Abstract
This chapter examines India’s experience with capital account liberalization, and management of capital flows. Aware of the risks posed by capital flows, Indian policy makers have taken a cautious approach to capital account liberalization—with inflows liberalized before outflows, and within inflows, equity flows, especially direct investment, preferred over debt flows. This approach has protected the domestic economy from financial contagion and crisis, while the liberalization of FDI flows has been beneficial for economic growth. Yet, as India has gone down the path of liberalization, the volatility of capital flows has increased. India has responded to this volatility by deploying multiple policy tools—including foreign exchange intervention, prudential measures, and adjustment of capital controls. Going forward, Indian policy makers need to carefully calibrate the pace of further liberalization, especially of short-term debt flows.
The views expressed in this chapter are those of the authors, and do not necessarily represent those of the IMF or IMF policy. We are grateful to the editors, Chetan Ghate and Ken Kletzer, for useful suggestions, and to Peter Lindner for sharing the data on corporate vulnerabilities in India.
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Notes
- 1.
To deliberate over the path toward capital account convertibility, the government has set up several policy committees over the years. For instance, the Tarapore and Second Tarapore Committees were formed in 1997 and 2006, respectively, to assess the feasibility and prerequisites for implementing capital account convertibility. In addition, the recommendations of committees on financial sector reforms, notably, the Mistry Committee (Government of India 2007) and the Rajan Committee (Government of India 2009), also had implications for India’s capital account regime.
- 2.
Remarks delivered at the IMF conference, “Rethinking Macro Policy II: First Steps and Early Lessons,” Washington DC, April 16–17, 2013. https://www.imf.org/external/np/seminars/eng/2013/macro2/pdf/ds2.pdf; last accessed on February 3, 2016.
- 3.
Remarks delivered at the Kale Memorial Lecture, Gokhale Institute of Politics and Economics, Pune, April 10, 2015. http://www.thehindu.com/business/Economy/rajan-says-full-rupee-convertibility-in-a-few-years/article7089869.ece; last accessed on February 3, 2016.
- 4.
Baru (1983) describes India’s post-independence “self-reliance” policy as an outcome of its colonial experience, which raised hostility towards dependence on foreign powers, and, by extension, on foreign capital.
- 5.
A significant step in the liberalization process was the adoption of the Foreign Exchange Management Act (FEMA) in 1999, which removed foreign exchange restrictions on current account transactions, and relaxed restrictions for some capital account transactions.
- 6.
For example, India allowed foreign institutional investors (FIIs) in 1992, but set a ceiling upon total ownership by all FIIs at 24 % of local firms. The ceiling was raised to 30 % in 1997, and further to 40 % and 49 % in 2000 and 2001, respectively. Eventually, the ceiling became sector-specific in 2001.
- 7.
See Appendix for variable definitions and data sources.
- 8.
The de jure measures of capital account openness are based on the restrictions and policies in place on cross-border capital movements, while the de facto measures capture the extent of actual cross-border capital flows. A caveat of de jure measures is that they mainly indicate the presence of capital account restrictions, rather than their severity. Moreover, they typically do not cover regulations that may affect capital flows indirectly such as certain prudential regulations.
- 9.
Countries considered as EMs here are those included in the IMF’s Vulnerability Exercise for Emerging Markets (as of May 2015). These are: Albania, Algeria, Argentina, Armenia, Belarus, Bosnia and Herzegovina, Brazil, Bulgaria, Chile, China, Colombia, Costa Rica, Croatia, Dominican Republic, Ecuador, Egypt, El Salvador, Georgia, Guatemala, Hungary, India, Indonesia, Jamaica, Jordan, Kazakhstan, Lebanon, Lithuania, Macedonia, Malaysia, Mexico, Morocco, Pakistan, Panama, Peru, Philippines, Poland, Romania, Russia, Serbia, South Africa, Sri Lanka, Thailand, Tunisia, Turkey, Ukraine, Uruguay, Venezuela, and Vietnam.
- 10.
