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Managing the Transition to Convertibility

There is little doubt that moving towards a more open capital account would benefit the country enormously. The domestic foreign exchange market is providing a leading edge in the move to convertibility. The Tarapore Committee should ensure that residual controls on foreign direct investment and external commercial borrowings are removed and sectoral imbalances in the economy are addressed.

Managing the Transitionto Convertibility

There is little doubt that moving towards a more open capital account would benefit the country enormously. The domestic foreign exchange market is providing a leading edge in the move to convertibility. The Tarapore Committee should ensure that residual controls on foreign direct investment and external commercial borrowings are removed and sectoral imbalances in the economy are addressed.


his article briefly reviews the reforms in the external sector over the last few years, assesses the market response, and examines the possible threats that we need to be conscious of in moving towards fuller convertibility on the capital account (CAC). The first part of the article deals with reforms so far and their bearing on CAC; the second part analyses the market response and exchange rate movements in the context of CAC. The third and final part uses some of the learning from recent crises – particularly the south-east Asian crisis – to assess where India stands vis-à-vis certain risk factors.

Reforms in the External Sector

The economic reforms, which were initiated in 1991 with the two-step devaluation of the rupee, progressed along two paths. The first path entailed the process of liberalisation – deregulation and phasing out of controls encompassing the entire economy, such as delicensing of industry, eliminating control of capital issues, deregulation of interest rates, relaxing various exchange control measures, etc. The second path was to pursue structural reforms, institutionalising policy changes, refining economic processes, and redefining regulatory and supervisory roles of the government and the central bank. The process of liberalisation enlarged the space for private enterprise, accelerated globalisation of domestic markets and exposed Indian industry to newer threats and opportunities.

The structural reforms, on the other hand, were necessary for an orderly transformation of the economy, and to ensure that the liberalisation process became irreversible (independent of political exigencies) and without destabilising the financial markets. New institutions were created both in public and private sectors, largely on public initiative, which included Securities Exchange Board of India (SEBI), National Stock Exchange (NSE), National Securities Depository (NSDL), Clearing Corporation of India (CCIL), credit rating agencies and primary dealers. Privatisation of public utilities necessitated regulatory authorities for telecom, electricity, insurance, etc, with a fair degree of autonomy. Self-regulatory organisations such as Foreign Exchange Dealer’s Association of India (FEDAI), Fixed Income Money Market and Derivatives Association of India (FIMMDA) and Association of Mutual Funds in India (AMFI) became increasingly important in financial markets. The new institutions created and supported new processes relating to dematerialisation of securities, electronic trading and real time payment and settlement systems.

Reforms in the external sector were part of the overall economic reforms, which were underpinned by the institutional changes described above. The first reforms were focused on reducing the controls on the rupee’s exchange rate. Following the recommendations of the High Level Committee on Balance of Payments, headed by Rangarajan, this phase culminated in August 1994, when the rupee was made fully convertible on the current account under Article VIII of the Articles of Agreement of the IMF.

The next nodal point was the setting up of the first Tarapore committee under the chairmanship of the then deputy governor of the RBI, S S Tarapore, which was mandated to create a road map to capital account convertibility. The committee, which submitted its report in June 1997, recommended a three-year timeframe for complete convertibility, subject to meeting certain preconditions. The preconditions included reduction in the inflation rate to the 3-5 per cent band, reduction in gross non-performing assets (NPAs) of public sector banks to 5 per cent, reduction in the cash reserve ratio to the minimum of 3 per cent, reduction in debt service ratio to 20 per cent, etc. The committee prescribed four indicators to evaluate the adequacy of foreign exchange reserves to safeguard against any contingency and also laid down a phased liberalisation of controls on capital flows.

While the south-east Asian crisis in late 1997 slowed down the reforms, almost all of the benchmarks and preconditions set by Tarapore I have since been met/or exceeded, except for the gross fiscal deficit as a percentage of GDP, which also appears to be very near to the targeted level of 3.5 per cent. Since 1997, the structural reforms directly bearing upon CAC fall into three categories: those relating to capital flows, in trade related areas, and reforms leading to market risk management, particularly in the derivative segment. Investment related reforms: FDI is actually under the purview of government of

Economic and Political Weekly May 13, 2006

Figure: Difference between Peak and Average Volatility June 2004 to April 2006

India and RBI is only the implementing agency. Most sectors of economy have been already opened to foreign investment, with only six prohibited sectors and only a few sectors – e g, insurance, banking and telecom, which have caps of below 50 per cent.

