ investments abroad: subject to open position limits, residual maturity less than a year, at least an AA(-1) rating.
  - Indian companies’ investments abroad: capped at 400 percent of their net worth.
  - Portfolio investments abroad: limited to $5 billion for all mutual funds; individual funds up to 10 percent of net assets, up to $200 million each; residents and corporates limited to $200,000 a year and 50 percent of net worth, respectively.

- Turkey — Box 2 (adapting framework to globalization):
  - Between 2002 and 2006, capital account balance rose from roughly zero to $45 billion (11 percent of GDP); real effective appreciation occurred.
  - In 2006, CBT moved from monetary targeting to inflation targeting.
  - CBT inflation target centered on a 4 percent point target with a plus and minus 2 percent tolerance band; when breached, the CBT issues an open letter to the government explaining the breach and remedial measures.
  - Operational tools include overnight deposit and repo operations, one- and two-week deposit auctions at rates above the overnight benchmark when mopping up liquidity, and issuance of central bank notes up to 91 days to deal with long-lasting excess liquidity.
  - Exchange-rate policy: pure floating with intervention to limit excessive volatility; since April 2002, transparent and pre-announced purchase auctions to build reserves; FX purchases typically sterilized.

- Malaysia — Box 3 (monetary management in a globalizing economy):
  - Two main objectives: sustainable growth and low inflation; exchange rate stability remains important despite exit from the dollar peg in July 2005.
  - Since April 2004, policy signaling via the Overnight Policy Rate (OPR); market-based liquidity operations to influence the overnight interbank rate toward OPR.
  - History of capital controls on inflows (1994) and outflows (1997 crisis), with controls unwound over time starting in 1999.
  - Lessons: limitations of sterilization over long periods; sterilization requires a large stock of securities and high interest rates can attract further inflows; controls can be effective but typically only temporarily.

*Source: _wp08131 - References.*

### References .............................................................................................................

### _wp08131 - References

### I. INTRODUCTION
- Core question: How should India adapt monetary policy to ongoing financial globalization?
- Recent developments noted:
  - Surge in capital inflows leading to volatile monetary conditions, rising exchange rate volatility, exchange rate appreciation, and burgeoning domestic liquidity.
  - Policy mix includes liberalizing and tightening measures on inflows, liberalizing outflows, allowing greater exchange rate flexibility, partially sterilized intervention, hiking policy interest rates and the reserve ratio.
- Key summary conclusions:
  - The most financially globalized countries tend to experience more volatile capital flows but do not necessarily experience more volatility in monetary conditions, monetary aggregates, or exchange rates.
  - As capital account restrictions are lifted, countries appear to shift to more flexible exchange rate regimes.
  - No clear association between broad policy regime type (e.g., inflation targeting versus eclectic regimes; exchange rate pegs versus floats) and stability in monetary conditions measured broadly.
  - Subtler elements—operations and communications—may be critical for managing monetary effects of financial globalization.

### II. HOW FINANCIALLY GLOBALIZED IS INDIA?
- Objectives of analysis:
  - Study India’s international balance sheet.
  - Examine flow data to assess pace of integration.
  - Examine market depth measures such as foreign exchange turnover and market pressure.

A. International comparison
- Sample: broad range of industrialized and emerging countries, including some financial centers (e.g., Hong Kong).
- Normalization: all proxies for financial openness normalized by GDP.
- Key findings:
  - India is not very financially globalized in stock terms; total foreign assets and liabilities are the lowest in the sample (Figure 1).
  - Flow-based measures yield broadly the same result because:
    - Capital outflows in India have averaged less than 0.4 percent of GDP since the beginning of the decade (the lowest value in the sample).
    - Capital inflows are now close to 5 percent of GDP, comparable to Brazil and China, but well below major financial centers.
  - India’s low openness partly reflects cross-border capital transaction restrictions (Figure 2 and Box 1).
    - Abiad-Detragiache-Tressel index: India more open than China, Thailand, or Brazil, but less so than Korea, Turkey, or Mexico.
    - Chinn-Ito index: India is one of the least open in the sample, along with China, Turkey, and South Africa.
  - De-facto openness: Kramer and Kohli (2007) and Pasricha (2007) indicate India may be more open de-facto than de jure measures suggest.
  - Less open countries, including India, tend to experience relatively low volatility in capital flows; financial centers (Hong Kong, United Kingdom, Singapore) have high and volatile capital flows (Figure 3).

