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Finance & Development
A quarterly magazine of the IMF
March 2007, Volume 44, Number 1

Point of View: Converting a Tiger
Yaga Venugopal Reddy, Governor of the Reserve Bank of India

Lessons from India's gradualist approach to capital account convertibility

India began liberalizing its capital account as part of wide-ranging economic reforms initiated in the early 1990s that reversed its 40-year experiment with centrally planned development. The hallmark of the reform process has been a gradual, cautious approach that has been carefully phased and sequenced across the economy. As a result, India has come a long way from its pre-1991 highly restrictive exchange control regime. With gradual liberalization of both foreign direct investment (FDI) and portfolio investment, the rupee has been made convertible for foreign investors. However, some controls remain in place to varying degrees for both foreign and domestic corporates and individuals, with resident corporates facing a more liberal regime than resident individuals.

Over the past decade and a half, India's economy has become increasingly open (see Table 1), and annual growth has accelerated to about 9 percent (see Table 2), while inflation has been low and stable since the mid-1990s. Foreign exchange reserves have risen sharply to more than $180 billion—well in excess of the country's total external debt—largely as a result of capital inflows rather than current account surpluses, while the financial sector, including the regulatory environment, has been strengthened. The phased approach to liberalization has enabled the country to withstand several external shocks, including the Asian crisis of 1997–98.

Table 1. More open

Table 2. Stronger position

This article examines how India has managed capital account convertibility and looks at the lessons from its gradualist approach.

Matching theory and practice

Given the apparent benefits, why has India been cautious about capital account liberalization? In theory, capital account convertibility is a good idea for several reasons. First, it is reasonable to presume that free capital mobility would permit efficient allocation of savings and divert resources toward their most productive uses. Second, it could promote trade, enabling countries to smooth consumption. Third, it could facilitate portfolio diversification and risk sharing, reducing transaction costs and improving returns. Fourth, there could be gains through specialization in financial services, incentives for innovation, and improvement in productivity.

Of course, there can be drawbacks. These benefits depend on the pace of liberalization in trade and services and on market efficiency. Asymmetric information could lead to inefficient markets, adverse selection, moral hazard, and herd behavior. In such an environment, unfettered capital account liberalization may increase risks leading to currency and banking crises. Further, financial globalization could be welfare reducing if there are domestic market distortions, such as perverse incentives in the form of trade barriers and discriminatory guarantees and subsidies.

But despite the theoretical advantages, economists have found it difficult to show that capital account liberalization by itself produces real benefits. A few years ago, a comprehensive and seminal IMF study that drew a distinction between de jure and de facto liberalization concluded that "it is difficult to establish a robust causal relationship between the degree of financial integration and output growth performance; . . . there is little evidence that financial integration has helped developing countries to better stabilize fluctuations in consumption growth; . . . and low to moderate levels of financial integration may have made some countries subject to greater volatility of consumption" (Prasad and others, 2003). The paper did provide evidence, however, that after a threshold level, financial integration could help provide financial sector development that would moderate domestic macroeconomic volatility.

The threshold level, though difficult to define, became a catchword for emphasizing the need for institution building in developing countries. In a recent reappraisal of financial globalization, the same authors have provided some qualified support to the view that developing countries can benefit from financial globalization, but with many nuances (Kose and others, 2006). In addition to traditional channels, benefits are also realized through a broad set of "collateral benefits"—financial market development, better institutions and governance, and macroeconomic discipline (see article on page 8 in this issue).

Practical experience has also underlined the need for caution. Most advanced countries liberalized their capital account relatively recently and gradually over about two decades from 1974 to 1994, maintaining intermittent controls during the liberalization phase. Some countries now categorized as emerging market economies (EMEs) embarked upon capital account liberalization from the early 1980s. While some EMEs faced the challenge of managing increased inflows, others experienced sudden stops and reversals of flows leading to a series of crises. In response, some countries reversed their policies and reimposed some capital controls.

During the 1990s, the financial crises in Brazil, East Asia, Mexico, and Russia highlighted one of the most important concerns for EMEs—that capital account convertibility carries the potential for currency crises. In the context of the East Asian financial crisis, although country circumstances varied, they largely reflected extant fundamental structural problems, financial sector weaknesses, and poor corporate governance. It became clear that sound macroeconomic policies, an adequate institutional framework, internationally comparable prudential regulation and supervision standards, and improved quality and disclosure of information were all prerequisites for mitigating such recurrences. It was realized that partial and flawed reforms could render financial systems more fragile and more vulnerable to a rapid reversal of capital flows. As a result, emerging market countries, particularly in East Asia, became more attentive to harmonizing capital account liberalization with appropriate macroeconomic, exchange rate, and financial sector policies.