FIIs are permitted to invest freely in equity markets, subject to sectoral caps. FII investment in the debt market, however, is capped at $ 1.5 billion for corporate bonds and $ 2 billion for government securities. A cap on this segment is felt necessary pending full convertibility, in order to reduce the interest arbitrage between the two currencies.

Indian companies may raise capital globally through very liberal American depository receipts/global depository receipts guidelines and/or up to $ 500 million through the external commercial borrowings (ECBs)/foreign currency convertible bonds window. There are certain restrictions on ECBs, in terms of maturity, enduse and pricing, all of which are not unreasonable (see below) but may be ready for some further liberalisation now. Indian companies may also invest overseas overseas direct investment (ODI) freely (the only exceptions being in the real estate and banking sectors) to the extent of 200 per cent of their net worth. This is perhaps the loudest element of capital flow liberalisation, and the window that is clamouring for more. Trade related reforms: With the rupee fully convertible on the current account, these reforms pertain mainly to terms of trade – maximum credit for exports is now permitted beyond one year, while for imports credit beyond one year is subject to approval of the RBI. RBI has permitted issue of financial guarantees/letters of comfort by Indian banks to secure trade credit; this and the roll-over of credit on such terms helped many companies to drastically reduce their import costs. Reforms related to risk management: While RBI has been continuously pushing banks to enhance their risk management processes – from detailed ALM guidelines in 1997 to Basel II guidelines (as recently as last month) – their efforts to develop a deep and liquid derivatives market, which is a necessary condition for effective risk management, has not been as successful as it should.

Rupee interest rate swaps were first permitted in 1998, followed by rupee options in 2002. An attempt to launch interest rate futures in 2003 was still-born.








More inexplicably, RBI’s restriction on the use of Mumbai interbank forward offer rate (MIFOR), which had evolved as the only tentative term money market benchmark, has dealt a body blow to the evolution of genuine hedging markets. This remains the key lacuna that needs to be addressed in going forward to CAC.

In several cases the reforms have resulted in conditions that met or exceeded the levels suggested by the Tarapore I. For instance, today ODI is permitted up to twice the company’s net worth as opposed to Tarapore I’s recommendation of $ 50 million in the first phase. As recommended, universal banks have come into existence in place of financial institutions. However, there are still several recommendations (pertaining to overseas investments by individuals and mutual funds, overseas borrowings by Indian banks, flexibility of operations to exporters, etc) that are yet to be implemented.

Of course, 2006 is a world apart from 1997 – both from the point of view of global markets and India’s new economic confidence and institutionalised strength – and it is appropriate to reassess the benchmarks, which explains why the second committee has been constituted. July 31 – the date that Tarapore II submits its report

– will provide a clearer picture of the next steps to capital account convertibility.

Behaviour of the ForeignExchange Market

It seems clear that the domestic forex market has been evolving ahead of the regulators and appears to provide a leading edge to the move towards capital account convertibility.

The domestic inter-bank forex market has grown dramatically since Tarapore I.


In the mid-1990s, daily turnover was in the range of $ 1-2 billion per day, providing a multiplier of around 3 to 4 on underlying trade transactions. Today, daily volumes are around $ 12-13 billion a day, and provide a multiplier of about 17-18 on underlying trade. Global markets trade at 85-90 times the underlying trade, so, while we have moved quite well, it is clear that there is still a long way to go.

The microstructure of the market, too, has changed. While in 1997, the total market volume was about evenly divided between spot and forwards, today, the forward market is about twice the spot market volume. Further, today there is “reasonably good” liquidity in USD/INR options, with market volumes averaging around $ 250 million a day – significantly, though, there are banks reporting that it is sometimes possible to push through $ 100-150 million quite easily on a good day.

However, regulation on the derivatives side – see above – has remained overly heavy-handed, which has limited the growth in derivative volumes, both in options and in interest rate swaps, the market for which is even more stunted. Further, there is a need to consolidate regulation – RBI regulates the over-the-counter (OTC) market, in which banks trade spot and forward foreign exchange, options and interest rate swaps; on the other hand, interest rate futures, which admittedly have not yet got off the ground, but in which banks would be significant players, were intended to be regulated by SEBI.