B. India’s globalization over time
- Capital flows and market depth:
  - Total net capital flows have risen about sixfold since Q1 2004 (Figure 4).
  - Foreign institutional investment (FII) inflows picked up since 2003/04; since 2004/05 the 12-month moving standard deviation of monthly FII inflows has risen notably.
  - External commercial borrowings (ECBs) accelerated after liberalization of ECB restrictions; more recently FDI inflows have also surged.
  - Foreign exchange turnover has risen over time, especially since H2 2002, accompanied by increased volatility (Figure 5a).
    - BIS Triennial Survey (including forwards and swaps) shows daily turnover rising from $7 billion to $34 billion since 2004 (Kramer and Kohli, 2007).
  - Volatility of daily rupee–U.S. dollar movements has increased; India’s exchange rate volatility is now almost at par with Mexico, but lower than South Africa.
  - Exchange market pressure (EMP), measured by the sum of rupee appreciation and change in foreign exchange reserves normalized by reserve money, has increased (Figure 5a).
  - Broader market pressure index (weighted sum of foreign exchange purchases and RBI sterilization via overnight repos and market sterilization bonds, normalized by reserve money) rose sharply in H2 2007, coinciding with the surge in inflows since July and more volatile monetary conditions (12‑month standard deviation of a broad MCI with weights 0.8 and 0.2) (Figure 5b).

### III. HOW DOES FINANCIAL GLOBALIZATION AFFECT THE MONETARY ENVIRONMENT?
- Measures used: exchange rate volatility, exchange market pressure (EMP), volatility in monetary conditions index (MCI), volatility in reserve money.
- Main empirical findings:
  - Currency market volatility in India is moderate compared to more financially open countries.
    - Average EMP over 2000–06 is lower in India compared to more financially open emerging countries with managed floats like Malaysia or Russia (Figure 6).
    - Exchange rate volatility has risen but remains among the lowest in the sample.
    - Suggests capital account restrictions help insulate India somewhat from exchange rate pressures.
  - Correlation between financial openness and exchange rate volatility is weak (and negative in the sample); some highly globalized countries have modest exchange rate volatility, possibly due to deep and liquid currency markets (Figure 7a).
  - Correlation between financial openness and EMP is also weak (Figure 7b).
  - Volatility in monetary conditions (MCI) shows:
    - India’s MCI volatility tends to be lower than some more financially open emerging countries (South Africa, Chile, Russia) (Figure 6).
    - Other financially globalized emerging countries (Thailand, Malaysia) and most advanced countries exhibit low MCI volatility.
    - Correlation of MCI volatility with financial openness in the sample is negative (Figure 8).
    - Volatility of reserve money (normalized by GDP) yields similar results (Figures 6 and 9).
  - Comovement with U.S. monetary conditions:
    - More financially open countries tend to have higher correlation of their MCI with the U.S. MCI (Figure 10), but relationship is statistically weak with significant outliers.
    - India’s MCI has a coefficient of correlation of 0.7 with the U.S. MCI—comparable to Thailand, Malaysia, and Singapore despite India’s relatively closed capital account.
  - Policy regime choice and openness:
    - De jure measures (Chinn-Ito index) show an association between capital account liberalization and adoption of flexible exchange rate regimes (Figure 11a, bottom panel).
    - Using de jure or flow-based measures, no evidence that more financially open countries prefer a particular type of monetary policy framework (Figure 11a, top panel).
    - Broad monetary policy framework seems to have little influence on MCI volatility over 2000–06; MCI volatility low across inflation targeters, exchange-rate-anchored, and multiple-objective frameworks (Figure 11a, top panel).
    - Exchange rate regime choice also not strongly related to MCI volatility; pegs/managed floats and flexible regimes both show below- and above-average MCI volatility distributions.
  - Narrower definition (EMP) reveals some regime correlations:
    - Inflation-targeting (IT) regimes have sometimes higher-than-average exchange rate volatility but intervened less and generally experienced below-average EMP.
    - Flexible exchange rate countries show similar patterns to IT countries.
    - Correlation remains weak; several non-IT and managed-float (and fixed-rate Hong Kong SAR) countries have also experienced low EMP (Figure 11b).

