An Intolerable Surge? International Capital Flows and the Indian Policy Response, Address by Anne O. Krueger, First Deputy Managing Director, IMF

January 21, 2004

An Intolerable Surge?
International Capital Flows and the Indian Policy Response
Address to National Institute for Bank Management
By Anne O. Krueger, First Deputy Managing Director
International Monetary Fund
Pune, India, January 21, 2004


I am delighted to be here in Pune, and at this distinguished institution. The National Institute for Bank Management has a reputation for excellence: being able to accept the invitation to speak here was a particular pleasure. It is a great honor for me that my old friend and former colleague, Dr Reddy, is chairing this meeting, and I appreciate it.

It is many years since I visited Pune and I am struck by the changes that have taken place since that trip. I think you could say that the transformation of this city mirrors that of much of India.

My visit here coincides with a significant improvement in the global economic outlook. The prospects for many countries—including India—are distinctly brighter than they were just a few months ago, when the IMF published its last economic outlook. We will not be releasing a new forecast until April. But it is already clear that the global economy will expand more rapidly than we had been expecting. And, just as important, the downside risks to growth have diminished in recent months.

As you know, the performance of the Indian economy has improved significantly over the past decade or so. The economic reforms that started in the early 1990s have already brought results. There is always more to do, of course: economic reforms are launched, but many challenges remain. A more buoyant global economy offers an excellent environment for taking the reform process further. It is always easier to introduce change in the absence of crisis and during periods of prosperity—even though periods of expansion can tempt all governments to postpone difficult decisions.

It is against this background that I want today to look at an issue that affects not just India, but many emerging market economies: capital flows. I want to examine ways in which they can be harnessed for maximum benefit. And I want to say something about Indian policy regarding capital account liberalization.


First, though, I must add a rider to my assessment about the improving global outlook. I noted that the downside risks have been reduced: but they have not been eliminated. Inevitably these days, optimistic forecasts have to be qualified by continuing concerns about international security—always hard to quantify. But a more tangible risk to the medium and long term health of the world economy is the threat to the global trading system that the failure to make headway in the Doha round of trade negotiations has brought to the fore.

The rapid growth of most of the world's economies over the past 60 years has owed much to the multilateral economic framework put in place at the end of the second world war. And the expansion of world trade has been central to economic progress and poverty reduction around the globe. Even during India's years of high protection, the country benefitted from the rapid expansion of international trade.

A worldwide slide back to protectionism at this juncture would represent a setback nobody wants to contemplate. It would harm the prospects for future economic growth in all countries and could even undermine what has already been achieved. It is hard to see how anyone could gain from that in the long run. And a serious setback on the trade front would surely have a significant negative impact on international capital markets—and substantially reduce the potential benefits to emerging market economies from capital account deregulation.

The Cancun meeting of trade ministers last September was a serious disappointment. Instead of giving new momentum to the Doha round, Cancun saw countries digging in, refusing to compromise. The failure to make any headway since then has been worrying.

In the past couple of weeks there have, at last, been some signs that the deadlock might be broken, with modestly encouraging statements from both America and Europe. But there is a long way to go before anyone can be confident that the Doha process is back on track.

It is, frankly, disturbing that the intellectual case for free trade has yet to convince many in the developing world. It is perhaps not surprising that attitudes towards the industrial countries are suspicious, skeptical. There can be no doubt that the industrial world has to do more to marry its words with its actions.

But it is vital to separate the understandable gut response to industrial country protectionism from the need for developing countries to act in their own best interests. The evidence is clear: trade liberalization benefits, above all, those doing the liberalizing. It is the developing countries that stand to benefit most from a Doha settlement, something like two thirds of the total gains would accrue to them. The multilateral liberalization that a Doha round agreement would represent is undoubtedly the best solution. And even unilateral liberalization brings significant benefits for the country concerned.

India is rightly seen as a leader in the developing world: and it is therefore appropriate that it wields considerable, and growing, influence in international discussions on trade and other issues. It is important to remember that India has more to gain than most from freer trade: in part because it was earlier slow to recognize and reap the benefits from increased trade and greater economic interaction with the rest of the world; and in part because its levels of protection are still high, so the potential gains still remaining from further liberalization are commensurately greater.

