Development Policy Review, 2001, 19 (1): 83-99

Operationalising Capital Account Liberalisation: The Indian Experience

Y.V. Reddy ∗

Although influenced by particular contextual factors that may not be capable of being generalised, the Indian experience of capital account liberalisation tends to vindicate a process approach, with the emphasis on caution and gradualism. This article explains the policy framework that governed liberalisation in the 1990s, and describes the current framework of controls; various facets of the Indian approach to managing the capital account; and current thinking on appropriate further steps. To date, the accent has been on progressively replacing administrative controls with prudential limits on transactions, these norms being guided by the country’s absorptive capacities and financing needs, and by the need to achieve a mix of short-term and long-term, debt and non-debt, and stable and volatile flows.

Introduction

The ideal framework for operationalising capital account liberalisation continues to be a subject of intense debate, and developments in the 1990s have brought the issue to the forefront of discussion in the realm of public policy. The Indian approach to the management of capital flows as it stands today, and the authorities’ perceptions of the various contours of a well-designed framework for operationalising capital account liberalisation, appear prima facie to have been vindicated in the period following the Asian crises. In India, capital account convertibility is viewed as a process, developed as a part of the overall reform process. The need for caution and gradualism arises from the fact that institutional and market structures, market practices and macro policies need to evolve, so that any risks arising from capital account convertibility can be minimised, if not avoided. In liberalising specific transactions, the focus has been on replacing administrative discretionary controls by prudential limits on transactions, allowing freedom of choice within these limits and expanding the number of transactions routed through automatic clearance windows. These norms have in general been guided by the country’s absorptive capacities and the financing needs as defined by the sustainable level of the current account deficit for India, as also the need to diversify capital inflows so as to achieve a desirable mix between short-term and long-term, debt and non-debt, and stable and volatile flows. In this process, the emphasis has shifted gradually from controls to regulation.

∗ Deputy Governor, .  Overseas Development Institute, 2001. Published by Blackwell Publishers, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA. 84 Y.V. Reddy

This article analyses the Indian experience in operationalising capital account liberalisation. The following section provides a brief account of the historical rationale behind the use of controls on capital flows, and describes the factors that triggered the process of liberalisation in the 1990s. The policy framework that governed liberalisation and the current framework of controls are then described, followed by an explanation of the various facets of the Indian approach to management of the capital account and a brief indication of the current thinking on further steps towards liberalisation. While recognising the stringent limitations of drawing inferences based on the experience of a single country, some general observations are offered in the final section.

Rationale for capital controls in the Indian context

Controls in the post-war era

During the Second World War, controls on capital flows were widely used by governments as a revenue-raising measure to finance their war effort. By not allowing capital to leave the country, both wealth and income on capital could be taxed. Capital controls also enabled governments to raise the inflation tax on residents. In the post-war period, particularly in developing countries, controls on capital permitted the pursuance of policies based on financial repression. Government-determined interest rates and the allocation of capital to specific sectors were critical elements of the public policy frameworks in many countries. Over time, particularly during the Bretton Woods period, capital controls operated as an effective tool for gaining monetary policy independence and also for containing a country’s vulnerability to balance-of-payments crises. Some governments even pursued a policy of ‘domestic saving for domestic investment’, guided by considerations of self-reliance. In the 1990s, as more and more countries began liberalising their capital accounts, controls on capital were mostly justified as the ‘second-best’ option for economies with poorly developed financial markets. For some, the lack of efficient markets and institutions may mean greater distortions and market disruptions resulting from an open capital account than when, fearing market failure, capital controls are used to ensure stability and minimise distortions. The effectiveness of capital controls, however, depends, inter alia, on how comprehensive they are and on the country’s administrative capacity to enforce them. India, for instance, had a well developed control apparatus and a comprehensive framework of control, of which control of capital formed a part. Capital controls have also been resorted to during periods of surges in the inflow of private capital. This restriction has essentially been aimed at preventing real appreciation of the exchange rate and at changing the composition of flows in favour of longer-term debt and higher non-debt flows. In some countries, controls on inflows of capital are also used to protect domestic firms, particularly with a view to giving them time to restructure and reform so as to face greater competition in the future. Controls on outflows are generally more significant than on inflows. Normal capital controls, however, differ from the use of reactive controls as a ‘last resort’ to resist severe pressures on the exchange rate. Operationalising Capital Account Liberalisation: The Indian Experience 85

