The Asian crisis was the world economy's closest shave since the Latin American debt crisis of the early 1980s and, arguably, since the Great Depression of the 1930s. A combination of currency and financial crises which erupted in east Asia during mid- and late 1997 rapidly developed into a global disturbance, engulfing not only most Asian newly industrialising economies but also Russia, South Africa and some Latin American countries. These systemic disruptions were major, but were not the only examples of financial volatility in recent years. The Asian crisis has been followed by further difficulties in Turkey and Latin America, and at time of writing it remains to be seen what the full effects of 11 September 2001 will be. Indeed, more than seventy financial and monetary crises of different proportions and characteristics have occurred in both developed and developing countries over the past two decades. Large and growing amounts of public money have been committed to tackling the financial crises and their socioeconomic consequences.

A common background to these developments is the intensifying process of global financial liberalisation and integration. Starting with the introduction of floating exchange rates and financial market deregulation from the 1970s onwards, the global monetary and financial system has undergone a radical transformation. Whereas national governments were once effective at shaping socioeconomic policies and development strategies in line with the imperatives of domestic political stability and legitimacy, there is now an increasingly market-oriented and integrated global system.

One of the striking features of the Asian crisis is that some countries, including India, were largely unaffected by it and the contagion that followed. This chapter argues that capital account controls are critical in explaining India's stability, a conclusion that should reinforce the second thoughts that have begun to emerge as regards the desirability of capital account convertibility (CAC) as an integral element of the redesign of the international financial architecture. Section one of this chapter describes India's capital account controls and their place in the country's payments regime. Section two examines various episodes of balance-of-payments strain in the 1990s and the role played by capital controls in managing them. Section three analyses why India escaped the Asian crisis and contagion and highlights the importance of capital controls in this context. Section four discusses the political economy of India's resistance to the adoption of CAC. Section five considers the desirability of adopting CAC in India in the near future. Section six offers some concluding remarks.

India's payments regime: managed floating and capital controls

India's capital controls operate within the framework of a payments regime, inaugurated in March 1993, that is officially described as a ‘market determined unified exchange rate’. The de facto position is different. ‘Market determined’ should not be understood to mean a clean float. There is active, sometimes heavy, intervention by the Reserve Bank of India (RBI) in the foreign exchange market.

The failure to manage the Asian crisis, to understand the mistakes and to institute reforms with any meaning for crisis-vulnerable countries, restates the importance of local, national and regional responses to financial globalisation.

The crisis which began when Thailand floated its currency on 2 July 1997 became a regional crisis and then a global crisis. The focus of subsequent analysis has, quite rightly, been on the international implications of the event. Thailand became a side-show in a much larger global drama. Yet the course of the crisis in the affected countries contains important lessons. Developing countries whose GDPs represent a minute fraction of the world economy are especially vulnerable to financial volatility. The discussion of reform in the international financial system petered out in 1999 once the crisis was contained in eastern Europe and Latin America. Proposals that the international financial institutions should have a duty to control volatility had already been struck off the agenda before this time. While the dangers of capital account liberalisation without appropriate monetary and regulatory policies are now well understood and thus unlikely to be repeated, the underlying vulnerability to volatility remains.

The lessons from the Thai case are obscured because early interpretations of the Thai crisis were highly ideological, and because the IMF has been intent on claiming credit for successful crisis management. In 1999, Michel Camdessus, the then Managing Director of the IMF, announced that Thailand has ‘graduated from the IMF University summa cum laude … graduation means victory … the job is done’.

Why don't emerging-market economies make more use of capital controls? Not long ago, in the wake of Asia's great financial crisis, limitations on capital mobility appeared about to make a comeback. At the intellectual level, scholars began to accord new respectability to the old case for controls as an instrument of monetary governance. At a more practical level, one country – Malaysia – imposed comprehensive restraints and, with seeming success, survived to tell the tale. As I wrote soon after the crisis broke: ‘The tide … is starting to turn. Once scorned as a relic of the past, limits on capital mobility could soon become the wave of the future.’ Yet in reality governments in the newly industrialising economies still hesitate to raise or restore impediments to the free flow of capital. Controls remain the neglected option. The question is: why?

Elsewhere, I have suggested that the explanation has much to do with the prominent role of the United States, the still dominant power in international finance. Washington, both directly and through the IMF, has brought its considerable power to bear to resist any significant revival of controls. Reflection suggests, however, that international politics is at best only part of the story; domestic politics too must be involved, in a mutually reinforcing interaction with the pressure of outside forces. The purpose of this chapter is to highlight the critical domestic side of the story.