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Effectiveness of Capital Controls in India: Evidence from the Offshore NDF Market

  • Michael Hutchison
  • Gurnain Kaur Pasricha
  • Nirvikar Singh

This paper examines the effectiveness of international capital controls in India over time by analyzing daily return differentials in the non-deliverable forward (NDF) markets using the self-exciting threshold autoregressive (SETAR) methodology. We begin with a detailed narrative on the evolution of capital controls in India and calculate deviations from covered interest parity utilizing data from the 3-month offshore non-deliverable rupee forward market. We estimate a no-arbitrage band using SETAR where boundaries are determined by transactions costs and by the effectiveness of capital controls. We identify several distinct periods reflecting changes in capital control application and intensity for India, and estimate the model over each sub-sample in order to capture the de facto effect of changes in capital controls on return differentials over time. We find that Indian capital controls are asymmetric over inflows and outflows, have changed over time from primarily restricting outflows to effectively restricting inflows; and that arbitrage activity closes deviations from CIP when the threshold boundaries are exceeded in all sub-samples. Moreover, our results indicate a significant reduction in the barriers to arbitrage since 2008. As a robustness test of the methodology, we also apply it to the Chinese RMB NDF market and find that capital controls are strictly limiting capital inflows with the exception of two periods of regional and international financial turbulence. The intensity of Chinese controls varies over time, indicating discretion in the application of capital control policy but, unlike India, show no sign of gradual relaxation or liberalization.

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File URL: http://www.bankofcanada.ca/wp-content/uploads/2011/12/wp2011-29.pdf
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Paper provided by Bank of Canada in its series Working Papers with number 11-29.

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Length: 52 pages
Date of creation: 2011
Date of revision:
Handle: RePEc:bca:bocawp:11-29
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  1. Eswar Prasad & Shang-Jin Wei, 2007. "The Chinese Approach to Capital Inflows: Patterns and Possible Explanations," NBER Chapters, in: Capital Controls and Capital Flows in Emerging Economies: Policies, Practices and Consequences, pages 421-480 National Bureau of Economic Research, Inc.
  2. Hansen, B.E., 1991. "Inference when a Nuisance Parameter is Not Identified Under the Null Hypothesis," RCER Working Papers 296, University of Rochester - Center for Economic Research (RCER).
  3. Frenkel, Jacob A & Levich, Richard M, 1975. "Covered Interest Arbitrage: Unexploited Profits?," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 325-38, April.
  4. Reuven Glick & Michael Hutchison, 2008. "Navigating the trilemma: capital flows and monetary policy in China," Working Paper Series 2008-32, Federal Reserve Bank of San Francisco.
  5. Bruce E. Hansen, 2000. "Sample Splitting and Threshold Estimation," Econometrica, Econometric Society, vol. 68(3), pages 575-604, May.
  6. Guonan Ma & Corrinne Ho & Robert N McCauley, 2004. "The markets for non-deliverable forwards in Asian currencies," BIS Quarterly Review, Bank for International Settlements, June.
  7. Taylor, Alan M, 2001. "Potential Pitfalls for the Purchasing-Power-Parity Puzzle? Sampling and Specification Biases in Mean-Reversion Tests of the Law of One Price," Econometrica, Econometric Society, vol. 69(2), pages 473-98, March.
  8. Yin-wong Cheung & Dickson Tam & Matthew S. Yiu, 2006. "Does the Chinese Interest Rate Follow the US Interest Rate?," Working Papers 192006, Hong Kong Institute for Monetary Research.
  9. Ajay Shah & Ila Patnaik, 2007. "India's Experience with Capital Flows: The Elusive Quest for a Sustainable Current Account Deficit," NBER Chapters, in: Capital Controls and Capital Flows in Emerging Economies: Policies, Practices and Consequences, pages 609-644 National Bureau of Economic Research, Inc.
  10. Pasricha, Gurnain, 2008. "Financial Integration in Emerging Market Economies," Santa Cruz Department of Economics, Working Paper Series qt7z35t1cn, Department of Economics, UC Santa Cruz.
  11. Hansen, Bruce E., 1999. "Threshold effects in non-dynamic panels: Estimation, testing, and inference," Journal of Econometrics, Elsevier, vol. 93(2), pages 345-368, December.
  12. Taylor, Mark P, 1989. "Covered Interest Arbitrage and Market Turbulence," Economic Journal, Royal Economic Society, vol. 99(396), pages 376-91, June.
  13. Jushan Bai & Pierre Perron, 2003. "Computation and analysis of multiple structural change models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 18(1), pages 1-22.
  14. Guonan Ma & RobertN McCauley, 2008. "Efficacy Of China'S Capital Controls: Evidence From Price And Flow Data," Pacific Economic Review, Wiley Blackwell, vol. 13(1), pages 104-123, 02.
  15. Martin Schindler, 2009. "Measuring Financial Integration: A New Data Set," IMF Staff Papers, Palgrave Macmillan, vol. 56(1), pages 222-238, April.
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