### IV. POSSIBLE POLICY RESPONSES
- Stylized facts in Indian data:
  - (1) Increase in size and volatility of all types of inflows.
  - (2) Relatively high co-movement of India’s MCI with the United States, despite India’s low financial openness.
- Cross-country implication:
  - Greater financial openness is not associated with higher volatility in monetary conditions across the sample.
  - This lack of association is not solely explained by choice of broad policy regime as countries globalize.
  - Confirmed patterns:
    - Countries tend to shift to more flexible exchange rate regimes as capital account restrictions are lifted.
    - IT and freely floating countries have experienced lower-than-average EMP.
    - No strong relationship between degree of stability in monetary conditions (using broader MCI) and choice of a particular exchange rate or monetary regime.

*Source: _wp08131 - References.*

### 24.      Success in maintaining monetary stability in the face of financial globalization

### 24.      Success in maintaining monetary stability in the face of financial globalization

### A. How Could Further Financial Globalization Affect Monetary Operations?
- Greater financial globalization deepens markets and encourages convergence of monetary policy operating procedures to market-based instruments, moving away from direct quantitative interventions toward forward-looking interest rate management that sends clearer signals through financial markets.
- Two elements of monetary operations are key: liquidity forecasting and liquidity management; capital controls and other non-standard instruments are also used in practice.

Liquidity forecasting
- Financial globalization increases volatility in capital flows (measured by the standard deviation), making it more difficult to forecast capital flows.
- Under strong exchange rate pressure, accurate prediction of future foreign exchange purchases or sales becomes impossible (Gray, 2007), which can:
  - Increase exchange rate volatility in countries using interest rates as a tactical target.
  - Contribute to short-term volatility in liquidity conditions in countries targeting the exchange rate.
- Implication: central banks may need to upgrade their ability to forecast foreign exchange flows.

Proactive liquidity management
- Central bank intervention to mitigate volatility and appreciation pressures can undermine monetary policy if surplus liquidity is not actively managed.
- Most central banks have shifted to market-based instruments or a mix of quantitative and market-based instruments for sterilization objectives.
- OMOs and deposit facilities (DFs), used at the initiative of the central bank, can be calibrated against liquidity forecasts to support operating targets (generally a short-term interest rate, or in some cases money or a bank reserves target).
- A key operational constraint under large inflows is the availability of domestic sterilization debt instruments with a broad range of maturities to allow:
  - Fine-tuning (dealing with short-term volatility in liquidity conditions).
  - Sterilization of more durable inflows.
- Examples and operational notes:
  - Mexico (May 2003): an automatic policy to slow reserve accumulation where each quarter the central bank supplies back to the market in equal daily installments half of what its previous quarter purchases; pre-announced and aimed solely at slowing accumulation without defining a reserve target or optimal level.
  - Some central banks use government securities for sterilization, which can avoid segmenting the risk-free bond market; some central banks (e.g., Mexico in 2000) eventually issued their own securities when commercial banks held excessive long-term government paper as a result of sterilization.
  - Foreign currency swaps can be used to sterilize liquidity impacts of FX intervention, but they do not promote capital market development like participation in bond/money markets and should cost the same as OMOs using central bank paper if conducted at market rates.
- Case for an "active" open market approach:
  - Shifts to a predominantly open market or “Fed”/“hands on” style assign a smaller role to reserve requirement changes and SFs and involve frequent market operations.
  - In well developed money markets, standing facilities (SFs) can support OMOs to limit overnight interbank rate volatility and act as a safety valve for banks.
  - Increased market depth increases effectiveness of OMOs and can further deepen markets.
  - The open market approach sets the policy rate below the marginal (repo) lending facility and above the deposit facility (reverse repo) rate to more clearly signal policy stance, especially when there is a structural liquidity surplus.
  - India example: notwithstanding three consecutive 25 bps hikes in the repo (lending rate) and four increases in the cash reserve ratio totaling 200 bps, yields on government securities have only gone up by 30–40 bps over the past year.
  - Required instruments: a wide range of maturities (short-term—1–2 weeks—and longer-term—91-day to 1 year); frequent/flexible OMOs determine effectiveness of liquidity management.
  - Turkey example: moved to issue paper up to 91 days and introduced deposit facilities to better control short-term liquidity.
  - India: uses longer-term instruments (MSBs) plus reserve requirements to sterilize structural surplus and relies on overnight operations through the Liquidity Adjustment Facility for short-term volatility; completing a shift to an open market approach would involve short-term instruments (regular deposit auctions or government securities with 1–2 week maturities) for fine-tuning and regular issuance of long-term OMOs.

