Risks of a Relatively Open Capital Account Need Assessment, Writes NIPFP's Suranjali Tandon

Capital controls evoke strong but divergent views. Even the IMF, which for many decades advocated for unfettered capital controls, adopted a softer stance after the global financial crisis. The IMF now recognises that capital controls may be used pre-emptively so as to ensure that the reversal of inflows does not pose a risk to macroeconomic stability. It is reasonable to expect some controls to continue, depending on the macroeconomic vulnerabilities.

Empirically, phases of tightening are associated with overheating of economies, excessive credit, say, a housing market boom, or periods of exchange rate appreciation. Cyprus and Greece, for example, raised restrictions after joining the EU and the global financial crisis. Globally, over the past two decades, the approach has been to ease controls, more so on outflows. India’s experiments with liberalisation over the past decades align with such global trends. It is interesting, though, that India compares well with other countries when ranked on financial openness in terms of inflows, be it investments in equity, debt or other investments. Whereas residents’ investments abroad are relatively more restricted than those of their peers. The changes to regulation have been incremental and, as per the IMF’s financial openness index, India compares with Russia, Argentina and Nigeria. The merit of having these guardrails cannot be dismissed, but do these work when global markets are interlinked? The current situation bears evidence of this, as the debt market in India is driven by global bond yields and equity investors migrate to markets depending on technological and regulatory shifts abroad. If there is such a feedback loop, the strength of these measures needs examination.

Capital controls are closely connected with exchange rate management. It is observed that the former are tighter when the latter is more closely managed. The RBI’s approach to the currency market pre-empts its conservative approach to capital regulation. The NDF is an amorphous market that allows traders to take a position on the INR without delivery. Following the recommendations of the committee in 2019, it was decided that the market could be onshored via GIFT City. At the start of the year, the Reserve Bank of India began to restrict banks’ access to the non-deliverable forward market, unwinding previous attempts to expand this market within the regulatory oversight of the RBI. Meanwhile, the RBI substantially built up a forward book and began to find other ways to mitigate the depreciation. Reliefs were offered for hedging foreign currency non-resident deposits, foreign portfolio investments permissible through the fully accessible route, taxes on government securities investments and limits on external commercial borrowings. The measures, imperfect substitutes for regulation, stand on thin ice, as there is a need for compelling prospects for long-term investors. The pressure on the INR continues, and capital flows have not stabilised, leading one to probe how independent the INR is of the goings-on abroad.

To defend the removal of controls on outflows requires evidence that volatility and depreciation in the exchange rate would be the same if the RBI left the market to its own devices. More so, would it make sense when the foreign exchange market is vulnerable?

Even for a gradual shift in control of outflows, it is imperative to reflect on the maturity of the Indian financial markets, the co-movements with global markets and the categories of investors to whom further relaxation can be afforded.

Policy has been accommodative of the flighty foreign portfolio investors, but what about resident companies and funds looking to invest outside India? In the years after the corporate tax breaks, growing reserves and surplus among corporates have been accompanied by a sharp rise in acquisitions, hinting that the prospects for investments outside India may be brighter. Retail investors are also more inclined to move money out as they invest in NASDAQ through mutual funds. Individuals prefer this as limits under the Liberalised Remittance Scheme apply, there are issues with market access, and a tax applies to transactions above INR 10 lakh. Mutual funds can only offer $7 billion in subscriptions linked to foreign markets, which represents approximately 1% of assets under management. The fact that fund investments keep reaching the limit is another indication of the growing need for portfolio diversification. India is not yet prepared to open the floodgates, but a more difficult question awaits. Should foreign investors be allowed to leave at whim while domestic fund investments abroad are controlled?

The Indian stock market has come of age, but it competes, albeit imperfectly, with developed markets. The NIFTY 50 and the SENSEX have reported elevated price-to-earnings multiples, as compared with, say, the NIKKEI and KOSPI. Factoring in such differentials, foreign investors exited, leaving domestic institutional investors to purchase these assets. There is an observed difference in returns on domestic and international investment funds. The average return of mutual funds investing in domestic markets has ranged between 5-7%, whereas those investing internationally reported an average of more than 20% over the past year. As household savings in mutual funds increase, funds must deliver returns. Flush with liquidity, the avenues to invest in are commodities and international stocks. In the absence of avenues for returns in domestic equity and the possibility of investing internationally, the equity markets may lose their fan base while the banks become flushed with liquidity amidst rising interest rates. The ramifications of these developments need to be weighed against the important institutional support funds provide to the Indian IPO market. The debate cannot be settled without understanding if the opening up of foreign investments robs the market of its anchor investors.

Risks from international capital markets are at our door, but the economy is less than insulated. Taxes are a quick fix and do not address any underlying cause. While there is a case to be made for a long-term vision for technology-led growth in India, in part being addressed through schemes such as the PLI, policymakers must consider, even if theoretically, whether India should tread towards capital account reform or continue to exercise controls. A good first step would be a comprehensive risk assessment of additional financial fragilities arising from a relatively open capital account.

The writer is an Assistant Professor at the National Institute of Public Finance and Policy (NIPFP).