For India, the ratio of portfolio debt in total debt liabilities is quite small—and averaged about 5 % during 2009–2013. (By comparison, among other BRICS countries, it was about 17 % for Brazil and 13 % for South Africa, but was 1 % and 5 % for China and Russia, respectively.)
- 11.
Another possible reason for limited FDI flows could be the attitude towards retail FDI, which was not permitted until January 2012 when single-brand FDI was liberalized (conditional on the requirement that the retailer would source 30 % of the goods domestically). While 51 % FDI in multibrand retail was allowed in December 2012, it remains a contentious issue to date. http://www.thehindu.com/business/india-to-disallow-fdi-in-multibrand-retail-nirmala/article6391737.ece; http://www.ndtv.com/india-news/government-retains-51-fdi-in-multi-brand-retail-which-bjp-had-opposed-762655; last accessed on February 3, 2016.
- 12.
In Fig. 5 (panel b), the decline in the institutional quality index for India since mid-2000 s stems from a drop in the underlying regulatory quality, government effectiveness and control of corruption indices as measured by the World Bank. (In terms of some other indicators, such as voice and accountability, and political stability, India has recorded an improvement; see appendix for details). For the global competitiveness index, the drop since 2012 is because of a weakening in technological readiness; labor and goods market efficiency; and financial market development, as measured by the World Economic Forum.
- 13.
The fall in the labor market efficiency index can be attributed to a decline in labor–employer relations, flexibility of wage determination, and reliance on professional management.
- 14.
As of March 2015, the limit on individual outflows for capital transactions stood at USD 125,000. Previously, the limit was tightened to USD 75,000 from USD 200,000 in August 2013 after India experienced sudden outflows and currency depreciation pressures following the announcement of tapering of the quantitative easing program by the US Fed in June 2013.
- 15.
Rodrik and Subramanian (2009) argue that financial globalization has disappointed because the underlying assumption of the neoclassical model that developing countries are saving-constrained (and financial integration, by alleviating that constraint, boosts investment and long-run growth) is invalid. In their view, developing countries are more likely to be constrained in investment opportunities; and greater inflows—by strengthening the value of domestic currency—undermine investment in crucial tradable-goods industries, thus undercutting the growth potential of liberalizing economies.
- 16.
Academic studies have been unable to pinpoint the thresholds precisely (e.g., Kose et al. 2010) provide much practical guidance on when countries should contemplate capital account liberalization.
- 17.
Patnaik and Shah (2007) note that—as per the reform agenda of the early 1990s—policymakers institutionally transformed and modernized the Indian equity market to attract portfolio equity flows.
- 18.
Ranciere et al. (2008) show that in liberalized economies with moderate contract enforceability, systemic risk-taking is encouraged, which spurs investment. This leads to higher mean growth, but also to greater incidence of crises.
- 19.
- 20.
- 21.
The VXO index, compiled by the Chicago Board Options Exchange, is a precursor to the commonly used VIX index. We use the VXO index as it is available from 1986, while VIX is available from 1990 onwards. The results, however, remain very similar if VIX is used in the estimations.
- 22.
The results for portfolio debt flows for India are based on post-2009 years only because of data availability, but for other EMs, data is mostly available from 1980 onward. (For portfolio equity flows, the data for India is available from 1990 onward.).
- 23.
See Mid-Year Economic Analysis 2014–15 and Economic Survey 2014–15, Ministry of Finance, Government of India, for a detailed discussion.
- 24.
ICR and profitability assess, respectively, the extent to which firm’s current activities allow the funding of interest expenses, and whether a firm’s combined operating and financial activities are self-funding (Lindner and Jung 2014). An ICR below one, or a lack of profitability, does not necessarily indicate insolvency (firms may have liquid investments, open credit lines, or other sources of funding available), yet low levels of ICRs are generally considered to be a good indicator of systemic vulnerabilities.
- 25.
Conducting stress-tests on corporate balance sheets, Lindner and Jung (2014) estimate that as a result of the increase in debt, Indian corporate sector’s vulnerability to severe systemic shocks has increased to 2001 levels (when India experienced a stock market crash).
- 26.
