RBI Deputy governor Shyamala Gopinath sums up the topic nicely in this speech. It has been gradual, based on feeling teh stones while crossing the river approach. As it has worked in the past, it is expected to be like this going forward as well.
She begins the speech tracking changes in thinking on capital account management as controls are more welcome now than in the past. Havings said that research shows cacontrols on inflows are more useful than outflows.
What is India’s approach? It has relied on using capital account to promote stability.
The policy approach in India to the issue of capital flows has evolved from the broader objective of maintaining financial and macroeconomic stability and not merely addressing the singular variable of exchange rate. The salient elements of this framework have been:
- an explicitly stated active capital account management framework, based on the policy stance of encouraging non-debt creating and long-term capital inflows and discouraging debt flows;
- having the policy space to use multiple instruments – quantitative limits, price based measures as well as administrative measures, particularly for foreign currency borrowing by corporates;
- short term debt permitted only for trade transaction;
- avoiding the ‘original sin’ of excessive foreign currency borrowings by domestic entities, particularly the sovereign;
- prudential regulations to prevent excessive dollarization of balance sheets of financial sector intermediaries, particularly banks;
- cautious approach to liability dollarisation by domestic entities and
- significant liberalization of permissible avenues for outward investments for domestic entities.
She then looks at the recent trends and shows how flows have increased in recent years. Within inflows, which kind of flows have been more? She points to an IMF study which shows exchange rate appreciation differs by types of flow. Portfolio investments, which are more volatile, have the highest appreciation effect, followed by FDI and bank loans. Since these flows are potentially related to an increase in productive capacity, the real appreciation associated with FDI and bank loans is barely one-seventh of the real appreciation due to portfolio investments. Private transfers (mainly remittances) are the flows that have the least appreciation effect. This may suggest that remittances are not procyclical.
In India’s case, FII equity flows have been dominant which in past led to RBI intervening to prevent appreciation. This year the intervention has been very limited.
Then Governor looks at issues of opening up equity ann debt markets to foreign flows. We need to invite more FDI flows and limit debt flows. The speech is summed as:
In an open economy like ours, there is need for greater recognition of currency and interest rate risks and the risk management in banks and corporate firms need to gear up their risk management practices further in this area. It is our experience that a large number of corporates still do not have well-designed risk management policies and practices to take care of volatile exchange rate movements and give scant regard to tail risks. There is also need for greater disclosure and adherence to accounting standards for financial instruments.
There is also need to more comprehensively qualitatively assess our external liabilities to also encompass liabilities of subsidiaries and branches of Indian financial institutions overseas, not in nominal terms but through a risk-based approach on the probability of recourse to parent bank liquidity support.
Operations of foreign financial entities in domestic markets also have implications on capital account due to cross border fund flow and derivative positions. During the crisis period, funds were held abroad temporarily to support parent bank liquidity. In India. there are prudential regulations on banks’ recourse to overseas funding markets, including for foreign banks. More local funding of local assets reduces systemic risk and helps to curb excessive risk taking and credit growth.
Nice primer on India’s capital account approach.