Liberalising capital account

Synopsis:  Further Liberalisation of capital account would increase risks.

Introduction

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.

What are the recent steps taken by RBI with respect to capital account liberalisation?

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 and allow the government to tap foreign savings to finance the fiscal deficit.

Further, 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.

Why India has to act cautiously w.r.t capital account liberalisation?

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.

Why India needs significant fiscal and financial sector reforms before further liberalisation of the capital account?

Firstly, 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. Capital account convertibility will require integration and development of financial markets.

Secondly, 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.

Thirdly, 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.

Fourthly, greater capital account convertibility would also run counter to India’s trade policy, which is becoming increasingly protectionist.

Fifthly, besides, currency management will become more difficult for the central bank. A significant real currency appreciation would affect India’s competitiveness and increase risks.

Source: This post is based on the article “Liberalising capital account” published in Business Standard on 18th October 2021.