The Indian context

The country context provides an essential background for explaining the process of operationalising capital account liberalisation in India. In order to understand the Indian context, one needs first to appreciate why strict capital controls continued in force until the reform of the 1990s. Firstly, in view of the colonial past and the fact that national freedom was lost to the foreign traders who were licensed to trade in India by the then Indian rulers, public opinion has been very guarded since independence in 1947 and suspicious of the presence of foreign trading interests or foreign capital. Secondly, as a natural consequence, there are concerns about outflows of capital, often reinforced by repeated stress on the balance of payments resulting from extraneous factors such as droughts, wars and supply shocks, mainly of oil. Thirdly, with the adoption of a planned approach to development, the emphasis has been on utilising domestic savings for domestic investment – a logical extension of the preference for national economic self-reliance. Fourthly, until the 1980s, the opinion of influential policy-makers was that world trade was not sufficiently open to permit strong export-led growth to a large economy like that of India. It was argued that protectionist barriers would be raised by the industrial countries if ‘a thousand Singapores’ were attempted by India. Similarly, it was felt that, given the volume and composition of capital flows, India’s substantial needs were unlikely to be met in any significant way. In other words, assessment of the possible quantities of capital inflows that India would be able to attract did not justify the risks of opening up the economy. Fifthly, it has also been the view that the domestic economy was endowed with a reasonable base of human skills, institutional, social and physical infrastructure and diversified industry sufficient to enable it to launch itself successfully on the path of self-reliant growth with a relatively low level of economic dependence on the rest of the world. Though there have been a number of international and domestic developments in the 1990s to modify the country context indicated above, significant public opinion is not yet fully convinced that objective conditions have changed so dramatically that there should be a complete reversal of policy. In particular, the critics of liberalisation point out that over 90% of domestic investment has been financed by domestic savings in accordance with the traditional strategies, and yet growth performance has not been unimpressive. Furthermore, it is argued that a large country like India would have faced a serious threat to national social cohesion if a crisis like that of East Asia had taken place; policy-makers should therefore adopt a risk-averse policy with regard to the capital account. Finally, it is held that, from the geopolitical angle as well as the design and operation of the international financial architecture, India is well advised to be cautious in its estimates of the international support for a bail-out in times of international crisis. Many observers in India feel that this caution is warranted, given the country’s experience so far. The approach to the capital account in recent years captures, as it should in a democratic set-up, these diverse but influential strands of public opinion in the country. 86 Y.V. Reddy

The control regime

It will be useful to present in the country context some of the characteristics of the control regime as they have evolved vis-à-vis developments in the external sector. Soon after independence, a complex web of controls was imposed for all external transactions; these were controls over transactions in foreign exchange independent of trade or other policies, and indeed the control regime extended to all transactions between residents and non-residents. In fact, a significant part of the control regime to promote the planned approach to development was built upon the framework of wartime (Second World War) controls, which were tightened up by legislation in 1973, owing to fears of capital flight. Severe restrictions on current account transactions continued till the mid-1990s. However, India accepted the obligations of Article VIII of the IMF’s Articles of Agreement in 1994. These obligations were fulfilled by relaxing the operations of the 1973 legislation to enable convertibility on the current account. In June, 2000 a legal framework was put into effect to guarantee this convertibility as a general rule rather than as an exception to the control framework. Since the control framework was essentially transaction-based (all transactions in foreign currency or between residents and non-residents were prohibited unless specifically approved), it was equally valid for the capital account, though the capital account itself was negligible until the 1980s. Most capital receipts were on the government account and took the form of external assistance, in addition to the bilateral arrangement with the former USSR. In the 1980s, there was significant resort to private capital flows in the form of External Commercial Borrowings (ECB) and deposits from Non-Resident Indians (NRIs). The situation changed in the 1990s, with a gradual liberalisation of the capital account and subsequent new legislation effective from 1 June 2000 which facilitates rather than prohibits capital transactions. Formalisation of the shift in external policy which began in the early 1990s is found in the preamble to the new legislation effective from 1 June 2000 which, inter alia, states that its objective is to facilitate external trade and payments and to promote the orderly development and maintenance of a foreign-exchange market in India. This effectively replaces the old legislation whose relevant preamble extract reads as: ‘for the conservation of foreign exchange resources of the country and the proper utilisation thereof in the interest of the economic development of the country’. The details of the new legal framework are described later in this article.

The trigger for liberalisation

After independence, India opted for a model of development characterised by what was then perceived as self-reliance. Hence, till the early 1980s, external financing was confined to external assistance from multilateral and bilateral sources, mostly on concessional terms, to or through the government. In the 1980s, global developments, particularly the perceptible decline in the availability of official concessional flows in relation to the external financing needs of developing countries, changed the situation in the external sector at a time when India was initiating liberalisation. The compulsion of repayment to the International Monetary Fund during the late 1980s of the drawings on Operationalising Capital Account Liberalisation: The Indian Experience 87 the External Fund Facility (EFF) in the earlier part of the decade added to the problems. Hence, recourse to on commercial terms became inevitable. In addition to institutional sources (such as export-import agencies), syndicated loans and bonds and deposits from non-resident Indians were accessed. These had to be supplemented in the late 1980s with significantly substantial recourse to short-term facilities, including, in particular, short-term non-resident deposits. Most of these liabilities were on the government account, or that of government-owned enterprises or financial institutions. The beginning of the 1990s, however, saw the impact of the Gulf crisis on India. Combined with the large fiscal deficits of the 1980s and political uncertainties, the repercussions of this development in the Gulf resulted in the commercial sources of financing drying up, giving rise to what could be described as a severe liquidity crisis in the balance of payments. Another global dimension which affected India’s management of the balance of payments during this period was the serious disruption of trade with the former USSR. The crisis was overcome by a series of stringent measures, the overriding objective of which was to honour all the country’s external obligations, with no rescheduling and no prioritisation in meeting its payments obligations. While successfully responding to the Gulf crisis by means of an adjustment programme, it was simultaneously decided to launch a comprehensive programme of structural reform, of which the external sector constituted a critical component.

