The discussion on capital account convertibility in the Indian context has resurfaced; and the reasons are the increasing forex reserves and the strength of the Indian rupee vis-a-vis the other emerging markets currencies. On a y-o-y basis, i.e. March-ending, the rupee has performed better than others, declining by only 2.5% compared with 35% for the Brazillian real, 11% for the Argentine peso, 15% for the Indonesian rupiah and Mexico, 17% for the Turkish lira and 67% for the Russian rouble. Forex reserves are at a high of around $340 billion. However, concluding that we have a very strong external position which supports capital account convertibility may be premature.
The external situation was weak in 2013, when Raghuram Rajan took over as RBI Governor. With a judicious combination of the government’s curbs on gold imports and RBI’s unique swap arrangement for banks on FCNR deposits, the balance of payments situation was restored to equilibrium after which several good things happened. The CAD came down from 4.2% and 4.8%, respectively, in FY12 and FY13 to 1.7% in FY14 and will probably be around this level in FY15. FII and FDI flows have been buoyant and have improved the forex reserves position, which gives a sense of strength to the external account. More important, crude oil prices have fallen by around 50% which has benefited all importing countries.
Convertibility on capital account exists for foreign investors today and hence going in for full convertibility would mean that Indians too could take dollars out of the country or bring in dollars without limits depending on market conditions. Two sets of issues have to be addressed before we contemplate opening up of the capital account. The first set of issues pertains to our belief in the market mechanism and the second revolves around future scenarios for our external account which ultimately answers the question as to whether or not our external situation is really as strong as believed.The Indian economic psyche has been ambivalent at best when it comes to dealing with the market. When the rupee starts to depreciate beyond what is considered “normal”, there is a call for restrictions on the flow of dollars. In FY14, there were severe restrictions placed on gold imports and every time RBI put some conditions on the outward remittances or overseas investments or tightened monetary stance on liquidity, the market took it that the rupee was weak, aggravating the the run on the currency. When we have convertibility, we have to show commitment to our stance and not get overly perturbed with temporary disturbances. Are we prepared for this?
Quite curiously, when the rupee has been stable and strong relative to our competitors, the call is for RBI to allow the rupee to depreciate, and the REER argument has been put forward which, though inappropriate, given that it captures trade and not overall forex flows, is still the ultimate weapon used to justify central bank intervention. Clearly, we are not ready yet to let the market decide the right rate and have a prejudged view on where the rupee should be. We want the rupee to be weak enough to prop up exports but, at the same time, despair when FII flows slow down. In fact, with the US Fed likely to increase rates, there is added pressure on RBI to maintain a higher interest rate as lowering rates would affect capital inflows to the debt segment. At present, pressure also mounts from the trade argument, but once we have full convertibility, we will have to tackle policies on external borrowings as well as overseas investments on a more regular basis and policy flip-flop will add volatility. In fact, full convertibility logically means that companies should be allowed to borrow without limits from overseas markets if conditions are favourable.
The second set of issues is based on economic fundamentals. While our forex reserves position looks fairly robust, a lot has come about due to the unconventional measures used to get in dollars when the economy was in a crisis-like situation. Over $30 billion came through the NRI-deposits route, adding to the external debt. The external debt touched $460 billion in December 2014, and the cover provided by reserves, which was above 100% till FY10 has now come to just about 69%. The share of concessional debt has come down, and the ratio of external debt-to-GDP has increased with RBI also allowing greater access to the ECB route. With full convertibility, the level of reserves would become even more volatile, leading to swings in the exchange rate. The central bank is now bound by the inflation doctrine and hence may not always be able to respond through monetary measures, especially if inflation warrants a different action.
Further, our fundamentals also appear to be rooted in fortuitous circumstances. The trade deficit, for instance, has come down to around $135 billion from a high of nearly $ 180-190 billion. This has been due to low crude-oil prices and limited demand for non-oil imports. A turnaround in both can upset the calculations. The invisible receipts on account of software and remittances can get in a stable $65 billion each. The trade deficit can, however, increase by $40 billion if both exports and imports grow by 20%, which is likely once the external situation returns to normal. This will blunt the import cover, too, which stands at 9 months based on FY15 growth.
