BQ Learning: Understanding the Convertibility of the Capital Account


How does this help?

Essentially, it facilitates the flow of funds from capital-rich advanced economies to low-capital emerging market economies. By broadening the global investor base, capital account convertibility can help improve the availability and cost of finance, and thus finance the growth of EMs. It can also help AE investors generate better returns, as EMs typically have higher growth prospects.

What is the reverse?

Capital account liberalization also exposes the economy to volatility in global markets and, therefore, to exchange rate fluctuations. Let’s say the US Federal Reserve increases the key rate. This could tighten global financial conditions and cause capital flight from emerging (riskier) countries to EAs (safer destinations). This would weaken the local currency (ME) against the US dollar, increase the cost of imports and increase domestic inflation.

Of course, the reverse could also happen.

The overall sense of risk can also be affected by non-economic factors such as geopolitical developments and natural disasters. All these financial cycles increase the volatility of financing in emerging countries and affect its exchange rate and inflation.

In such cases, EM central banks can step in and use their foreign exchange reserves to stabilize the local currency. But when foreign exchange reserves run out, a central bank could be forced to raise its national policy rates to prevent further capital outflows. This could lead to a further domestic downturn.

Is India’s Capital Account Convertible?

Currently, it is partially so.

What does it mean?

After the BoP crisis of 1991, India quickly and completely liberalized its current account, but chose to go slowly to the capital account.

Foreign portfolio investments – which are part of capital flows – were first allowed in Indian stock markets in 1992, in corporate debt markets in 1995, and in government securities (G-sec) in 1997.

While the entry of REITs into the equity market is open, it remains limited in the debt market. Currently, G-sec REIT limits are 6%, government development loans 2%, and corporate bonds 15% of outstanding.

More recently, India has introduced a “fully accessible route” for investments in certain government bonds. From 2020-2021, all new issues of government securities with a maturity of five years, 10 years and 30 years will be eligible for investment through the fully accessible channel.

India has also gradually reduced restrictions on foreign direct investment. It has increased FDI limits for a number of sectors since 2014, allowing 100% FDI in more than 35 sectors. The guidelines for external commercial borrowing are also gradually being broadened to accommodate more domestic borrowers.

Reserve Bank of India Governor Shaktikanta Das recently spoke about the convertibility of the capital account in India which continues as a process rather than an event, given current macroeconomic conditions and risks.

What about other MS? What can we learn from their experiences about capital account convertibility?

Many emerging countries with liberalized capital accounts have suffered the negative consequences of the type of cycles we have described above.

In the 1980s, Latin American countries with high levels of external debt were unable to repay them as EAs embarked on a cycle of rate hikes. In 1997, the economies of Southeast Asia faced a severe currency crisis due to current account imbalances. More recently, in 2013, the mere suspicion of a decrease in asset purchases by the US Fed triggered significant capital outflows from emerging countries, including India. This significantly weakened their currencies, with the Indonesian rupiah depreciating by 26.5% against the US dollar and the Indian rupee weakening by 14%.

Foreign investors closely monitor factors such as current account deficit, external debt, foreign exchange reserves, the combination of growth and inflation, and the fiscal health of economies while making investment decisions.

While FDI inflows are more volatile and depend on short-term developments such as monetary policy changes in EAs, FDI inflows are more sustainable, stimulated by the domestic economic outlook. That said, a strengthening of India’s macroeconomic fundamentals since 2013 makes it less vulnerable to the fallout from global politics.

Maintaining solid fundamentals therefore remains an essential precondition for greater openness of the capital account.


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