Such a long journey: Indias opening of its capital account' Suman Bery, DirectorGeneral, NCAER

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Such a long journey Indias opening of its
capital account. Suman Bery, Director-General,
NCAER

• ANU Lecture
• National Museum, Canberra,
• February 21, 2006

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About NCAER

• An independent economic research organisation 50
  years old
• Research Areas include
• -Macro Analysis and Forecasting
• Household Behaviour
• Consumer Trends
• Trade Policy Analysis
• -Infrastructure and Regulation

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Structure and Performance
4
Ten Largest Economies
ICP Billion at current year prices. Source
World Development Indicators 2004 CD-ROM.
5
Changing Structure of GDP ()
Includes Manufacturing, Electricity, Mining
Construction Source CSO
6
Regional Variation in Per Capita Income
(US)2002-03
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Income Groupings and Ownership (Ownership per
household, 2001-02)
Source The Great Indian Middle Class, NCAER
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Structure and Performance

• Significant success on external side trade,
  external debt, reserves.
• Greater resilience, reduced vulnerability
  (sanctions, drought, oil price shock, etc.)
• Services sector growth (domestic and
  international) has been big positive surprise.
• Success elusive in several key areas targeted by
  reform fiscal adjustment, manufacturing,
  investment, infrastructure.

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Structure and Performance

• Poverty outcome disputed has declined (but by
  how much)?
• Formal employment growth disappointing, but
  rapid growth in real wages, even in rural sector.
• Significant regional differences key large
  states (Hindu heartland) underperforming.

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Current Policy Concerns

• Sectoral Issues Agriculture, Industry,
  Infrastructure
• Fiscal Adjustment and Tax reform
• Employment and Labour Reform
• Trade and FDI policies
• Social Protection
• Governance Service Delivery, Regulation,
  Corruption

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Capital Account Liberalisation
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Introduction

• Indias capital account liberalisation closely
  linked with other aspects of reform banking,
  capital markets, fiscal, regional integration.
• Presentation focuses on issues of linkage,
  sequencing between these areas.

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Background

• Indias financial system relatively unrestricted
  until late 1950s however not seen as
  growth-oriented.
• Exchange controls, bank nationalisation, directed
  lending, interest rate regulation and portfolio
  controls greatly increased in 1970s and 1980s as
  part of autarky model.
• Domestic financial deregulation started in late
  1980s external liberalisation in 1990s.

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Background

• Why liberalise?
• Stability Concerns about asset quality in banks.
• Growth Market-driven investment required a
  better financial system.
• Resources Desire to expand inflows of private
  capital.
• Monetary management desire to shift from direct
  to indirect instruments.
• Domestic liberalisation considered precondition
  for external financial integration.
• Fiscal improvement expected to parallel financial
  liberalisation.

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Process

• How is reform agenda developed, implemented?
• Heavy use of expert commissions to float, develop
  ideas, agendas. Little direct use of foreign
  advisors.
• Market consultations by both regulators (RBI and
  SEBI).
• Legislation reviewed by Ministry, Parliament.
• Important role of scams.
• Active press debate.
• Active coordination between RBI, SEBI, Ministry

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Reforms

• Interlinked reforms have included
• A. Monetary and Credit Policy
• Controlled liberalisation of domestic interest
  rates.
• Increasing, but regulated linkage with foreign
  rates through banks, corporates, non-resident
  Indians.
• Managed float of the exchange rate.
• Development of government debt market by design
  largely limited to domestic players.
• Reduction in statutory preemptions of banks
  (CRR/SLR).
• Market-driven framework for monetary management
  (repo corridor/LAF), integrating domestic/FX
  generated liquidity
• Increased autonomy, capacity of central bank.

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Reforms

• B. Regulation
• Evolving rules for banking entry, ownership,
  capital, supervision. Basle I and now Basle II.
• Equity market regulation maturation of SEBI.
• Regulatory framework for direct, portfolio
  investment, inbound and outbound debt and
  equity corporate and individual.
• New laws on foreign exchange (FEMA), creditor
  rights (SARFAESI).
• Regulations governing derivative markets for
  interest, equity and FX products.

