Finance

New Exchange Rate Regime: Partial and Full Convertibility, Capital Account Convertibility

Note: Capital account covers variety of financial flows, such as FDI, portfolio flows (investment in equities and debt), and bank borrowing, all of which have in common the acquisition of assets in one country by residents of another country.

There are no set benchmarks for measuring a country’s capital account openness- the IMF maintains a list of each country’s capital account restrictions, but there’s no way to quantify their ‘intensity’.

Current indicators:

External debt to GDP: 23% (was 29% in 1991)

Forex reserves to External debt: 70% (7% in 1991)

Until the early 1990s, India had very strict capital controls, which allowed for monetary policy independence along with fixed exchange rates. Since 1993, however, India substantially eased capital and current account restrictions, and hence had to deal with increased money flows, meaning that exchange rate no couldn’t be strictly fixed.

India’s exchange rate regime has been, on paper, one of market-determined exchange rates. In reality, the RBI intervenes regularly in currency markets, and the rupee is de-factolooselypegged to the USD. The extent of the pegging does vary according to market conditions, but is usually not allowed to fluctuate wildly.This leads to some loss of monetary policy autonomy.

India currently has full convertibility of the rupee in current account, but for capital account, there are ceilings, including on government debt, external commercial borrowings, and equity.

Full Capital Account Convertibility (FCAC) allows local currency to be exchanged for foreign currency without any restrictions on the amount. Although CAC freely enables investment in the country, it also enables quick liquidation and removal of capital assets from the country, both domestic and foreign. It also exposes domestic creditors to overseas credit risks, fluctuations in fiscal policy, and manipulation.

Reasons countries want to shield themselves from unbridled global capital flows:

  • Stabilization of exchange rate
  • If domestic banking systems are not well developed, exodus of domestic savings to foreign countries
  • Short-term capital flows can be reversed quickly, thereby adversely affecting the macroeconomic situation of the country
  • Controls allow for directing the flows towards more stable forms of capital inflows, such as FDIs, rather than ‘hot money’ flows

Arguments in favor of capital account liberalization:

  • Achieves optimum allocation of global financial resources; helps attract foreign investment, and also allows domestic companies to better tap foreign markets
  • Allows EMEs to raise the level of capital formation above their domestic savings rate
  • Access to capital markets can allow countries to ‘insure’ themselves to some extent against fluctuations in their national incomes such that national consumption levels are relatively less volatile
  • It can signal a country’s commitment to good economic policies. A perceived deterioration in a country’s policy environment could result in capital flight. This provides a strong incentive for policymakers to maintain sound policies
  • Inflows stemming from liberalization should also facilitate the transfer of foreign technological and managerial know-how and encourage competition and financial development, thereby promoting growth

What does the evidence say?

  • The linkage between capital account liberalization and sustained high growth is weak at best
  • EMEs have not been able to use international financial markets effectively to reduce consumption volatility; there is a significant pro-cyclical element to international fund flows for such countries. Thus, investors pull back in hard times, thereby deepening domestic crises
  • Open capital accounts can lend a hand to imprudent fiscal policies, by providing access to excessive external borrowing
  • Open capital accounts along with efforts at maintaining a stable exchange rate regime has led to macroeconomic crises; countries that have only gradually eased capital account restrictions seem to have had overall better outcomes
  • One of the key pillars of the success and stability of East Asian economies was that debt was largely domestically financed. This allowed these countries to sustain high levels of leverage as well as high levels of investments for a long time. Capital controls ensured that external dependence was minimal. But once the capital account was opened up, these economies became extremely vulnerable to global funding shocks

Nevertheless, sound domestic policies and institutions, a regulatory framework that promotes a strong and efficient financial sector, and effective capital flow monitoring systems greatly improve the chances of ensuring stable and beneficial flows.

Before 2008, the IMF was overwhelmingly of the view that full capital account openness and free exchange rates were necessarily a good thing. Since 2008, however, there is an emerging consensus the world over that countries should have sufficient tools at their disposal to tide over difficult times, and hence capital account liberalization should be slow and well thought out.

Some questions for India to consider:

Should all inflows be made completely free? Currently, there are restrictions, mainly in the form of limits on amounts invested by foreign investors in government and corporate bonds. This is to promote financial stability. The policy objective here should be to create domestic market conditions that will minimize the potentially destabilizing effects of foreign investment. We need to figure out if such conditions exist and can realistically be created; if not, some prudence, in the form of caps, may continue to be justified

Critically, capital controls cannot go unless there is macroeconomic stability, a healthy fiscal situation, and the inflation is low. India is a long way away from this.In general, given the international experience, India should keep prioritizing FDI as the preferred route for foreign investments into India, and go slow on completely opening up the capital account.

