Cross-Border Capital Flows Cause Financial Fragility, Says Raghuram Rajan

Cross-border capital flows have been a source of financial fragility, former RBI governor and top economist Raghuram Rajan has said as he underscored that countries should see how best they can benefit from cross-border flows, without incurring the costs.

In his 'Mundell-Fleming Lecture' at the International Monetary Fund headquarters Rajan argued that even if countries at either end of the flows follow reasonable policies, the nature of the expansion in liquidity in the up-cycle may, by increasing leverage and reducing pledgeability, set the stage for a costly downturn.

"In a world where nationalism is on the rise, such spillovers create an environment that is prone to misunderstanding and potential conflict," Rajan said in his lecture held during the 19th Jacques Polak Annual Research Conference on 'International Spillovers and Cooperation' of the IMF.

Sending countries may see reserve build-up in receiving countries as unfair exchange rate manipulation, while receiving countries may feel indignant that they have to assume full responsibility for managing the collateral effects of industrial country monetary policies.

Rajan, who now is the Katherine Dusak Miller Distinguished Service Professor of Finance, at University of Chicago's Booth School of Business, was previously the chief economist of the IMF from 2003 to 2007 and India's chief economic adviser in 2012-2013 before becoming RBI governor.

In his paper, Rajan said that when monetary policy in source countries tighten, receiving-country exchange rates depreciate, and liquidity dries up in their corporate sector even if the country's prospects are sound.

Since pledgeability has been neglected, debt capacity plummets, leading to a sudden stop in funding and subsequent financial distress, the paper noted. And to avoid such booms and busts, authorities in receiving countries often try to smooth exchange rate volatility by leaning against abrupt appreciations and depreciations.