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Managing Capital Flows: The Case of India

Managing Capital Flows - The Case of India From the early 1990s, India embarked on easing capital controls. Liberalization emphasized openness towards equity flows, both FDI and portfolio flows. In particular, there are few barriers in the face of portfolio equity flows. In recent years, a massive increase in the value of foreign ownership of Indian equities has come about, largely reflecting improvements in the size, liquidity and corporate governance of Indian firms. While the system of capital controls appears formidable, the de facto openness on the ground is greater than is apparent, particularly because of the substantial enlargement of the current account. These changes to capital account openness were not accompanied by commensurate monetary policy reform. The monetary policy regime has consisted essentially of a pegged exchange rate to the US dollar throughout. Increasing openness on the capital account, coupled with exchange rate pegging, has led to a substantial loss of monetary policy autonomy. The logical way forward now consists of bringing the de jure capital controls up-to-date with the de facto convertibility, and embarking on reforms of the monetary policy framework so as to shift the focus of monetary policy away from the exchange rate to domestic inflation.

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  1. R.K. Pattnaik
    (posted 13 August 2008 / 03:49:44 PM)

    High Level Conference on Managing Capital Flows:
    Comments received from R.K Pattnaik, Reserve Bank of India

    The Asian Development Bank Institute (ADBI) organized a high level conference on managing capital flows for ASEAN+3 and India in Tokyo on March 14, 2008. In the conference, under the session on country case studies a paper by Ajay Shah and Ila Patnaik was presented on India titled “The Evolution of Indian Capital Flows”. Our comments on factual inaccuracies on the above mentioned paper are set out in the following paragraphs.

    1. Sovereign Debt1
    The authors observed that banks have borrowed abroad depending on the government's assessment of the stock of foreign exchange reserves and their adequacy. One form this has taken is borrowing in the form of bank deposits of Non-Resident Indians (NRIs). Three-quarters of deposits are with government-owned banks, which are explicitly guaranteed by the Government. (Page 7-8)
    Response:
    The authors' argument that NRI deposits are quasi-sovereign borrowings is factually erroneous. In the first place NRI deposits are held by the commercial banks (both public and private sectors) and the cooperative banks. These deposits are not backed by any Government guarantee—explicit or implicit. Furthermore, banks do not extend any exchange rate guarantee on the rupee deposits. The decisions to raise NRI deposits are purely based on the business considerations of the banks and not the Government's assessment of foreign exchange reserves and adequacy as argued by the authors.

    2. Remittances and Invoicing
    The authors observed that if the capital inflows component of remittances were correctly measured, net capital inflows might need to be revised upwards by roughly 50%. Second, Indian and global firms, with operations in India are able to move capital across the boundary through misinvoicing. Given that gross flows on the current account are over 60% of GDP, if misinvoicing of 10% on average takes place in a single direction, this could add roughly 6% to net capital flows. (Page 15-16)
    Response:
    On the argument of the authors on treatment of remittances as capital flows, it may be mentioned that as per the best international practices, remittances are unilateral current transfers from migrants to their families back home without any quid pro quo. Since the beneficiary is a resident, the subsequent domestic use of such funds does not change the basic balance of payments characteristics of such funds. Second, the authors have used imaginary estimates on misinvoicing without providing any evidence on the nature and magnitude of such misinvoicing, or explaining the incentives to do so.

    3. Capital controls
    The authors state that RBI has advocated a significant reversal of liberalization of the capital account. In addition, the autarkic policy goals of RBI have been out of tune with the broad consensus in India about moving forward towards becoming a mature market economy that is integrated into the world economy. At this point in India's progression towards integration into the world economy, the rapid dismantling of capital controls appears to be the best strategy. (Page 20)

