A Decade of Economic Reforms - Review by RBI
[Source: RBI Report on Currency and Finance 2001-2002 dated March 31, 2003]

Module: 5 - External Sector - Capital Account, External Debt and Exchange Rate:
Approach, Development & Issues

Introduction

It has been noted that developing countries typically run CAD in their early stages of development to supplement their domestic saving to achieve higher level of investment and growth. This process enables recipient countries to achieve higher growth without cutting their current consumption; at the same time, higher productivity of capital in developing countries benefits foreign lenders by earning higher returns on their capital. This raises the question of an optimal CAD level for a country which, however, needs to be circumscribed by a sustainable level of capital flows. The external payments problems faced by India in 1991 and the East Asian crisis in 1997 have highlighted, inter alia, the role of large current account deficits and the consequent build-up of external debt, in precipitating the crisis (Rangarajan, 1993; RBI, 1999 and 2002a).

The current account sustainability depends upon external as well as domestic macroeconomic factors (Ghosh and Ostry, 1994; Milesi-Ferretti, Gian and Razin, 1997). Accordingly, a sustainable level of CAD would have elements of time and country specificity. Ultimately it is determined by the foreign investors’ confidence in the domestic economy, depending upon the various external and domestic factors identified above. While a ratio of CAD-GDP of 8 per cent or so turned out to be unsustainable in the case of Thailand, the same ratio continues to remain sustainable in the case of New Zealand. This level of deficit need not be a cause for alarm as long as transparent and consistent policies remain (Brash, 1998).

In the Indian context, as mentioned before, it was recommended that the CAD be contained at 1.6 per cent of GDP, given the level of normal capital flows. The Report of the Committee on Capital Account Convertibility, 1997 (Chairman: S.S. Tarapore) felt that a sustainable CAD-GDP ratio cannot be static for all times. It, therefore, recommended that the CAD-GDP ratio could be varied in line with the servicing capacity of the economy proxied by trends in current receipts/ GDP ratio. The actual outcome of CAD-GDP ratio averaging just over 1 per cent in the 1990s so far could be reflective of the limited absorptive capacity and infrastructural and other bottlenecks in the economy that hamper higher levels of investment (RBI, 1999).

In recent years, the current account deficits have been progressively narrowing and now turning into a modest surplus in 2001-02 and first two quarters of 2002-03, which reflects the underlying conditions of weakening aggregate demand. The target growth path in the Tenth Five Year Plan would presage a greater recourse to higher imports and enlarged capital flows. At the same time, there remains considerable degree of concern regarding the sustainable level of the current account deficit for an economy of India’s size and diversity. Clearly, exports hold the key to achieving a sustainable balance between the requirements of higher growth and the imperative of ensuring viability in the external sector. The projections of import growth underlying the growth rate of 8 per cent for the Tenth Plan have to be modulated and conditioned by the achievement of export targets along the course charted by the Medium-Term Export Strategy, 2002-07 (RBI, 2002b).

Against this background, financing of an average current account deficit of about 2.8 per cent of GDP as projected in the Tenth Five Year Plan may require a two-fold increase in the size of annual capital flows from the current levels. From a policy perspective, international investor confidence is critical to mobilise capital flows of this order. For this purpose, accumulation of reserves at a high level is an important pre-requisite.

In sum, during the decade of 1990s, the reform measures coupled with sound macroeconomic management succeeded in reducing the current account deficit well within the sustainable level for India. Given the sluggish export performance, the moderate current account deficit experienced in the recent years, including the condition of modest surplus recorded in 2001-02 can be largely attributed to sustained buoyancy in invisibles receipts. This reflects sharp rise in software service exports and subdued non-oil import demand, which in turn is symptomatic of a slowdown in industrial growth. There is, thus, a need for concerted policy efforts to raise the CAD-GDP ratio in line with the Tenth Plan projections so that higher growth is feasible over the medium term.

Reflecting the inward oriented economic policies in pursuit of self-reliance through export bias and import substitution, the role of the capital account during the 1980s was basically that of financing the current account deficits (RBI, 1999). The widening of the current account deficit during the 1980s coupled with the drying up of traditional source of official concessional flows necessitated a recourse to additional sources of financing in the form of debt creating commercial borrowings, non-resident deposits and exceptional financing in the form of IMF loans.

The external payment crisis of 1991 brought to the fore the weaknesses of the debt-dominated capital account financing. Recognising this, structural reforms and external financial liberalisation measures were introduced during the 1990s. The policy shift underscored the need for gradually liberalising capital account recognising that this is a process rather than a single event (Jalan, 1999). Throughout the 1990s the role assigned to foreign capital in India has been guided by the consideration of financing a level of current account deficit that is sustainable and consistent with absorptive capacities of the economy (Rangarajan, 1993; Tarapore, 1995; Reddy, 2000). In India, the move towards full capital account liberalisation has been approached with extreme caution. Taking lessons from the international experience, the Committee on Capital Account Convertibility, 1997 (Chairman: S. S. Tarapore) suggested a number of pre-conditions, attainment of which was considered necessary for the success of the capital account liberalisation programme in India. The need for supplementing debt capital with non-debt capital with a clear prioritisation in favour of the latter has characterised the policy framework for capital inflows in the 1990s. The High Level Committee on BoP had recommended the need for achieving this compositional shift. Keeping in line with the policy thrust, capital flows have undergone a major compositional change in the 1990s in favour of non-debt flows.

