Capital Flow Management with Multiple Instruments
We examine theoretically the role of reserves management and macro-prudential capital controls as ex-post and ex-ante safeguards, respectively, against sudden stops, and argue that these measures are complements rather than substitutes. Absent capital controls, reserves to be deployed ex post are partially undone ex ante by short-term capital flows, a form of moral hazard from the insurance provided by reserves in sudden stops. Ex ante capital controls offset this distortion and thereby increase the benefit of holding reserves. Thus, these instruments are complements. With foreign investment flows into both domestic and external borrowing markets, capital controls need to account for the possibility of regulatory arbitrage between the markets. Through the lens of the model, we analyze movements in foreign reserves, external debt, and the range of capital controls being employed by one large emerging market, viz. India.
We are grateful to Saswat Mahapatra, Jack Shim and Jonathan Wallen for excellent research assistance. Authors are grateful for feedback from Governor Urjit Patel and participants at the Reserve Bank of India Financial Market Operations, Regulation and International Departments’ 2017 Retreat in Bekal (Kerala, India) and NYU-Stern / IIM-Calcutta 2017 Conference on India. We also thank Markus Brunnermeier, Guillaume Plantin, Ricardo Reis, and participants at the XXI Annual Conference of the Central Bank of Chile for their comments. The views expressed are entirely those of the authors and do not in any way reflect the views of the Reserve Bank of India. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.