Liberalising capital account

Further opening up would increase risks

Reserve Bank of India (RBI) Governor Shaktikanta Das had noted in an address last year that capital account convertibility would continue to be approached as a process and not as an event. India has been progressively liberalising its capital account and further opening up would depend on a combination of factors. Deputy Governor T Rabi Sankar in a speech last week talked about various issues in this context. India took a big step towards further liberalising the capital account last year with the introduction of the fully accessible route (FAR) for government securities. This essentially removed the limit on non-resident investment in specified government securities. The channel has been opened up with the objective of getting government bonds included in the global bond indices, which will lead to stable fund flow from index investors and allow the government to tap foreign savings to finance the fiscal deficit.

In this context, Mr Rabi Sankar noted with the FAR in place, the entire government security issuance over time would become eligible for non-resident investment. It is likely that the majority of outstanding bonds will not be held by non-resident investors, as is the case in other countries, but a significant holding can increase risks. As index investors are unlikely to opt for sudden withdrawal, it may be examined if the FAR can be linked to index inclusion. However, India may not be able to avoid the risks associated with removing the limit for non-resident investors even in select categories of bonds because it would need to sustain such issuance to maintain liquidity in the market. Further, capital account convertibility will require integration and development of financial markets. As India is progressively opening up the capital account, considering the changing requirement, the limit under the Liberalised Remittance Scheme can also be reviewed. This would help residents looking to spend or invest abroad.
 

Greater integration with international markets can broaden the base for Indian assets and help push up economic activity. But it can also increase risks to financial stability. Therefore, it’s important for policymakers to consider the trade-offs at different levels of development. India has moved cautiously on this front to minimise the level of risk involved and should continue with this approach. Portfolio investment in the equity market is now practically unrestricted aside from sectoral caps. Foreign direct investment is also broadly open except in some sectors. Portfolio investment in corporate and government debt is subject to caps and other prudential norms.

Further liberalisation and opening of the debt market should be well considered. The Indian financial system is not prepared for full capital account convertibility. The recommendations of the Tarapore Committee (2006) in this regard have not been implemented, either. The combined fiscal deficit over the years remained elevated and the situation has only worsened because of the Covid crisis. A higher sustained fiscal deficit with elevated levels of debt can increase financial stability risks. The financial sector has also not been reformed to the desired extent. The banking system, for instance, is still dominated by public sector banks with differential regulations. India needs significant fiscal and financial sector reforms before further liberalisation of the capital account. Fundamental weakness is often disproportionately punished in global markets. Greater capital account convertibility would also run counter to India’s trade policy, which is becoming increasingly protectionist. Besides, currency management will become more difficult for the central bank. A significant real currency appreciation would affect India’s competitiveness and increase risks.