«I ndia and China are both large, poor countries that have benefited from greater integration into the world economy; both are still at an early but ...»
As the committee had been asked to examine the positive case for KAC, it is not surprising that it accepted that there were several benINDIAN FINANCIAL LIBERALIZATION AND INTEGRATION efits that could be expected to flow from a more open capital account.
These included mobilization of external capital for domestic investment, convergence between domestic and international interest rates, portfolio diversification by residents, and enhanced innovation in the domestic financial sector. The TC emphasized that capital controls progressively become ineffective, costly, and even distortionary. One could add that, like all other discretionary controls, restrictions on access to cheaper sources of overseas capital are also a potential source of both corruption and discrimination.
The TC further noted that domestic financial liberalization had already served to expose weaknesses in the domestic economy. The introduction of KAC could be even more damaging, so that “proactive policy action” would be needed to prepare the economy for KAC. But, on the whole, the committee believed that KAC would impose a strong (presumably positive) discipline on the financial system and would “expedite the early rectification of infirmities in the system and lead to widening/deepening of markets to enable the spreading distribution of risks” (RBI, 1997, para.
1.27). Thus the TC was commendably clear on the two-way links between domestic liberalization and KAC: the financial system had to be prepared for KAC, but, in turn, KAC would stimulate further development of the financial system for the greater benefit of both the government and the private sector.
At this point it is worth distinguishing between official capital account convertibility and de facto convertibility. With expanding trade, foreign investment, and travel, and given India’s large overseas migrant population, it is increasingly difficult to make capital controls even partially effective. Opening trade without opening capital flows creates opportunities for under- or over-invoicing as export and import activity is used as a cover for capital exports and risks constraining the growth of trade as cumbersome controls are needed to enforce capital account restrictions (Krueger, 2004). In addition to such manipulated invoicing, there are legion other mechanisms of unauthorized capital flight. Evidence from China as well suggests that capital movements have been much more volatile than anything that could be suggested from having effective capital controls (Anderson, 2005).
In India, the distinction between remittance flows and capital movements is particularly blurred. India has historically been the hub of the so-called “hawala” market for informal financial flows between the subcontinent and the Persian Gulf. This market has been associated with smuggling, tax evasion, and illegal gold transactions (even allegedly the financing of terrorism, making this market a major focus for control of Suman Bery and Kanhaiya Singh 171 money laundering). But this market also serves legitimate cross-border payments needs of individuals efficiently, cheaply, and swiftly. India’s ambivalence on the need for effective capital controls is exemplified by the numerous exemptions made for NRIs, a very broadly defined category of foreigners of Indian ethnic origin who are granted privileged access to Indian financial and physical assets as compared to other overseas natural persons.
KAC is not an unambiguous concept in the literature, and the concepts of capital account convertibility and currency convertibility are sometime intertwined and conflated. Bhalla (1999) follows the definition of the TC report, which defines KAC as “the freedom to convert local financial assets into foreign assets and vice-versa at market determined rate of exchange” (Reserve Bank of India, 1997, p. 339). India too has relaxed inflows of FDI and portfolio flows by foreign institutional investors but outflows by residents have been more strictly controlled. In fact, some feel that liberalization of inflows is almost complete (Bhalla, 1999). However, there remains a marked difference in treatment by type of entity. Differential restrictions are applied to residents vs. nonresidents and to individuals vs. corporates and financial institutions (Reddy, 2002). Nonresident corporates now have almost complete FDI access other than limits on FDI related to the financial and infrastructure sectors, and to retail trade.