The bottom line is that in both advanced economies and EMEs, studies have shown that an open capital account does not have to mean unfettered capital account liberalization, and in practice some capital controls and significant prudential regulations are consistent with capital account convertibility.

Laying the groundwork

India's approach was carefully considered and planned step by step. Each phase was assessed in advance by a series of committees. The broad framework was laid out in the 1991 Report of the High Level Committee on Balance of Payments, chaired by Dr. C. Rangarajan, former Governor of the Reserve Bank of India and currently Chairman of the Economic Advisory Council to the Prime Minister. The committee recommended liberalization of current account transactions leading to current account convertibility; a compositional shift in capital flows away from debt- to non-debt-creating flows; strict regulation of external commercial borrowings, especially short-term debt; discouraging volatile elements of flows from nonresident Indians; gradual liberalization of outflows; and disintermediation of the government in the flow of external assistance. The committee also recommended introducing a market-determined exchange rate regime while emphasizing the need to contain the current account deficit.

Since 1997, the process of liberalization has been guided by the recommendations of the Report of the Tarapore Committee on Capital Account Convertibility. This committee identified several macroeconomic, institutional, and market preconditions for progress in capital account liberalization in terms of fiscal, financial, and inflation indicators. It also gave a road map for specific measures over a period of three years. The analytical framework provided by the committee anticipated, in a way, the dangers of capital account liberalization when the financial sector remained weak. This underlying framework, coupled with sensitivity to domestic sociopolitical as well as global developments, including the lessons from several crises in EMEs, governed the liberalization process.

While the IMF has been blamed for encouraging EMEs to liberalize their capital accounts too quickly (see box), in India's case, the IMF supported the government's strategy of a gradualistic approach from the beginning. In the early 1990s, the Fund was tolerant of transitional current account restrictions, but in February 1994, it indicated that the adoption, at an early stage, of Article VIII status—meaning agreement not to impose restrictions on payments and transfers for current international transactions—would be an important signal of India's transition to a more open economy. India had already decided to proceed in that direction and became convertible for current account transactions later in 1994.

Assessing the IMF's role

The IMF's overall approach to capital account liberalization—both before the Asian crisis and in its wake—was documented by the Fund's Independent Evaluation Office in a report published in 2005. An important question raised was whether the IMF was pushing the liberalization of capital accounts. This is a very complicated issue. The evaluation concluded that at the bilateral level, during the 1990s the Fund clearly encouraged capital account liberalization, but the process for the most part was driven by the economic and political agendas of the countries themselves. In my view, this conclusion is not intuitively appealing.

First, multilateral surveillance during the 1990s tended to emphasize the benefits to developing countries of greater access to international capital flows and to pay comparatively less attention to the potential risks of capital flow volatility. Second, the Fund in parallel moved close to reaching an agreement in late 1997 on an amendment to its Articles of Agreement, incorporating a new chapter giving the Fund full surveillance jurisdiction over the capital account, comparable to current account surveillance, which the Fund had available since its inception. In the absence of a clear mandate relating to the capital account, the Fund could have chosen some sort of moral suasion to encourage countries, particularly under a Fund program, to liberalize their capital accounts. This is evident from the Letters of Intent of many countries incorporating such features. The Fund, in my view, was philosophically exuberant and bent on accepting free, albeit orderly, capital flows as a desirable goal for the international community and pressed ahead with the proposed amendment through 1997 and 1998. Stanley Fischer, then First Deputy Managing Director, said at a seminar in March 1998 that "there is a case for the Fund to get involved in this [capital account] . . . and it is something . . . we have pushed in the context of programs."

The IMF also differed strongly with Professor Jagdish Bhagwati's arguments against treating free trade and free capital flows on par, arguing that in terms of economic benefits they were similar and the IMF should push both, carefully. The Fund seems to have learned a hard lesson, post–Asian crisis.

While India welcomed the move toward capital account convertibility, it did not strongly favor the amendment to the IMF's Articles, arguing that "given the differences among countries with regard to progress toward structural reform and stabilization, it may be unwise to put all the members in a straitjacket when they lose their independence to take corrective action in times of crisis." India also maintained that the ability of the Fund to come to the rescue of its members in case of balance of payment crisis was inhibited.

