Speeches of central bankers are tracked widely across the financial markets. While speeches by central bankers from developed countries are tracked for economic outlook, and possible impact on financial markets, those by central bankers from developing countries are tracked for new developments, and changes in policy. In a speech on policy developments, any mention of capital account convertibility (CAC) immediately catches the attention.
So when Reserve Bank of India (RBI) Deputy Governor T Rabi Shankar gave a speech on ‘India’s Capital Account Management – An assessment’, on October 14, it was not surprising that it created excitement among market participants.
What is CAC? Countries trade with each other, and these transactions are recorded in the Balance of Payments (BOP). The BOP transactions are classified under two heads. The current account transactions comprise exports and imports of goods and services, remittances, and so on. The capital account transactions comprise inflows and outflows of investments, which could take the form of either direct investment or investment via the financial markets.
Current account convertibility is the ease at which a domestic currency can be converted into a foreign currency, and vice-versa. Capital account convertibility (CAC) means the same ease of convertibility but for investments. The advantage of both types of convertibility is that it enables higher and more efficient trade in goods, services, and finance, which leads to higher growth.
Since Independence, there were several restrictions on both current and capital accounts convertibility. Following the 1991 crisis, India opened up its economy. While India has made substantial progress on convertibility in the current account, on the capital account the progress has been much more cautious. This is because experiences with full CAC suggest that it runs in both directions. When the times are good, CAC leads to large capital inflows which when channelised productively leads to higher economic efficiency and growth. When the times turn bad, we see large capital outflows leading to multiple economic problems.
Given past experiences, economists are highly divided on the topic of full CAC. Some have suggested a third way, which is that we need preconditions for availing CAC benefits. First, before adopting CAC, an economy should have sound macroeconomic fundamentals, and a well-developed financial system. Second, the economy needs to develop policies and tools to counter the CAC risks. Third, experiences have shown that there is a hierarchy of riskiness in foreign capital inflows with foreign direct investment (FDI) being the least risky, followed by equity investment, and, finally, debt capital. Thus, FDI should be encouraged, whereas we need to have regulations for debt capital.
India’s journey with respect to CAC has been quite an adventure in itself. In 1997, the RBI instituted a committee under the chair of then Deputy Governor SS Tarapore to advise on CAC. The committee suggested that India should phase out restrictions on CAC in three stages, and adopt full CAC by 1999-2000. It also suggested that as the financial system is one of the central players in a CAC, the financial sector reforms should be completed in the interim period. After the submission of the report, the East Asian economic crisis struck, where it was seen that countries which had a more liberal CAC were impacted severely. The crisis, and its experiences, led India to proceed cautiously on reforms suggested by the committee.
In the 2000s, economies around the world, including India, were doing well. This led to renewed interest within policymakers on liberalising CAC. In 2006, the RBI once again instituted a committee under Tarapore to suggest a roadmap for 'fuller CAC'. The word fuller was added to suggest we might not move towards a full CAC but an improvement over current status quo. This time the committee suggested adoption of a 'fuller CAC' in three phases over five years, and to be completed by 2009-10.
While the RBI was still apprehensive over the pace of CAC reforms, the Government of India was more optimistic about the CAC’s role in pushing higher growth. In 2007, the finance ministry constituted a committee to study Mumbai as an International Finance Centre (chaired by Percy Mistry) and in 2008 the Planning Commission constituted another committee to study the financial sector reforms (chaired by Raghuram Rajan). Both the committees suggested a faster approach towards full CAC.
The 2008 financial crisis struck, undoing all the efforts of the three committees. Then RBI Governor YV Reddy, who was seen as the key barrier for faster CAC reforms, saw an overnight change of perception as he was showered with high praise for his cautious stand against capital reforms. A dramatic change was also seen in the approach of the IMF, which changed its view from an aggressive supporter of CAC to suggesting capital controls as one of the policymaker’s tools for safeguarding economies from a crisis.
Given this long backdrop, Shankar’s speech not just summarises the developments so far, but also discusses the way forward. India has already made rapid strides in allowing foreign investors in FDI, and in the equity markets. Shankar mentions that “the next step in liberalising CAC is enabling wider participation of foreign investors in bond markets”.
Currently, the FII’s own around 1.5-2 percent of government bonds, and this percentage is likely to go up in future. There are proposals to allow non-resident investors to invest in specified benchmark securities, and over time there will be an unfettered access for non-residents into government securities. There are ongoing efforts to include India in global bond indexes, which will be a complimentary step, and nudge global investors to purchase Indian bonds.
As India has restricted capital inflows, markets for trading Indian assets have developed in foreign markets. One such market is the Non-Deliverable Forwards (NDF) which allows buyers to buy forwards in Indian Rupees without settling the transaction in Indian Rupees. The RBI had established a committee to bridge the gaps between onshore and offshore markets.
In this regard, the speech points that increased convertibility over the years has led to lower spreads between the two markets, which is a big positive. We need to consider whether we are ready to allow foreign investors to own rupee accounts. The above steps will also help in one of the policy goals of internationalisation of the Indian Rupee, where it is used actively by foreigners for transactions, just as the US Dollar, Euros, etc.
The speech ends by asking banks “to prepare themselves to manage the business process changes and the global risks associated with capital convertibility”.
The speech provides us with ideas on the recent policy thinking on CAC. It is interesting that the RBI is moving ahead with the trickier phase of liberalising capital inflows in the debt markets. Since 2008, India faced its own crisis in 2013, and the impact of the pandemic was also severe. But this has not dented the efforts to liberalise CAC. A liberalised CAC has been one of the unachieved goals of the 1991 reforms, and we are likely to see some interesting action in the space going ahead.
Amol Agrawal is faculty at Ahmedabad University.Views are personal and do not represent the stand of this publication.