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Assessment

• Greatest progress made in equity markets,
  monetary management.
• Reasonable success in government debt, stability
  of commercial banking system, micro-credit and
  development of FX, derivatives markets.
• Little progress on corporate bonds, market-driven
  rural, SME credit.
• Role of foreign banks less significant than
  expected.

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Assessment

• Financial market regulation, competition
  affected by dominance of publicly-owned
  institutions.
• Very uneven capacity for credit, market risk
  management across banks.
• Interest rate management affected by politically
  popular and quantitatively significant small
  saving schemes.

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Capital Account Current Status

• Significant differences by type of entity
• Non-resident corporates Almost completely free
  some remaining sector-specific limits on FDI
  (financial sector, some infrastructure).
• Domestic corporates Regulatory approval required
  for external borrowing, equity issues, overseas
  acquisitions. Regime increasingly liberal.

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Capital Account Current Status

• Nonresident Individuals Regime differs between
  non-resident Indians (NRIs), others. NRIs
  allowed to invest directly in onshore bank
  accounts, shares, real estate others restricted.
• Strict controls on overseas trading of rupee.
  Contrast to colonial period when rupee was medium
  of exchange in the Gulf.
• In contrast to 1980s, no significant gap between
  official, black market exchange rate capital
  flight largely tax, crime driven. Liberalisation
  of gold imports an important step in 1990s.

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Capital Account Current Status

• Resident Individuals Severe exchange controls of
  1980s (travel, study) progressively eased over
  1990s.
• Cautious recent moves to permit overseas bank
  accounts, portfolio investments by individuals.
• In contrast to 1980s, no significant gap between
  official, black market rate residual capital
  flight largely tax, crime driven.

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Commentary

• Main concern of authorities apparently to avoid a
  speculative attack on currency mounted by
  domestic banks, residents.
• Unlike e.g. Chile less apparent concern for
  moderating inflow surges, real exchange rate
  appreciation etc.
• Actions largely administrative. No legal,
  external commitments.

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Issues Going Forward

• Capital controls are instrumental to financial
  repression in India in that they separate
  domestic financial intermediation from
  international financial markets and capture
  domestic savings for the financing of the public
  sector deficit (Kletzer 2004).

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Fiscal/Public Debt

• Public debt stock high, rising. Additional
  contingent obligations. Together around 100 of
  GDP.
• Reflects fiscal deficits, sterilisation
  operations, but also impact of real interest
  rates, GDP growth.
• Liberalisation, debt market development has
  allowed debt to be placed in domestic market.
  Long debt maturities facilitated by capital
  controls.

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Fiscal/Public Debt

• Debt substantially held by publicly-owned
  financial institutions commercial banks,
  insurance (in 2003, 52 held by State Bank, Life
  Insurance Corp alone).
• Govt. funding risk converted into market risk for
  intermediaries further encouraged by zero
  risk-weights for bank regulatory capital.

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Consolidated Debt and Deficits of Central and
State Governments ( of GDPMP)
Year Public Change
Fiscal Primary Interest
Debt in Debt to Deficit
Deficit
GDP ratio 1990-91 64.4 9.4 5.0
4.4 1991-92 60.9 -3.5 7.0 2.3
4.7 1992-93 60.5 -0.4 7.0 2.1
4.9 1993-94 62.5 2.0 8.3 3.3
5.0 1994-95 60.1 -2.4 7.1 1.9
5.2 1995-96 61.2 1.2 6.5 1.6
5.0 1996-97 56.5 -4.7 6.4 1.3
5.1 1997-98 58.6 2.0 7.3 2.1
5.1 1998-99 59.5 0.9 9.0 3.7
5.3 1999-00 62.2 2.7 9.5 3.8
5.7 2000-01 70.4 8.3 9.6 3.6
6.0 2001-02 75.8 5.4
10.0 3.7 6.3 2002-03 80.0
4.2 9.5 3.1 6.4 2003-04 81.1
1.1 8.4 2.0 6.4 2004-05 82.0
0.9 8.3 2.2 6.1
Sources Reserve Bank of India, Handbook of
Statistics on the India Economy, 2002, Reserve
Bank of India, Bulletin, June
2004, and Reserve Bank of India Annual Report
2004-05.
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Decomposition of Fiscal Deficit and Public Debt
( of GDPMP)
Sources Reserve Bank of India, Handbook of
Statistics on the Indian Economy, 2003-04, and
Reserve Bank of India Annual Report 2004-05.
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Fiscal/Public Debt