Other measures: capital controls and liberalization of outflows
- FX interventions can be costly and only effective short-term; some central banks apply non-standard instruments to manage inflows/moderate reserve accumulation.
  - India recently imposed restrictions on ECBs and issuance of offshore equity derivatives.
  - Malaysia in 1994 imposed temporary controls on short-term inflows.
  - Thailand in late 2006 imposed an unremunerated reserve requirement to fend off speculative inflows.
- Often controls were later relaxed and accompanied by liberalization measures:
  - Malaysia and Thailand liberalized outflows.
  - Several Asian countries (Korea, China, Taiwan) raised limits on national pension funds’ and insurers’ investments abroad.
  - Malaysia provided greater flexibility to licensed onshore banks to undertake foreign currency business and allowed residents to increase foreign currency borrowing and investment in foreign currency assets.
  - India has recently increased limits on individual, corporate, and institutional investments abroad.
- European experience (selected countries) 1994–2005:
  - Gross flows averaged about 9.6 percent of GDP.
  - Common responses: sterilized intervention and exchange rate changes (widened bands or switch to floating).
  - Capital controls on short-term inflows were used in Bulgaria, Hungary, Poland; Bulgaria and Czech Republic liberalized outflows.
- Conclusion from experience: as countries integrate further, effective regulation of capital flows becomes harder; most effective responses include deepening financial markets, strengthening supervision and regulation, and improving capacity to design and implement sound macroeconomic and financial sector policies.

### B. How Could Further Financial Globalization Affect Monetary Strategy?
Increased uncertainty
- Financial globalization increases uncertainty about the medium-term inflation outlook due to greater exposure of asset prices to foreign shocks/spillovers and their long-term implications for price stability.
- Strategies emphasizing monetary aggregates are challenged because cross-border financial flows (portfolio investments and M&A activity of non-financial corporations) affect net foreign assets and money and cannot simply be netted out when analyzing external sources of money growth.
- Such transactions must be analyzed for likely impacts on residents’ income and asset prices (to assess potential wealth effects), with repercussions for price stability that could occur over a number of years.
- Implication: monetary policy in a financially globalized economy may need increased emphasis on preserving price stability over a longer time horizon, extending beyond the medium term, and factor in developments in monetary liquidity on output volatility and price stability.

Changes in the monetary transmission mechanism
- Domestic asset prices increasingly determined by global factors; domestic interest rates could be increasingly influenced by global factors.
- Evidence shows increasing co-movement of countries’ MCI with that of the United States as financial globalization rises, implying policy makers must pay increased attention to conditions abroad as well as at home.
- Theoretical note: under a floating exchange rate and higher capital mobility, monetary policy becomes more effective (Mundell-Fleming), with the exchange rate channel offsetting weakening of the interest rate channel.
- Central banks can retain leverage over short-term and, to a lesser extent, long-term rates through:
  - Active liquidity management to drain surplus liquidity and keep interest rates close to the policy rate or within a policy corridor, preserving control over short-term nominal rates.
  - Clear communication to shape market expectations about short-term nominal rates, thereby influencing long-term rates (as expected future short-term rates plus a term premium).
  - Anchoring inflation expectations through consistent and predictable policies to influence long-term real rates.

Communication and transparency
- Increased uncertainty and changes in transmission heighten the importance of effective and consistent central bank communication.
- Stepped-up communication is especially important when financial globalization implies a greater share of foreign investors who may be less informed about domestic conditions or expect communication modalities used in large developed countries.
- Several emerging countries, sometimes prompted by a shift to an IT regime, have emphasized clear and frequent communication, contributing to a trend toward increased transparency.
- Example: Turkey’s central bank presents a quarterly analysis of risks to price stability and issues summary reports of the monetary policy committee’s views on the inflation outlook within 5 days of policy meetings.