The liberalisation process

Control and regulatory framework and liberalisation

Mainstream thinking up to the time of the Asian crises was averse to capital controls, but, in the recent past, this aversion has yielded to a lively debate on the efficacy of such controls, and consequently on their framework and operation. The control framework can be viewed from different angles. Basically, the control instruments are quantitative or price-based, including price ceilings or floors and possibly a combination of the two. Controls or lack of them may be based on the size of a transaction, its purpose, or the category of the participants. Asymmetrical treatment in regard to the applicability and nature of the controls is common between inflows and outflows; between outflows associated with inflows (i.e. principal, interest, dividends, profits and sale proceeds) and other outflows; between residents and non-residents; and between individuals, corporate entities, banks and other financial intermediaries. The instruments of control vary from non-applicability to total prohibition, with intermediate regimes, say, of approval on an automatic basis, case by case or simply price-based. The control may also differentiate financial instruments by their nature or ratings. In managing the capital account by means of a control framework, there can be a prioritisation of capital flows − in terms of their desirability or otherwise. Thus, for example, a higher preference could be given to foreign direct investment and long-term debt as compared with portfolio flows and short-term debt. It has to be recognised that the efficacy of control depends, among many other things, on the category of flows or participants. For example, it is less complex to control inflows from non-residents, since non-residents are keen to have a legal title to their assets. Empirical evidence indicates that control of outflows from residents is 88 Y.V. Reddy facilitated more by appropriate tax regimes and acceptable exchange rates, than through the control framework. It is also necessary to make a distinction between the control framework and the regulatory framework. An important component of the latter relates to prudential regulation over banks vis-à-vis the external sector. This may include provisioning requirements for net external positions; limits on open positions; and limits on investment in foreign-currency-denominated assets. There could also be differentiated tax regimes affecting the maturity pattern. Monetary measures such as reserve requirements have both an external-sector and a monetary angle. These regulatory instruments are part of the package available for influencing the size and composition of capital flows. Similarly, restrictions on portfolio investments by a securities regulator will also provide for different degrees of openness from time to time. While controls may be potentially inefficient, there is considerable merit in using the regulatory framework described above to moderate the ebb and flow in capital movements. The gradual move towards liberalisation can be put into effect by means of a change in the mix and rigour of controls or the regulatory framework, especially taking into account the tendency towards perceived excess in inflows or outflows. However, the objective should not be to dilute prudential regulations, but to use them additionally as instruments to influence capital movements as well. In regard to the dynamic of control or regulation vis-à-vis liberalisation, it is clear that a workable framework appropriate to each country is needed. The more important aspect of managing the capital account is the flexibility available in the framework to progressively liberalise capital-account transactions, depending on domestic and international developments. At the same time, such flexibility could permit quick responses to changes in the magnitudes, direction and composition of flows that may appear to be inappropriate to the relevant circumstances. To be successful, this flexibility in operations may warrant complementarity with other policies. Finally, there may be a case for retaining the freedom to re-impose controls or tighten regulations so long as the vulnerability to highly speculative or motivated attacks on the currency exists, since market corrections may be more destabilising to the economy. Thus, it may be wise, even in the liberalised framework, to retain an option to impose controls or tighten regulations.

The policy framework in India

The broad approach to reform in the external sector following the Gulf crisis was set out in the April 1993 Report of the High-Level Committee on the Balance of Payments chaired by Dr C. Rangarajan. The Committee recommended the introduction of a market-determined exchange-rate regime and emphasised the need to contain the current account deficit within sustainable limits. It recommended, inter alia, the liberalisation of current account transactions leading to current account convertibility; compositional shifts in capital flows, away from debt to non-debt-creating flows; strict regulation of external commercial borrowing, especially short-term debt; measures to discourage the volatile elements of flows from non-resident Indians; full freedom for outflows associated with inflows (i.e. principal, interest, dividends, profits and sale proceeds) and the gradual liberalisation of other outflows; and dissociation of the government from intermediation in the flow of external assistance. Operationalising Capital Account Liberalisation: The Indian Experience 89

The policy framework for the external sector based on the Rangarajan Committee Report was implemented, along with appropriate policy changes in the trade, industrial and financial sectors. With regard to trade policy, there has been a virtual elimination of licensing, a progressive shift of restricted imports to the Open General Licence (OGL) system, and lowering of tariff barriers. Industrial policy has been characterised by delicensing, and the removal of monopoly clauses defining large industrial houses and of most reservations for public sector enterprises. Reforms in the financial sector were guided by the recommendations of the 1991 appointed by the government. Alongside deregulation of the banking industry including permitting entry for new private sector banks, the general thrust of monetary policy has been towards reduction in pre-emptions (i.e. reduction in the cash reserve and statutory liquidity ratios prescribed for banks), greater recourse to open market operations, deregulation of interest rates and a widening and deepening of financial markets. Simultaneously, measures have been undertaken to strengthen the institutional framework in banking, non-banking financial institutions, financial institutions and stock markets, by means of prudential norms, stipulations regarding capital adequacy, improvements in payments and settlement mechanisms, and strengthening of the supervisory framework. Institutional measures have also included the recapitalisation of banks, improvements in debt recovery and, most important, the setting up of the Board for Financial Supervision and strengthening the Reserve Bank’s supervisory mechanisms. A second Narasimham Committee (1998) has provided a map for further reform of the banking sector, and a number of recommendations on prudential norms have been implemented. Fiscal adjustment has also been undertaken, a significant measure in this regard being that the system of automatic monetisation of the fiscal deficit has been replaced by a system of Ways and Means Advances. In the 2000 Budget, the intention to promulgate a Fiscal Responsibility Act was announced; the Act is in an advanced stage of drafting. To sum up, reform in the external sector was co-ordinated with reform in other related sectors, and within the external-sector reform, capital flows are now managed bearing in mind the need for efficiency and stability. There was a fairly smooth shift from an administered exchange-rate system to a market-determined exchange rate. The Reserve Bank attempts to ensure that volatility and speculative elements are curbed by means of both direct and indirect measures.

