Shyamala Gopinath: Approach to capital account management - shifting
contours
Keynote address by Ms Shyamala Gopinath, Deputy Governor of the Reserve Bank of India,
at the Annual Conference of the Foreign Exchange Dealers' Association of India (FEDAI),
Thimpu, 18 February 2011.
* * *
Thank you for inviting me to this forum once again and that too in these sublime environs.
Only in such sublimity could the deeply spiritual concept of "Gross National Happiness" have
been crystallised into a national policy mission. The theory of Gross National Happiness
(GNH) established by His Majesty the King of Bhutan in 1972, defines Bhutan's development
objective as improvement in the happiness and satisfaction of the people rather than growth
of Gross National Product (GNP). Included in GNH is a "middle path" approach in which
spiritual and material pursuits are balanced. I can only hope that after a deep, long standing
relationship with Bhutan over the last several years, we are able to incorporate at least the
spirit of this approach in our economic policies.
I have been a inaugural speaker at the FEDAI conferences during past few years, in person
or in absentia and it is always a challenge to select an appropriate topic in line with the
overall theme of the conference. I felt really relieved that the theme for this Conference
attempts to capture a broader canvas, revolving around long-run growth cycles. I hope the
deliberations enable us to focus more closely on the relationship between the cart and the
horse so that foreign exchange flows do support growth.
There are several ways in which capital flows and growth are related. First, growth
expectations drive capital flows. In turn, capital flows accelerate growth. If capital flows are
well absorbed by the real economy and do not generate macro-economic or financial
instabilities, they stay. Such capital flows augment growth over the long-run and may help
income levels in developing economies converge towards the income levels in advanced
economies. Second, capital is likely to be attracted towards countries with high productivity
growth and higher marginal productivity of capital. However, in practice this is found to be not
necessarily true. Third, what is generally missed is the fact that it is not just the net capital
flows that drive growth, but also the gross capital flows contribute to growth. Gross capital
flows contribute immensely to diffusion of technology and international knowledge flows.
Fourth growth augmentation can also take place because capital flows enforce
macroeconomic discipline and force firms to improve governance. However, the impact of capital
flows on growth ultimately depends on their being stable and less volatile. Durable capital
flows bring durable growth, while non-durable and volatile capital flows not only bring about
non-durable growth but also large output losses in cases of currency or banking crisis. This
however does not make a case for capital controls as in a globalised world capital account
liberalisation is seen as a plus-sum game.
According to IMF's World Economic Outlook (October 2010), private financial flows to EMEs
are projected to increase to USD 339.6 billion in 2010 as compared to US 234.8 billion in
2009 accounted for mainly by equity flows. Growth in bank lending, after the rebound since
the crisis lows, is expected to slow down. Going further, however, the improved growth
scenario in developed markets (DM) and the rising concerns regarding inflation in the EMs
has created uncertainty in regard to the quantum of flows to EMEs. Global imbalances, which
have been the driver of capital flows over the past several years, are expected to continue.
Given the inherent uncertainties, most of the capital recipient EMEs are going to find it
challenging to respond dynamically. If the tide of global flows changes, it may not be easy to
change policy gears swiftly though magnitude of impact would depend on the specific
macroeconomic situation, particularly the current account position. Over a longer horizon,
therefore, it makes sense to have a broad framework for capital account management from a
macroprudential perspective.
It is this post-crisis shift in regard to the approach to capital account that I intend to talk about
today. Beyond the immediate impact of capital flows on exchange rate dynamics, the
procyclicality of such flows and implications for financial stability are being clearly recognised.
In this context, the underlining theme that I want to bring out is that irrespective of the stage
of liberalisation of capital account, there seems to be an imperative need for a framework for
capital account management which gives the policymakers sufficient space and instruments
to be able to modulate policy to the different characteristics of capital flows. Not having such
a framework only enhances the disruptive impact of sudden capital control measures when
they are announced.
Shift in the approach to capital account management
The recent crisis has clearly been a turning point in the world view on capital controls. The
issue of regulation of capital flows has slowly but steadily moved to the centrestage from
earlier being confined to the periphery of the mainstream policy discourse. The hesitancy of
policymakers at the helm in discussing this openly earlier has given way to a welcome
openness.
Even the Bretton Woods institutions have revisited their earlier approach on the issue of
management of capital flows. There was a time in the nineties that, backed by the intellectual
force of the "Washington Consensus", the IMF at one point was considering including
liberalization of international capital movements as a central purpose of the Fund. The
subsequent crisis in East Asia in 1997, however, halted such moves of the IMF.
It seems to have come full circle now. The experience of many EMEs during the crisis
underlined the financial stability implications of volatile capital flows. At the G-20 Seoul
Summit in Nov 2010, the Leaders agreed "to work on financial stability issues that are of
particular interest to emerging market and developing economies and called on the FSB, IMF
and World Bank to develop and report before the next Summit. These issues include the
management of foreign exchange risks by financial institutions corporations and
households..........."
A recent policy note prepared by the IMF Staff1 puts the issue of cross-border capital flows in
perspective. It recognises the destabilising impact of capital floods and droughts particularly
on emerging economies, noting that volatile capital flows played a key role in the recent
crisis, both in increasing vulnerabilities and in transmitting shocks across borders. Recently a
group of more than 250 economists have written an open letter to the US Government,
explaining the benign influences of capital controls and stressing the need for the US to
dilute the capital control covenants in the U.S. trade and investment treaties. Increasingly
many EMEs are beginning to impose capital controls and regulations, both of the traditional
kind such as reserve requirements, URR and restrictions on investment in debt including
minimum investment period but also more innovative ones such as prudential measures,
administrative measures, tax measures and quantitative limits, particularly targeting the
derivative positions held by banks. Indeed, many of these derivatives were initially invented
to avoid precisely regulations on capital inflows or other types of financial activity.
The key elements of this shift have been the following:

Ex-ante management of capital flows is now accepted as a legitimate instrument of
macroeconomic policy and financial stability. Though exchange rate appreciation is
ex-post
still considered the preferred policy option in dealing with inflows,
intervention is now justified if there is major veering away of the currency from its
fundamental value.
 The limitations of individual country-specific measures are being articulated. The
IMF policy note seeks to address the issue through development of rules of the
game for global capital flows and in fostering multilateral, non-discriminatory,
approaches that look to the interest of both the originators and recipients of capital.
Is such a framework possible? I am not sure but till then countries impacted by this
would need to continue to find their answers.

It is increasingly being recognised that it is gross flows that determine risk
exposures and are therefore important for financial stability. Netting of
crosstemporal flows does not capture the real impact of gross capital flows on exchange
rate as well as asset price impacts.
 Capital control measures are being designed more innovatively for effectiveness.
Derivative transactions are increasingly being specifically targeted and many
countries are resorting to enhanced supervision and data reporting to monitor the
build up of currency positions in the books of banks.

The issue of capital flows is getting factored in the macroprudential framework being
envisaged for financial institutions globally. Procyclicality of capital flows and of
wholesale market funding can engender vulnerabilities. Prudential measures to
address asset market volatility such as risk weights, provisioning, LTV ratios, margin
requirements and the build up of foreign currency liabilities in the financial system
are also considered as legitimate instruments to respond to destabilising capital
flows.

There is greater recognition of the insurance needs of countries. While it was
commonly argued before the crisis that many Asian countries were incurring
avoidable costs in accumulating large foreign currency reserves, it has been widely
noted that countries with large reserves fared relatively well during the crisis. Forex
reserves have provided self-insurance during the global liquidity crisis. Those
countries that built up precautionary reserve holding were able to avoid large
depreciation in the "Panic of 2008" (Obstfeld, Shambaug, and Taylor, 2009).

The argument for compositional irrelevance of capital flows stands questioned. A
recent IMF paper2 has concluded that the appreciation effect of private flows differs
by type of flow. Portfolio investments, which are more volatile, have the highest
appreciation effect, followed by FDI and bank loans. Since these flows are
potentially related to an increase in productive capacity, the real appreciation
associated with FDI and bank loans is barely one-seventh of the real appreciation
due to portfolio investments. Private transfers (mainly remittances) are the flows that
have the least appreciation effect. This may suggest that remittances are not
procyclical.
The cross-country experience of controls on inflows and outflows provides some conjectures
for policy purposes. These are summarised below:
 It is evident that while the controls on capital inflows have proved somewhat
effective in containing pressures on foreign exchange markets, the experiments with
controls on outflows
by the EMEs, particularly in crisis situations did not help in
alleviating the exchange market pressures.