Again, on the structural side, in the early to mid-1990s, voice brokers were the main intermediaries in the inter-bank market; however, with Reuters’ dealing and other electronic brokers coming into the market in a big way, the bulk of transactions are now conducted electronically with voice

Economic and Political Weekly May 13, 2006 brokers capturing perhaps 15 per cent of the volumes. It is significant, however, that voice brokers are most active when market volatility spikes, since “market intelligence” comes at a premium at that time. Obviously, brokers are more active in the less liquid segments, like forwards and, more recently, options. RBI needs to empower brokers to a greater extent to drive volumes in the derivative segment, particularly as there remains a huge diversity of knowledge levels between different market players.

In fact, as in the case of regulation of banking activity, there is considerable confusion on the regulation of brokers. Forex and forex derivatives brokers report in to FEDAI, whereas money market and gilts brokers report in to FIMMDA. There is no clarity on brokerage in interest rate swaps, which often straddle both markets, andcurrency derivatives, which would provide an excellent half-way house to capital account convertibility. This would alsofall between the two pillars of regulation.

Despite all this confusion, the spot USD/ INR market, as mentioned earlier, has been making steady strides towards freedom. Not only have daily volumes risen to “respectable” levels, market volatility, particularly over the past year, has risen as well, to an average of around 6 per cent, from average levels of around 2 per cent in previous years.

More importantly, the volatility has become more stable in the past year, with RBI less frantic to control intra- or interday movements. In times past, RBI would step in to discipline the market if the rupee moved by even a few paise in a day. Today, however, we find 10 to 20 paise (0.2 to

0.5 per cent) intra-day movements quite commonplace. As a result, the difference (in percentage terms) between the peak and average volatility of the rupee has become much more stable. The chart shows how this parameter has moved since June 2002 for the rupee, the Thai baht, the Singapore dollar and the euro. Using this as a measure of market development, the Indian forex market is far more developed than the Thai market and even comes in a bit better than the Singapore dollar. It has a long way to go to get to the fully liquid conditions that obtain for the euro, but clearly, the Indian forex market is on its way.


There are, of course, concerns that moving to full convertibility of currency could lead to problems in the financial markets. These concerns are based on the experiences of various debt and payment crises faced by emerging market countries in the post-Bretton Woods era. The widespread Latin-American and Nigerian default in the 1980s, the Argentinian crisis of early 1990s (which had a dramatic revival that was reversed by a repeat crisis in early 21st century), the Mexican crisis of mid1990s, south-east Asian crisis of 1997, closely followed by collapse of Russian markets point out the vulnerability of emerging markets, often in the wake of financial deregulation and liberalisation of exchange controls.

Various studies have shown that poor financial infrastructure (which resulted in both high-risk lending and over borrowing), low returns on investment, implicit guarantees by the state, speculative boom in equity and real estate markets and inadequacies in macroeconomic policy constitute the recurring theme throughout the financial crises over the last two decades. Interestingly, imbalances in government finances, though an obvious suspect, are not seen as a major driver of crises, unless, of course, the imbalances are huge and growing – a situation that does not describe India today. In fact, in most of these areas, India is reasonably well placed. Financial infrastructure: As described earlier, Indian institutional restructuring has been comprehensive. SEBI and stock exchanges have been developing sound risk management practices. Banking supervision has been strengthened with a focus on market risk management. Provisioning norms, capital adequacy and accounting practices conform to global standards. The entry of foreign banks and investment institutions have strengthened competition in the market. The only area where we need to further evolve is with regard to derivative products. Overborrowing: Though there has been a spurt in ECBs recently, foreign debt is less than our forex reserves, and external debt in proportion to GDP at below 25 per cent is quite comfortable, as compared to, say, 45-60 per cent in the case of Malaysia, Indonesia and Thailand (MIT) just before the crisis. This suggests that we need to be cautious about removing the overall ceiling on ECB.

Short-term debt as at end-December 2005 was less than 7 per cent of foreign reserves

– again, this compares well with Thailand’s 122 per cent and Indonesia’s near-300 per cent right before the crisis. Clearly, we have very little to be concerned about in this regard.