The process of liberalisation

The Interim Report of the High Level Committee on the Balance of Payments, published in March 1992, while providing the basic framework for policy changes in the external sector, also indicated the transition path. Accordingly, the Liberalised Exchange Rate Management System involving a dual exchange-rate system was instituted the same month, in conjunction with other liberalisation measures in the areas of trade, industry and foreign investment. This dual exchange-rate system was essentially a transitional stage leading to the ultimate convergence of the two rates effective from 1 March 1993, which brought about the era of the market-determined exchange-rate regime of the rupee. It also marked an important step in progress towards 90 Y.V. Reddy current account convertibility, which was finally achieved in August 1994 by the acceptance of Article VIII of the IMF Articles of Agreement. The appointment of a 14-member Expert Group on Foreign Exchange (Sodhani Committee) in November 1994 was a follow-up to the above measures, aimed at the development of a foreign-exchange market in India. The Group studied the market in great detail and its Report of June 1995 came up with far-reaching recommendations to develop, deepen and widen the forex market, including the introduction of various new products for risk management and greater efficiency in the market, plus tighter internal control and risk-management systems. Many of the subsequent actions were based on this Report. The Tarapore Committee on Capital Account Convertibility of 1997, appointed by the Reserve Bank of India, recommended a number of measures while inviting attention to a number of preconditions. Among the various liberalisation measures undertaken in the light of these recommendations are those relating to foreign direct investment, portfolio investment, investment in joint ventures/wholly owned subsidiaries abroad, export projects, the opening of Indian corporate offices abroad, the raising of the Exchange Earners Foreign Currency (EEFC) entitlement to 50%, forfaiting, allowing acceptance credit for exports, allowing foreign institutional investors to cover forward a part of their exposures in debt and equity markets, etc. The current framework of controls needs to be analysed from different angles to capture its operational reality. First, there is a differentiation between current (convertible) and capital account (subject to some controls) transactions. Secondly, there is a distinction and asymmetrical treatment between inflows (less restricted), outflows associated with inflows (free) and other outflows (more restricted). Thirdly, residents are treated differently from non-residents (less restrictively). Non-resident Indians have a well defined intermediate status between residents and non-residents. Fourthly, there are also differences in the treatment of individuals (highly restrictive), corporate entities (restrictive) and financial intermediaries such as institutional investors (less restrictive) and banks (more restrictive). The control instruments are also varied and are applied individually or in conjunction. Thus, some transactions are totally free and some totally prohibited. The intermediate category ranges from prior approval on a case-by-case basis to an automatic basis, the application of automaticity or otherwise being defined with reference to the size of transactions, their purpose, or the category of the parties involved. The restrictions can also apply with reference to the financial instrument concerned. In some cases, price-based (tax or reserve requirements) or administrative (interest-rate ceilings) controls are used. The process of liberalisation is put into operation by relaxing the degree of control. Thus, moves from more restrictive to less restrictive take place from time to time based on both micro-experience and the macro-policy environment. For example, in times of capital surges, the pace of liberalising outflows is accelerated and vice versa.

Management of the capital account in India

Based on the policy framework and the projected financing requirements for each year, management of the capital account is operationalised via transparent procedures for external debt and non-debt inflows as well as foreign currency outflows. Operationalising Capital Account Liberalisation: The Indian Experience 91

As regards inflows, it may be observed that the external debt on the government account comes basically from bilateral and multilateral sources, with long maturities. There are quantitative and a number of end-use restrictions on external commercial borrowings, and access is permitted mainly to corporate entities and development financial institutions. There are severe quantitative restrictions on short-term borrowings as well, apart from those strictly related to trade. Banks are permitted access under prescribed quantitative ceilings. Deposits from non-resident Indians are accepted by the banking system, and while non-repatriable deposits are akin to domestic deposits, interest rates on repatriable ones are subject to ceilings. There is a more relaxed approach to Foreign Direct Investment, which contains two routes, namely, a gradually expanding automatic approval route and a gradually diminishing case-by-case route. There is a very short prohibited list. Portfolio investments are restricted to selected players, and are mainly for approved institutional investors. The taxes on short-term gains are higher than for long-term gains. In addition, Indian companies are allowed to raise resources through depository receipts, subject to approval. There are no restrictions at all on outflows associated with permitted inflows. In respect of outflows, direct overseas investment is permitted via two routes, namely, case-by-case approval, and an automatic list generally restricted to exporters. Other individual residents are virtually prohibited from holding financial assets in foreign currency.