While controls to limit short-term inflows could be helpful in specific circumstances,
such restrictions in force for longer-term entail costs. However, temporary uses of
controls are more effective and can even improve the financial environment.

It is important to recognize that neither the use of capital controls is uniform nor the
results are identical. In addition, their impact can be subdued by global conditions.

In case of pressures arising out of capital outflows, the controls in the form of
numerous restrictions on the banks' external transactions were not fully effective as
they were circumvented in many instances.

Moreover, the various instruments of controls provided only temporary relief or
contained the initial pressures on forex markets when there were internal or external
imbalances (i.e., high fiscal deficit, weaknesses in the financial sector, high current
account deficit).

Offshore markets for the domestic currency (e.g., NDF markets) proved to be an
important source of speculation and in some instances control measures could not
succeed.

In case of crises countries, the instruments deployed to control outflows were
ultimately replaced by the abandonment of exchange rate band/peg in favour of
float.
Indian context
The policy approach in India to the issue of capital flows has evolved from the broader
objective of maintaining financial and macroeconomic stability and not merely addressing the
singular variable of exchange rate. The salient elements of this framework have been:
i. an explicitly stated active capital account management framework, based on the
policy stance of encouraging non-debt creating and long-term capital inflows and
discouraging debt flows;
ii. having the policy space to use multiple instruments - quantitative limits, price based
measures as well as administrative measures, particularly for foreign currency
borrowing by corporates;
iii. short term debt permitted only for trade transaction;
iv. avoiding the "original sin" of excessive foreign currency borrowings by domestic
entities, particularly the sovereign;
v. prudential regulations to prevent excessive dollarization of balance sheets of
financial sector intermediaries, particularly banks;
vi. cautious approach to liability dollarisation by domestic entities and
vii. significant liberalization of permissible avenues for outward investments for
domestic entities.
Recent trends
During the past five years, like other Emerging Market Economies (EMEs), India has been
experiencing consistently strong capital flows, barring the crisis year of 2008-09. During the
crisis year of 2008-09, net capital flows plummeted to USD 6.8 (0.5 per cent of GDP) from
USD 106.6 billion (8.7 per cent of GDP) in 2007-08. The net capital flows again surged to
USD 53.6 billion (4.1 per cent of GDP) during 2009-10. During the first half of 2010-11
(April-September 2010), the net capital flows were USD 36.7 billion, which was 59.6 per cent
higher than the net flows during the same period of the previous year (USD 23.0 billion).
The latest trends in capital flows indicate that the net capital flows during 2010-11 are
expected to be higher than in 2009-10. FII investment, ECBs and trade credit dominate
capital flows with FIIs flows remaining as the major driver of capital flows during the current
year so far. During the period up to February 4, 2011, the net FIIs flows stood at
USD 29.6 billion as against USD 22.4 billion during the corresponding period of 2009-10.
The ECBs registered during April-December 2010 amounted to USD 15.8 billion as against
USD 13.8 billion during April-December 2009.
FCCBs have constituted a significant part of the ECBs raised during the last few years,
except for the sudden decline in the immediate aftermath of the crisis.
Table 2 : Issuance of FCCBs (USD million)
However, with focus on capital flows on a net basis, it is often not realized that portfolio flows
were US$174 billion a year over last three years on a gross basis, far outstripping FDI flows
at US$37 billion a year. In gross terms, over the last five years (2005-06 to 2009-10) FII
flows have accounted for 47% of the gross capital inflows to India as against 9% for FDI
inflows. This of course has more to do with the nature of these flows with a much larger
churn for portfolio capital. High gross flows make economy more susceptible to such
reversals and as such we need to continue to maintain adequate buffers.
In the current context, a high CAD has been absorbing much of the capital flows in aggregate
terms. The concerns, however, arise on account of the composition of flows coupled with
lower order of reserves accretion and faster increase in external liabilities.
The enhanced exposure to external liabilities is reflected in the sharp increase in the ratio of
external debt to foreign exchange reserves from 89.1 per cent of GDP in 2008-09 to 99.1 per
cent as at end June 2010. Moreover, the ratio of short-term debt to reserves has increased
from 17.2 per cent to 21.0 per cent during the same period. Another issue that may come up
going forward relates to repayment of FCCBs. The redemption pressures on account of
FCCBs would start building up from 2010-11 and peak in the next couple of years till
2012-13.
The relaxation of buy-back guidelines and refinancing has helped the corporates to better
plan for the impending repayments. The lessons of the crisis will hopefully lead to better
management and accounting of such liabilities by the corporates.
As is evident from the accretion to reserves and given the current account deficit, unlike
other central banks from emerging markets, RBI has been the least interventionist. India's
foreign exchange reserves (excluding valuation effects) increased by US$ 7.0 billion during
the first half of 2010-1. Foreign exchange reserves as on January 14, 2011 stood at
US$ 297.4 billion. Though it is recognized that foreign exchange reserves can only be partial
antidote to capital flow volatilities, they indeed work as comfort buffers during times of crisis.
Key issues and road ahead
Going forward, the issue in our context is not really about the limited context of capital flows
but a more fundamental one of the capital account management architecture which is
responsive to the needs of the real economy and maintaining financial stability. The issue of
opening up of the capital account fully has become, so to speak, the last frontier in reforming
the financial sector. In some quarters, the capital account constraint has come to be
perceived as impacting other elements, particularly the development of markets. However,
what such arguments fail to recognise is that the macroeconomic framework is an intricately
inter-connected model with several cross-impact elements. One can't touch just one element
without disturbing some other.
It thus becomes necessary to progress with liberalisation of different elements of the capital
account within the overall context. We have been measuring our readiness in terms of
certain metrics but these have proved to be contextually variable. The practical approach
seems to be to move towards further liberalisation but retain the broad principles of the
approach pursued hitherto. In this context, let me touch upon the key issues in regard to
major elements:
FDI flows

