India’s Experience with Capital Flow Management

Rajiv Ranjan

Director

Department of Economic and Policy Research

Reserve Bank of India

1

Meeting of BRICS Economic Research Group

February 27, 2011

New Delhi

Outline

Trends in Capital Flows to India

India’s Approach to Capital Account Management

Lessons from Capital Account Management in

India

2

Trends in Capital Flows to India

Table I: Key Components of Balance of Payments

(US$ Million)

Crisis Year Period Average

1990-91 1991-92 1992-93 to

2002-03

2003-04 to

2007-08

2008-09 to

2010-11

1. Equity 103 133 4,549 20,036 33,231

1.1 Net FDI 97 129 2,360 6,544 16,566

1.2 Portfolio Investment 6 4 2,189 13,492 16,664

2. Debt 7,069 4,272 3,885 17,913 19,884

2.1 External Assistance, Net 2,204 3,034 747 931 3,424

2.2 ECBs, Net 2,254 1,462 1,393 8,698 7,456

2.3 NRI Deposits, Net 1,536 290 1,773 1,993 3,483

2.4 Short Term Trade Credits 1,075 -514 -28 6,290 5,521

3. Other Capital 16 -628 184 7,050 -14,118

4. Capital Account Balance (1+2+3) 7,188 3,777 8,617 44,999 38,997

5. Current Account Balance -9,680 -1,178 -2,340 -4,718 -36,860

6. Change in Reserves (5+6)

(+: Increase/-: Decrease) -2,492 2,599 6,277 40,280 2,137

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Trends in Capital Flows to India

Table II: Relative Share of Debt and Equity in Capital Flows

(in per cent)

Crisis Year Period Average

1990-91 1991-92 1992-93 to

2002-03

2003-04 to

2007-08

2008-09 to

2010-11

1. Equity 1.5 3.0 54.0 52.8 62.6

1.1 Net FDI 1.4 2.9 28.0 17.2 31.2

1.2 Portfolio Investment 0.1 0.1 26.0 35.6 31.4

2. Debt 98.5 97.0 46.0 47.2 37.4

2.1 External Assistance 30.7 68.9 8.8 2.5 6.4

2.2 External Commercial Borrowings 31.4 33.2 16.5 22.9 14.0

2.3NRI Deposits, net 21.4 6.6 21.0 5.2 6.6

2.4 Short Term Trade Credits 15.0 -11.7 -0.3 16.6 10.4

Note: Equity Debt composition of Capital Accounts excludes other capital

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Trends in Capital Flows to India

Table III: Key Components of BoP as a percentage of GDP

(in per cent)

Crisis Year Period Average

1990-91 1991-92 1992-93 to

2002-03

2003-04 to

2007-08

2008-09 to

2010-11

1. Equity 0.0 0.0 1.2 2.3 2.3

1.1 Net FDI 0.0 0.0 0.6 0.8 1.1

1.2 Portfolio Investment 0.0 0.0 0.6 1.5 1.2

2. Debt 2.2 1.6 1.0 2.0 1.4

2.1 External Assistance, Net 0.7 1.1 0.2 0.1 0.2

2.2 External Commercial Borrowings, Net 0.7 0.6 0.4 1.0 0.5

2.3NRI Deposits, Net 0.5 0.1 0.4 0.2 0.3

2.4 Short Term Trade Credits 0.3 -0.2 0.0 0.7 0.4

3. Other Capital 0.0 -0.2 0.0 0.8 -1.0

4. Capital Account Balance (1+2+3) 2.2 1.4 2.2 5.1 2.7

5. Current Account Balance -3.0 -0.4 -0.6 -0.5 -2.6

6. Change in Reserves (5+6)

(+: Increase/-: Decrease) -0.8 1.0 1.6 4.6 0.1

Memo Item:

