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Convertibility of Exchange Rate - FAQ (Part: 3)

Remarks on capital account liberalisation and capital controls
[by Dr. Y.V. Reddy, Governor, Reserve Bank of India at the Central Bank
Governors Symposium convened by the Bank of England
in London on June 25, 2004]

There is evidence of a threshold effect in the relationship between financial globalisation and economic growth, and the heightened risks of volatility in capital flows to developing countries gets reduced only after a particular level of integration. In contrast, empirical evidence shows that trade liberalisation has had beneficial impact. A review of evidence provides no road map for the optimal pace and sequencing of financial integration. Many questions in this regard are best addressed only in the context of country-specific circumstances and institutional features.

In this background, based on the Indian experience, I will present some issues relating to managing capital account.

  1. First, capital account liberalisation is a process and it has to be managed keeping in view elasticities in the economy, and vulnerabilities or potential for shocks. These include fiscal, financial, external, and even real sector – say, oil prices and monsoon conditions for India. Professor Rogoff's presentation places special emphasis on government borrowings as a vulnerability.

  2. Second, caution is needed in moving forward with each step in capital account liberalisation, recognising that reversal of any step in liberalisation is very difficult since markets tend to react very negatively to reversals, unless there is already a crisis situation.

  3. Third, the capital account itself needs to be managed during the process of capital account liberalisation. There is a hierarchy in the nature of different types of capital flows in real life. For example, foreign direct investment is preferred for stability, and quantum of short-term external debt, by residual maturity, should not be excessive. Furthermore, adequate reserves, keeping in view the national balance sheet considerations, which include public and private sectors, provide comfort. Public policy can achieve these desirable conditions only through some sort of management of capital account

  4. Fourth, the management of capital account will be effective under enabling conditions, such as, reasonable confidence in macro policies, in particular tax regimes, and safeguards against misuse of liberalised current account regime to effect capital transfers. Sound management will also avoid dollarisation of the domestic economy and internationalisation of domestic currency.

  5. Fifth, operationally, management of capital account involves a distinction not only between residents and non residents or between inflows and outflows but also between individuals, corporates and financial intermediaries. The financial intermediaries are usually a greater source of volatility amongst these. If such financial intermediaries operating in the developing countries are owned or controlled by foreign entities / investors, there is perhaps greater tendency to volatility in the flows. It is noticed that such foreign owned / controlled intermediaries are often influenced by considerations other than domestic economy and have less appreciation of local conditions – apart from the issues relating to cross-border supervision of financial intermediaries by the host country supervisor.

  6. Sixth, the prudential regulations over financial intermediaries, especially over banks, in respect of their forex exposures and forex transactions must be effective and a dynamic component of management of capital account as well as financial supervision. Such prudential regulations should not be treated as capital controls.

  7. Seventh, capital controls should be treated as only one of the components of management of capital account. As liberalisation advances, the control-regime would contract, and thus, it is the changing mix of controls that charecterises the process of liberalisation in management of capital account

  8. Eighth, capital controls may be price based, including tax-regimes, or administrative measures. Depending on the legal framework and governance structures, the mix between the two would vary. As liberalisation advances, the administrative measures would get reduced and price-based increased, but the freedom to change the mix and reimpose controls should always be demonstrably available. Such freedom to exercise the policy of controls adds comfort to the markets at times of grave uncertainty.

  9. Finally, as mentioned by Professor Kenneth Rogoff, a distinction needs to be made between de jure and de facto financial integration in general and hence, in the context of capital account in particular. In practice, there are difficulties in measuring the degree of financial integration. However, the institutional structures, both of public policy and markets, need to be evolved to meet the imperatives of liberalised capital account. In the final analysis, the basic issue in any policy context is whether capital controls lead to distortions in exchange rate or the liberalised capital flows that lead to distortions in exchange rate. In respect of emerging economies, the conduct of market participants shows that automatic self-correcting mechanisms do not operate in the forex markets. Hence, the need to manage capital account – which may or may not include special prudential regulations and capital controls. There are many subtleties and nuances in such a management of capital account which encompasses several macro issues and micro structures.

