It can and arguably it should if Indian economic and financial history is any indication. The balance of payments (BoP) crisis in the early 1990s, for instance, was the trigger for the landmark reforms in economic policies - encompassing industrial, trade, tax and financial sector policies or in other words, the entire gamut of macro economic policies - in India under different political dispensations since then.

The second such occasion when an economic crisis could have potentially triggered financial sector reforms was following the sanctions imposed on India in the late 1990s as a sequel to the nuclear tests. But as it turned out, a favorable twist in geopolitical developments and 'success' with the overseas bond issues (the Resurgent India Bonds and the India Millenium Deposits) mitigated the severity of the sanctions and with that the urgency for fundamental financial sector reforms.

Be it as it may, the on-going global financial crisis seems to afford emerging market economies (EMEs) such as India yet another unique opportunity to take a fundamental re-look at their economic policies - specifically their financial sector policies.

Indeed, the key difference between the catalysing environments of the early/ late 1990s and currently is that fundamental review and reforms at the current juncture may possibly have to be limited to the financial sector only.

Is it time to re-visit financial globalisation?

And a very fundamental issue which national policy makers have to address now is the level and intensity of the Indian financial sector's relationship (and in a broader sense, the economy's) with the global financial system. In other words, how integrated should India's financial sector be with the global financial system? Should we have more BoP capital account liberalisation? Should we encourage more domestic investment avenues for foreign capital? Overall, should we have a higher level of financial globalisation? Or, is there a case for capping the level of financial integration with global markets and restricting the flow of foreign capital into the Indian markets?

As can be noted, the questions above are focused only on the level and nature of integration with the global financial system. Trade openness is not being called into question here.

One of the enduring truths about international finance which has been highlighted by recent developments in the Indian financial markets is that about the 'impossible trinity' or the 'iron triangle' law of international finance. This law says that with free capital flows, a country will be able to control either the exchange rate of its domestic currency or local interest rates, but not both simultaneously. In this sense, it is said that a country faces a trilemma - it has to choose between free capital flows, exchange rates or interest rates.

Policy makers, particularly in EMEs, have never accepted this postulate that easily. They have always striven to de facto peg their exchange rates while aspiring for domestic interest rates independence also, all in the face of open capital accounts. When capital inflows are very strong, this combination may initially seem like enabling countries to achieve both stable exchange rates and soft(ening) interest rates. But, in course of time, it leads to over-heated economies, asset bubbles and high inflation - as we have very clearly seen in India in the past eight years.

When capital is withdrawing - again what we have been witnessing in India in the past several months - the policy- maker is compelled to juggle between exchange rates and interest rates, with success eluding him on both the fronts.

'Impossible trinity' of international finance

We have seen a real time demonstration of this principle in the Indian markets in recent months. The large scale withdrawal of foreign capital from the stock markets, combined with the drying up of international dollar liquidity (for Indian companies raising both medium-term and short-term dollar trade loans abroad, such as the Indian oil companies and other companies raising import finance) has applied tremendous (downward) pressure on the Indian rupee.

The rupee has lost around 20 per cent of its value in the last 6 months with around 75 per cent of this value loss occurring in just the last 3 months. (It is interesting to note here that despite this level of fluctuation in the rupee's exchange rate in the past few months, official statements still maintain that Indian financial markets have been stable!).

There has been official intervention to support the rupee in this environ-ment - the decline in the country's FX reserves shows that clearly - but it still can be inferred from official statistics that this support has not been forceful enough (in terms of timing, frequency and quantum of intervention) to convincingly reverse the downslide in the rupee. A key reason for that muted support for the rupee is the realisation that full-scale rupee support in the FX markets would result in local interest rates rising very sharply in the current environment. That is, in a crisis, policymakers have been forced to give priority to local interest rates and have therefore allowed the rupee's exchange rate to fluctuate considerably.

Resolving the 'trilemma'

One of the ways to resolve the trilemma or the impossible trinity obviously is to prioritise between exchange rates and interest rates even in normal times. India, for instance, can decide to focus on better managing rupee interest rates for the benefit of its local economy, rather than let domestic rates be a hostage of foreign capital flows. The rupee's exchange rate will then be purely market-determined. Local interest rates could be far more stable in such an environment with fluctuations and changes coming through more gradually.

The considerable volatility we have witnessed in India during the course of 2008 amply proves this point. From reducing rates in the first quarter of this year to raising rates sharply in the middle of the year, commercial banks now, in the last quarter, are now being driven towards lowering interest rates again.