India needs to use its influence wisely, in a way that benefits the Indian economy: because that, in turn, will add to global economic welfare.


Before you think I've strayed from my topic, let me put what I've said so far in the context of today's theme. I noted earlier that expanding trade had been a central driving force of the rapid expansion of the global economy. I should note too that promoting world trade and supporting economic growth are the principal objectives of the IMF. Our mandate to foster international economic stability is the means to that end.

Trade has become increasingly important to economic progress at the national level as the global economy has become more integrated. Globalization and trade growth are inseparable.

I know that globalization gets bad press in some quarters. Many of those attending this week's World Social Forum in Mumbai believe that globalization has so far failed to reduce poverty and inequality. I think this is unfair, and downright wrong—and I think the figures bear me out. Globalization has brought huge benefits—for rich countries, of course, but for poorer ones too. The improvement in living standards seen in most countries in the past few decades underlines an essential truth: that sustained and rapid economic growth, fuelled by trade expansion, has consistently proved to be the best way to achieve lasting poverty reduction.

And India has undoubtedly been one of the important beneficiaries of this improvement. In recent years, the number of people around the world who live in poverty has fallen quite steeply. Much of the fall can be directly attributed to improvements in living standards in India and China.

India has seen significant gains from policy reforms aimed at integrating the economy more closely with the rest of the world. One obvious example is in software development, where this country is a world leader. Other examples—such as the growth of remote call centers—show how technological advances have helped create jobs in countries like India. But new unskilled jobs are also desperately needed and there is still enormous untapped potential in this country. More foreign direct investment could help exploit that potential. The elimination of textile quotas in 2005 under the auspices of the World Trade Organization is something that could bring considerable benefits to India if the appropriate investment opportunities are created and then financed.

I do not mean to underestimate the scale of the challenge India still faces in tackling problems like poverty. My point is that trade liberalization and closer integration with the world economy will help enormously in meeting those challenges, especially as India's economic reforms progress further, and permit the further acceleration of economic growth.

Capital flows

Free, or freer, movement of goods is only one aspect of the globalization story, of course. The free movement of capital—and large-scale movement at that—is another feature of the modern global economy. Indeed, it is not possible to have trade liberalization without relatively free capital flows—at least not over an extended period. Opening trade without opening capital markets runs a high risk either of under- or over-invoicing as export and import activity is used as a cover for capital exports; or of constraining the growth of trade as cumbersome controls enforce capital account restrictions.

There is no doubt that sustained and rapid growth is the best way to deliver lasting poverty reduction. Economic growth is best achieved through the expansion of trade. And the fewer capital controls there are, the better the opportunities for trade growth.

Private capital flows are beneficial for the world economy. They underpin the expansion of trade. They channel capital to where it can be most productive and where it can best enhance economic growth. Despite what some argue, capital flows do not destroy jobs, they create them. They spur productivity growth—and not at the cost of rising unemployment.

Does that sound too good to be true? Look at the recent experience of the United States. It has been the world's largest importer of capital, on any measure. It has also created an enviably large number of new jobs, both skilled and unskilled. Capital has flowed to the US on such a large scale because of the high returns to be had. Yes, much of that capital financed the high-tech boom. But the increase in living standards that Americans enjoyed also brought a surge in demand for unskilled service jobs—demand so great that the U.S. economy is now also a large importer of labor.

America might, just now, be exceptional among industrial countries. But capital flows have fuelled rapid growth in many other countries around the world. Ireland's impressive growth record in recent years owes much to the deliberate efforts to attract foreign investment capital.

And many emerging market economies have benefited from capital inflows, especially during periods of rapid growth: look at Singapore, Taiwan, Korea, China. In every case their experience has been positive—they want more investment capital, not less. Capital inflows from other countries provided the resources needed for expansion.

A sustainable economic framework

Now, I am not here to argue that all capital controls should be removed at once, without regard to other policy reforms. Capital account liberalization has to be undertaken in a way that helps countries enjoy the benefits of freer capital movements, not so that it risks undermining economic progress already made. Countries need to have in place the right economic framework in order to exploit capital flows in a way that generates growth.

