Capital Controls


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What are capital controls?

Foreign capital inflows in the form of loans and equity that are allowed in a restricted form are said to be controlled. Many countries which had closed economies had imposed severe restrictions on foreign capital.

However, as these economies started opening up in the 1980’s, capital controls were eased, facilitating free flow of capital and ensuring integration with global financial markets.

What are capital inflows?

From the perspective of balance of payments — a country’s external sector balance sheet — foreign currency inflows are broadly divided into current account and capital account flows. While current account flows arise out of transactions in goods and services and are permanent in nature, capital account flows are essential in various kinds of loans and equity investments, which can be reversed. That is why policy makers have to keep a close eye on capital flows.

What are the kinds of capital inflows in India?

These would include inflows through foreign borrowings by Indian corporates and businesses, NRI deposits and portfolio flows from institutional investors into the stock markets Loans to government and short-term trade credit are also included.

What has been the extent of dismantling of capital controls in India?

India had controls on both capital account transactions as well as on the current account with the local currency fixed by the central bank. However, since 1991, when structural changes to the Indian economy were carried out, the rupee was first made convertible on the current account. Subsequently, capital controls were eased. In 1994, a big shift took place with the government allowing foreign portfolio investments. Over a period of time, foreign direct investment norms and overseas borrowing norms were eased.

Why are policy makers thinking of reimposing controls?

Though allowing foreign capital allows firms in a capital scarce economy to access cheaper resources to finance their growth plans, the flip side is that it presents risks to value of the country’s currency as well as managing local liquidity arising out of such inflows (as the central bank buys the foreign currency and pumps in local currency).

Dependence on foreign capital could leave a country vulnerable to risks, arising out of a abrupt reversal of flows. With many emerging economies remaining relatively unscathed after the global financial crisis, there has been a surge in such inflows, leading to an appreciation in their currencies, including in India. But inflows beyond the absorptive capacity of an economy pose other challenges such as high demand side inflation.

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Bibliography : The Economic Times

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