The International Monetary Fund (IMF) has advised Pakistan to "consider developing a strategic plan for an orderly dismantling of the remaining capital controls," according to an IMF Financial Sector Assessment report.

The recommendation has come at a time when the rupee is under pressure on two counts: first, the perceived vulnerability of the external sector to the widening trade deficit on soaring international oil prices and increasing import requirements of a growing domestic economy. Second, the volatility of the inter-bank forex market caused by pre-payments, in instalments staggered over months of some $350 million debt by PARCO.

Even a $20-30 million demand on a single day creates fluctuations, says a treasury official in a leading commercial bank and adds: "The market has no depth". This situation prevails when controls have been lifted on current account transactions only, the State Bank has more than $12 billion reserves to beat back speculative attack on the rupee and the inflow of massive remittances exceeds trade deficits.

That the exchange market lacks depth has also been admitted in the Fund's assessment report issued at the fag end of July this year. "Pakistan's capital markets have grown, but remain relatively narrow and shallow compared to the larger regional markets," says the report.

The IMF officials say that reforms have made the financial system better placed to absorb shocks, but admit that consolidation of these gains is likely to take more time. An easing of capital controls across national borders results in a high degree of financial integration with the global economy through high volumes of capital inflows and outflows.

Developing countries are often tempted to liberalize capital account transactions to attract foreign direct investment, not necessarily with positive outcomes. There is a whole range of factors that impact on capital inflows and money spending.

Bankers tend to agree that premature easing of capital controls could bring about a reversal in the current ongoing process of developing a robust external sector. It opens the door for flight of capital which Pakistan witnessed before 9/11 because of geo-politics and security risks.

No doubt, the central bank allows repatriation of capital and profits on foreign investment but technical curbs remain to regulate the capital outflows including in terms of numbers.

The central bank however keeps capital controls under review to remove irritants. Capital controls are applicable to foreign multilateral and bilateral debts and foreign direct/portfolio investments. Many developing countries use controls to steer capital inflows towards more stable forms of investment such as FDI.

A cautious approach is always recommended for easing of capital controls. Addressing the Institute of Bankers in early August, Prof Dr Norbert Walter, chief economist, Deutsche Bank group advised against that capital account liberalization before the financial markets become mature as it could lead to a mismatch of resources and could cause serious damage to the economy.

Eminent economists admit that many countries have suffered from a fiscal crises in which liberalization of capital account transactions play a critical part. Walter cautioned that the issue needs to be handled with care.

Financial analysts say that even mature markets have to be effectively regulated. Controls on capital transactions help developing economies shield themselves from risks associated with volatility in the global markets.

Global FDI flows are many times over the volume of the multilateral and bilateral official assistance but restricted to selected countries, depending on the size of the market and the level of its prosperity. In Pakistan, bilateral and multilateral assistance far exceeds the FDI. The growth of emerging market is still state-driven.

Those in favour of capital account liberalization see it a long-term goal. Presently, they say, there are constraints on demand and supply in the exchange market and there is lack of monitoring and awareness in the concerned quarters.

What is needed is a think tank to study related issues in depth and develop the needed expertise. Premature liberalization poses serious risks when financial regulation, monitoring and supervision are inadequate.

If Pakistan is looking for big inflow of FDI through liberalization of capital controls, it needs first to remove other irritants, without which easing of curbs would not work.

It is the security concerns, the law and order situation, the cost of doing business, the bureaucratic hassles, lack of sanctity of commercial contracts, that impede the flow of foreign direct investment. Foreign professionals do not want to risk their lives for a career. The country's sovereign risk comes first.

According to press reports, the minister of state for finance Omar Ayub and MoF advisor Dr Salman Shah, are now involved in carrying out an in-depth review and are expected to come out with a fresh strategy to boost investment.

The lifting of capital controls covers a variety of financial flows (FDI, portfolio investment and bank borrowing included) and acquisition of assets in one country by residents of another.

In an economy with a fragile banking system, economists reckon, investments abroad allowed freely could result in an outflow of savings and impact the banking system's viability. Pakistani banks need a much stronger balance-sheet as also sufficient global reach.

Short-term investments can be quickly reversed when a country is hit with an adverse macroeconomic shock. But international lenders lend to nation-states in good times but pull back in bad times, worsening the fiscal and economic crises.

The global economy is awash with excess money in trillion of dollars that cannot find avenues for productive investment. It could be productively employed in developing states with vast potential for economic growth. But global financial markets and system prosper through speculative business.

This threatens the financial stability in developing states when capital controls are eased. I t would take sometime for finance capital to adjust to a fast changing global realities.