After last week's disappointing summit of the Group of 20 leading economies, a full-blown currency war may look unavoidable. But consider India. At a time when more and more nations are resorting to capital controls and currency intervention, India shows there is another way.
Since a change of heart nearly two years ago, India has stopped intervening in markets to manage its exchange rate. It has not followed countries from Brazil to Thailand by slapping on new capital controls. Unlike China and other east Asian mercantilists, it does not run an export surplus; nor does it insist on showering excess savings on rich countries that have no good use for them. Instead, India manages its economy as the textbooks say a developing country ought to. It runs a trade deficit, thereby contributing to the rich world's recovery; and it imports capital to help lift its people out of poverty, registering growth of 8 per cent or so a year.
To many observers, including a lot of Indian ones, the country has succeeded because it has always kept capital controls, even if it has imposed no new ones recently – for example, its bond market remains largely closed to foreigners. Yet although India retains de jure restrictions on capital inflows, de facto global integration has progressed dramatically, as Ajay Shah of India's National Institute of Public Finance and Policy has argued. Gross cross-border flows of money have jumped from around 50 per cent of India's gross domestic product to more than 120 per cent over the past decade. Some 500 Indian multinationals have access to global capital markets and can funnel cash into and out of their home country. When you have globalisation of trade and investment, it is not in the power of government to suppress globalisation of capital.
If India has become surprisingly open, will it remain so in the face of today's strains? China's exchange-rate manipulation encourages its trade rivals to hold down their currencies; the manipulators drive capital into the economies of non-manipulators, pushing up their exchange rates and threatening them with asset bubbles. The more some governments intervene, in other words, the harder it is for non-interveners to stick to their principles. And yet, at least so far, India appears committed to its open model. The Reserve Bank of India acted the part of the anti-currency warrior recently, raising interest rates even at the risk of a stronger rupee.
What explains India's resolve? The country is certainly not immune to the danger of an asset bubble. The government's recent initial public offering of the state coal company was subscribed 15 times over; investors put in bids for $54bn worth of paper, enough to build 25 airports like the splendid new structure that just opened in Delhi. But at least some of India's financial leaders recognise that, to tame surging demand for equities, you just need an equivalent surge in the supply of equities. Lined up behind the coal company, scores of other state companies are ripe to be privatised. Through IPOs, India can mop up outside capital, converting potentially reversible “hot” portfolio flows into something more akin to stable foreign direct investment.
Of course, new equity issuance will not prevent the rupee from rising. But here again, most Indian leaders see the case for sticking to the country's open model. They do not want to impose new capital controls, because they know that these leak and are a nightmare to administer. They are reluctant to intervene against the rise of the currency, because they see that the best way to staunch inflows of hot money may be to allow it to appreciate – at a certain point, investors will fear that the rupee may reverse direction and hit them with losses.
Today's eager interventionists should take note. Far more than they realise, they are setting up one-way bets for traders. Hedge funds know that South Korea's won is being artificially held down by the government and is therefore more likely to rise than to depreciate, so they are hosing Seoul with capital and compounding the problem of hot inflows that Korea is desperate to alleviate. If India's leaders stick to their open policies, and if the neo-interventionists meet their comeuppance, the current dirigisme may prove mercifully short-lived.
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