India is on the cusp of fundamental shifts in the capital account convertibility space, with increased market integration in the offing and freer non-resident access to debt on the table, according to T Rabi Sankar, Deputy Governor, Reserve Bank of India (RBI).
In this regard, Sankar observed that there is an effort to liberalise foreign portfolio investment (FPI) debt flows further, with the introduction of the Fully Accessible Route (FAR), which places no limit on non-resident investment in specified benchmark securities.
“Since, over time, virtually all securities will fall under the FAR category, the move is unambiguously aimed at an eventual unfettered access for non-residents in Government securities (G-Secs),” he said in a speech delivered at the Fifth Foreign Exchange Dealers’ Association of India (FEDAI) Annual Day.
Capital account convertibility is the ability or freedom to convert domestic currency for capital account transactions. The Tarapore Committee (2006) defined capital account convertibility as the “freedom to convert local financial assets into foreign financial assets and vice versa.”
The Deputy Governor emphasised that efforts to get India included under global bond indexes and the complementary move towards placing G-Secs under global custodians, once implemented, will encourage debt flows in future.
FAR: linked to index inclusion?
With FAR, over time the entire G-Sec issuance would be eligible for non-resident investment.
“While the experience of other countries suggests that non-residents are unlikely to hold a major portion of outstanding stock, substantial debt holdings might make India vulnerable to the risk of sudden reversals.
“Since this channel was permitted in the context of inclusion of India’s G-Secs in global bond indices, there is a natural safety mechanism as index investors are unlikely to indulge in sudden reversals,” Sankar said.
He felt that it may need to be considered from a macroprudential perspective, whether FAR should be linked to index inclusion.
LRS review
Sankar said as the Liberalised Remittance Scheme (LRS) has operated for some time, there may be a need to review it keeping in mind changing requirements such as higher education for the youth, requirement of start-ups, etc.
“There might even be a case for reviewing whether the limit can remain uniform or can be linked to some economic variable for individuals,” he added.
Smaller entities: prone to over-pricing
The Deputy Governor underscored that as onshore and offshore financial markets get integrated, it should be ensured that price discovery in the domestic markets is efficient, lest flows move to the offshore segment.
Referring to the rupee exchange rate, he noted that it is market determined, with fairly tight bid-ask spreads in the interbank market.
“Major corporates also seem to benefit from tight pricing. Yet, many entities, especially SMEs, small exporters, individuals, etc., are prone to over-pricing,” he said.
“Do processing charges and market risk for warehousing odd-lot positions justify these spreads? An effective way is to shift price discovery for retail forex users to a platform,” Sankar said.
While such a platform (FX Retail) has been developed, it appears that banks do not find it in their interest to navigate customers to use that platform, he added.
“In this age of technology, it may not really be possible to shun superior technology for any length of time. There should be a debate on the use of the platform and banks should make an effort to give it a fair trial,” the Deputy Governor said.
Internationalisation of the Rupee
A key aspect of currency convertibility is integration of financial markets.
Sankar opined that over time, it is essential that two markets – onshore and offshore – for domestic currency or interest rates cannot exist with efficiency.
“With increased convertibility, these markets need to be linked. An effort has already commenced in the interest rate derivative segment. Allowing Indian banks access to NDF markets for the rupee is also consistent with this objective,” he said.
As G-Secs get held by global custodians and traded abroad more and more, non-residents get to hold rupee assets and take rupee exposure. These measures have had the desired results – for instance, NDF (non-deliverable forward) onshore spreads have substantially narrowed after allowing Indian banks into the NDF space.
“We need to now consider whether India is ready to allow such non-residents to hold rupee accounts.
“This will be an important early step in internationalisation of the rupee and, therefore, needs to be carefully considered,” he said.
Further, there is a need to consider a proper mechanism for information flow so that exchange and interest rate management can continue to be effective in an environment of larger offshore transactions.