India needs to open up further for capital account convertibility

18 May 2015


Reserve Bank of India executive director G Padmanabhan India needs to continue moving towards full capital account convertibility, thereby making the Indian rupee a free-floating and fully convertible currency and there cannot be a going back from it. The moot question is how fast to achieve it and this will depend on factors such as fiscal consolidation, inflation, bad loans, and strength of financial markets, Reserve Bank of India executive director G Padmanabhan said.

Although India has made visible progress on these fronts, there are still risks associated with opening up of currency market, but these risks have to be faced to move forward while controlling the risks as far as practicable, Padmanabhan said in a speech, published on the RBI's website.

If the experience of developed countries is any pointer, sound policies, robust regulatory framework promoting a strong and efficient financial sector, and effective systems and procedures for controlling capital flows greatly enhance the chances of ensuring that such flows foster sustainable growth and do not lead to disruption and crisis, he added.

As things stand, there is virtually no restriction on foreign direct investment (FDI) in India. Any foreign individual or firm or any other association of people can invest in any Indian company or set up an Indian company through FDI, which essentially means long-term engagement with influence on management. However, there are some restrictions on the extent of entry into select sectors, but that is motivated by social, stability or strategic interests. For instance, restriction on entry into socially sensitive print media sector, strategically important defence sector or bubble prone real estate sector cannot really be faulted on economic logic.

There are some operational restrictions on FDI in so far as the universe of instruments of investment is rather narrow comprising mostly equity instruments and that these instruments have to be sold and bought at fair value. The logic is fairly simple. An instrument of FDI should not be a camouflage for debt. In normal times and for traditional industries, these provisions are fine. But of late, we are increasingly being made aware that richer instruments with more structure may be needed for investment in, say, infrastructure sector where cash flows are typical.

Similarly, there may be need for some flexibility in valuation in, for example, start-up technology firms. We are seized of the problems and working towards a solution to remove the irritants.

Citing Jagdish Bhagwati's arguments, Padmanabhan said, ''If growth and welfare are the ultimate objectives, as they indeed are, FDI is the best instrument to achieve this. The advantages of FDI - better access to technology, management practice, and so on - have been chronicled in detail.

''The 'Make in India' programme is indeed based on this principle. It is true that making in India for the world may not be easy, for that would mean outcompeting the existing incumbents. But making in India for the large and latent domestic demand is surely a possibility - just look at the automobile sector - though it would pose difficult, but manageable problems relating to demand management.''

The regime for Foreign Portfolio Investment (FPI) has also been fairly liberal. The two principal areas of FPI are equity and debt. As far as equity is concerned, portfolio investment has virtually unrestricted access. The access to both sovereign and corporate debt is wide enough. There are aggregate limits on FPI in sovereign as well as corporate debt but these limits are progressively increased over time in keeping with the volume of capital flows and macroeconomic conditions. In recent times, we have been adopting a policy of nudging FPI into debt instruments of a certain minimum maturity so that the investment assumes credit risk and does not involve mere interest rate arbitrage.

Much will depend on how fast we can meet the most important preconditions like fiscal consolidation, inflation control, low level of NPAs, low and sustainable current account deficit, strengthening of financial markets, prudential supervision of financial institutions, etc, he said.

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