*Source: _wp08131 - 24.      Success in maintaining monetary stability in the face of financial globalization*

### 44.      Financial globalization can also alter the response of markets to monetary policy

### 44.      Financial globalization can also alter the response of markets to monetary policy

### Effects of financial globalization on monetary policy transmission and credibility
- Financial globalization can alter market responses to monetary policy in unexpected ways, putting a premium on clear and frequent guidance by the central bank.
- An interest reduction aimed at slowing inflows may on the contrary accelerate them if investors take it as a sign that domestically-financed investment will pick up.
- Greater liberalization through the easing of restriction on outflows can encourage more capital inflows, as it reduces the cost of exit.
- Monetary policy’s ability to deal with the volatility of capital inflows depends on the central bank’s credibility in guiding private-sector expectations.
- Policy objectives must be mutually consistent. Inconsistent objectives:
  - lead to periodic shifts in policy priorities,
  - add to uncertainty and noise in financial markets,
  - undermine policy credibility,
  - make policy formulation more susceptible to lobbying by special interests.

### Transparency, instruments, and communication
- Greater transparency of monetary policy encompasses the need to explain the role of different monetary instruments, and the circumstances under which different instruments might be used.
- There could be a trade-off between:
  - a monetary framework with fewer instruments, which would promote simplicity and make it easier to predict what any policy moves would accomplish, and
  - one with a broader range of instruments, e.g., for fine-tuning.
- It is important that the central bank clearly communicate:
  - the framework,
  - the objectives,
  - the ways in which different instruments will be used to achieve the goals of monetary policy.
- Any changes in the framework should be pre-announced and their rationale explained as well (Poirson, 2008).

### Timing and predictability of policy decisions
- The timing of policy moves is important.
- More frequent reviews would help enhance the predictability of policy-making, by ensuring that policy is set mainly in the context of well-anticipated policy reviews, except in exceptional circumstances (Poirson, 2008).
- In countries which exhibit significant co-movement of their MCI with that of the United States, moving to a pre-announced schedule for policy decisions may also help focus market participants on domestic monetary conditions, rather than on developments abroad.

### Empirical relationship between transparency and financial openness
- There is a weak positive correlation (at least in our sample) between numerical transparency measures and financial openness.
- Based on the Nergiz-Eichengreen measure, transparency appears to have been a main ingredient of successful strategies adopted by some of the most financially integrated countries (United Kingdom, Euro Area).
- While these countries (United Kingdom, Euro Area) exhibit high levels of transparency, many of the emerging countries with inflation targeting regimes have achieved comparable levels of transparency (Figure 12).
- Using a different measure of transparency (based on observance of certain principles, as defined in the IMF’s Standards and Codes Gateway), the overall monetary policy transparency of the least financially open countries in our sample is broadly similar (even slightly higher) than that of the most financially open countries (on average).

### Box 1 — India: Key Capital Account Restrictions (As of end-September 2007)
- Foreign Institutional Investment (equity):
  - restricted to approved foreign institutional investors (FIIs), up to 30 percent of capital.
  - Investment in government and corporate debt is capped at US$2.6 billion and US$1.5 billion; FIIs are also restricted from buying unlisted corporate debt.
  - No restrictions upon associated outflows, viz. repatriation of profits.
  - Short-term gains (below a year) are taxed at 10 percent; longer-term gains are tax-exempt.
- Foreign Direct Investment (FDI) limits:
  - 74 percent in private banks, telecoms, satellites and atomic minerals,
  - 51 percent in single-brand retailing,
  - 49 percent in air transport services and investing companies in infrastructure /services,
  - 26 percent in defense, insurance, oil refining and publishing news and current affairs,
  - 20 percent in radio.
  - Prohibited in retail trading, atomic energy, lottery, gambling, real estate business, and agricultural businesses such as tea plantations.
  - Composite caps apply in the case of banks, telecoms and radio; investment in insurance can only be through joint ventures.
  - Official approval is required when the foreign investor has an existing venture in the same field.
- External Commercial Borrowings (ECBs):
  - minimum average maturity of 3 years (up to US$20 million) and 5 years (US$20–500 million);
  - additional loans of up to US$250 million can be raised if they have an average maturity of 10 years.
  - Funding cost must be below Libor plus 200 basis points (3–5 years’ maturity) and Libor plus 350 basis points for maturities greater than 5 years.
  - Conversion of ECBs into equity is allowed if certain conditions are met.
  - Capital raised abroad through global or American depository receipts is prohibited for domestic financing of investment in real estate and the stock market at home.
  - Prepayment of ECBs is subject to a $500 million annual limit.
- Short-term external borrowing:
  - subject to a US$20 million ceiling applied to import-linked short-term loans, per transaction and for permissible imports.
  - Trade-related foreign loans with 1–3 year maturity and up to US$20 million are allowed for capital goods imports.
  - Funding costs cannot exceed Libor plus 50 basis points for credits up to 1 year, and Libor plus 125 basis points for credits with 1–3 year maturity.
- Domestic banks’ investments abroad:
  - subject to open position limits and must have a residual maturity of less than a year and at least an AA(-1) rating.
  - They can invest non-residents non-repatriable foreign currency deposits abroad in long-term fixed income instruments (minimum AA- rating) with maturity below that underlying these deposits.
  - Opening of offshore banking units is subject to Foreign Exchange Management Act regulations.
- Indian companies’ investments abroad:
  - capped at 400 percent of their net worth.
- Portfolio investments abroad:
  - limited to $5 billion for all mutual funds.
  - Individual funds can invest up to 10 percent of net assets, up to $200 million each.
  - Residents and corporates are limited to $200,000 a year and 50 percent of their net worth, respectively.

