The Issue of Capital Account Convertibility

[Key Note Address at the Assembly of the Forex Dealers' Association of India at Bangalore on September 28, 2002 delivered by Smt K.J.Udeshi, Executive Director, RBI]

The Asian financial crisis led to a rethinking of the various issues relating to the CAC. Earlier, CAC was the mantra on everyone's lips and even international agencies like the IMF were nudging - not too gently - countries like India towards liberalising the capital account. While on the subject of capital account convertibility, I recall the observations of our Governor, Dr.Bimal Jalan and I quote, "...It must be understood that merely by lifting all capital controls, the markets of a developing country do not get as deeply integrated as a developed country's markets. As such, each country would need to decide on its own path of capital account liberalization with regard to the timing and sequencing". The critical role played by a well capitalised, well managed and well-regulated financial system which has all along been stressed by the Indian authorities has come into sharper focus. Further, the dangers from a highly leveraged corporate structure without proper norms for corporate governance are better appreciated. Needless to say, the fiscal position has to be taken into account. As far as developing markets in general are concerned, there would be six tenets that would need to be kept in mind by the authorities while deciding on the pace of capital account liberalisation.

First, it is not necessary for a country to have a totally open capital account. Secondly, it is imperative to make a distinction between controls that hinder efficient international intermediation and those that are necessary to control potential problems while sequencing the capital account liberalisation. Thirdly, a developing country with underdeveloped financial markets should reserve the right to reimpose controls if warranted. By a well paced calibration of the liberalisation process we have had a remarkable record of minimal backtracking. Fourthly, it is important to remember that it is necessary to have an overall environment where the measures on outflows are well sequenced. Fifthly, the Asian Crisis clearly demonstrated the dangers of hidden risks in the balance sheets of highly leveraged corporates. Therefore, information about the potential impact of corporate activity at times of crisis could prove very useful to the authorities. Reserve Bank took a definite step in this regard recently by directing banks to collect information relating to unhedged exposures of their clients. Finally, it is important to recognise that the more we liberalise the more we would need to monitor flows and we need not be defensive of the monitoring of flows.

Some facts about capital account liberalisation. In the absence of a well chalked out sequencing, the liberalisation of capital account has often been followed by crisis in many countries. It is often a mistake to over emphasise the permissive factor of capital account liberalisation while under estimating the importance of weakness in fiscal policy as well as the compatibilities between the desirable monetary and exchange rate policies and the actual ones followed in practice. At the same time, it also stands to reason that the cost of maintaining controls and the inefficiencies and distortions that result should be carefully evaluated. Nevertheless, given the fact that effect of a crisis is often of a long term nature as far as real sector of the economy is concerned, economists are increasingly recognising the merit of a gradual, well thought out, prioritised opening up of capital account. What lessons do we need to draw from the episodes of crises in other countries?

First, countries need to pursue sound macro economic and trade policies to minimise risk while carefully opening up the capital account. Secondly, countries should strengthen their financial and supervisory systems before going capital account convertible. Thirdly, a strong corporate sector with good governance is an essential pre-requisite for a faster opening up of the capital account. Fourthly, CAC essentially pre-supposes a market determined exchange rate system.

This brings me to the issue of India's march towards CAC, which has hastened in recent times and our efforts at liberalising various procedures. There is an erroneous impression in certain quarters which are meant to be otherwise well informed. It is stultifying to claim that the Indian approach to CAC is one of encouraging inflows while discouraging outflows. Nothing could be farther from the truth. Capital inflows were always encouraged and repatriability assured. In fact, the thrust of the policy in recent years has been to minimise or totally abolish administrative hurdles. The added emphasis in the last few years has been a gradual and measured opening up of outflows by residents e.g.: i. ii. iii. iv. Resident individuals can now get upto $ 500 without filling any form or submission of any documents. Remittance of foreign exchange for medical treatment upto $ 50,000 is also without submission of any documents. Remittance of foreign exchange for travel and education or gifting of funds upto $ 5000 had already been freed. Individual professionals can now retain upto 100% of his foreign exchange earning in EEFC accounts.

To the NRIs we have sent a strong and unequivocal signal and thereby to the world at large about our commitment to convertibility i. ii. iii. Repatriable status accorded to all non-resident depositors except balances in NRO accounts. Capital transfers for NRIs upto $ 1,00,000 out of sale of immovable property as also inheritances and legacies, permitted. Even for balances in NRO accounts greater freedom for repatriation of balances for medical treatment, studies, etc.

For exporters, suffice it to say, that it is a continuous process of rationalisation of procedures, with a view to minimising transaction costs, and to ensure easier and cheaper availability of credit. i. To increase the competitiveness of the Indian corporates, limits for Indian direct investments under the automatic route has been doubled to US$ 100 million. - Software exporters are encouraged by permitting them to receive 25% of the value of their exports in the form of equity of start-up companies. Two-way fungibility of ADRs/GDRs were operationalised to bring about alignment in the prices of Indian stocks in the domestic vis--vis international markets. Corporates have also been accorded greater freedom to raise (upto $ 50 million) and prepay foreign currency borrowings (upto US$ 100 million). Corporates have also been accorded greater freedom to raise short-term suppliers/buyers credit for imports (up to US$ 20 million). An even greater relief to corporates and banks alike is the relaxation in the submission of exchange control copy of Bills of Entry for imports upto US$ 25,000.

