A silver lining of the devastating global economic crisis has been greater acceptance of more open-minded policies in several sectors, especially in the financial sector. A doctrinaire approach, reflecting the ?Washington Consensus? that guided the IMF?s actions in emerging economies over the last six decades, was based on a mistaken presumption that markets will always deliver and that any intervention to restrain free functioning of capital markets will result in efficiency losses. This economic orthodoxy was challenged by many economists, including Jagdish Bhagwati, who had famously noted after the Asian crisis in 1997 that trade in widgets is not the same as trade in dollars. But the IMF steadfastly refused to be persuaded, even in the face of mounting evidence that short-term capital flows could trigger a crisis as it did in South America in the 1980s and in East Asia in the
mid-1990s. Well until now. In March this year, the IMF held a conference on rethinking macroeconomics where it reached the conclusion that the current economic crisis challenged the economic orthodoxy behind the Fund?s previous policies.
The new thinking acknowledges that unfettered capital flows may contribute to collateral damage, including exchange rate appreciation (overshooting), asset booms and busts. According to the Fund, under certain circumstances, capital controls can be a legitimate policy
response to counter volatile and destabilising capital flows. The other elements in the nation?s toolkit include currency appreciation, reserves accumulation, adjustments in fiscal and monetary policy, and strengthening the prudential framework. That these other policy responses may not always be desirable and/or appropriate is demonstrated by the success of Chile and Brazil, among others, in managing capital surges by imposition of controls. Although the IMF has recognised the role of capital controls as a vital policy tool, it also outlines when nations should use capital controls, and what types of capital controls should be used under what circumstances?eventually it?s the balance of the benefits and the distortions caused. It also warns of the systemic dangers that could result from widespread adoption. But, rather than criticise, we should applaud the Fund for recognising,
although belatedly, the potentially destabilising influence of freer
capital movements in emerging economies. While India undeniably delayed moving from the draconian FERA to FEMA, it perhaps stands vindicated for the gradualist approach it has followed, at least on capital account convertibility.