Aside: Participatory notes-

  • Participatory Notescommonly known asP-NotesorPNsare instruments issued by registered foreigninstitutional investors(FII) to overseas investors, who wish to invest in the Indian stock markets without registering themselves with the market regulator (SEBI)
  • They account for about 50% of all FII inflows
  • Need:

Anonymity: Any entity investing in participatory notes is not required to register with SEBI (Securities and Exchange Board of India), whereas allFIIshave to compulsorily get registered. It enables large hedge funds to carry out their operations without disclosing their identity

Ease of Trading: Trading through participatory notes is easy because participatory notes are like contract notes transferable by endorsement and delivery

Tax Saving: Some of the entities route their investment through participatory notes to take advantage of the tax laws of certain preferred countries

Money Laundering: PNs are becoming a favorite with a host of Indian money launderers who use them to first take funds out of country throughhawalaand then get it back using PNs

  • SEBI is not happy with P-Notes because it is not possible to know who owns the underlying securities and hedge funds acting through PNs might therefore cause volatility in the Indian markets

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India’s capital account:

  • Two benefits of financial openness- access to foreign capital, and development of local finance systems: The principal benefit of financial openness for developing economies may not be access to foreign capital that helps increase domestic investment by relaxing the constraint imposed by a low level of domestic saving. Rather, the main benefits may be indirect ones associated with openness to foreign capital, including the catalytic effects of foreign finance on domestic financial market development, enhanced discipline on macroeconomic policies, and improvements in corporate governance as well as other aspects of institutional quality
  • In recent years, the Reserve Bank of India (RBI) has taken what it calls a calibrated approach to capital account liberalization, with certain types of flows and particular classes of economic agents being prioritized in the process of liberalization
  • At this juncture, a more reasonable policy approach is to accept rising financial openness as a reality and manage, rather than resist (or even try to reverse), the process of fully liberalizing capital account transactions
  • It is not advisable to remove all the restrictions on the capital account in one broad sweep; rather, a steady progress towards a more open capital account is needed
  • Current evidence as to the impact of having an open capital account on growth in inconclusive- however, it can be established that usually the constraint to development in developing economies is not the lack of domestic savings, but a lack of investments, which is caused by underdeveloped financial systems. In this regard, an open capital account can indirectly promote growth by aiding the development of local financial systems, and hence promoting both domestic and international savings
  • India has generally moved towards an open capital account when it comes to two kinds of flows- FDI inflows and equity portfolio inflows. It has maintained restrictions on debt flows, which is prudent, given that the international experience shows that stocks of external debt liabilities are more risky (I think this means that Indians can not buy debt abroad easily, and foreigners cannot buy Indian debt easily, but I’m not certain). Evidence also shows that for developing countries, the benefits to TFP flow from FDI investments, and not from debt flows (debt flow is when an Indian company issues debt shares abroad)
  • The RBI has in fact eased a number of controls, both on inflows and outflows. For instance, although capital outflows by individuals are in principle still restricted, each individual is allowed to take up to $200,000 of capital out of India each year, a generous ceiling by any standards. The restrictions on outflows by Indian corporates are even weaker. As for inflows, FDI inflows into certain sectors such as retail and banking are restricted, and foreign investors are not allowed to participate in the government debt market. These restrictions are gradually being lifted. Equity market investments are permitted by registered foreign institutional investors (although there are limits on their ownership shares in certain types of Indian firms), and those who do not wish to register can invest only indirectly through an instrument called participatory notes, which are tightly regulated by the government.
  • Despite this, on relative scales, India’s financial openness ranks towards the bottom of the pile when compared with other emerging market economies (and very much so when compared against the rest of the BRIC countries)
  • India’s inflows are majorly composed of FDI and portfolio inflows; outflows are overwhelmingly FDI, and minuscule portfolio flows
  • Foreign investors are not allowed to invest in government debt markets => government doesn’t borrow from abroad, but only from domestic investors
  • India is still a minor player in the global financial markets- in terms of FDI inflows, we account for about 5% of total global glows; and about a similar % of FDI outflows
  • Recent global experience suggests that it might be unwise to hastily move towards full capital account openness- India’s current strategy of promoting FDI and portfolio flows and limiting debt flows seems to be working well. However, with the rising integration via FDI and portfolios, it is near- impossible to limit only certain kinds of flows (debt), and might well prove impossible. It might thus be better to move towards more openness, to leverage the indirect benefits (development of local financial systems)
  • In Budget 2015, it has been mentioned that the regulation making power for equity-related capital flows will now move to the government, while the RBI will continue to regulate other kinds of flow (primarily, FDI and debt flows)

Fiscal Responsibility Act, Fiscal Consolidation

This was introduced in 2003, but scrapped in 2009 following the government’s rising fiscal deficit following the 2007 financial crisis. The FRBM act was enacted to:

  • Introduce transparent fiscal management systems in India
  • Introduce a more equitable and manageable distribution of the country’s debts over the years
  • Aim for fiscal stability for India in the long run

The main aim was to eliminate revenue deficit of the country, and bring down the fiscal deficit to a manageable 3% of GDP by March 2008.