See Economic Survey 2014–15, Ministry of Finance, Government of India, which also notes that weak institutions relating to bankruptcy are one reason why the over-indebtedness problem cannot be easily resolved, and that is reflected in the persistence of stalled projects (that have stayed at 7–8 % of GDP since 2010–2011). The Survey indicates that unfavorable market conditions are behind the stalled projects in the private sector, while regulatory reasons largely explain project delays (mainly related to public private partnerships in infrastructure) in the public sector.
- 27.
On RBI’s Strategic Debt Restructuring (SDR) and Flexible Structuring of Long-Term Project Loans to Infrastructure and Core Industries schemes, see https://rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=9767 and https://rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=9498 (last accessed on February 3, 2016).
- 28.
A vast body of literature exists assessing the effectiveness of temporary capital controls, especially on inflows (see Ostry et al. 2010; Magud et al. 2011 for a survey), which generally finds little effect of inflow controls on the total volume of inflows (or on exchange rate appreciation), but a statistically significant impact on the composition of liabilities and on mitigating financial-stability risks. Regarding outflow controls, most studies examine their effectiveness in crisis situations and report mixed results (e.g., Edison and Reinhart 2001); though Binici et al. (2010) find that they tend to be associated with significantly lower capital outflows in advanced countries even in noncrisis situations.
- 29.
India does not have a formal exchange rate target, but has been managing the exchange rate to varying degrees over time. It is thus classified as a de facto managed float by the IMF.
- 30.
A measure of sterilization constructed by estimating monthly changes in net domestic assets on changes in net foreign assets suggests that India sterilized most of its foreign exchange intervention during 2009–2012.
- 31.
In addition to FX intervention, the RBI also limited currency depreciation during the taper tantrum by offering FX swaps to banks to attract NRI deposits and to encourage long-term overseas FX foreign borrowing by banks, and provided dollar liquidity to oil importers (IMF 2014b). To maintain investor confidence, the RBI also increased its swap line with the Bank of Japan from USD 15 billion to USD 50 billion.
- 32.
India’s annual CPI inflation averaged about 10 % over 2009–2013, while its real GDP growth rate fell from about 9 % in 2009–2010 to 6 % during 2011–2013.
- 33.
The liquidity tightening measures included limiting the provision of liquidity to banks; tightening the rules for banks’ cash reserve ratio; undertaking open market sales of government securities; and raising the marginal standing facility interest rate (IMF 2014b). These measures were relaxed as external pressures abated.
- 34.
Arguably, restrictions on gold imports could be considered as a form of capital outflow restrictions since gold was mostly being hoarded as an asset.
- 35.
Although Fig. 10 does not cover the year 2013, capital account restrictions on FDI inflows, banks’ FX borrowings, and external commercial borrowing were loosened further during the taper tantrum, while restrictions on outflows were tightened (IMF 2014b). The latter were however partly reversed as external pressures eased.
- 36.
Remarks delivered at the Kale Memorial Lecture at the Gokhale Institute of Politics and Economics, Pune, April 10, 2015. http://www.thehindu.com/business/Economy/rajan-says-full-rupee-convertibility-in-a-few-years/article7089869.ece.
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Appendix
Appendix
See Figs. 17, 18, 19 and Table 5.
Governance indicators. Source World Bank’s Worldwide Governance Indicators. Notes Indices range from −2.5 (weak) to 2.5 (strong)
Corporate, capital gains and dividend taxes in BRICS. Sources The Alliance for Savings & Investment; and authors’ estimates based on South African Revenue Service, National Treasury, and KPMG International. a Corporate tax rate (In percent), b top captial gains tax rate (in percent), c top dividend tax rate (in percent)
Equity and bond funds flows to India (in USD billions) Source EPFR database. Note Flows are total country fund flows, which include the dedicated fund flows along with parts of other fund flows (regional, sector) that are estimated to enter the country. Bond funds flows data begins in 2005
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Ghosh, A.R., Qureshi, M.S., Jang, E.S. (2016). Capital Flows and Capital Controls in India: Confronting the Challenges. In: Ghate, C., Kletzer, K. (eds) Monetary Policy in India. Springer, New Delhi. https://doi.org/10.1007/978-81-322-2840-0_10
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