Managing volatility in capital flows

Between 1993 and the present, even with a managed capital account, there have been occasional surges in inflows and outflows. In general, the short-term response to surges in inflows has taken a number of forms, namely, raising reserve requirements, reviewing the pace of removing restrictions on capital inflows, relaxation of end-use specifications, liberalisation of capital outflows, partial sterilisation through open market operations, and deepening the foreign-exchange market by routing an increased volume of transactions through it. During times of pressure on the exchange rate emanating from large-scale outflows or leads and lags, the Reserve Bank has resorted to both monetary and administrative measures to contain the pressure, apart from market operations to even out lumpy demand. These measures were undertaken mainly to even out temporary demand/supply mismatches. For instance, in order to encourage the faster realisation of export proceeds and to prevent an acceleration of import payments, the interest-rate surcharge on import finance was raised, interest charges were imposed on overdue export bills, and the scheme of post-shipment export credit denominated in foreign currency was scrapped. Monetary measures included raising the Bank rate and repo rates and tightening up liquidity by raising the cash reserve ratio. In order to mitigate exchange-rate fluctuations due to large payments, payments on account of oil imports have been met directly out of reserves. An extraordinary situation arose in 1998-9, consequent upon the imposition of US sanctions. The issue of Resurgent India Bonds (RIBs) is an interesting example of the management of the capital account in such a situation. The RIBs were designed to meet the extraordinary political events of 1998-9, which might have resulted in some shortfall 92 Y.V. Reddy in the normally expected level of capital inflows in relation to the country’s sustainable current account deficit. A policy of depleting reserves might have affected market sentiment adversely, and compressing current account demand by means of drastic import cuts could have worsened the growth outturn. The government’s preferred alternative was to enhance debt flows at the least possible cost. There was a need to offset the adverse negative sentiment created in the international capital markets, due to the downgrading of India’s sovereign rating to the non-investment grade. This warranted the raising of debt resources at a cost lower than any organised financial intermediary was prepared to arrange in the context of the rating downgrade. Raising resources through sovereign borrowing was considered to be time- consuming and it would have been inadvisable to launch a maiden offering under adverse circumstances. At the same time, it was necessary to ensure that the amounts raised were sufficient to meet essential needs, that they were an adequate replacement for normal debt flows, that they offered the authorities an option of premature closure, and that the borrowing was of an appropriate medium-term maturity, say, five years. The RIBs, which are essentially in the nature of foreign currency deposits on a par with foreign currency non-resident deposits (banks), were devised bearing in mind these considerations. It was also necessary for the Reserve Bank to ensure that these funds did not disrupt the money, forex or government securities markets. A total amount of US$4.23 billion was mobilised at a relatively moderate cost in a difficult international environment and in the face of a downgrading of India’s credit rating.

Link with current account and dollarisation

When India adopted current account convertibility in 1994, it was recognised, as emphasised by the Rangarajan Committee, that there could be capital outflows from residents in the guise of current transactions. Hence, certain safeguards were built into the regulations relating to these account transactions. A highly conservative approach was adopted with reference to dollarisation and internationalisation of the domestic currency. First, the requirement of repatriation and surrender of export proceeds was continued. Exporters were allowed, however, to retain a portion of their earnings in foreign currency accounts in India which could be used for approved purposes, thereby avoiding the costs of conversion and reconversion. Secondly, all authorised dealers were allowed to sell foreign exchange for underlying current account transactions, which could be readily identified and supported by some documentary evidence. Thirdly, indicative value limits were set for different kinds of transactions so that the amounts sold were reasonable in relation to the purpose. For higher amounts, the banks had to approach the Reserve Bank. This operational framework for current account transactions strengthened the effectiveness of management of the capital account. With regard to dollarisation, it was recognised that large-scale dollar-denominated assets within a country can disrupt the economy by creating the potential for destabilising flows. In general no dollar-denominated transactions are allowed between residents. EEFC accounts can be used only for external payments; if these balances need to be used for local payments, they have to be converted into rupees. The counterpart of dollarisation is internationalisation of the domestic currency. For example, there are instances when the currency of a developing country could be Operationalising Capital Account Liberalisation: The Indian Experience 93 officially traded outside the country without any underlying trade or investment transactions. When such currencies are held increasingly outside the country and there is multiplication of such holdings, any expectation of a fall in the currency due to fundamental economic factors or contagion leads to a widespread sell-off which results in a very sharp fall in the currency, especially when the local markets are not well developed. India does not permit the rupee to be traded offshore; in other words, the rupee is not allowed to be officially used as an international means of payment or store of value. Indian banks are not permitted to offer two-way quotes to NRIs or non- resident banks.

Policy on reserve accumulation

Reserves have been steadily built up by encouraging non-debt-creating flows and de- emphasising debt-creating flows. It is recognised that a level of reserves that satisfies the need for liquidity and offers insulation against unforeseen shocks is reasonable. Foreign-exchange reserves are kept at a level which is adequate to withstand both cyclical and unanticipated shocks. The liquidity needs are assessed over various time horizons, namely, on a daily, weekly and monthly basis. The long-run perspective on liquidity is also kept under constant review by ensuring that the reserves are adequate not only in terms of conventional norms like import cover, but also in terms of debt servicing, the stock of short-term debt and portfolio investment. The essence of reserve management being safety, liquidity and returns, with the preponderant weights assigned to the former two, all investments made in reserves are of top quality and excellent liquidity. Liquidity risk is also mitigated to a large extent by keeping a good proportion of the reserves invested in those assets/deposits which are of top credit quality and convertible into cash at short notice. There is rigorous internal rating of the institutions and instruments in which reserves are invested, and the counterparties with which deals are conducted are also subject to screening. These ratings are reviewed on an on-going basis. There is a further in-built safeguard, in that capital flows are closely monitored and the contracting of debt itself is controlled.

