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RBI can only envy China's forex situation

T. B. Kapali

IS there any Chinese magic which endows that country with an enviable combination of financial market conditions? For instance, its bulging foreign exchange reserves, a highly stable exchange rate and most importantly, all that comfort on the exchange ra te front despite extremely soft interest rates.

Indeed, it would appear that the Chinese have so mesmerised the international capital markets that foreign capital continues to pour in despite the country having some of the most stringent controls on capital account transactions in place.

Such is the economic potential and, in turn, profit possibilities in the Chinese domestic financial markets that foreign capital is quite willing to condone what it would otherwise condemn in the strongest terms -- extensive capital controls -- in an y other market.

The Chinese success with attracting capital flows despite the nation's currency -- the yuan -- not being convertible on the capital account has been emulated quite well by Malaysia.

The question then arises: Can other emerging market countries also resort to a full-fledged system of capital controls and, thereby, insulate their domestic economies/interest rate markets from the pressures of the international markets?

Or, are China and Malaysia notable exceptions?

Statistics on the net private capital flow to the emerging market countries (see accompanying table) seem to suggest that there could even be cases where relief may not be possible on the interest rate front despite open capital accounts and a relatively good level of flows. One can then easily imagine the fate of countries which rule out convertibility on the capital account.

Indeed, it is quite possible that China is an exception and could keep attracting capital flows -- with all its concomitant benefits for domestic yuan interest rates -- despite a closed capital account. (A closed account meaning capital convertibi lity being possible only on the stiffest of terms.)

The numbers relating to Latin America in the table, for instance, do show that this zone has attracted a relatively higher level of capital through the worst crises of the past three or four years in the international financial markets.

But benchmark short-term interest rates in Brazil -- a key member in the Latin zone -- are still quite high at around 15 or 16 per cent. The inference: despite open capital accounts and good capital flows, there is still considerable concern about the c urrency and Brazil cannot go the whole hog on domestic interest rates.

The total flows to the Asian bloc have turned negative in the past two years on the back of heavy repayments of bank loans/securities. Direct investments, of course, have been quite okay -- China dominating here. But the story in Asia, partic ularly China, is interesting. Commercial borrowing rates in China are around 6/7 per cent on the back of solid capital flows, rising forex reserves and the resultant increase in domestic liquidity.

Monetary and exchange rate managers in many Asian countries would, then, definitely be envious of the Chinese. Can India, for instance, try capital controls? Will it help procure lasting relief on the interest rate front? Or will restrictions on capital flows limit the creation and expansion of domestic liquidity and peg market interest rates higher?

Having permitted complete convertibility for non-residents, it is quite unlikely that India will backtrack the whole way and go back to capital controls. More than that, talk of capital controls could adversely affect sentiment towards India.

At the same time, monetary and exchange rate management in India (the RBI) would not leave the exchange rate to find its own levels and, instead, enjoy the benefits of domestic monetary policy independence. There will then be periodical phases -- such as the current one -- where the pressures on the exchange rate manifest themselves on the interest rate front. The Reserve Bank of India would continue to juggle around with both its exchange and interest rate responsibilities.