Returns on investment: Corporate India is going through a boom cycle and earnings are at historic highs. The return on capital employed for the top 500 companies as at end-December 2006 amounted to 25 per cent. Return on equity of companies with FDI for the year 2003-04 was 18.4 per cent as compared to 17.2 per cent in the previous year (RBI survey). Clearly, the economy is strong and, as such, would be a good time to take aggressive steps.

The government of India no longer guarantees commercial borrowings by public sector undertakings or banks. While there is implicit support from the government, it is believed that PSUs have been able to borrow on their own strength. The government, however, may not allow any major bank to fail, whether in the public or private sector. There is some more work to be done in this area, but we believe, given the current strength of the economy, this is a moot point at the moment. Speculative boom: The Sensex as at end March 2006 has grown by 72 per cent over January 2005 level and it is not clear how long the levels will be sustained. However, the growth is apparently supported by higher corporate earnings and the ascendancy was fairly well sustained over last few months. Current P/E is around 20, but the market had earlier seen levels above

24. Real estate on the other hand paints a more worrisome picture. Real estate prices have shown an increase of 60 per cent to 100 per cent in the metros and some of the high end investment could be speculative.

However, the speculative boom either in stock markets or in real estate is unlikely to affect the stability of financial markets as the exposure of banks to both the sectors is strictly controlled by RBI – note, in particular, RBI’s increase in risk provisioning norms in the last monetary policy. Macroeconomic policy: Macroeconomic policies have long ceased to be protective, with opening of economy and adherence to WTO agreements. Fiscal policies are clearly aiming at reducing the deficit to below 3 per cent of GDP. The central bank has operational autonomy and monetary policies are largely devoid of political influence.

In sum, we would say that the Indian economy seems very comfortably placed with respect to these risk factors.

There are, of course, some concerns with respect to global and domestic imbalances. Global imbalances are today largely about high and volatile oil prices and the possibility of a sharp rise in US interest rates

Economic and Political Weekly May 13, 2006

to support the dollar in the event of a collapse (which could trigger significant outflows from emerging markets including India). In our view, the underlying strength of the Indian economy is more than sufficient to sustain any shocks here. Of course, if global growth drops sharply, we will be affected, but not any more so as a result of having a substantially more open capital account. In fact, in the event that the resolution of global imbalances (if and when it happens) results in a collapse of the dollar, India could actually benefit from increased capital flows.

Domestic imbalances, however, are another issue, and mainly relate to sectoral growth differences and social inequities. While these may not have a direct bearing on CAC, their political impact can create greater volatility in a more open financial environment. Of course, this is not to suggest that these concerns should slow down the move towards capital account convertibility, the bottom line of which is a substantial increase in the efficiency of the Indian economy. It is rather to point out that Tarapore II should – and, considering its composition, likely will – focus as much on the real economy as on financial markets in laying down an express road map.


There is little doubt that moving towards a more open capital account would benefit the country enormously; amongst others, here are some of the key issues we feel Tarapore II should address.

  • (i) Residual controls on FDI/ECB need to be removed: In particular, global issuers and investors should have free access to the rupee debt market, so as to make rupee debt paper globally tradable even before fuller CAC is achieved (as in the case of ADR/GDR issues). This is perhaps the right time to take the step, as ADB is proposing to issue rupee debt of 1,320 crore.
  • Banks and non-bank infrastructure finance companies may be provided free access to ECB/global debt issues, within the overall ceiling of ECB; RBI may prescribe eligibility norms in terms of financial strength of the Indian issuers, in order to avoid credit default.
  • (ii) Taxation: Tax laws and stamp duty must be simplified without scope for ambiguity. Removal of withholding tax on long-term investments (FDI) and borrowings (ECB) would incidentally
  • help create a global finance centre in India. All fiscal issues relating to debt market should be held exclusively in the central list.

    (iii) Social Equity: Sectoral imbalances in the economy need to be addressed seriously. Corporate finance to agriculture needs to be encouraged; credit insurance to agriculture and SMEs would also provide them easier access to institutional credit. Credit derivatives will become imperative for hedging corporate as well as non-corporate credit risks. Some affirmative action by the government may become necessary in the initial stages.



    Economic and Political Weekly May 13, 2006

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