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, Reserve Bank of India. 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.