    Response:
    Liberalization of the capital account has been a gradual process with a distinction being made between households, corporates and financial intermediaries, along with the recognition of a hierarchy of preferences for capital flows. The equity markets are more liberalized, relative to debt markets. Experience has shown that investment in equities, especially in terms of foreign direct investment, may bring in collateral benefits such as technological and organizational know-how. There is, therefore, considerable openness in regard to equity along with active management of external debt. While the policy readily recognizes the benefits of liberalization of trade, it constantly weighs the risks and rewards based on both domestic developments and global conditions in regard to management of capital account. Thus, the process of liberalization of the capital account reckons the pace of concomitant developments in domestic financial sector, fiscal health and flexibilities in the real sector.
    A number of initiatives have been taken by the RBI recently in the capital account—encompassing both inflows and outflows—to further develop and integrate financial markets with a view to enhancing allocative efficiency, while undertaking active capital account management. Simultaneously, the RBI adopted the framework for fuller capital account convertibility as recommended by the Committee on Fuller Capital Account Convertibility appointed by the Reserve Bank and implemented a number of measures.
    At no time has the RBI advocated a significant reversal of liberalization of the capital account; and nor has it had any ‘autarchic policy goals'.

    4. Exchange Rate Regime
    According to the authors, while the INR currency regime has been de facto pegged to the USD, the extent of pegging has varied significantly through this period. The pegged exchange rate regime has required a massive scale of trading on the currency market by the RBI. By the late 1990s, reserves were more than adequate for self-insurance, and currency purchases were primarily motivated by implementation of the pegged exchange rate. (Page 21)

    Response:
    The authors' attempt to put India in the category of pegged exchange rate regime is based on the relatively lower volatility of rupee against the US dollar vis-à-vis other major currencies. This is based on a very narrow approach. It may be mentioned that lower volatility of domestic currency against a particular international currency may, inter alia, be on account of relative stability of that international currency in the global market vis-à-vis other international currencies. Thus, the lower volatility of domestic currency against such international currency does not mean any sort of pegging. In the above context, it may be mentioned that the monthly volatility of rupee with respect to major currencies (measured in terms of standard deviation) reveal that in the recent period the volatilities with respect to all these currencies are moving in tandem. Furthermore, the volatility of the rupee with respect to the US dollar has increased over times.
    It is pertinent to note that classification of the exchange rate regimes done by IMF is based on the country's de facto regimes, which differ from their officially announced arrangements. The scheme ranks exchange rate arrangements on the basis of their degree of flexibility and the existence of formal or informal commitments to exchange rate path. Under this classification, India as exchange rate regime is classified as “managed float with no predetermined path for the exchange rate”.
    It may be mentioned that volatility of exchange rates (measures by standard deviation of monthly exchange rate returns) of India has been almost aligned with the volatilities of exchange rates observed from the countries with managed float exchange rate regime over the years (Table 1). In 2007, the volatility of India among the emerging markets with managed floats was second highest after Czech Republic, which contradicts the authors observations about the pegged exchange rate based on flexibility criteria.

