VoxEU Column Macroeconomic policy

Did the Indian capital controls work as a tool of macroeconomic policy?

Can we agree that capital controls are an effective tool for macroeconomic policy? If so, should they be permanent or temporary? This column argues that under a permanent system of capital controls, a country will always bear costs whether there is a surge or capital flight or not. Looking at the Indian experience, it’s clear that capital controls do not necessarily help a government meet its macroeconomic goals in times of need.

The empirical literature on the effectiveness of capital controls for macroeconomic management has generally found that transitory capital controls have a relatively limited impact on the magnitude of flows (Magud et. al. 2011). Controls appear to influence the composition of capital flows, but they seem to do so only for a short time. Often, economic agents can find ways to circumvent controls, particularly those on specific types of flows.

The efficacy of capital controls?

The current debate on the effectiveness of capital controls emphasises their potential role as tools for macroeconomic policy. While some remain sceptical about capital controls (Warnock 2011, Mallaby 2010), others have suggested that the effectiveness of capital controls may depend on whether a country has comprehensive and permanent capital controls, or temporary controls (Klein 2012, Ostry et al. 2011, Wagstyl 2012). This disagreement represents somewhat of a reopening of the policy debate about capital controls in recent years, largely created by a shift in the IMF’s position.

All or nothing

There is the possibility that in countries with full-blown legal and administrative machinery for capital controls, the goals of macroeconomic policy could be usefully pursued by dynamically varying capital controls. This emerging literature implies a bipolar hypothesis; countries should choose between a fully open capital account on one hand, versus comprehensive and permanent controls on the other. Relatively few countries have comprehensive and permanent controls, other than China and India. This has motivated researchers to carry out careful country studies focusing on China and India, analysing their experiences on the extent to which capital controls were useful in achieving the goals of macroeconomic policy. 

India and China’s experiences

In a recent paper (Patnaik and Shah 2012), we analyse the costs and benefits of capital controls by studying the experience of India, where a comprehensive system of capital controls has never been dismantled. We find significant costs to the financial system imposed by comprehensive and permanent controls. To be effective – even in the limited sense in which they are – such as the capping of foreign debt flows, long standing controls require a regulatory framework that gives discretionary and broad powers to regulators. This yields costs in three parts:

  • Price differences between foreign and domestic capital markets arise
  • Higher domestic cost of capital and inferior risk sharing
  • Implications for growth and welfare

Economic agents change their behaviour in response to controls, giving distortions in resource allocation. We thus identify important problems in the realm of governance and the rule of law.

Can these costs be justified?

These costs might be justified on the grounds that when a capital surge arises in either direction, the system of comprehensive and permanent controls will assist the goals of macro policy. The welfare analysis of comprehensive and permanent controls thus requires a comparison of the costs to society (which are pa id at all times) versus the gains to society (in episodes of a capital surge or flight). Hence, we examine the effectiveness of the Indian capital controls framework in the period of a surge. We find that when used as tools of macroeconomic policy, during a capital surge, the Indian experience is similar to that of other countries where the system of control had been dismantled.

A systematic approach to costs and benefits

We analyse the Indian country experience by using a classification scheme that distinguishes between different costs:

  • Reduced financial integration
  • Micro-economic distortions in the decisions of economic agents
  • Problems of governance and the rule of law

And different benefits:

  • Reduced capital inflow surges
  • Monetary policy autonomy
  • Avoiding real exchange rate appreciation
  • Avoiding boom-and-bust of asset prices; avoiding a credit boom
  • Avoiding balance sheet exposures

Arriving at a judgment about the usefulness of a system of capital controls involves assessing the extent to which these kinds of costs were present, and assessing the extent to which these goals of macroeconomic policy were achieved.


After the turn of the millenium, when emerging markets worldwide got a surge in capital flows, India also experienced a surge. This peaked at $100 billion, or 8% of GDP. The capital controls did not avert a big surge in inflows. This surge induced stress for the prevailing exchange rate regime and monetary policy framework. In the biggest ever business cycle expansion in Indian history, the policy rate (expressed in real terms) dropped from 3% to -4%. The erstwhile exchange rate regime, which had a low volatility against the US dollar, gave way to much higher flexibility. The capital controls were not able to provide monetary policy autonomy.

Further, from 2000 to 2007, the index of the real effective exchange rate went from 85 to 110, showing a significant real appreciation. The capital controls did not avert a real appreciation.

In the boom, bank credit was growing at over 30% per year. A measure of the boom-to-bust ratio of stock prices shows that India was one of the worst emerging markets in terms of the boom-and-bust of stock prices. The capital controls did not avoid the problems of a credit boom or a boom-and-bust in asset prices.

The system of capital controls did deliver on reduced foreign borrowing. There was a quantitative restriction on the dollar value of outstanding foreign borrowing. The stock of foreign borrowing was thus prevented from growing, while GDP grew, so the foreign borrowing-to-GDP ratio fell sharply. At the same time, firms appear to have circumvented the controls, and obtained currency exposure through other methods. Balance sheet effects were not avoided.

These are, broadly speaking, the areas where capital controls are expected to achieve the goals of macroeconomic policy. The Indian experience was not different from that of countries that had opened up their economies and then imposed transitory controls.


Several papers in recent years have demonstrated that the Indian capital controls are effective in reducing financial integration. As such, the law of one price is violated, covered interest parity is violated, and American Depositary Receipts are priced differently from the shares on the local market. India paid a higher cost of capital as a consequence of the introduction of a wedge between foreign and domestic markets. This cost was constant, even when there was no surge of capital.

The capital controls introduced unintended microeconomic distortions. As an example, the authorities introduced a rule in August 2007 where foreign borrowing was permitted only for the purpose of importing capital goods. This appears to have led to a substitution away from domestic capital goods in favour of imported capital goods.

In any country, the operation of a permanent and comprehensive system of capital controls would pose a challenge for public administration. These problems are exacerbated in countries with weak governance. It is difficult for a bureaucracy to obtain sound information, process it correctly, resist political pressures, and come up with sound decisions. We document many examples where poor policy decisions were taken in the operations of the Indian capital controls. We also document many situations where there was a breakdown of the rule of law. These difficulties of governance need to be viewed as one element of the costs associated with capital controls.


Under a permanent system of capital controls, costs are borne by the country at all times, whether there is a surge or capital flight or not. These costs may be justified if the capital controls are able to deliver on the goals of macroeconomic policy. The Indian experience does not suggest that these goals were met.


Klein, Michael W (2012), “Capital controls: Gates and walls”, Brookings working paper, September.

Mallaby, Sebastian (2011), “The IMF needs to find its voice again”, Financial Times, April.

Patnaik, Ila and Ajay Shah (2012), “Did the Indian capital controls work as a tool of macroeconomic policy?”, IMF Economic Review, September.

Ostry, Jonathan D, Atish R Ghosh, Marcos Chamon, and Mahvash S. Qureshi (2011), “Capital Controls: When and Why?”, IMF Economic Review, August.

Magud, Nicolas, Carmen Reinhart and Kenneth Rogoff (2011), “Capital Controls: Myth and Reality - A Portfolio Balance Approach”, NBER Working Paper, 16805, February.

Wagsty, Stefan (2012), “Currency wars: Brazil-style capital controls have ‘zero’ effect”, FT blog, September.

Warnock, Francis E (2011), “Doubts about capital controls”, report, Council on Foreign Relations, April.

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