India’s Approach to Capital Account Liberalization

“Drawing on the experience of the past decade and a half, India's approach to capital account liberalization can be summarized as follows:

First, capital account liberalization is treated as a process and not an event.

Second, it is recognized that there may be links between the current and capital accounts and, hence, procedures are in place to avoid capital flows in the guise of current account transactions.

Third, capital account liberalization is kept in tune with other reforms. The extent and timing of capital account liberalization is sequenced with other reforms, such as strengthening of banking systems, fiscal consolidation, market development and integration, trade liberalization, and the changing domestic and external economic environments.

Fourth, a hierarchy is established in the sources and types of capital flows. The priority has been to liberalize inflows relative to outflows, but all outflows associated with inflows have been totally freed. Among the types of inflows, FDI is preferred for stability, while excessive short-term external debt is eschewed. A differentiation is made between corporates, individuals, and banks.

For outflows, the hierarchy for liberalization has been corporates first, followed by financial intermediaries, and then individuals. Restrictions have been eased for corporates seeking investments and acquisitions abroad that strengthen their global presence. But banks and financial intermediaries are a source of greater volatility. It is widely understood that banks and financial intermediaries are fragile because their assets are relatively illiquid but their liabilities are demandable, and they are susceptible to contagion and self-fulfilling crises of confidence. Therefore, liberalization in this sector has been tied to financial sector reforms. For individuals, residents are treated differently from nonresidents, and nonresident Indians have a well-defined intermediate status between residents and nonresidents.

Fifth, the pace and sequencing of liberalization is responsive to domestic developments, especially in the monetary and financial sectors, and to the evolving international financial architecture. As liberalization advances, administrative measures are reduced and price-based measures are increased, but the freedom to change the mix and reimpose controls is demonstrably available. In the process, an integrated view of the state of development of all financial markets is taken.

Sixth, significant liberalization on outflows on behalf of individuals, corporates, and mutual funds depends on a comfortable level of foreign exchange reserves and greater two-way movement in the exchange rate. This is reflected in increasing global operations of Indian corporates in search of global synergies and in knowledge related to their operations."

-Point of View: Converting a Tiger,Yaga Venugopal Reddy, Governor of the Reserve Bank of India in the latest edition of Finance and Development