    Table 1: Exchange Rate Volatility of Countries with Managed Float Regime

    Year

    Bangladesh

    Myanmar

    Sri Lanka

    India

    Malaysia

    Singapore

    1998

    0.8

    1.3

    2.0

    1.5

    5.7

    3.0

    1999

    0.8

    1.0

    0.5

    0.3

    0.0

    1.0

    2000

    1.1

    2.3

    1.5

    0.7

    0.0

    0.8

    2001

    1.2

    0.9

    1.6

    0.4

    0.0

    1.7

    2002

    0.4

    1.0

    0.5

    0.4

    0.0

    0.9

    2003

    0.2

    1.3

    0.7

    0.4

    0.0

    1.0

    2004

    0.7

    1.2

    0.9

    1.5

    0.0

    0.9

    2005

    0.8

    0.9

    1.5

    0.9

    0.3

    0.9

    2006

    2.2

    1.0

    1.1

    1.3

    1.0

    0.9

    2007

    0.3

    1.3

    1.0

    1.5

    1.1

    1.1


    Year

    Thailand

    Kenya

    Mauritius

    Russia

    Czech
    Republic

    Croatia

    1998

    6.1

    2.3

    0.8

    22.6

    2.7

    1.8

    1999

    1.9

    2.4

    0.2

    3.2

    3.1

    2.4

    2000

    1.7

    2.1

    0.8

    1.7

    3.4

    3.0

    2001

    1.6

    0.5

    0.4

    0.3

    2.1

    2.1

    2002

    1.4

    0.3

    0.3

    0.4

    3.0

    2.4

    2003

    1.1

    2.3

    2.6

    0.7

    3.3

    2.6

    2004

    1.6

    0.9

    2.0

    1.1

    2.4

    1.8

    2005

    1.4

    1.5

    0.3

    0.8

    2.4

    1.7

    2006

    1.2

    1.2

    1.0

    0.6

    2.1

    1.9

    2007

    1.0

    1.2

    1.3

    0.9

    2.3

    1.5


    Source: Calculated from IFS, IMF data

    In this context, it can be stated that IMF has already mentioned in its Article IV Consultation paper that “since the start of 2007, the BRICs (Brazil, Russia, India and China) have experienced significant REER appreciation. Most of the real appreciation in 2007 for India and Brazil came from nominal appreciation, whereas China and Russia had inflation-led appreciation. In China and India, the appreciation is a recent phenomenon, while in Brazil and Russia, the exchange rate appreciation in 2007 comes on top of sharp rises in 2005-06”. This statement is sufficient to state that India has enough flexibility in its currency, and the exchange rate can not be classified as pegged.

    5. Loss of Monetary Autonomy and Transparency
    In the context of rapid and unprecedented globalization of the Indian economy, the impact of huge capital inflows in the form of enlargement of monetary aggregates RM and M3 is considered by authors as a product of the inability of the Reserve Bank to effectively sterilize the liquidity impact of such flows, leading to loss of monetary autonomy. (Page 25)

    Response:
    This shows a lack of understanding of the manner in which monetary policy instruments are operated and how they are reflected in monetary aggregates. For example, while the MSS reduces net domestic assets in reserve money, the CRR actually increases RM. Thus RM growth keeping pace with NFA growth shows an active and frequent use of CRR and therefore, more active and aggressive sterilisation, and not the other way round. The CRR has been raised from 4.5 percent in 2004 to 7.50 percent by 2007 to manage domestic liquidity. The CRR has become a much more effective tool as it has been made non-interest bearing. It limits the expansionary impact of monetary policy by making credit costlier.
    As far as transparency and accountability of monetary policy is concerned, the RBI is ranked relatively high against the standards set by the IMF in its “Code of Good Practices on Transparency in Monetary and Financial Policies”. The Reserve Bank has set high standards of data disclosures including explanation on the rationale and implications of policy actions taken by it from time to time. Most decisions that impact stakeholders are based on consultative processes and public feedback. Transparency is enforced also through public and media interaction and through information disseminated through speeches made by the top management. In any case, the terms accountability and transparency have been used in the generic sense in the paper by the authors who need to further elaborate what they actually imply on their observation.

    6. External Sector Crisis
    According to the authors, there is a significant possibility of experiencing an external sector crisis owing to the inherent contractions of this policy framework. In addition, upholding this policy framework involves significant costs. (Page 27)

    Response:
    On authors' observation on an external sector crisis owing to the inherent contractions of this policy framework, it may be stated that the argument about the possibility of external crisis appears to be completely baseless, contrary to the facts: (a) the CAD-GDP ratio has been within one percent of GDP as against the tolerate limit of about 3 per cent of GDP as defined by FCAC, (b) the size of current receipts (CR) to GDP ratio is the crucial determinant of the ability of the economy to make current payments and meet servicing of external debt. Since the mid-1990s, there has been a steady improvement in CR-GDP ratio from 8 per cent in 1990-91 to 24.8 per cent in 2006-07, indicating that a relatively higher current account deficit can be sustained, (c) the debt service ratio (DSR) for India has steadily fallen from a high of 35 per cent in 1990-91 to 16 per cent in 2000-01 and has reached the level of 4.8 per cent in 2006-07. This has moved in tandem with declining debt-GDP ratio (from 28.7 per cent in 1990-91 to 16.4 per cent in 2006-07), (d) import cover of reserves is around 12 months of imports, (e) the share of short term debt (including suppliers' credit up to 180 days) in total debt at 15.5 per cent at end –March 2007 is among the lowest among the top debtor countries.

The views expressed in this paper are the views of the authors and do not necessarily reflect the views or policies of the Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms.

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