The Hindu Business Line : RBI Governor urges caution over capital account liberalisation

CAPITAL account liberalisation is a process that has to be managed keeping in view the elasticities in the economy, and vulnerabilities or potential for shocks, according to Dr Y.V. Reddy, Governor, Reserve Bank of India.

Illustrating these factors, while speaking at the Central Bank Governors Symposium convened by the Bank of England in London on Friday, Dr Reddy said these include fiscal, financial, external, and even the real sector — such as oil prices and monsoon conditions for India.

Dr Reddy said caution is needed in moving forward with each step in capital account liberalisation, recognising that reversal of any step is difficult since markets tend to react negatively to reversals, unless there is already a crisis situation.

There is a hierarchy in the nature of different types of capital flows in real life. For example, foreign direct investment is preferred for stability, and quantum of short-term external debt, by residual maturity, should not be excessive.

Furthermore, adequate reserves, keeping in view the national balance sheet considerations, which include public and private sectors, provide comfort. Public policy can achieve these desirable conditions only through management of capital account, said Dr Reddy.

Management of capital account will be effective under enabling conditions such as reasonable confidence in macro policies, tax regimes, and safeguards against misuse of liberalised current account regime to effect capital transfers.

Sound management will also avoid dollarisation of the domestic economy and internationalisation of domestic currency, he added.

Institutional structures, both of public policy and markets, need to be evolved to meet the imperatives of liberalised capital account. The basic issue in any policy context is whether capital controls lead to distortions in exchange rate or the liberalised capital flows that lead to distortions in the exchange rate.

In respect of emerging economies, the conduct of market participants shows that automatic self-correcting mechanisms do not operate in the forex markets.

Hence, the need to manage capital account — which may or may not include special prudential regulations and capital controls, he said.

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