Tuesday, March 15, 2016

India’s Path toward Open Trade

This article was first published by the Global Association for Risk Professionals on March 14, 2016; Co-author-Anisha Sircar (Flame University, Pune)

FCAC – full capital account convertibility – may be inevitable but requires careful preparation

“If countries do not plan for an orderly integration with the world economy, the world will integrate them in a manner which gives them no control over events. Thus, the question is not whether a country should or should not move to capital account convertibility, but whether an orderly or a disorderly transition is required.” — SS Tarapore, former deputy governor, Reserve Bank of India

SS Tarapore, a former deputy governor of the Reserve Bank of India (RBI), passed away on February 3, 2016. He wore multiple hats — writer, columnist and teacher — apart from being a dyed-in-the-wool macro-economist and central banker. He was well known for his views on full capital account convertibility (FCAC). It is as a mark of respect that we revisit the issue of FCAC for India.

The Reserve Bank of India has been contemplating permitting FCAC — an important step that would bring about many changes through liberalization of the use of foreign exchange as well as domestic currency. At the same time, one is left wondering whether India is ready for such a move, considering the impact on movement of capital, volatility of exchange rates and potential disruption of overall macroeconomic stability.

In the recent foreign policy adopted by the government, India aims to be made an integral part of the global trade system by 2020. Given this background, Capital account convertibility (CAC) emerges as a key factor in determining the feasibility of trade between countries.

Integral to the monetary policy of any economy, CAC defines the ease with which financial assets may be converted into those of a different currency. Simply put, flexibility in capital account would ensure no restrictions exist on foreign investments with respect to ownership of assets or purchasing of capital — factors commonly involved with phenomena such as real-estate bubbles or setting up subsidiaries in other countries. A flexible capital account would also involve the ability to convert domestic into foreign currency for a resident to purchase a foreign asset, and vice versa.

Investment Flow
CAC enables movement of foreign capital into the country, paving the way for foreign direct investment (FDI) into domestic projects and portfolio investment in the capital market. With the investments comes access to a global pool of resources and technological advancements.

Lifting capital restrictions could be looked at as a policy measure or incentive to bring about more macroeconomic prudence and stability. This could all potentially result in a stronger domestic and even international economy, as India may expand its market share in foreign economies, receive better returns and possibly experience more progressive policies overall with foreign exposure to the reform processes. Flexibility in the capital account can thus accelerate the economy of an emerging market.

Indian policymakers have until now maintained certain restrictions on asset inflows and outflows: on foreign investors, on resident Indians, and on companies wanting to borrow or spend money abroad.

As part of the reforms process in India, triggered by the balance of payments crisis in 1991, and since 1994, the Indian rupee has been convertible on the current account. Many types of controls have since been replaced. The currency is no longer pegged. FDI norms have been significantly eased. For foreigners and non-resident Indians, there is an equal and reasonable amount of convertibility in India, despite the persistence of several procedural restrictions.

Concerns from Abroad
While FCAC is desirable in principle, events elsewhere have been discouraging and lead some to believe that an open capital account invites economic crisis, and closed capital accounts ensure security.

The Asian financial crisis of 1997-98 saw easy and hazardous fleeing of capital from the country, which severely hampered the economy. During the crisis, Thailand, Indonesia, South Korea (followed by Hong Kong, Laos, Malaysia and the Philippines) were severely affected; India was relatively insulated because of a stabilization policy that involved restrictions on capital flows.

The ‘Grexit’ fiasco also resulted in harsh capital controls.

Globalization and risks of contagion are almost inescapable today. Not to miss the bus on globalization, yet remain insulated from crisis due to the contagion effect, is a task, not many would envy.

As India’s economy grows, FCAC is regarded as inescapable, and resisting it would be futile and counterproductive. Much more macroeconomic management and safeguards would be required to facilitate this movement.

Preparatory Steps
Most evidence points to the inevitability of full capital account convertibility in the near future, and thus the focus must be on the need for better preparation. The RBI has been creating prudential regulations for a framework to guide, monitor and enforce FCAC in India.

However, many things must be kept in mind before FCAC is undertaken, such as monetary policy, fiscal and foreign trade balance and, in the Indian context, banking system reforms. Strong macroeconomic stability is required before implementing full convertibility, especially to withstand global shocks.


As the late Deputy Governor Tarapore envisioned, FCAC must be implemented in an orderly fashion, taking into account all risks and other influencing factors, along with a well-researched, holistically-approached analysis of its impact on the Indian market, informed by successful policies and paradigms in other countries and supervision by analysts and committees from the field.
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