Exchange-rate management

The exchange rate of the is determined by the market, i.e. by the forces of demand and supply. The objectives of exchange-rate management are to ensure that economic fundamentals are reflected in the external value of the rupee, as evidenced in the sustainable current account deficit. Subject to this general objective, the conduct of exchange-rate policy is guided by three major considerations:

• to reduce excess volatility in exchange rates, while ensuring that the movements are orderly and calibrated; • to help maintain an adequate level of foreign-exchange reserves; • to help eliminate market constraints with a view to the development of a healthy foreign-exchange market.

Basically, the policy is aimed at preventing destabilising speculation in the market, while facilitating foreign-exchange transactions at market rates for all permissible 94 Y.V. Reddy purposes. The Reserve Bank of India makes sales and purchases of foreign currency in the forex market, primarily to even out lumpy demand or supply in the thin market; substantial lumpiness in demand is mainly on account of oil imports and external debt servicing on the government account. Such sales and purchases are not governed by a predetermined target or band around the exchange rate.

Monitoring

The RBI monitors closely the foreign currency/gold maturity mismatch limits and open foreign currency and gold positions of the banks. The open foreign currency position is applicable to all currencies collectively using the shorthand method, i.e. the higher of the total short or long positions; no limits have been set for individual currencies. While vetting these limits, the RBI ensures that they have a reasonable relationship with the Tier I capital funds of the banks. In addition, the RBI has prescribed capital requirements for market risk on open foreign currency positions. Banks are required to add the open position limit to the total risk-weighted assets and maintain the required capital ratio.

Dissemination of data

India was one of the earliest subscribers to the Statistical Data Dissemination Services of the International Monetary Fund, and it disseminates important external sector statistics. The RBI publishes annually detailed data on the external sector in its Annual Report and the Report on Currency and Finance, while balance-of-payments data are published in its monthly bulletin on a quarterly basis with a three-month lag. The Weekly Statistical Supplement to the RBI Bulletin contains data on monetary and financial aspects as well as the external sector. In the external sector, the daily exchange rates, spot and forwards, and the weekly forex reserves position are given. The total external debt of India is compiled and published by the Ministry of Finance and the RBI at different frequencies. The Ministry of Finance publishes data annually in the form of a Status Report and in the Economic Survey, which are public documents. These reports provide information on multilateral, bilateral and commercial debt and identify government debt separately. The data include debt for defence purposes, rupee-denominated debt and NRI deposits. The sources of the data are also reported. Since all external borrowings need approval, the quality of the data is reasonably sound. Currently, data are reported on the original maturity basis as well. The data on foreign investments, both direct and portfolio, as well as on outstanding balances under various non-resident deposit schemes, are published on a monthly basis in the RBI Bulletin. This is in addition to trade data. The RBI disseminates data on the forex reserves on a weekly basis with a one-week lag. Data are given separately with regard to foreign currency assets and SDR and gold holdings. Information on the sale and purchase of foreign currency by the RBI as well as on the forward liabilities of the central bank is disseminated to the public on a monthly basis, with a one-month lag. Data on the forex reserves are disseminated via the Weekly Statistical Supplement and the monthly RBI Bulletin, and are also available on the RBI website. The RBI also publishes the 5-country and 36-country Nominally Effective Operationalising Capital Account Liberalisation: The Indian Experience 95

(NEER) and Real Effective Exchange Rate (REER) on a monthly basis with a one- month lag. The government has recently set up a National Statistical Commission to examine the deficiencies of the present statistical system with a view to recommending measures for its systematic revamping. One of the subgroups is looking into the financial and external sector statistics, and has already identified aspects of external sector data that require further refinements. It has initiated follow-up action to bridge the data gaps.

Legal framework

The Foreign Exchange Regulation Act (FERA) has been replaced by the Foreign Exchange Management Act (FEMA) with effect from the beginning of June 2000. The philosophy of foreign-exchange management has shifted from that of conservation of foreign exchange to one of facilitating trade and payments as well as developing financial markets. This definitive shift in objectives will automatically be reflected in the operations of the Reserve Bank. There is a clear distinction between the current and the capital accounts. Under the new system, all current account payments, except those notified by the government, are eligible for appropriate foreign currency from the authorised dealers in respect of genuine transactions, without any restrictions. The surrender requirements in respect of exports of goods and services continue to operate. The Reserve Bank, however, is to have the necessary regulatory jurisdiction over capital account transactions. To this extent, further action in regard to capital account liberalisation appears to have been put by the government squarely in the court of the RBI. It should be noted that the new legal framework retains the option of re-imposing controls on the capital or current account, if this becomes necessary. Thus, the central government is vested with the power to suspend or revoke any permission granted if it is satisfied that circumstances warrant such action in the public interest.