### Box 2 — Turkey: adapting monetary framework to financial globalization
- Between 2002 and 2006:
  - the capital account balance rose from roughly zero to $45 billion (11 percent of GDP);
  - over the same time period, the lira substantially appreciated in real effective terms.
- In 2006, the Central Bank of Turkey (CBT) moved from the monetary targeting regime to inflation targeting.
- Legal and operational features:
  - The CBT Law states that “the primary objective of the Bank shall be to achieve and maintain price stability” (Article 4).
  - The target is medium-term in nature, with end-year targets for the CPI set jointly with the government for the coming three years.
  - It is currently centered on a 4 percent point target with a plus and minus 2 percent tolerance band; supply-side shocks and changes in international liquidity conditions are explicitly mentioned, along with other factors, as a rationale for building in some flexibility around the target.
  - When inflation falls outside of the tolerance band, the CBT issues an open letter to the government explaining the reasons for the breach and the measures to be taken to bring inflation back to its point target.
- Communication and reporting:
  - The CBT produces a quarterly Inflation Report with forecasts for the output gap and inflation, as well as uncertainty bands for the latter, and an analysis of risks to price stability.
  - It issues press releases following the preannounced monthly meetings of the Monetary Policy Committee (MPC).
  - Summary reports discussing the Committee’s views on the inflation outlook are also issued within eight working days of the MPC’s meetings.
- Monetary operations and liquidity management:
  - To ensure that the money market interest rates remain close to its benchmark borrowing rate, the CBT absorbs liquidity through its overnight deposit (at the posted benchmark rate) and repos on the Istanbul Stock Exchange (ISE).
  - When mopping up “excess liquidity” at times of lira weakness, the CBT has temporarily resorted to one- and two-week deposit auctions validating interest rate well above the posted benchmark (overnight) rate.
  - In cases of liquidity shortages, the CBT stands ready to supply liquidity through one-week repo auctions to be conducted in the ISE at 1 percentage point above the benchmark rate target.
  - To improve ability to deal with long-lasting bulges in excess liquidity, the CBT has also recently issued central bank notes with maturities of up to 91 days.
- Exchange-rate policy:
  - After abandonment of the crawling peg and adoption of a pure floating regime, the CBT announced in July 2001 that it would only intervene to limit excessive volatility in the exchange market.
  - Since April 2002, the CBT has conducted transparent and pre-announced purchase auctions to build foreign exchange reserves for prudential reasons (reserves do not yet fully cover short-term debt on a remaining maturity basis).
  - Foreign exchange purchases are typically sterilized, to avoid compromising the monetary stance.
  - High domestic interest rates have been maintained to bring inflation down to the 4 percent target, and this in turn has put upward pressure on the exchange rate.