FDI contributes to stable growth through transfer, diffusion and spill-over effects and
it is considered stable. Except for a few sectors the policy is liberal and investments
can be made under the automatic route. There have been some concerns on the
declining FDI flows in the recent past though as stated earlier it has little to do with
the regulatory framework per se except in certain sectors. The moderation in FDI
inflows to India during April-November 2010 has been driven by sectors such as
construction, mining and business services. Certain structural factors, if addressed
expeditiously, could raise the share of India in the projected FDI flows to EMEs in
the near future. According to the IIF, net FDI flows to EMEs are forecast to increase
by 11 per cent in 2011.
In this context, it may need to be recognised that FEMA, in terms of its scope, is
concerned only with the transactions, both capital and current account, and not with
the economic activity per se. FDI policy is not just a capital account issue but is
linked to Government's regulatory policies governing specific sectors that are much
broader in nature. This too needs to be addressed appropriately.
Portfolio flows

The Report of the Committee on Foreign Investment has recommended introducing
a single channel of foreign investments, QFI, for all foreign investors. While the
regulations for various channels is well appreciated, the Committee has suggested
opening up the QFI route to all foreign investors, including individuals, subject to
compliance with KYC requirements. The issue here is not merely access to stock
markets but has much larger implications. In effect, it would imply permitting all
foreign residents to open accounts in India for their transactions and permitting them
access to other market segments for their hedging requirements. The entire gamut
of ramifications needs to be thought through carefully as this would result in full
capital account convertibility.
Investments in debt

The recent experience of many countries during the crisis as well as the worsening
external sector ratios for India preclude any case for further liberalising the debt
Having a dominant investor class in the short term segment, susceptible to sudden
stops and reversals, is clearly a risk from macroeconomic perspective. As illustrated
by the chart below, FIIs have demonstrated a clear preference for short term tenors,
with 40% each of the investment in government and corporate debt in tenors up to
one year.
The time honoured principles that underlie opening up of debt markets to foreign
investment are convergence in nominal and real interest rates on sustainable basis,
low debt/GDP ratio and low fiscal deficit to GDP ratios on a consistent basis. In case
of sovereign borrowing, given the huge market borrowing requirements, there will be
increased susceptibility to global market developments and rating changes if there is
increased participation of foreign investors. In the recent market turmoil, while the
private sector did feel the adverse impact of worsening global credit conditions, the
sovereign borrowing program was largely unaffected from direct impact on this
count.
Outflows
 The regime for outward flows by individuals, mutual funds as well as corporates, has
been significantly liberalised over the years. The most visible manifestation of this
policy has been the increasing cross-border acquisitions by Indian companies
(Table 2).
Liberalising outward flows may not be a solution to offset large portfolio inflows as is
often recommended. The modus operandi of overseas acquisitions is to undertake
acquisitions through SPVs overseas. The funding is often arranged through
overseas banks backed either by shares or assets of the target company and/or
guarantees by the Indian parent. The actual outflow in the form of equity and loans
is therefore not equivalent to the actual value of the deals. Similarly, we have
allowed mutual funds to invest unto USD 8 billion overseas; only around
USD 1 billion of this limit has been used. Such outflows may potentially take place at
inopportune times from a systemic perspective. It this becomes imperative from a
financial stability perspective to have some prudential limits in place.
Access to financial markets
 One of the key arguments favouring a more open capital account has been the
attendant benefits it brings to the development of domestic markets. It was believed
that free capital flows into the financial markets are necessary for efficient allocation
of resources and for completion of markets by providing more liquidity. The potency
of this argument has at least partly been dented by the crisis which has
per se
demonstrated that pursuit of development of financial markets cannot be an
end in itself.