Nonresident corporates and individuals are required to channel their portfolio investments through registered FIIs. FIIs are allowed to invest in Indian stocks and Indian corporates and are allowed to raise funds abroad through depositary receipts. They are also allowed to list in selected overseas stock exchanges. Domestic corporates require approval for ECB, equity issues, and overseas acquisitions, but these regulatory approvals are generally liberally provided. The regime for nonresident individuals discriminates between NRIs and other nonresidents. While NRIs are allowed direct access to onshore bank accounts, shares, and real estate, other nonresidents face restrictions in undertaking such investments. Following the budget announcements of 2002–03, NRI accounts have been made fully convertible. Transactions involving NRIs and Indian joint ventures abroad have been made more liberal for investment in fully convertible countries subject to specific limits.
While inflows have thus been liberalized for domestic and foreign corporates and for nonresident individuals of Indian origin on the outflow side, India continues to maintain a restrictive regime for capital outflows on individual accounts for domestic residents; such relaxations as have occurred are discretionary and easily reversed. With the recent marked improvement in external sector conditions, particularly the surge in foreign exchange
172 INDIAN FINANCIAL LIBERALIZATION AND INTEGRATIONreserves, cautious moves have been made in small steps to permit overseas bank accounts and portfolio investments by individuals. Most recently, some provisions have also been made to allow controlled outflows by Indian corporates. Companies can now offer all forms of guarantees subject to an overseas investment cap of 200 percent of their net worth, corporates can disinvest their stakes in wholly owned subsidiaries and joint ventures without RBI approval, and proprietary concerns can set up joint ventures and subsidiaries abroad without prior RBI approval.
The consolidated fiscal deficit position of the central and state governments has improved relatively little. Combined total net domestic public debt is around 76 percent of GDP. It is often noted that India’s fiscal and debt indicators now are worse than many other emerging markets that have suffered crisis, and comparable to levels at the time of India’s 1991 crisis (Ahluwalia, 2001a). Kletzer argues that the maintenance of capital controls has been critical to preventing the fiscal position from leading to crisis: “Capital controls are instrumental to financial repression in India in that they separate domestic financial intermediation from international financial markets and capture domestic savings for the financing of the public sector budget deficit” (Kletzer, 2004, p. 256).
Greater integration would increase pressure for fiscal reform, which would be growth enhancing in the long run. Empirical studies have shown that, if capital account liberalization were to be exogenously imposed, ceteris paribus, the government’s budget deficit would be reduced by 2.275 percent of GDP (Kim, 2001). The disciplinary effect was also found to be stronger in the 1990s. With the Fiscal Responsibility and Budget Management (FRBM) Act, 2002 (in effect as of July 2005), the central government is bound to bring in fiscal discipline. Capital account liberalization will only add to the urgency with which such measures are implemented.
India has been faced with huge capital inflows since 2000. Like other Asian economies, India has chosen to accumulate foreign exchange reserves, rather than allow its nominal exchange rate to appreciate. In addition, India has chosen to sterilize the domestic counterpart of this intervention. On the whole, India’s management of its exchange rate and its domestic monetary affairs has been well regarded, although the wedge between domestic and international monetary conditions has only been possible because of capital controls. One of India’s successes has been to lengthen the maturity of its (relatively low) external debt. This may be difficult to maintain with convertibility. India’s trade liberalization still has some way to go. Greater volatility in nominal and real exchange rates would make this harder to sell politically. The increased competitiveness of the corporate sector, however, and a large and diversified economy, are Suman Bery and Kanhaiya Singh 173 positives. Given its competitive private sector, India stands to reap substantial benefits from the more efficient resource allocation that would likely flow under a liberalized capital account.
Conclusion International financial integration offers significant economic gains for countries, but it also carries the possibility of crises. The history of international financial market growth and economic development suggests that financial crises cannot be avoided, just as India’s domestic financial liberalization has been punctuated by politically painful but economically salutary scams. Many officials and some researchers fear that premature liberalization of the capital account could be so damaging as to jeopardize the whole reform effort. In our view, this is too risk-averse a position to take. The banking system has demonstrated stability and strength over recent years. Similarly, an open capital account would supplement the transparency provided by the FRBM Act to get on with promised fiscal adjustment. The strength of the international and domestic economies and India’s strong reserves position are other propitious factors. Monetary and financial integration sooner or later must accompany the real integration that is under way (and desired) in South Asia and East Asia and would facilitate India’s desire to develop as a regional financial center.
