India's Capital Account Management - An assessment1
1. In the previous FEDAI Annual Day address in November 2020, Governor Shri
Shaktikanta Das had observed that CAC will continue to be approached "as a
process rather than an event". What I will do in this address is to expand on that
theme and bring into focus some of the important issues on which, in my opinion,
further public debate is warranted, to continue along this process of capital account
convertibility.
What is capital account convertibility?
2. The balance of payments (BOP) of a country records all economic transactions of
a country (that is, of its individuals, businesses and governments) with the rest of
the world during a defined period, usually one year. These transactions are broadly
divided into two heads - current account and capital account. The current account
covers exports and imports of goods and services, factor income and unilateral
transfers. The capital account records the net change in foreign assets and
liabilities held by a country. Convertibility refers to the ability to convert domestic
currency into foreign currencies and vice versa to make payments for balance of
payments transactions. Current account convertibility is the ability or freedom to
convert domestic currency for current account transactions while capital account
convertibility is the ability or freedom to convert domestic currency for capital
account transactions. The Tarapore Committee (2006), for instance, defined
capital account convertibility as the "freedom to convert local financial assets into
foreign financial assets and vice versa."
3. The degree of BOP convertibility of a country usually depends on the level of its
economic development and degree of maturity of its financial markets. Therefore,
advanced economies (AEs) are almost fully convertible while emerging market
economies (EMEs) are convertible to different degrees.
Why is capital account convertibility important?
4. Free capital mobility, or internationalization of capital markets, is commonly
recognized as an engine of global growth. Specifically, benefits of
internationalization of capital markets are well accepted, in terms of broadening
the investor base for recipient country financial assets, improved liquidity in
financial markets and positive pressures for market infrastructure and market
practices. International capital markets, by enabling access to a global savings
pool and to different currencies, can potentially reduce borrowing costs, facilitate
better risk allocation and enhance global liquidity (OECD, 2017)2.
What are the risks of free capital mobility and how are these risks managed?
5. The various currency and banking crises experienced over the last few decades
have simultaneously highlighted the costs and risks of internationalization such as
exposure to global shocks, credit and asset bubbles, exchange rate volatility
associated with sudden exit of capital and higher refinancing risk. Increased
globalization has brought to the fore the vulnerability to contagion effects. While it
was argued that such risks are the short-term pains needed to reap long term gains
(Kaminsky and others, 2008)3, there is now a wider acceptance that benefits of
internationalization are not an unmixed blessing and that there is a nuanced trade
off between growth and crisis risk. Such awareness has led to policy focus on three
fronts.
a. First, that benefits of internationalization presupposes sound
macroeconomic fundamentals, a well developed financial system and a
sound market infrastructure, including efficient markets for funding and risk
transfer.
b. Second, that countries need to develop appropriate tools to deal with the
risks of internationalization, in particular, tools to manage the volume and
composition of capital inflows and macro prudential tools.
c. And third, that different types of capital flows carry different risks - some
are riskier than others. The agreed hierarchy of capital flows is that foreign
direct investment is the least risky, followed by equity investment, followed
by debt capital. While FDI is seen to contribute to long-run growth, portfolio
equity gives a shorter run boost. Debt flows, while necessary, are
susceptible to be volatile. Understandably, the focus of capital flow
regulations, and macro-prudential regulations, has been debt flows.
6. Capital flow measures are effective insofar as they lead to safer external liability
structures, by reducing dependence on foreign borrowing and could be particularly
effective during sudden-stop episodes. They work essentially by avoiding risky
flows or containing short-term debt or controlling currency exposure of domestic
borrowers. Especially for economies where capital flows are relatively large, or the
exposure of banking systems is significant, these measures could be more
effective than macro prudential tools.
7. Macro prudential measures target systemic stability issues and tend to be capital
based or liquidity based or borrower based. Capital based measures like counter
cyclical capital buffers or higher-than-standard capital requirements or calibration
of capital risk weights intended to change incentives for certain types of funding
are commonly used. Liquidity Coverage Ratio or Net Stable Funding Ratio can be
used to manage exposure to short term flows. Similarly, credit or asset bubbles
can be controlled using Loan-to-Value ratio or Debt Service-to-Income ratios.
