How to manage portfolio capital flows

A new government at the Centre will take guard in about three weeks. The government and the Reserve Bank of India (RBI) will need to work out appropriate strategies to deal with issues requiring immediate attention. One of these is foreign capital flows. The challenge will be to devise policies that can deal with two-way foreign capital portfolio flows — large inflows and outflows — not knowing which way the cat will jump.

In this context, RBI Deputy Governor Harun R Khan’s inaugural address at the FEDAI Conference on April 12, 2014 provides ‘Thoughts on Regulating the Capital Account’.

This address should be mandatory reading for policy-makers, opinion-makers and forex market operators as it is a brilliant exposition of the way capital account management has evolved, the shift in policies over time and the rationale for future policy responses.

The RBI had commissioned two reports on capital account convertibility (CAC) in 1997 and 2006. Nothing fires up the imagination of commentators like the subject of CAC. An unfortunate aspect of the debate is that strong views are expressed by renowned experts. There are those who argue that the first Committee had recommended full CAC in three years and that the second Committee, by back-tracking, missed an opportunity to make the leap to full CAC. A strong lobby, led by former top RBI officials, vehemently canvassed that the two Committees should never have been set up!

To illustrate the extent of misunderstanding and misinterpretation, two short references from these Reports would suffice.

The 1997 Committee emphasised that some capital controls would still be necessary and recommended that at the end of three years, there should be a stock taking. The Committee stressed that CAC would be a continuing process and, as such, there was no question of the Committee recommending full CAC without any capital controls.

The 2006 Committee recommended a five-year roadmap followed by a comprehensive review to chalk out the future course of action.

Deputy Governor HR Khan’s talk provides an excellent survey of the policy responses on exchange rate stability, the tools used to deal with heightened volatility and the need for adequate forex reserves. He also offers a hierarchy of choices on capital inflows and outflows and the non-deliverable forward market.

The RBI’s institutional memory and prowess in deploying appropriate policy tools is such that it does not need to reinvent the wheel. One concomitant of large portfolio inflows would be excess domestic liquidity which will need to be mopped up. For this, the RBI could use an array of instruments.

First, central bank accommodation could be reduced under various windows including the liquidity adjustment facility (LAF). Second, the RBI could undertake open market operations (outright sales of securities). Third, the market stabilisation scheme (MSS) could be operationalised; an initial amount of ₹50,000 crore has already been put in place by the government.

Fourth, the growth of domestic liquidity would swell banks’ balance sheets and banks must participate in burden-sharing along with the government and the apex bank. In such a situation the RBI should not hesitate to raise the cash reserve ratio (CRR) but should never pay interest on the impounded balances.

Payment of interest on cash balances merely attenuates the efficacy of this instrument. In the late 1980s and early 1990s, interest payouts totally blunted the CRR as an instrument of policy. A relatively low CRR with no interest is far more effective than a very high ratio with interest.

Last, if portfolio inflows explode, an unremunerated reserve requirement on such inflows could be considered.

When portfolio inflows increase it is only appropriate to relax the restrictions on capital outflows by resident individuals, which was reduced from $200,000 a year to $75,000.This is a symbolic measure and early action to partially relax this restriction would greatly enhance confidence. Likewise, limits on capital outflows by resident banks and corporates need to be gradually restored to pre-August 2013 levels.

With the integration of the economy with the global economy, the futility of restrictions on gold needs to be recognised.

Restrictions on gold merely shift gold imports from the official to the unofficial market. Harsh restrictions on import of the precious metal are not consistent with a liberalised capital account.

With large and sudden portfolio inflows there is a tendency for the nominal exchange rate to appreciate. Given the present dollar-rupee exchange rate any significant appreciation of the rupee would render Indian exports uncompetitive. Hence, the endeavour should be to ensure against any big appreciation of the rupee.

The policy objective should not be a strong rupee or a weak rupee but an appropriate rupee exchange rate; this translates into a rate that takes into account the inflation rate differential between India and the major international currencies.

The experience the world over is that sudden large portfolio inflows are, in time, followed by equally sudden large portfolio outflows. This is unlikely in the immediate future. But in the event of large portfolio outflows, the RBI has adequate expertise to quickly reverse policies to keep the economy on an even keel.

The writer is an economist.