Real GDP Growth Rate 5.3 1.4 5.8 8.7 7.8 5

Trends – 2007-08 - Deluge

Example 1: During the phase of high inflows

Net capital flows to India increased from US$ 45 billion in 2006-07

to US$ 107 billion during 2007-08

Inflows excess of CAD (US$ 15 billion) – Reserve accretion of

US$ 92 billion

RBI used a number of instruments in combination to manage the

surplus;

Around US$ 78 billion purchases of forex

MSS (US$ 26 billion)

CRR ( US$ 12 billion)

LAF

OMO

Combination of GOI surplus balances, Foreign exchange swaps,

liberalization of capital outflows, pre-payment of external debt,

lowering of interest rates on NRI deposits

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Trend – 2008-09- Crisis

Example 2: Experience during the crisis and RBI policy

measures

During 2008-09 capital flows ebbed to US$ 9 billion.

CAD rose to US$ 29 billion – Reserves declined

Volatility in capital flows translated into sharp volatility in

the exchange rate. Drying up of forex liquidity,

RBI took several measures to ease liquidity;

Rupee-dollar swap facility for Indian banks

Special Market Operations (SMO)

Upward adjustment of the interest rate ceiling on NRI deposits,

relaxation in the ECBs and short-term trade credits.

Domestic liquidity enhancing measures- OMO, special repos, buyback

of MSS securities (de-sequestering), special refinance facilities, sharp

and swift reduction in policy rates

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Bretton Woods institutions have reversed their earlier

approach

IMF (2010):

“circumstances in which capital controls can be a

legitimate component of the policy response to surges

in capital flows”

The World Bank :

“capital controls might need to be imposed as a last resort

to help mitigate a financial crisis and stabilize

macroeconomic developments.”

G20: Acceptance

Capital Account Management – Changing Views

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Capital Account Management in India

Capital account liberalization began in 1991 following balance of

payments (BoP) crisis

The analytical foundations for reforms were provided by three

reports:

Report of the High Level Committee on Balance of Payments

(Chairman: C. Rangarajan, 1991) and

Two reports on Capital Account Convertibility (Chairman:

S.S.Tarapore, 1997 and 2006).

Reports suggested:

i. Encouragement to private capital inflows

ii. Shift from debt creating to non-debt creating flows

iii. Within debt - A shift from short-term to long-term debt

iv. Monitoring of external commercial borrowings

v. Gradual liberalisation of outflows. 9

India’s Approach to Capital Account Management

India has used mild capital controls as a part and parcel of

the liberalized process- to grant 'a breathing space' to

implement more fundamental reforms

The policy approach in India to the issue of capital flows has

evolved from the broader objective of maintaining financial

and macroeconomic stability.

sequencing of the process conditional on underlying

domestic macroeconomic fundamentals and sustainability of

the BoP.

The CAL is a process rather than an event.

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Capital Account Management: Salient elements

An explicitly stated active capital account management

framework- Non-debt creating Flows and Long Term Flows

Policy space to use multiple instruments

Short-term debt permitted only for trade transaction

Avoiding the „original sin‟

Prudential regulations to prevent excessive dollarisation of

balance sheets of financial sector intermediaries - banks

Cautious approach to liability dollarisation by domestic entities

Significant liberalisation of permissible avenues for outward

investments for domestic entities

11

Capital Account Liberalization - current status

Considerable Progress made. Non-residents provided

considerable extent of convertibility - Can invest through

portfolio investment route- Recently QFI including

individuals and groups permitted to invest

Residents: More restricted - Corporates, financial

institutions & individuals

Corporates- ADRs/GDRs/ECB

Banks can borrow up to 50 % of unimpaired Tier I capital

Outward Investment –

Corporates 400% of net worth

Banks can invest abroad upto 25 % of DTL

Mutual Funds can invest abroad with agg. Limit of US$ 7 billion

Individual can remit upto US$ 100,000 per annum

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Capital Account Management: Instruments

Preference: FDI over FII; Rupee over FC; LT over ST

FDI is freely allowed subject to sectoral limit – ceilings

revised upward; certain sectors prohibited; Outward Also

Foreign Portfolio Investment –No prior approval- sectoral

and individual limits - no reversal of policies

Debt flows – ECB and NRI deposits modulated- both Price

and quantity

FII Investment in Sovereign debt – US$ 15 billion

FII Investment in corporate debt – US$ 45 billion

ECB – Automatic and approval Route; All in Cost ceiling;

End use restrictions and minimum maturity.

