Capital Account Convertibility Could Open Up Further, Says Barclays Report

On 14 October 2021, the Reserve Bank of India’s Deputy Governor, T Rabi Shankar gave a speech on India’s Capital Account Management, fuelling hopes for liberalised capital account convertibility (CAC).

Capital account convertibility is the ability to convert foreign currency into Indian currency and vice versa, for various investments in fixed and financial assets. While the government has liberalised CAC over the years, it still remains apprehensive about full convertibility.

During good times, money flows in from external sources, helping the economy perform better. However, during bad times, money could easily flow out in case of full convertibility. Hence, some markets, such as the debt markets, have been kept off limits for foreign portfolio investors.

In the light of RBI’s positive sentiment about further opening up CAC, Barclays has released a report advocating for opening up of CAC. The report argues that the cost of holding foreign reserves is higher than the direct cost.

Foreign reserves make up around 70 per cent of RBI’s total assets, the returns on these reserves do not compensate for the negative carry generated by sterilisation operations. These operations are conducted to remove excessive money supply from the system, while keeping the currency stable. Hence, with large reserves, the cost of sterilisation goes up as well.

CAC has been a major topic of discussion in India, and since 1947 to 1991, India remained a closed economy. Post-1991, convertibility for inflows received great attention, with several areas witnessing an opening up to foreign capital. However, convertibility for outflows from India remained relatively constrained over the years.

Since 2016, the RBI has followed an interventionist approach and adopted the use of forward book, FX swaps, and non-deliverable forwards to augment currency management. There has been an easing of restrictions as well, to make the markets more accessible to foreigners.

“The RBI and the government have also eased restrictions for debt inflows, despite a clear preference for equity inflows, and are making efforts to get India included under global bond indices. As a first step towards this route, certain government securities were made eligible for the Fully Accessible Route (FAR), with no FPI limits, in early 2020,” said the report.

The report highlights the “Thirlwall constraint”, which imposes a limit on growth imposed by current account financing requirements. The Indian economy is prone to disruptions due to external factors, leading to ballooning of the current account, and a tightening of the monetary policy, constraining aggregate demand. The gap between imports and exports widens sharply during periods of increased domestic activity.

Therefore, a country that wishes to grow would have to fund its import bills through capital inflows or by increasing exports. Despite efforts on growing exports, the constraints are likely to continue over the near term, hence, there is an incentive for opening up CAC.

The lack of focus on outflow convertibility shows up in NIIP data, where India’s net investment position is deeply negative due to assets being quite small relative to liabilities. Direct investment makes up a significant portion of these assets, but amounts to just around 7 per cent of GDP.

Ultimately, opening up the capital account could help India alleviate several problems that it faces today. The report highlights the policy-makers willingness to make necessary changes to offer wider capital market access to non-residents.

Some signs of the change is the freely accessible route, and the inclusion in the global bond index could provide greater scope for foreign investors to participate in India’s capital markets. Even the outflows from India that have been restricted heavily so far could see some reconsideration from the policy-makers. However, outflow convertibility wouldn’t be a priority.

In order to become fully convertible, certain macroeconomic pre-conditions must be met. While many countries have open capital accounts, only a few have truly “hard” currencies. In order to help the rupee to be used more widely, RBI has been taking several steps – reduction of arbitrage between onshore and offshore derivatives, allowing domestic banks to use NDFs, and allowing access to onshore interest rate derivatives for offshore banks.

With the rupee gaining clout in international markets, investors would feel more comfortable holding assets denominated in Indian currencies.