After the Asian crisis, the move to amend the Articles weakened and has apparently been shelved. The Fund seems to have generally softened its stance and broadly follows an eclectic and integrated approach toward capital account liberalization, emphasizing proper sequencing and phasing combined with several concomitant reforms.

In addition, the Fund's approach to capital account liberalization should be viewed in relation to its stance on the management of capital flows, use of capital controls, and exchange rate management. Here the Fund seems by and large flexible, recognizing specific country circumstances.

Subsequently, the Fund concurred with the gradual opening up of FDI, the appropriateness of a cautious attitude toward potentially volatile short-term capital flows, and, overall, the generally cautious approach to capital inflows. On exchange rate management, the Fund continued, however, to emphasize greater flexibility and two-way movement of the exchange rate, which would encourage hedging of currency exposures and development of a deep derivatives market. In recent years, the Fund has recognized that India's exchange rate is more flexible. In my view, the perception about the volatility and flexibility in the exchange rate is contextual. What may be perceived as flexible for some economies may turn out to be volatile for other economies. The level of development and preparedness of financial markets and their risk-taking ability are crucial in this context.

With the relaxation of capital account restrictions, particularly for funds coming into the country, sustained foreign capital inflows began from 1993/94 and picked up sharply after 2003/04 (April–March), jumping from $16.7 billion to $23.4 billion in 2005/06. These inflows were largely non-debt-creating and, as a result, the proportion of nondebt flows in total capital flows increased significantly.

Apart from increased exchange rate flexibility, a number of steps have been taken to manage the excess capital flows. What counts as excess flows needs to be viewed dynamically, taking due account of the distinction between enduring and temporary flows and the level of flows that could normally be absorbed in the domestic economy. These measures include a phased liberalization of the policy framework in relation to current as well as capital accounts, flexibility to corporates on prepayment of external commercial borrowings, extension of foreign currency account facilities, allowing banks to liberally invest abroad in high-quality instruments, and liberalizing requirements for exporters to surrender foreign exchange earnings. In the context of domestic liquidity management, a market stabilization scheme has been made operational for sterilizing excess inflows without significant fiscal impact.

Distinct features of India's approach

For India, the important lesson from the crises of the 1990s was to realize that domestic policy and especially the strength of the financial system are critical when financial integration with the rest of the world is under way. It was partly the set of prudential regulations that prevented Indian banks from putting their balance sheets at risk, as they operated with limits on assets in real estate, currencies, and stocks. From the policy perspective, the message is that regulatory and supervisory systems needed strengthening so that financial institutions could manage risks prudently. The crises of the 1990s also made policymakers realize that they needed to be more aware of the likely sources of contagion and to exercise vigilance, hunting for signs of potential distress and being ready with appropriate policy actions.

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.

The political economy also has significant influence and is critical for the success of reforms. Since 1990, there have been six elections for the national parliament in India and seven prime ministers, while a number of national and regional political parties have been part of coalition governments. India has also faced border conflicts and sanctions.

Despite the coalition cabinets and periodic elections both at the center and in several states, India's political system, overall, is characterized by system stability. It is remarkable that, despite diversity in political ideologies and frequent elections, the progress of well-calibrated economic reforms continues to be impressive.

Going forward, India plans to continue the gradualist approach because it enables harmonization with other reforms. Yet another committee has recently laid out a road map for moving toward fuller capital account convertibility within a transparent framework over the next five years. The plan for further liberalization will depend, however, on several domestic factors, as well as on international developments. Among issues to be addressed are progress in reforming the real sector, further fiscal consolidation, strengthening the domestic financial system, and the achievement of certain concomitant macroeconomic parameters relating to the soundness and stability of the economy.


International Monetary Fund, 2005, "The IMF's Approach to Capital Account Liberalization," Evaluation Report (Washington: IMF Independent Evaluation Office).

Kose, M. Ayhan, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei, 2006, "Financial Globalization: A Reappraisal," IMF Working Paper No. 06/189 (Washington: International Monetary Fund).

Prasad, Eswar S., Kenneth Rogoff, Shang-Jin Wei, and M. Ayhan Kose, 2003, Effects of Financial Globalization on Developing Countries: Some Empirical Evidence, IMF Occasional Paper No. 220 (Washington: International Monetary Fund).

Yaga Venugopal Reddy has been RBI Governor since September 2003.