Many less sophisticated economies have had open capital accounts for a long time; others, in Southern Europe, for example, moved to integration with Europe even before the euro. It is interesting that Mr. Tarapore has been called upon once again, in 2006, to examine the case for full convertibility. Given the progress that India’s financial system has made, and the natural caution of our bureaucracy, it is unlikely that India will do anything reckless.
The Tarapore Committee (TC) recommended that India achieve the following benchmarks as preconditions for capital account convertibility.
1. Consolidate public finances to achieve a sustainable position (defined as a deficit of the central government of 3.5 percent of GDP or less, accompanied by a reduction in the deficit of the states and the quasi-fiscal deficit). The fiscal deficit in 2005–06 is 4.1 percent of GDP.
174 INDIAN FINANCIAL LIBERALIZATION AND INTEGRATION
2. Reduce inflation, to 3–5 percent annually. Average inflation for last three years (2003–04 is 5.5 percent; 2004–05 is 6.5 percent; 2005–06 is 4.4 percent).
3. Strengthen the financial system, including by:
a. taking steps to reduce the net nonperforming asset ratio to 5 percent in 1999–2000; achieved 5.2 percent in 2004–05.
b. reducing the cash reserve requirement to 3 percent over the same period.
c. leveling the playing field between banks and nonbanks.
d. harmonizing the cash reserve requirement on domestic liabilities with those on overseas and nonresident liabilities (with a possibly higher cash reserve requirement on nonresident liabilities including overseas borrowing by banks).
e. improving risk management by financial institutions (marking to market, monitoring currency and maturity mismatches, internal control systems, accounting and disclosure, capital adequacy to cover market risk, and training in best practices techniques with the adoption of corresponding technology).
f. improving prudential supervision (effective off-site surveillance, more stringent capital adequacy norms than the Basel minimums, tighter income recognition, and asset clarification norms).
g. increasing the autonomy of public sector banks and financial institutions to deal with increased competition from foreign banks and the growing private sector.
h. strengthening legal framework for loan recovery and execution of collateral to deter default.
4. Establish a monitoring band for real exchange rate developments (+/–5 percent around an estimate of a neutral real exchange rate).
5. Adopt macroeconomic policies consistent with a current account deficit that can be sustainability covered by normal capital inflows and, consistent with this, trade and external financing policies that would allow the debt service ratio to decline. The current account surplus (+)/deficit (–) positions for the last three years are as follows (percentage of GDP):
2003–04 2.3 percent (surplus) 2004–05 0.8 percent (deficit) 2005–06 (April–December) 1.7 percent (deficit)
6. Maintain adequate foreign exchange reserves (at least six months of imports) and legally required reserves to currency ratio of at least 40 percent.
Appendix II Types of Capital Transactions Possibly Subject to Control Restrictions on Inflow Restrictions on Outflow Controls on capital Shares or other securities Purchase locally by nonresidents Sale or issue locally by nonresidents market instruments of a participatory nature Sale or issue abroad by residents Purchase abroad by residents Bonds or other debt securities Purchase locally by nonresidents Sale or issue locally by nonresidents Sale or issue abroad by residents Purchase abroad by residents
References Ahluwalia, Montek S., 2002a, “India’s Vulnerability to External Crises: An Assessment,” in Macroeconomics and Monetary Policy: Issues for a Reforming
Economy, ed. by Montek S. Ahluwalia, Y.V. Reddy, and S.S. Tarapore (New Delhi:
Oxford University Press).
———, 2002b, “Economic Reforms in India Since 1991: Has Gradualism Worked?” Journal of Economic Perspectives, Vol. 16, No. 3, pp. 67–88.