Active Stocks
Thu Mar 28 2024 15:59:33
  1. Tata Steel share price
  2. 155.90 2.00%
  1. ICICI Bank share price
  2. 1,095.75 1.08%
  1. HDFC Bank share price
  2. 1,448.20 0.52%
  1. ITC share price
  2. 428.55 0.13%
  1. Power Grid Corporation Of India share price
  2. 277.05 2.21%
Business News/ Opinion / Usha Thorat | Limits of capital convertibility
BackBack

Usha Thorat | Limits of capital convertibility

Freer capital flows constrain fiscal space, monetary policy and the country's competitiveness

Photo: Pradeep Gaur/Mint Premium
Photo: Pradeep Gaur/Mint

The Reserve Bank of India (RBI) governor Raghuram Rajan and the minister of state for finance Jayant Sinha have both made public statements in the last month that India should get to capital account convertibility in a few years. The governor mentioned that the critical remaining controls are on debt flows.

The former deputy governor Subir Gokarn (Who’s afraid of capital convertibility?, Business Standard, 19 April) has pointed out that this essentially means discussing three issues. First, should all inflows be made completely free? Second, how should exchange risk be efficiently managed and third, what should be the role of RBI in intervening in forex markets especially during periods of turbulence?

In a speech in early April, referring to external commercial borrowings (ECBs), the executive director of RBI G. Padmanabhan said that the key attractiveness of and rush for foreign currency borrowing can be explained only by the inclination of borrowers to remain unhedged and this raises systemic concerns.

In this context, the recommendations of the Sahoo committee on ECB released on 10 April are very relevant. The committee has recommended removal of all cost, end-use and maturity restrictions on ECBs, and introduction of a mandated minimum hedge ratio commensurate with market development and macro conditions, continuation of a “soft" overall cap and removal of all restrictions on foreign investment in local currency bond markets. These measures, they feel are adequate to managing the twin systemic risk of large unhedged exposures and global volatility in capital flows. Simultaneously, they recommend development of a vibrant onshore bond-currency–derivatives (BCD) market to make markets liquid and reduce hedging cost.

The International Monetary Fund (IMF), which has all along been a champion of full convertibility, has acknowledged that capital flow measures (CFMs) are a part of the tool kit for macroeconomic management especially by emerging non-reserve countries. Freer capital flows constrain fiscal space, monetary policy and the country’s competitiveness, as there are limits to exchange rate intervention—sterilized or non-sterilized. Hence a variety of measures need to be available always to deal with large and volatile capital flows. These include monetary measures, macro-prudential measures, exchange rate intervention and capital flow measures. Fiscal and quasi fiscal decisions such as budgetary provisions/central bank balance sheet impact for meeting cost of sterilization are also involved. Consequently, any discussion on liberalization of debt flows including ECBs has to be viewed in this context.

Take the first of the three issues viz. ECBs, rupee denominated debt and exchange market intervention. Debt flows, if freed in the manner suggested by the Sahoo committee, can be so huge (especially short term flows) that they can be overwhelming and destabilizing. The single instrument suggested to manage the risk is the minimum mandated hedge ratio. Other tools such as tax and auctions are not favoured. The soft cap on ECB is proposed only for deciding on mandated hedge ratio.

As in many other CFMs, mandated hedging ratio work in an asymmetrical fashion. While it may work during times of inflows, it is unlikely to prevent outflows or encourage any new inflows when overall capital flows are exiting the country, as we saw in mid June 2013. This apart, with the local BCD market open to global players, there could be overwhelming unidirectional moves depending on global liquidity, geopolitical and macroeconomic conditions. The leverage afforded by derivatives, with higher position limits and lower margins, can further exacerbate the problem at times of volatility.

Second, rupee-denominated debt is advocated as an alternative to foreign currency borrowings as it seems to be free of exchange risk. While this may be so at the individual corporate level, the suggestion by the committee to remove all quantitative restrictions on exposure of foreign investors to such debt can still lead to systemic risk as the overall external debt could become unsustainable and vulnerable to global shocks. The example of huge carry trades in other jurisdictions warns us of risks of removal of all restrictions of overseas borrowings through local currency denominated debt. Also as the Mexican experience showed, the conversion of local currency into forex exposures through derivatives markets is quite possible.

The last issue is on exchange rate management—will mandating hedging ratio be construed as interference with corporate freedom to take decisions based on risk-return appetite? Further as Padmanabhan has said, the total risk contacted by the system will have to be managed within the system unless all global speculators and arbitrageurs not having any Indian exposure are allowed to operate in onshore markets. Should all borrowers be treated same—should critical importers such as oil companies and those where pass through is immediate be treated differently? By managing volatility, is RBI allowing free riding by companies who want to borrow in foreign currencies? What should be the appropriate intervention strategy—what is undue volatility? At times of inflows, preventing huge appreciation is a strong driver. At times of outflows, the opposite is true.

These are issues that have challenged us since we started liberalizing and as the integration with the global economy increases will only accelerate as long as India’s growth rate, inflation and interest are higher than global rates.

Usha Thorat is a former deputy governor of the Reserve Bank of India.

Comments are welcome at theirview@livemint.com

Follow Mint Opinion on Twitter at https://twitter.com/Mint_Opinion-

Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
More Less
Published: 05 May 2015, 06:30 PM IST
Next Story footLogo
Recommended For You
Switch to the Mint app for fast and personalized news - Get App