Above all, capital account liberalization must be part of a sustainable macroeconomic strategy. Economic stability is clearly important, and cannot be delivered without sound monetary and fiscal policies. But we do all we can to support the efforts of our member countries both to ensure that their public sectors operate in an efficient manner, and to reduce and eliminate structural budgetary imbalances. It is clear from experience that large unsustainable fiscal deficits and open capital markets make uncomfortable bedfellows.

Large fiscal deficits pose increasing risks for the financial sector as capital flows are freed up. And here I want to emphasize that deficits financed in large part by domestic creditors can be especially dangerous. In such cases, the onset of a crisis can have catastrophic consequences for the domestic banking system.

One result of persistent fiscal deficits is a large debt build-up. This increases a country's vulnerability to crisis—and makes any crisis more painful. It is disturbing that the debt to GDP ratios of many emerging market economies continue to rise. Fiscal policies should aim at reducing these debt burdens—especially when, as now, economic activity is buoyant.

The role of the exchange rate is also important. The Asian crisis of 1997-98 highlighted the fact that fixed exchange rates can make the situation far more difficult to handle in the event of troubles on the capital account. Fixed exchange rates, capital mobility and an independent monetary policy are not a feasible policy regime over time. Moreover, fixed exchange rates mean that in the event of a crisis, and a consequent devaluation, currency mismatches can seriously weaken a hitherto sound banking system.

And, as the capital account is liberalized, the importance of a sound, competitive financial system within an appropriate regulatory framework increases. A well-functioning financial system is in itself important for growth, but it is also essential for the most productive use of capital inflows.

Economic reform and the development of sustainable macroeconomic policies are essential conditions for rapid and sustained economic growth. They are also a necessary accompaniment to capital account liberalization which, as I pointed out, will itself help accelerate growth. In other words, the aim should be to create a virtuous circle.

Lessons from the recent past

This recipe is a direct result of what we have learned from the international financial crises of the past decade. And I should here make it clear that by `we' I mean the Fund, national policymakers and academic economists. I recognize that these events like Mexico's tequila crisis that erupted just 10 years ago last month, have made many governments uneasy. Some regard international capital flows with suspicion and, as a result, have tried to curb what they see as the dangerously unfettered power of capital markets. Others have seen the turmoil as a reason—or a justification—for retaining existing controls.

Such fears are misplaced. It is true that the speed with which private international capital can flow sometimes catches the most experienced market-watcher off guard. Even powerful industrial economies have, on occasion, been subject to the harsh judgment of the markets: political leaders have seen their policy objectives thrown off course, even their political credibility undermined.

But to conclude that the way to prevent such turmoil is to curb international capital flows is to miss the point. The adoption of sound economic policies makes much more sense—and provides much greater opportunities for growth.

The crises in Mexico, Thailand, Indonesia, Korea, Russia, Turkey and Argentina were different from the sort of crises that the Fund had been used to handling over the years. They were capital account crises, and in every case, the country involved had one form or another of a fixed exchange rate regime.

Capital account crises occur when the holders of a country's debt lose confidence in its ability to service that debt. Countries with sound economic policies are vulnerable if the markets judge that those policies will not be sustained or adhered to. And one striking feature of such crises is the urgency with which help must often be provided.

At the Fund, we cannot prevent every crisis and nor do we seek to do so. Eliminating every single risk would be disproportionately costly. But we have refined the way we seek to prevent crises. And we have introduced changes in the way we assesses macroeconomic policies; in particular, the way we judge whether such policies are likely to be sustainable.

What we have learned, and the changes we have implemented, have a direct bearing on the way we believe capital account liberalization should be handled.

The development and maintenance of a sound financial sector is vital both for crisis prevention and for capital market liberalization—as well as for accelerated growth. And here I want to pay tribute to the work of this Institute which I know is doing much to provide not just India but many other emerging market countries with the skills that are essential to a well-run banking system.

Nowadays we pay close attention to the health of the financial sector, not least because of the contingent liabilities involved. The level of non-performing loans in the banking sector; the extent to which risk is clearly defined and hedged in the financial system as a whole; the degree of competition in the sector; the breadth of financial instruments; the transparency of the system; and whether the appropriate regulatory regime is in place are all ways that can help us make a judgment about the robustness of the financial sector.