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The freedom of FIIs in the Indian financial market has been substantially increased and they are allowed to trade in exchange traded derivatives. Alongside, liberalisation has also been effected in the foreign exchange market. For instance, the freedom to rebook cancelled contracts has been restored, so also booking of contracts based on past performance. Swap and open position limits available to banks have been enhanced to enable banks to offer finer rates to the customers. RBI is also actively considering introducing rupee based currency options. A Committee constituted to look into various related aspects is expected to submit its recommendations to the Reserve Bank very soon. I also understand that the Forex association has aptly arranged a panel discussion on this subject tomorrow. I hope that my colleagues who will be participating in the discussions will carry back several useful suggestions on the subject.

The issue of capital account convertibility also leads me to the current spate of debates and opinions in respect of the level and cost of reserves. Should countries hold larger reserves or less reserves? Countries need to set their reserves holding on the basis of capital as well as current account variables. Apart from the computable charge on the reserves arising out of commitments relating to capital account transactions both long and short term, as well as trade requirement, the impact of external and internal shocks have to be kept in view in formulating policy on reserves. As the capital account becomes more open and international capital flows more readily, the demand for reserves will increase. Merely comparing global interest rates with domestic interest rate as a proxy for cost of reserves may not be appropriate. It is not the arithmetical difference in interest rate on substitutable assets but the various other unquantifiable benefits that the economy derives on account of strong reserves which needs due recognition in such discussions. Two aspects relating to liberalisation need reiteration even at the cost perhaps of repetition. First and more important for the fruits of liberalisation to reach the common man the role of officials at the bank branches is crucial. Our experience based on the feedback from media reports and the public in this regard is unfortunately not too encouraging. There is just no purpose in talking about CAC from high podiums if action at the grass roots level is still embedded in FERA mindsets. Let me emphasise on one important irritant that a common man is concerned about. He is becoming increasingly intolerant and sensitive to too much documentation particularly for small value transactions. Our efforts in this direction are yet to bear satisfactory results. My message to you, perhaps the most important one, is, to put in special efforts to ensure hassle free service to customers. Second, a more technical one. Recent market developments have underscored the importance of improved risk management practices in the financial sector. To amplify this let me recapitulate the exchange rate movements in recent times. Moving away from pronounced one way movement; the market has started exhibiting fair degree of two-way movements and finer prices. Unlike the earlier periods when market spreads narrowed down faster even at times of volatility the observed pattern of merchant supply and demand viz. falling supplies with a weakening rupee in anticipation of further weakness and shooting up demand due to worry of further weakness and vice versa continue. The more volatile the currency gets, it is the end-users, rather than the intermediaries, who get hurt in the process. It is therefore disconcerting that the two-way movements have not resulted in activating risk management strategies among the end users. Instead, two-way movements have been looked at as opportunities for staying away from the market by opposing segments. Corporates are looking at the treasury as a profit centre. There is a great deal of work to be done by the banks in widening the awareness of risk management among business entities who are yet to look at the market as a place for disposal/acquiring currency rather than a place for profit maximisation. It is necessary that the business entities do not look at

exchange rate movements as an exclusive source for profit enhancement of the business. Corporates must appreciate the risks involved. RBI has cautioned banks extending foreign currency loans about the need for assessing the market risk in their clientele books arising out of unhedged currency risks. There is a convincing need for banks and corporates to look at the business balance sheets and identify the sources of market risk, implicit and explicit, and mange it meaningfully in tune with the business objectives of corporates. Another aspect that needs to be given serious thought is the invoicing of trade. The market seems to be very much focussed on the USD -Re rate and the opportunity available in other currencies appears to have been completely over looked. The invoicing pattern of trade reveals that USD continues to be the major currency of invoice. RBI communicates with the market in the language of USDRe. The stability of Rupee against USD does not mean that Re is equally stable against all the other currencies. Though it is not the intention to discuss invoicing strategy here it is necessary that the end users look at the global currency movements and effectively use the relaxation permitted to evolve appropriate risk management strategies. The increasing integration of the economy with the global markets may bring about change in the currency composition of trade. Recognising this possibility in the long run Government of India recently permitted RBI to use Euro as another currency for intervention. In the context of the market one of the other issues is transparency in rate quotations. Electronic trading platforms are taking over the role of brokers and gradually the volumes through these platforms are increasing in the global markets. With an outright offer and bid price and volume available price discovery has become superior. India cannot be away from the developments and I am sure this development would gain further ground in the times ahead. The recent development in the context of capital markets transactions, relaxing several regulations are an indicator of the emerging trend. The country is committed to a gradual and well calibrated move to capital account convertibility. Convertibility is not a one-time affair; it is a process of evolution and the process is an on-going one. As we move towards an increased level of convertibility, it must be emphasised that the responsibility of the end users and the intermediaries becomes significant. The freedom would bring in two way capital flows and the impact of these flows must be absorbed in an efficient manner. It is necessary that the market develop adequate risk transfer mechanisms, which would provide shock absorption capability in the event of adverse movements. We have to move together to develop risk management products beyond the current age-old product viz. the forwards.

Dr.Bimal Jalan (then Governor RBI) on Capital Account Convertibility

"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 Indias 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]

Remarks on capital account liberalisation and capital controls

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. i. 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. 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. 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 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. 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 crossborder supervision of financial intermediaries by the host country supervisor. 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.

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