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    Dr.Bimal Jalan (then Governor RBI) on Capital Account Convertibility
    [Extract from Address at 14th National Assembly of Forex Association of India on 14.8.2003]

    "A frequently discussed question is about Capital Account Convertibility (CAS), i.e. when is India going to move to full CAC? As you are aware, we have already liberalized and deregulated a whole host of capital account transactions. It is probably fair to say that for most transactions which are required for business or personal convenience, the rupee is, for all practical purposes, convertible. In cases, where specific permission is required for transactions above a high monetary ceiling, this permission is also generally forthcoming. It is also the declared policy of the Government and the RBI to continue with this process of liberalization. In this sense, Capital Account Convertibility continues to be a desirable objective for all investment and business related transactions and India should be able to achieve this objective in not too distant a future.

    " There are, however, two areas where we would need to be extremely cautious – one is unlimited access to short-term external commercial borrowing for meeting working capital and other domestic requirements. The other area concerns the question of providing unrestricted freedom to domestic residents to convert their domestic bank deposits and idle assets (such as, real estate), in response to market developments or exchange rate expectations.

    " In respect of short-term external commercial borrowings, there is already a strong international consensus that emerging markets should keep such borrowings relatively small in relation to their total external debt or reserves. Many of the financial crises in the 1990s occurred because the short-term debt was excessive. When times were good, such debt was easily accessible. The position, however, changed dramatically in times of external pressure. All creditors who could redeem the debt did so within a very short period, causing extreme domestic financial vulnerability. The occurrence of such a possibility has to be avoided, and we would do well to continue with our policy of keeping access to short-term debt limited as a conscious policy at all times – good and bad.

    "So far as the free convertibility of domestic assets by residents is concerned, the issues are somewhat more fundamental. It has to do with the differential impact of "stock" and "flows" in determining external vulnerability. The day-to-day movement in exchange rates is determined by "flows" of funds, i.e. by demand and supply of spot or forward transactions in the market. Now, suppose the exchange rate is depreciating unduly sharply (for whatever reasons) and is expected to continue to do so for the near future. Now, further suppose that domestic residents, therefore, decide – perfectly rationally and reasonably – that they should convert a part or whole of their stock of domestic assets from domestic currency to foreign currency. This will be financially desirable as the domestic value of their converted assets is expected to increase because of anticipated depreciation. And, if a large number of residents so decide simultaneously within a short period of time, as they may, this expectation would become self-fulfilling. A severe external crisis is then unavoidable.

    "Consider India’s case, for example. Today, our reserves are high and exchange rate movements are, by and large, orderly. Now, suppose there is an event which creates external uncertainty, as for example, what actually happened at the time of the Kargil or the imposition of sanctions after Pokhran, or the oil crises earlier. Domestic stock of bank deposits in rupees in India is presently close to US $ 290 billion, nearly three and a half times our total reserves. At the time of Kargil or Pokhran or the oil crises, the multiple of domestic deposits over reserves was in fact several times higher than now. One can imagine what would have had happened to our external situation, if within a very short period, domestic residents decided to rush to their neighbourhood banks and convert a significant part of these deposits into sterling, euro or dollar.

    " No emerging market exchange rate system can cope with this kind of contingency. This may be an unlikely possibility today, but it must be factored in while deciding on a long term policy of free convertibility of "stock" of domestic assets. Incidentally, this kind of eventuality is less likely to occur in respect of industrial countries with international currencies such as Euro or Dollar, which are held by banks, corporates, and other entities as part of their long-term global asset portfolio (as distinguished from emerging market currencies in which banks and other intermediaries normally take a daily long or short position for purposes of currency trade)

    [Note: we present another more detailed speech exhaustively covering all issues about CAC in the next article. the speech was by Smt K.J.Udeshi, Executive Director, RBI]


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