As part of the attempt to refine this process, the Financial Sector Assessment program (FSAP) was introduced in 1999. Many of you may be familiar with this. The FSAP is a joint program with the World Bank—at least insofar as low-income countries are concerned. The program aims to help member governments strengthen their financial systems by making it easier to detect vulnerabilities at an early stage; to identify key areas which need further work; to set policy priorities; and to provide technical assistance when this is needed to strengthen supervisory and reporting frameworks. The end result is intended to ensure that the right processes are in place for countries to make their own substantive assessments.

The work carried out under the program involves a broad range of financial experts, many of them from outside the Fund. Some come with substantial experience in regulating the financial sector of individual member countries; others are involved with international regulatory bodies. Still others have specific qualifications needed for the tasks involved. The aim is to bring powerful expertise to bear in a detailed examination of the financial system of individual members.

The FSAP also forms the basis for Financial Stability Assessments (FSAs) in which IMF staff address issues directly related to the Fund's surveillance work. These include risks to macroeconomic stability that might come from the financial sector and the capacity of the sector to absorb shocks.

We have also worked with the World Bank to develop a system of Standards and Codes—using internationally-recognized standards—that result in the rather literally-named Reports on Standards and Codes (ROSCs). These cover twelve areas, including banking supervision, securities regulation and insurance supervision. The financial sector ROSCs are an integral part of the Financial Sector Assessment program and are published by agreement with the member country. They are used to sharpen discussions between the Fund—and, where appropriate, the World Bank—and national authorities; and, in the private sector, including rating agencies, for risk assessment purposes.

India and capital controls

By explaining what we have learned about the causes of capital account crises, and by outlining the steps we have already taken to benefit from previous experience, I have sought today to show how countries can best enjoy the benefits of capital account liberalization while minimizing the risks.

I know that the Indian government is in favor of greater capital account liberalization. Let me say at this point that the Fund generally endorses the policy of gradual movement towards removing capital controls in conjunction with the strengthening of the financial sector. The Tarapore report, which the Reserve Bank of India sponsored in 1997, set out several important conditions which it said ought to be satisfied before full capital account liberalization could be contemplated. These conditions for a stronger financial sector, the adoption of inflation targeting and bringing the fiscal deficit under control—are closely in accord with the Fund's own approach, as I've just outlined it. Some progress has been made on the first of these requirements, but I think it is clear that India still has some way to go before the other Tarapore conditions are fulfilled.

But this does not, and should not, detract from the need to press ahead with economic reform and, in particular, with the adoption of sound and sustainable fiscal policies. As I emphasized earlier, reducing fiscal deficits and reversing the build-up of public debt are desirable objectives in and of themselves. Such steps are essential if sustained rapid economic growth is to be achieved. They also pave the way for capital account liberalization that could do so much to foster growth, job creation and poverty reduction in India.

So it is important to remember that a gradual approach implies continuing progress towards the desired goal. The appropriate response, then, to the requirements of the Tarapore Report is to seek to meet the conditions it laid out as quickly as is reasonably possible. Misplaced fear of the consequences of full capital mobility should not be an excuse for postponing action to meet the Tarapore conditions. Meeting those conditions is in any case the best approach if India is to continue to enjoy rapid growth and poverty reduction.

We must not lose sight of the ultimate goal. Capital mobility is a highly desirable aim, and indeed it is, as I argued, essential for a country to reap the full benefits of a more integrated global economy. The fact that international capital flows when accompanied by misguided macroeconomic policies can wreak considerable havoc is not a reason to reject liberalization. Rather it reinforces the need for a proper macroeconomic framework: that must include a strong, well-regulated financial sector as well as sound, sustainable fiscal policies.


This economy has made enormous strides in recent years. India has always been an influential leader of the developing world. It has begun to embrace the world beyond its borders to an even greater extent—and it has begun to discover the economic benefits of doing so. It has enjoyed higher levels of growth, and has accelerated progress in reducing poverty.

At home, the long slow process of economic liberalization is under way, accompanied by a greater determination to establish the sound macroeconomic policies that will bring sustained economic growth.

This is progress worth having and we welcome it.

But let us not stop there. More trade and capital account liberalization will bring enormous returns, for India, for its neighbors, and for the world as a whole. Global economic expansion provides the best possible environment for a process of reform. I hope India, along with all emerging market economies, will grasp the opportunities now in prospect.

Thank you.


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