Hence, capital account convertibility has to be considered with some caution because once we take this route, there should ideally be no retraction in stance as it would create too much volatility. The next few years will be interesting as they will reveal how the external account stands when global economic conditions take a new turn with the Fed and the European Central Bank playing their roles and the Indian economy returning to normal, which may also mean crude-oil prices climbing. Our policy response under these conditions will probably indicate our preparedness for such convertibility.
The external situation was weak in 2013, when Raghuram Rajan took over as RBI Governor. With a judicious combination of the government’s curbs on gold imports and RBI’s unique swap arrangement for banks on FCNR deposits, the balance of payments situation was restored to equilibrium after which several good things happened. The CAD came down from 4.2% and 4.8%, respectively, in FY12 and FY13 to 1.7% in FY14 and will probably be around this level in FY15. FII and FDI flows have been buoyant and have improved the forex reserves position, which gives a sense of strength to the external account. More important, crude oil prices have fallen by around 50% which has benefited all importing countries.
Convertibility on capital account exists for foreign investors today and hence going in for full convertibility would mean that Indians too could take dollars out of the country or bring in dollars without limits depending on market conditions. Two sets of issues have to be addressed before we contemplate opening up of the capital account. The first set of issues pertains to our belief in the market mechanism and the second revolves around future scenarios for our external account which ultimately answers the question as to whether or not our external situation is really as strong as believed.The Indian economic psyche has been ambivalent at best when it comes to dealing with the market. When the rupee starts to depreciate beyond what is considered “normal”, there is a call for restrictions on the flow of dollars. In FY14, there were severe restrictions placed on gold imports and every time RBI put some conditions on the outward remittances or overseas investments or tightened monetary stance on liquidity, the market took it that the rupee was weak, aggravating the the run on the currency. When we have convertibility, we have to show commitment to our stance and not get overly perturbed with temporary disturbances. Are we prepared for this?
Quite curiously, when the rupee has been stable and strong relative to our competitors, the call is for RBI to allow the rupee to depreciate, and the REER argument has been put forward which, though inappropriate, given that it captures trade and not overall forex flows, is still the ultimate weapon used to justify central bank intervention. Clearly, we are not ready yet to let the market decide the right rate and have a prejudged view on where the rupee should be. We want the rupee to be weak enough to prop up exports but, at the same time, despair when FII flows slow down. In fact, with the US Fed likely to increase rates, there is added pressure on RBI to maintain a higher interest rate as lowering rates would affect capital inflows to the debt segment. At present, pressure also mounts from the trade argument, but once we have full convertibility, we will have to tackle policies on external borrowings as well as overseas investments on a more regular basis and policy flip-flop will add volatility. In fact, full convertibility logically means that companies should be allowed to borrow without limits from overseas markets if conditions are favourable.
The second set of issues is based on economic fundamentals. While our forex reserves position looks fairly robust, a lot has come about due to the unconventional measures used to get in dollars when the economy was in a crisis-like situation. Over $30 billion came through the NRI-deposits route, adding to the external debt. The external debt touched $460 billion in December 2014, and the cover provided by reserves, which was above 100% till FY10 has now come to just about 69%. The share of concessional debt has come down, and the ratio of external debt-to-GDP has increased with RBI also allowing greater access to the ECB route. With full convertibility, the level of reserves would become even more volatile, leading to swings in the exchange rate. The central bank is now bound by the inflation doctrine and hence may not always be able to respond through monetary measures, especially if inflation warrants a different action.
Further, our fundamentals also appear to be rooted in fortuitous circumstances. The trade deficit, for instance, has come down to around $135 billion from a high of nearly $ 180-190 billion. This has been due to low crude-oil prices and limited demand for non-oil imports. A turnaround in both can upset the calculations. The invisible receipts on account of software and remittances can get in a stable $65 billion each. The trade deficit can, however, increase by $40 billion if both exports and imports grow by 20%, which is likely once the external situation returns to normal. This will blunt the import cover, too, which stands at 9 months based on FY15 growth.
Hence, capital account convertibility has to be considered with some caution because once we take this route, there should ideally be no retraction in stance as it would create too much volatility. The next few years will be interesting as they will reveal how the external account stands when global economic conditions take a new turn with the Fed and the European Central Bank playing their roles and the Indian economy returning to normal, which may also mean crude-oil prices climbing. Our policy response under these conditions will probably indicate our preparedness for such convertibility.
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