8. There is extensive global discussion on the choice and effectiveness of these tools
to deal with specific vulnerabilities. There is reasonable consensus that none of
these measures is undesirable in itself. There is also broad agreement on the
sequencing of these measures. That the first line of defence against risks of capital
flows are prudent macroeconomic policies and a strong institutional base. External
borrowing should be controlled until corporate governance and supervisory
standards are robust.
9. Not all emerging economies, however, may have this choice, and may be
constrained to depend on capital flows, either to meet their investment needs or to
develop financial markets. For many of these countries, the required development
of policy and markets has to happen simultaneously with dependence on foreign
capital. Often, there is only a limited choice on the type of capital that flows in,
leading to dependence on risky debt capital. Managing these flows with a not-so-
efficient domestic institutional base requires policy flexibility. Usually, managing
the spillover risks of global capital involves a combination of these and macro
prudential measures. Building up reserves has been an acceptable course,
especially after the Asian crisis. Having some control on the amount of debt capital
as well as on its nature is another defence. Long-term debt flows could be preferred
to short-term flows, stable investors (pension or insurance funds, reserve
portfolios) could be preferred to flighty investors such as carry traders, arbitrage
traders etc. In a sense capital flow measures may really be used to compensate
for lack of strong macro-fundamentals and adjustment mechanisms (Fratzscher,
2012)4.
10. Thus, capital flows are useful, and in case of many EMEs, even necessary. The
choice is in how to manage the attendant risks. Effective management of these
risks, especially those associated with debt flows, requires a diversified policy tool-
kit. Which of these is used is basically a function of the degree of development of
the economy and markets of the country.
Capital flow management in India
11. External sector liberalisation started in India with the economic liberalisation
process that commenced in the early nineties - moving to a a floating exchange
rate regime and freeing up current account transactions. The enactment of the
Foreign Exchange Management Act, 1999 codified this arrangement with relatively
free current account transactions (except for a negative list) and controlled capital
account transactions. Liberalisation in this context basically meant gradually
freeing up capital account transactions. Over the last two decades, FDI has
become more or less unrestricted except (i) for some sectoral caps and (ii)
restrictions in a few socially sensitive (e.g., gambling) or volatile (e.g., real estate)
or strategic (e.g., atomic energy) sectors.
12. The policy regime for foreign portfolio investments in India commenced in 1992
when Foreign Institutional Investors (FIIs, or, since January 2014, FPIs) were
allowed to invest in domestic financial instruments, basically equity. FPIs were
given access to corporate debt markets in 1995 and to G-secs in 1997. Thus, the
FPI regime has followed the standard process of liberalising equity flows first and
then gradually freeing up debt capital. Apart from sectoral caps to regulate control,
portfolio flows into equities in India are virtually unrestricted. Access to debt
markets - sovereign and corporate - is subject to macro caps and other
macroprudential limits. These are designed to safeguard the domestic economy
from excessively speculative hot money flows.
13. There is an effort to liberalize FPI debt flows further with the introduction of the
Fully Accessible Route (FAR) which places no limit on non-resident investment in
specified benchmark securities. Since over time, virtually all securities will fall
under the FAR category, the move is unambiguously towards an eventual
unfettered access for non-residents into Government securities. Efforts to get India
included under global bond indexes and the complementary move towards placing
G-secs under global custodians, once implemented, will encourage debt flows in
future.
14. The first comprehensive guidelines on External Commercial Borrowing (ECB)
were issued by Government, in July 1999. It has been liberalised over time.
Currently, ECB by corporates, while more open than portfolio flows, seeks to
enable medium to long term debt (minimum tenor) only healthy corporates to
borrow (through cost ceilings) subject to an overall soft limit. A few "end uses" -
real estate, capital market, equity - are not permitted.
15. Chart 1 (see Annex for all charts) shows that the actual flows of capital have been
broadly in the desirable direction with direct investments (FDI flows) outstripping
portfolio investments (FPI flows) and equity flows (FDI plus FPI equity5)
outstripping debt flows (FPI Debt plus ECB). The gradual liberalization of capital
inflows has been consistent with the realization of the preferred composition of
capital inflows.
16. The focus on capital outflows has understandably been far less given that India's
priority is to attract foreign capital to fund its savings gap. There is basically one
channel - Overseas Direct Investment (ODI). The Liberalized Remittance Scheme
(LRS) for individuals, while it is open for both current and capital account
transactions, is largely (more than 90%) in current account transactions like travel,
studies etc.
