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Towards fuller capital convertibility

The path to full convertibility will not be linear and India looks set to continue moving gradually

The process of capital account convertibility is likely to receive a further push this year, as the government and Reserve Bank of India (RBI) move towards allowing greater foreign participation in domestic bond markets.
The process of capital account convertibility is likely to receive a further push this year, as the government and Reserve Bank of India (RBI) move towards allowing greater foreign participation in domestic bond markets.

By Rahul Bajoria& Prakhar Misra
Economic liberalisation set in motion by the Narasimham Committee’s recommendations in 1991 put India on the path to opening its previously closed economy. Within five years, the country had moved to a market-determined exchange rate and full current account convertibility, a remarkable achievement in such a short time span. 

Though this also marked the beginning of the process of liberalising the capital account, in the three decades since liberalisation began, progress on this aspect has remained gradual. While the current position is a partially open capital account, non-residents essentially have complete freedom to engage in most investment and other capital transactions in India.

The process of capital account convertibility is likely to receive a further push this year, as the government and Reserve Bank of India (RBI) move towards allowing greater foreign participation in domestic bond markets.Capital account convertibility has mostly been in a single direction since 1991—with more flexibility around inflows rather than outflows. In 2006, the Tarapore Committee on Fuller Capital Account Convertibility acknowledged this distinction as a feature of, not an anomaly in, India’s approach.

As discussed above, liberalisation began with a market-determined exchange rate in the mid-1990s, and the enactment of the Foreign Exchange Management Act, 1999 further liberalised current account, and to some extent, capital account transactions, albeit maintaining strong control over the latter. Gradually, foreign investors have been allowed to participate in the domestic equity, debt and bond markets over the past two decades.As a result, foreign direct investment in India now is largely unrestricted, and its impact is stark: in the past five years, the flow of FDI has accounted for almost 50% of total FDI inflows since 1991.

Foreign Portfolio investors (FPIs) have also been active in the equity, debt and G-sec markets. During 2021, FPIs invested $10.8 billion in initial public offerings (IPOs) of Indian firms—the highest ever amount!However, the rules governing residents investing abroad remain controlled. Consider Overseas Direct Investment (ODI). According to latest data on India’s international investment position, direct overseas investments total around $200 billion, while portfolio investments are below $8 billion, after several years of moderate growth. Combined, these are equivalent to just ~7% of India’s GDP. 

To be fair, liberalisation of the capital account has been consistent through business cycles in the past three decades. This suggests that institutional capacity and political willingness to achieve capital account convertibility is strong. The two Tarapore Committee Reports—1997 and 2006—laid out a path to full convertibility. However, both reports did set a number of preconditions for convertibility to be achieved.

These include the gross fiscal deficit being less than 3.5% of GDP, an inflation rate of 3-5% over three years, the effective CRR being 3% and gross NPAs of 5% or less. India has yet to fully meet all of these criteria. However, there has been an improvement in the economy. India’s foreign reserves today stand at $635 billion, the fourth largest in the world.Two other factors indicate that fuller convertibility would benefit India.

First, large foreign exchange reserves lead to high sterilisation costs. In 2018, the State Bank of India estimated the sterilisation coefficient at -0.93, while Raj et. al estimated it at -1.03. If some control is brought over India’s sterilisation costs through an opening of the capital account, we estimate this could free up almost 1% of GDP in sterilisation costs over time. Second, as Harsh Madhusudan, the economic commentator and author, recently argued, further liberalisation of the capital account is needed to power the next stage of India’s economic development.

According to Madhusudan, dropping some macro targets, such as limiting sovereign debt to 60% of GDP (as recommended by the NK Singh panel) should be part of economic policy in a post COVID-19 world.Deputy Governor T Rabi Sankar also recently indicated that RBI may be rethinking policy towards the capital account along these lines. In this case, a logical step could see RBI allowing residents greater flexibility to invest capital outside India.

In its recent pronouncements, RBI has indicated that it is willing to look at liberalising rules on outflows, but we do not sense a shift is imminent.Notwithstanding a vigorous debate, RBI governors have been cautious time and again, calling for convertibility to be seen as a process, and not a single event.

This indicates willingness to move forward but not urgently. Thus, the process towards full convertibility will not be linear and India looks set to continue moving gradually. RBI can bank on India’s current economic strengths and macro stability to further the cause of capital account convertibility in 2022. 

Respectively, managing director & chief economist, India, at Barclays, and an independent researcher based in Mumbai

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