With the growing role of private capital flows and the possibility of occasional sharp reversals, the issue of capital account liberalisation and convertibility has spurred extensive debate since 1992 - the period which witnessed a series of currency crises; in Europe (1992-93), Mexico (1994-95), East Asia (1997-98), Russia (1998), Brazil (1999), Turkey (2000) and Argentina (2001-02). These crises have raised the question of desirability of liberalisation and whether it is advisable to vest the IMF with the responsibility for promoting the orderly liberalisation of capital flows. The IMF in its study (1998) stated that "as liberalised systems afford opportunities for individuals, enterprises and financial institutions to undertake greater and sometimes imprudent risks, they create the potential for systematic disturbances. There is no way to completely suppress these dangers other than through draconian financial repression, which is more damaging." The view of IMF itself has changed over time (RBI, 2001). While opening up of the capital account may be conducive to economic growth as it could make available larger stocks of capital at a lower cost for a capital-deficient country, the actual performance of the economy, however, typically depends on a host of other factors. For a successful liberalised capital account, emerging market countries could:

1. pursue sound macroeconomic policies;

2. strengthen the domestic financial system;

3. phase capital account liberalisation appropriately and

4. provide information to the market.

At the international level, there is also the role of surveillance to consider, including the provision of information and the potential need for financing (Fischer, 1997).

In India, the move towards full capital account liberalisation has been approached with extreme caution. The Report of the Committee on Capital Account Convertibility, 1997 (Chairman: S.S.Tarapore) taking into account lessons from international experience suggested a number of signposts, the attainment of which are a necessary concomitant in the move towards capital account convertibility. Fiscal consolidation, lower inflation and a stronger financial system were seen as crucial signposts for India .

A number of Southern Cone countries in Latin America undertook rapid liberalisation of their capital account in the late 1970s in conjunction with a pre-announced or fixed exchange rate. Asian countries, such as Malaysia, Indonesia and Singapore also liberalised their capital account against the background of strong balance of payments positions (Rangarajan and Prasad, 1999 and 2001). Many countries prematurely opened their capital account. There was a reversal in the process of liberalisation among many developing countries in the early 1980s. Pre-existing weaknesses in the banking system led to the emergence of serious banking problems which in turn led to the reimposition of controls in Southern Cone countries and debt crisis in Latin America. Restrictions in the capital account were relaxed in the Latin American countries towards the end of 1980s with the resolution of the debt crisis under the Brady Plan and significant reorientation of macroeconomic and structural policies leading to the restoration of international investor confidence. The process of capital account opening in developing countries accelerated in the 1990s, especially with emerging market economies substantially liberalising their capital controls in Asia, Latin America (Argentina, Venezuela) and transition economies (Czech Republic, Hungary, Estonia, Poland). Among these countries, Argentina had to reimpose controls in its capital account in December 2001 in the wake of an unprecedented sovereign debt crisis. In the aftermath of the Asian crisis of 1997, the international perception on liberalisation of capital controls and the national policy thinking on the relative benefits of an open capital account vis-à-vis the associated costs have changed considerably. The policy debate now centres around the contours of an orderly liberalisation framework and countries like Malaysia have even reverted to capital controls as the key instrument of crisis management.

Reversal to the process of capital account liberalisation can be prevented if reforms are appropriately sequenced. Appropriate sequencing of capital flows depends, inter-alia, on the initial conditions. It is generally agreed that capital account liberalisation should be preceded by macroeconomic stabilisation. Countries which complete the process of macroeconomic stabilisation first, can remove exchange controls on current account transactions to begin with, to be followed by capital account openness as the benefits of domestic reforms on growth and financial stability become visible and appear durable (Arteta, Eichengreen and Wyplosz, 2001).

In general, liberalisation of the capital account should follow the current account since the former may involve a real appreciation of the exchange rate whereas the latter may require a real depreciation to offset the adverse impact of the dismantling of tariff and non-tariff protection on the balance of payments. Since goods market takes a longer time to clear than financial asset markets, the current account needs to be liberalised first. This is also borne out by the successful experience of Chile as opposed to that of Argentina. Reform of domestic financial markets before capital account liberalisation is generally considered critical, since domestic financial institutions can then be better equipped to face international competition and to intermediate movement of funds efficiently without exposing the system to avoidable risks.

India followed a gradualist approach to liberalisation of its capital account. India did not experience reversal of its policies towards the capital account as was the case with some emerging market economies that had followed a relatively rapid liberalisation without entrenching the necessary preconditions. This is particularly important since cross-country studies do not provide clear evidence of increase in capital flows resulting from capital account openness across all developing countries, with only 14 developing countries accounting for about 95 per cent of net private flows to developing countries in the 1990s. Besides, empirical evidence on the positive effects of financial capital flows on economic growth is not yet conclusive (Edison et al, 2002).