• Data clearly show rising real funding rate,
  impact on interest burden. This despite extremely
  benign global interest rate environment.
• Significant adjustment in primary deficit
  largely inflicted on capital spending.
• Private investment crowded out both in financial
  markets and through poor provision of public
  goods.

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Gross Fixed Capital Formation as Percentage of
GDPMP
Percent of GDP Year Public Sector
Private Sector Total 1990-91 9.0 13
.9 22.9 1991-92 9.2 12.9 22.0 1992-93 8.2
14.2 22.4 1993-94 8.0 13.4 21.4 1994-95
8.8 13.2 21.9 1995-96 7.7 16.7 24.4 1996-
97 6.9 15.9 22.8 1997-98 6.4 15.3 21.7 1
998-99 6.5 15.1 21.5 1999-00 6.2 15.6 21.
8 2000-01 6.0 15.9 22.0 2001-02 5.6 16.5
22.0 2002-03 5.6 16.6 22.2 2003-04 6.0 1
6.8 22.7
Sources National Accounts Statistics 2005
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Fiscal/Public Debt

• Further liberalisation of outflows could raise
  real funding costs as global opportunities
  provide competition
• Wider foreign access to local currency debt might
  reduce funding costs, but would increase
  vulnerability.
• Greater integration would increase pressure for
  fiscal reform, which would be growth-enhancing in
  the long run.

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Banking/Financial

• Traditional concern is that capital surges can
  overwhelm a poorly regulated, weakly managed
  banking system.
• While Indian banks have improved, risk management
  systems remain weak.
• However, as noted, even now, relatively few
  controls on inflows (although these could be
  re-imposed)

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Banking/Financial

• Impact on domestic credit neutralised through
  sterilised intervention.
• Controls relatively porous given sizable
  invisibles flows services, workers remittances,
  trade leads and lags.
• Controls on outflows do serve as a protective
  device for the domestic financial system.

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Other Issues

• One of Indias successes has been to lengthen the
  maturity of its (relatively low) external debt.
  This may be difficult to maintain with
  convertibility.
• Indias trade liberalisation still has some way
  to go. Greater volatility in nominal and real
  exchange rates would make this harder to sell
  politically.

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Summing Up

• Fiscal adjustment has lagged financial
  liberalisation, raising risks.
• Expert opinion on capital account liberalisation
  has also shifted following crises of the 1990s.
  This affects domestic debate.
• Agree that reversals of policy are more harmful
  than taking a little longer.

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Summing Up

• But capital controls are anti-competitive and
  discriminatory, and remove an important
  instrument for monitoring economic management.
• Monetary, financial integration sooner or later
  must accompany the real integration that is
  underway and desired in South Asia, East Asia.
• Would facilitate Indias desire to develop as a
  regional financial centre.
• Many less sophisticated economies have had an
  open capital account for a long time. Not rocket
  science.

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Summing Up

• A time-bound road-map should be established to
  move to full capital convertibility
• This should be dovetailed with existing
  timetables for separating debt management and
  monetary policy, the removal of the RBI from
  primary auctions of public debt and the fiscal
  adjustment envisaged under the FRBM Act.
• Will need political endorsement. Cannot just
  remain a technocratic project at the official
  level.

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Thank You