Issues for wider debate
17. While the progress so far can be considered to have moved broadly along the
desirable direction, there are some issues which require a wider debate as there
are no standard answers. We will discuss some of these issues below.
a. With the Fully Accessible Route, as discussed above, over time the entire
G-sec issuance would be eligible for non-resident investment. While
experience of other countries suggest that non-residents are unlikely to hold
a major portion of outstanding stock, substantial debt holdings might make
India vulnerable to the risk of sudden reversals. Since this channel was
permitted in the context of inclusion of India's G-secs in global bond indices,
there is a natural safety mechanism as index investors are unlikely to
indulge in sudden reversals. It may need to be considered, from a
macroprudential perspective, whether FAR should be linked to index
inclusion.
b. As the LRS Scheme has operated for some time, there may be a need to
review it keeping in mind the changing requirements such as higher
education for the youth, requirement of start-ups etc. There might even be
a case for reviewing whether the limit can remain uniform or can be linked
to some economic variable for individuals.
c. A key aspect of currency convertibility is integration of financial markets.
Over time, it is essential that two markets - onshore and offshore - for
domestic currency or interest rates cannot exist with efficiency. With
increased convertibility, these markets need to be linked. An effort has
already commenced in the interest rate derivative segment. Allowing Indian
banks access to NDF markets for the Rupee is also consistent with this
objective. As G-secs get held by global custodians and traded abroad more
and more non-residents get to hold Rupee assets and take Rupee
exposure. These measures are already seeing the desired results - for
instance, NDF-onshore spreads have substantially narrowed after allowing
Indian banks into the NDF space (Chart 2, see Annex). We need to now
consider whether India is ready to allow such non-residents to hold Rupee
accounts. This will be an important early step in internationalization of the
Rupee and, therefore, needs to be carefully considered. Further, there is a
need to consider a proper mechanism for information flow so that exchange
and interest rate management can continue to be effective in an
environment of larger offshore transactions.
d. As onshore and offshore financial markets get integrated, it should be
ensured that price discovery in the domestic markets is efficient lest flows
move to the offshore segment. Take the case of the Rupee exchange rate.
It is market determined with fairly tight bid-ask spreads in the interbank
market. Major corporates also seem to benefit from tight pricing. Yet many
entities, especially SMEs, small exporters, individuals, etc., are prone to
over-pricing. Do processing charges and market risk for warehousing odd
lot positions justify these spreads? An effective way is to shift price
discovery for the retail forex users to a platform. While such a platform (FX
Retail) has been developed, it appears that banks do not find it in their
interest to navigate customers to use that platform. In this age of
technology, it may not really be possible to shun superior technology for any
length of time. There should be a debate on the use of the platform and
banks should make an effort to give it a fair trial.
Conclusion
18. India has come a long way in achieving increasing levels of convertibility on the
capital account. It has broadly achieved the desired outcome for the policy choices
it has made, in terms of achieving a stable composition of foreign capital inflow. At
the same time, India is on the cusp of some fundamental shifts in this space with
increased market integration in the offing and freer non-resident access to debt on
the table. The rate of change in capital convertibility will only increase with each of
these and similar measures. With that comes the responsibility to ensure that such
flows are managed effectively with the right combination of capital flow measures,
macro-prudential measures and market intervention. All of us need to consider
deeply the issues I have highlighted above and arrive at effective solutions. Market
participants, particularly banks, will have to prepare themselves to manage the
business process changes and the global risks associated with capital
convertibility. The regulator's job is somewhat different. As someone once said,
the job of a regulator is like the gas regulator in the kitchen - it cannot ensure the
quality of the dish, but it can prevent the kitchen from blowing up. The quality of
the dish - that is, the efficiency with which investment needs of the country are
met - is up to how well Authorized Dealers and other intermediaries adjust to the
increasingly fuller capital account convertibility.
Annex - Charts
Chart 1 - Capital Inflows - Cumulative from 2006-07
600
500
400
300
200
100
0
FDI FPI ECB - Net Inflow
Chart 2 - Spread (NDF-Onshore)
150
130
110
90
70
cent
50
Per
30
10
-10
-30
-50
Jul-20 Jul-21
Apr-20 Oct-20 Apr-21 Oct-21
Jan-20 Jun-20 Jan-21 Jun-21
Dec-19 Feb-20 Mar-20 Aug-20 Sep-20 Nov-20 Dec-20 Feb-21 Mar-21 Aug-21 Sep-21
May-20 May-21