Lack of clarity in policy objectives

Free markets do produce volatility but all such variations are the result of economic agents making differing interpretations about the effects of a particular policy stance of the monetary and fiscal authorities. The policy stance or more broadly the policy objective itself does not change so frequently and widely. In other words, there is consistency in the policy objective - for example, policy being geared towards producing low and stable inflation or other such objective. The peculiarity in the Indian situation is that market participants are not clear about the policy objectives also. This adds to the volatility.

If control over domestic interest rates policy is not the main objective, India can give priority to maintaining greater stability in the exchange rate of its currency. In that case, one has to accept greater variability in rupee interest rates.

A far deeper and structural way to resolve the trilemma is to have a fundamental re-look at the issue of open capital accounts and free capital flows itself. As mentioned earlier, the trilemma arises only if free capital flows are a given and a country still wants to control both exchange rates and interest rates simultaneously.

The question then is: should free capital flows be a given?

It need not if the statistics relating to foreign capital flows of the past many years and their relation to and the impact they have had on local economic activity is any indication. Studying the impact of free capital accounts and flows on economic growth is particularly important since proponents of free capital markets and capital flows frequently and passionately advocate that open capital accounts can have large, beneficial spin offs on economic growth.

The case for substantially opening up capital accounts and capital flows is also not supported by the fact that the Indian economy, over the past many years, has been largely generating the savings it needs for its investments. In other words, the level of investment in the Indian economy is largely determined by the level of domestic savings itself, with only a small financing gap to be met by external capital.

Small difference between savings and investments

Foreign capital flows have had a weak to moderate relationship with economic activity in the past 15 years. A basic statistical estimate shows that capital flows and GDP have co-moved only around 25 per cent of the time in the above period. Moreover, domestic savings in India are currently running around 35 per cent of GDP with investments at 37 per cent. These were lower in the earlier years but it is important to note that the differential between savings and investment (the gap which may have to be funded by external capital) has not exceeded 2 per cent right through the last 15 years.

One can say that the level of financial integration India has had in the past decade - a fairly open capital account with foreign investments being permitted in the equity capital markets as well as directly in industry, progressively higher degree of freedom in accessing external commercial borrowings - has been quite high.

But has such a large degree of openness in the capital account enabled India to generate much higher levels of investment activity than has been achieved? No, if the statistics given above on the small differential between savings and investments is any indication. With the available level of capital account openness, one would have expected that investments in the Indian economy would have diverged quite well from domestic savings, with the gap being comfortably financed by external capital.

Foreign capital and economic growth

The Indian experience, by and large, seems to validate the results of international research in this area. Globally, researchers have found little robust evidence of a direct and causal relationship between capital flows and GDP growth in EMEs. Those studies conclude that the main benefits of financial integration and open capital flows for developing countries are indirect (and catalytic) - in the form of better corporate governance(?), productivity and efficiency gains and better government.

Where is the need for large foreign capital in this environment? The surplus in the BoP capital account in 2007-08, for instance, was as much as 9 per cent of GDP against the funding requirement (the gap referred to above) of only around 1.5 per cent.

Where did all the excess foreign capital go? They got transformed as India's FX reserves with their rupee counterpart pushing inflation into the double digits and fuelling the boom in asset prices of the last few years.

The key question then now as 2008 - a horrible year in financial markets across the world - winds to a close is: will EMEs such as India make use of the opportunity provided by the financial crisis to do a fundamental re-appraisal of their policies with respect to foreign capital and the 'impossible trinity' of international finance?

It does not seem like such a fundamental re-visit of the policy is on the cards if some of the policy moves in recent months, even during the tendency of the crisis, are any indication. Indian policy makers, for instance, have liberalised external commercial borrowings and have also permitted commercial banks to offer higher rates of interest on foreign currency deposits - broadly these work out to higher rates of around 1 per cent / 2.5 per cent on deposits / commercial borrowings.

An impossible balance

Now, one wonders if foreign investors (and lenders) would be enthused by these rates at the current juncture when the Indian currency has lost almost 20 per cent of its value against the dollar in the short span of a few months. The value loss in the Indian currency is much higher than the increased rates India now offers for foreign currency deposits / external commercial borrowings. This policy move, therefore, once again points to policymakers' preference for having the best of all worlds - open capital account, low interest rates and stable currency. This trinity seems impossible.