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.