### Box 3 — Malaysia: monetary management in a globalizing economy
- The central bank of Malaysia has two main monetary policy objectives—sustainable growth and low inflation.
- Despite exiting from the peg against the U.S. dollar in July 2005, the central bank also intervenes in the foreign exchange market and has stated that exchange rate stability remains an important goal.
- The central bank pursues financial stability in addition to the above objectives.
- Since April 2004, the Bank Negara Malaysia (BNM) has been signaling its policy stance through the Overnight Policy Rate (OPR).
- Market based liquidity operations are aimed at ensuring the appropriate level of liquidity that would influence the overnight interbank interest rate to move closer to OPR.
- Malaysia has used capital controls on inflows (1994) and outflows (1997 crisis), providing room for monetary maneuvering in spite of a fixed exchange rate regime.
- Historical shifts:
  - Prior to the mid-1990s, the monetary policy strategy was based on targeting monetary aggregates.
  - Private net capital inflows of long-term capital rose from 5.7 percent of GDP in 1990 to 8.2 percent of GDP in 1993.
  - Net short-term inflows increased from 1.2 percent of GDP to 8.9 percent during the same period.
  - To neutralize effects of intervention in the foreign exchange market, the central bank sterilized domestic liquidity by selling government securities and later issuing its own paper; sterilization operations increased domestic interest rates and continued to attract capital flows.
  - Authorities increased reserve requirements of banks to mop up liquidity; fiscal stance was tight, but the real exchange rate appreciated significantly owing to higher inflation.
  - Faced with a trade-off between keeping interest rates high to contain inflationary pressures and the need to discourage short-term inflows, the authorities imposed temporary controls on short-term inflows; most controls were removed in 1994.
- The large capital inflows in 1992–93 and their reversal in 1994 exposed the limitations of monetary targeting and resulted in a shift to interest rate targeting in the mid-1990s.
- During the Asian crisis, amid capital outflows and excessive exchange rate volatility, the trade-off was between raising interest rates to attract capital inflows and containing the downturn; controls imposed combined temporary controls on outflows with exchange controls.

*Source: _wp08131 - 44.      Financial globalization can also alter the response of markets to monetary policy*

### Box 3. Malaysia, Concluded

### Box 3. Malaysia, Concluded

### Monetary policy and exchange rate management
- After the crisis, management of monetary policy focused primarily on maintaining the exchange rate peg.
- Liquidity management aimed at keeping interest rate at levels conducive to economic growth, exploiting the room for maneuver created by the capital controls.2
- From September 1998 to July 2005, the ringgit was pegged to the U.S. dollar.
- In July 2005, Malaysia shifted to a managed float against an undisclosed trade-weighted basket of currencies.
- Following the change in exchange rate regime, the ringgit was under significant downward pressure as some speculative positions were unwound; the central bank resorted to intervention to prevent ringgit depreciation.
- Since end-2005, intervention has been mainly one-sided.

### Episodes and timeline of capital flows and intervention
- Between 1998 and 2003, BNM was able to effect monetary policy based on domestic policy objectives, mainly because most of the inflows were on account of trade flows, rather than capital flows.
- In the first half of 2005, capital inflows surged with the expectation of a currency revaluation, resulting in a large accumulation of reserves.
- In 2006, Malaysia experienced renewed net inflows and exchange rate pressure, which the central bank countered through sterilized intervention.
- During the equity sell off in July 2006, the central bank again intervened to prevent ringgit depreciation.

### Limitations of instruments and role of controls
- The experience demonstrates the limitations of sterilization over long periods: in the face of continuous inflows, a country can only temporarily resist appreciation pressures.
- Sterilization requires a large “war chest” of securities; high interest rates needed for sterilization can themselves induce larger capital inflows.
- Controls on capital inflows can be effective, although only for short periods of time; in Malaysia, controls were unwound over time starting in 1999, particularly after 2003.

### Key findings and implications
- The commitment to exchange rate stability has posed challenges to the maintenance of low inflation in episodes of capital inflows.3
- Strong fundamentals (growth and inflation) and many prudential and administrative controls helped in balancing capital flows and financial stability in the post-crisis period.
- Malaysia’s experience managing volatile capital flows during the 1990s offers lessons about the trade-offs among exchange rate commitment, sterilization capacity, interest rate levels, reserve accumulation, and the temporary effectiveness of capital controls.

*Source: Box 3. Malaysia, Concluded (excerpt).*

### REFERENCES

### _wp08131 - REFERENCES

### References
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- Cheong, Latifah, 2005. “Globalization and the Operation of Monetary Policy in Malaysia”, Globalization and Monetary Policy in Emerging Markets, BIS Papers No. 23.  
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- Sidaoui, J. J., 2005, “Policies for International Reserve Accumulation under a Floating Exchange Rate Regime: the Experience of Mexico,” in BIS Papers No. 23, pp. 216–229 (Basel: Bank for International Settlements).  
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- Williams, M.V., 2005, “Foreign Exchange Reserves: How Much is Enough,” Speech (Nassau: Central Bank of the Bahamas).  

*Source: _wp08131 - REFERENCES*

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