The average fiscal deficit numbers for a few periods are as follows:

Period / 1985-94 / 1995-04 / 2004-07 / 2007-08 / 2008-09 / 2009-10 / 2010-11 / 2011-12 / 2012-13 / 2013-14
Gross Fiscal Deficit / 7% / 5.5 / 3.9 / 2.7 / 6 / 6.9 / 5.1 / 5.8 / 4.9 / 4.5

Thus, it can be seen that before the FRBM act came into place, India’s fiscal deficit was generally quite high, and the enactment of the act did lead to fiscal consolidation till the financial crisis hit, and the compulsions of providing a stimulus package for the economy again led to a widening fiscal deficit. The goal for the current fiscal year is 4.1%, with the aim of reducing the FD to 3% by 2016-17.

However, while looking at the above table gives the impression that the FRBM act was an unmitigated success, we need to see where the reduction in the expenditure was coming from. In essence, there are three ways to reduce the fiscal deficit: increasing the revenue receipts (generally possible via higher tax receipts), decreasing revenue expenditure, or reducing capital expenditure. While the first two are preferred ways to reduce FD, cutting down on CapEx is easier, but hurts the economy (thereby hurting tax receipts as well), and also social services expenditure in education and health.

Data shows that the structure of expenditure has worsened in the post-FRBM phase, with a rising share of revenue expenditure and a falling share of capital expenditure: share of revenue expenditure in the budget rose from 77% in 2004 to 89% in 2008, and to xx in 2014-15. Although the fiscal deficit has been reduced to 4.1% in the current budget, a large part of the decline comes from declining capital expenditure.

A budget deficit emerging from capital expenditure is much less harmful than when it emerges from current expenditure, because the latter means the government has to borrow capital to fund consumption. This reduces the total savings in the economy and puts pressure on prices. Borrowing for capex does mean that the government’s over-presence in the debt market will push up interest rates, but there is no reduction in savings and no pressure on prices.

Thus, the government should try and bring the revenue deficit to zero, but not by cutting capital expenditure. So far, the gains that have been seen in recent fiscal consolidation have come from robust economic growth and macroeconomic stability, coupled with a tax structure based on reasonable rates, fewer exemptions, and better compliance. The focus has not been on expenditure restructuring, and that is what we need.

Going forward, we should focus on the following things:

  1. Restructuring of expenditure composition
  2. Institutional reform: Either instituting an autonomous Fiscal Council that recommends ways towards fiscal consolidation to the government, or increasing the current powers of the CAG so that it can play out this role.
  3. Deficit reduction targets need not be insisted upon rigidly year to year, but should be operated with some flexibility depending upon he exigencies. A golden rule as in UK, i.e., borrowing only for capital spending, should be instituted
  4. Reporting requirements should be made more stringent
  5. Escape clause must be tightened and penalties imposed for non-compliance

Twelfth Finance Commission, Fiscal Federalism

In any federal fiscal system, resources are generally assigned more to the center, while the states have larger responsibilities. This creates a vertical imbalance. Also, different states within the union have different revenue-raising capabilities, which results in horizontal imbalances. The constitution of India mandates the creation of a Finance Commission every 5 years to suggest ways to correct these two kinds of imbalances (vertical and horizontal).The role of the FC is generally two-fold:

  • Recommend how to split the total tax revenue accruing jointly to the union and the states
  • Recommend grants-in-aid depending on specific needs of different states (these can be in the nature of budget support for state plans, block grants under different sectoral heads (education, health, infrastructure, power, roads, heritage conservation etc.), centrally planned schemes, part of centrally sponsored schemes etc.)

While this has been the general trend of the job of FCs, the TFC’s ToRs included another query- how to ensure fiscal consolidation in the country (i.e., how to restructure public finances with a view to restore budgetary balances, maintain macroeconomic stability, and bring about debt reduction along with equitable growth)?This was something new, only included in the TFC’s ‘questions to answer’ list.

During the time of TFC’s drafting recommendations, the overview was that almost all state governments had large debt burdens that translated into such huge interest payments by state governments that they effectively couldn’t undertake productive social expenditure, leading to deterioration in quality of public services.