Capital account convertibility - further steps

The Tarapore Committee on Capital Account Convertibility, which submitted its Report in May 1997, observed that, although there are benefits to be reaped from a more open capital account, international experience shows that this could impose tremendous pressures on the financial system. Hence, the Committee indicated certain signposts or preconditions for capital account convertibility in India. The three crucial preconditions were fiscal consolidation, a mandated inflation target and, above all, strengthening of the financial system. The Committee recommended a reduction in the Gross Fiscal Deficit/Gross Domestic Product ratio from 4.5 to 3.5% in 1999-2000 and a mandated rate of inflation for the period 1997-8 to 1999-2000 at an average of 3 to 5%. In the financial sector, the timeframe for recommended signposts was stated in terms of the cash reserve ratio (CRR) and non- performing assets (NPAs). The recommendations were to reduce the gross NPAs of banks as a percentage of total advances from 13.7% in 1996-7 to 9% by 1998-9 and 5% by 1999-2000, and the average effective CRR from 9.3% as of April 1997 to 3% by 1999-2000. While there has been universal approval of the appropriateness of the 96 Y.V. Reddy preconditions, several analysts have expressed reservations about the feasibility of adhering to the timetable. The process of convertibility on the capital account has been gradual and, as the experience shows, it contains a hierarchy. There is a differentiation between inflows and outflows and, within this, between corporate entities, individuals and banks. Currently, the priority is to liberalise inflows, in particular on the corporate account. The recent freedom given to corporate entities to raise funds through American Depository Receipts/Global Depository Receipts is a signal to this effect. All outflows associated with inflows are totally free. With regard to the liberalisation of outflows, the hierarchy stands as corporate entities, financial intermediaries and then individuals, although the Tarapore Committee preferred the liberalisation of flows on individual account to come higher in the hierarchy. It would, therefore, be reasonable to expect some liberalisation on outflows with regard to corporate entities in the near term, and in regard to banks and other financial intermediaries after some progress has been made in the financial sector reforms. On the path towards capital account convertibility, public opinion is now much more favourable and the issue has become more one of technical judgement on sequencing rather than whether to open up or not. Between the preconditions and the timeframe recommended by the Committee, it is clear that achievement of the preconditions has emerged, as perhaps intended, as the more important criterion for liberalising the capital account, while the timetable itself has less significance. Thus, the pace of liberalisation will now depend on domestic factors, especially the progress made in financial sector reform, and the evolving international financial architecture.

Conclusions

The Indian context described in this article is significantly different from that of many other countries. These concluding observations are particularly relevant to countries which operate with a more or less similar framework to that of India. Given the variety of situations and the fluidity of the issue, inferences drawn from the Indian experience may need to be either totally eschewed or viewed with great circumspection. With this cautionary note, some broad generalisations are attempted here. These are somewhat narrowly focused on the external sector and not the broader macro-policy issues such as the implications for monetary management and exchange-rate policy. First, the current account deficit represents the use of growth-supportive external resources within a country. Capital inflows which finance such deficits are welcome for their role in supplementing domestic saving, and thereby sustaining long-term development. At the same time, it should be apparent that a large current account deficit correspondingly implies a large dependence on such capital inflows and associated elongation in the stock of external liabilities. The developing countries are vulnerable in many spheres, and hence such substantial dependence has a potential for instability. The issue is not whether there are inflows or outflows at a point in time, since a fall in inflows is enough to cause a crisis when there is large dependence. It is precisely in accordance with this view that India resisted the urge to allow the current account deficit to exceed 2 % of GDP. (No doubt the level of normal capital flows or sustainable current account deficit is contextual to the country concerned, the level of development, the extent of the external sector and Operationalising Capital Account Liberalisation: The Indian Experience 97 even geopolitical considerations.) Briefly stated, for developing countries, non-volatile flows are ensured only if the current account deficit is sustainable, and policy-makers need to review this sustainability constantly. Second, there is a trade-off between financial stability and efficiency, which all policy-makers are aware of. The more prudential the regulations, the greater is the cost of intermediation, though in the long term it is the stability that imparts efficiency. Seeking higher efficiency gains in one stage of its development, a country may accept the risk of an open capital account and in the process end up with greater instability. (But the trade-off has to be viewed in a contextual sense in relation to both the domestic policy stance and the international environment.) There is an impression, in the light of the Asian experience, that the policy choice should in future tilt totally in favour of stability at the cost of efficiency. While the crisis has drawn attention to the risks and inadequacies in international financial systems, there is now a greater global awareness of the issues. In other words, the relative weights of efficiency and stability need to be constantly reviewed in deciding the pace of capital account liberalisation. Third, in the context of normal flows, one way of giving a greater weight to stability would be to emphasise longer-term flows. The issue would, of course, be how to distinguish between long-term and short-term. It is necessary to recognise the existence of a hierarchy, however difficult it is to achieve. From the purist point of view, an efficient system of financial intermediation would require easy movements and transmission mechanisms. But, with all the globalisation, cross-border flows are not subject to the same logic as domestic flows. True, the presumed differences between portfolio flows and FDI flows can be overdone, as FDI flows can also be volatile. Similarly, longer-maturity external liabilities may seem less vulnerable to volatility than short-maturity ones; but if there are active secondary markets long maturities may be highly liquid and volatile. Foreign owners of equity can choose to exit at any time, although a falling market or depreciating currency should provide a market-based disincentive. Nevertheless, experience has shown that FDI has a tendency to be less volatile, because the original motivations for the inflow are both financial and non-financial. Furthermore, there is also a gestation period, namely to project completion, which is built into the profit projection, thus necessitating a stay-put orientation. Hence, there is merit in giving greater weight to FDI than portfolio flows in deciding what is relatively long-term, even though one might consider the possibility that, even if measured FDI flows are less volatile, FDI positions can be used for leveraging a currency. Fourth, the treatment of trade-related flows for defining short-term debt assumes importance. It is important to distinguish between shorter-maturity trade credits, which provide a rather stable source of financing, and other types of short-term borrowing. It is also essential to capture the leads and lags in trade-related payments that affect the level of short-term debt. Fifth, while the size and maturity structure of debt are important, the bunching of repayments is critical. In this context, the impression that all long-term debt is a panacea may not be totally correct. The approach should not be merely to contain certain debt under all circumstances, but to moderate the size and changes in debt flows. Keeping the external debt within limits has a role to play in the avoidance of financial crisis, but the bunching of repayments has a potential to create liquidity problems. 98 Y.V. Reddy