However, trying to balance all objectives does bring its own challenges for
policymaking. It has been argued that in today's financial world of complex
derivatives, it is really not possible to have restrictive policies for flow of capital. The
significant increase in the NDF volumes involving INR is a case in point. The recent
BIS Triennial Survey was pretty revealing in this regard. From a regulatory
perspective, the real issue is the impact of this market on the onshore markets.
Our preliminary estimates have not been able to establish a causal relationship
between the NDF and onshore markets but going by the experience of other
countries, the NDF market can indeed be a source of vulnerability. It does raise
certain issues particularly regarding the nature of operations of banks as well as
corporates having cross-border presence which may need to be looked into.
Recently, there were reports that Korea has a similar audit of some overseas banks
over trading in currency derivatives which are suspected of being "speculative
moves".
It is often suggested that the way to deal with the NDF market is to bring it onshore.
In other words allow non-deliverable forwards in the Indian market with free access
to all non-residents which have the same impact as full capital account convertibility.

Another related issue is that of use of Rupee for trade invoicing. It is argued that
rupee invoicing may be a preferred option to help domestic exporters and importers
to deal with currency volatility. Even now, there are no regulatory restrictions coming
in its way. The issues are twofold: first, the acceptability of rupee invoicing to the
overseas trade counterparty; and two, the attractiveness of rupee for credit facilities.
Acceptability may be increased by devising a mechanism to permit the overseas
party to hedge its rupee exposures onshore. The RBI is willing to examine this and I
would urge FEDAI to come up with feasible suggestions in this regard.

The guidelines on CDS will be released shortly. One of the issues is the access to
this market for FIIs. RBI is examining the suggestion to allow them to hedge the
credit risk in India provided they have invested in the underlying bonds.
Conclusion
The balance of costs and benefits of capital flows for recipient countries has started getting
reassessed in the aftermath of the crisis. A similar reassessment happened after the Asian
crisis. Many studies have since concluded that the cross-country evidence on the growth
benefits of capital-account openness is inconclusive and lacks robustness. The present
crisis, however, has led to a shift in the approach to capital account from its narrow exchange
rate implications and management of capital flows is now accepted as a legitimate
instrument of growth, macroeconomic policy and financial stability. The role of forex reserves
in providing insurance is also recognized particularly since countries with large foreign
exchange reserves were better positioned to weather the liquidity crisis.
India has now had some experience with the above model of a framework and the way
forward seems to be continuing liberalisation within this framework.
To conclude, I would like to flag a few issues from a systemic perspective:

In an open economy like ours, there is need for greater recognition of currency and
interest rate risks and the risk management in banks and corporate firms need to
gear up their risk management practices further in this area. It is our experience that
a large number of corporates still do not have well-designed risk management
policies and practices to take care of volatile exchange rate movements and give
scant regard to tail risks. There is also need for greater disclosure and adherence to
accounting standards for financial instruments.

There is also need to more comprehensively qualitatively assess our external
liabilities to also encompass liabilities of subsidiaries and branches of Indian
financial institutions overseas, not in nominal terms but through a risk-based
approach on the probability of recourse to parent bank liquidity support.

Operations of foreign financial entities in domestic markets also have implications on
capital account due to cross border fund flow and derivative positions. During the
crisis period, funds were held abroad temporarily to support parent bank liquidity. In
India. there are prudential regulations on banks' recourse to overseas funding
markets, including for foreign banks. More local funding of local assets reduces
systemic risk and helps to curb excessive risk taking and credit growth.
I hope that we will continue to have constructive engagement with FEDAI and I wish the
conference all success.