NRI deposits - interest rate ceiling linked to LIBOR/SWAP

In sum, gradual and calibrated liberalization - sequencing

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Lessons from Capital Account Management in India

1. It is necessary to integrate the capital account management

(CAM) with other policies.

Especially fiscal management, regulation of the financial sector and

monetary policy

2. CAM should be treated as an essential component of

countercyclical policies.

3. CAM cannot be divorced from the development in foreign

exchange markets and developments in current account.

4. To ensure credibility and effectiveness of the CAM, it is

necessary to ensure that there is full commitment of the

public policy both at the level of the government and the

central bank.

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Lessons from Capital Account Management in India

5. CAM may involve both price and administrative measures.

6. Capacity of the central bank to intervene at the time of the

depreciation of the currency is limited , while not so in

appreciation. So policy in reduction in volatility has to

incorporate necessary caution in strategies adopted.

7. Nature of capital flows and the complexity in the operations

of financial intermediaries keep changing requiring

sufficient flexibility in the CAM measures .

8. CAM is a tool that is necessary at all times, even when used

as a purely temporary measure.

9. The critical part of CAM relates to the financial sector

where the stability of financial institutions and the

exchange rate are closely inter-twined- Important

regulation of financial sector 15

Trends in Capital Flows to India (Contd..)

External Sector Vulnerability Indicators (Per cent)

Indicators

End-March

2008

End-March

2011

End-Sep

2011

1. Ratio of Total Debt to GDP 18.1 17.4 -

2. Ratio of Short-term to Total Debt (Original

Maturity)

20.4

21.2

21.9

3. Ratio of Short-term to Total Debt (Residual

Maturity)

37.6 42.2 -

4. Ratio of Concessional Debt to Total Debt 19.7 15.5 14.7

5. Ratio of Reserves to Total Debt 138.0 99.5 95.4

6. Ratio of Short-term Debt to Reserves 14.8 21.3 22.9

7. Reserves Cover of Imports (in months) 14.4 9.6 8.5

8. Reserves Cover of Imports and Debt Service

Payments (in months)

13.6 9.1 8

9. Debt Service Ratio (Debt Service Payments to

Current Receipts)

4.8 4.3 4.9

10. External Debt (US$ billion) 224.4 306.4 326.6

-: Not available 16

Infrastructure financing with global savings

To facilitate infrastructure financing 100 per cent FDI is allowed

under the automatic route in some of the sectors

FDI is also allowed through the Government approval route in

some other sectors

Debate on possibility of using foreign exchange reserves for

investment in infrastructure sector

Reserves for such purposes does not meet the criterion of

reserve management objectives

However, a special and limited window has been created

RBI invests in Special Purpose Vehicles (SPV) of the IIFCL

Investment on repatriation basis by new class of eligible non-

resident investors in Rupee and Foreign Currency denominated

bonds issued by IDF-NBFCs and Rupee denominated units issued

by IDF-MFs 17

Infrastructure financing with global savings

Opening of debt market to foreign investors with a three year

lock-in period

RBI has liberalised and rationalised the ECB policies concerning

infrastructure sector

The limit for corporates implementing infrastructure projects to avail

ECB in a financial year raised to USD 750 million from USD 500

million under the automatic route

Indian companies in the infrastructure sector allowed to import

capital goods by availing of short-term credit in the nature of „bridge

finance‟

Indian companies in the infrastructure sector allowed to avail of ECB

in Renminbi, under the approval route 18

Thank You

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