Sixth, it would be as well for the authorities to monitor continuously the level of private-sector debt and the positions that it takes. Since large transactions have the potential to disrupt the market, it is better to keep a check on such transactions. Financial institutions have to be sensitised to monitor the unhedged positions of corporate entities. Seventh, there is a need to be careful about dollarisation of the economy. It is now recognised that large-scale dollar-denominated assets within a country can disrupt the economy by creating the potential for destabilisation. It is, of course, true that some countries with severe macroeconomic imbalances are, however, opting for or considering formal dollarisation. Eighth, the discipline of releasing timely data compels the authorities to be more accountable and markets to be less prone to surprises. The dissemination of data should be regular, relevant, timely and authentic, though such transparency does not eliminate the risk of wrong inferences being drawn by market participants. Ninth, the skills of market participants as well as regulators need to be continuously upgraded in order to keep pace with the developments in technology and the innovations in the market, if both policy changes and responses are to be effective. There is in some sense a dilemma here. Controls are imposed because markets are imperfect and participants’ skills are inadequate; but markets do not get less imperfect and participants’ skills do not improve so long as controls exist. The interactive process is critical here. Tenth, the nature of the relationship between different financial markets is important. It is now recognised that capital account liberalisation should not be undertaken without a strong financial sector, since the strength of the financial sector has systemic implications. It is not appropriate to assume that since markets are developed they are fully integrated. There can be varying patterns of integration. Thus, opening up the capital account should take account of the specific country circumstances, while establishing a strong legal, regulatory and institutional framework. An added dimension, of course, is developing the international financial architecture. Thus, the pace and sequencing of liberalisation have to be determined by both domestic and international developments. It is important, however, to appreciate a financial sector that is financially strong, well managed and well regulated and supervised. Eleventh, should liberalisation of the capital account totally foreclose the option of imposing controls? It is perhaps wise for many developing countries to possess the legal framework for re-imposing controls at times of necessity and to keep the policy option open for both prudential and ad hoc controls. Such options for domestic action are warranted so long as the international financial system imposes unequal burdens between the domestic economy and market participants in the event of volatility. Finally, an issue that is often raised relates to the speed with which a country should open up. As evident from the description in this article, the issue of liberalisation of the capital account cannot be approached in isolation. The degree of sustainable openness, in some ways, depends on productivity and the prospects for improvements in productivity in the real sector. Even more important, it depends on the size and structure of the domestic economy, the political economy of the country concerned, and the assurances of stability and support, when needed, from the international financial system. As of now, the burden of crises arising from the capital account appears to fall Operationalising Capital Account Liberalisation: The Indian Experience 99 predominantly on the residents. In sum, capital account liberalisation has both a national and international context − a truism indeed.

Selected bibliography

Bhinda, Nils et al. (1999) Private Capital Flows to Africa: Perception and Reality. The Hague: FONDAD. Darbha, Gangadhar (ed.) (2000) India’s Monetary Policy in the Crucible of Reform. The collected speeches of Savak S. Tarapore (1992-96). New Delhi: Visan Books. Fischer, S. (1998), ‘Capital Account Liberalisation and the Role of the IMF’, in P.B.Kenen (ed.), Should the IMF Pursue Capital Account Convertibility? Princeton Essays in International Finance No.207. Princeton, NJ: Princeton University Press. Jalan, Bimal (1999) ‘International Financial Architecture: Developing Countries’ Perspectives’, Reserve Bank of India Bulletin, October. Kalyalya, H. Denni et al. (1999) Survey of Private Capital Flows in Zambia. PCF2 Country Team Report, March. Matale, Austin et al. (1996) ‘Capital Inflows and Macro Economic Policy in Zambia’, Bank of Zambia Fortnightly Statistics. Nayyar, Deepak (2000) Capital Controls and the World Financial Authority - What Can We Learn from the Indian Experience? DSA Working Paper, Jawaharlal Nehru University. Rangarajan, C. (2000) Perspectives on Indian Economy: A Collection of Essays. New Delhi: UBSPD. Rangarajan, C. and Prasad, A. (1999) ‘Some Critical Issues in the East Asian Crisis – An Evaluation’, ICRA Bulletin Money and Finance, October-December. Reddy, Y.V. (2000) Monetary and Financial Sector Policies in India: A Central Banker's Perspective. New Delhi: UBSPD. Tarapore, S.S. (2000) Issues in Financial Sector Reforms. New Delhi:UBSPD.