RBI Speech – April 2019

India’s growing significance in global arena. Is it Sustainable? Are we ready for it?

This speech is given by Deputy Governor of the Reserve Bank of India, Shri B.P.Kanungo on April 19, 2019 at the FEDAI annual conference in Beijing. The questions raised in the speech are: Is India’s growing significance in global arena sustainable and are we (Indians) ready for it. The important economic points raised by him during his speech is given below.

What is FEDAI: Foreign Exchange Dealers Association of India

The Foreign Exchange Dealers’ Association of India was formed around six decades ago to secularise foreign exchange transactions. India and China were the world’s two largest economies till the 18th century. Currently, on PPP basis, China is the world’s largest economy and India is the 3rd largest. According to the 2017-18 data, China is India’s largest trading partner.

Beginnings of International Trade.

The need for international trade increased with the industrial revolution. Till the middle of the nineteenth century, Europe supported mercantilism for all commodities except gold. But it also sought to discourage imports by imposing tariffs. Free trade was established only from the repeal of the British Corn Law of 1846. Shri Kanungo observes that while free trade is the objective, restrictive laws are needed and must be passed by keeping in view the macroeconomic factors of the nation. The Bretton Woods system introduced certain laws on international capital flows. But after its breakdown in the early seventies, the IMF endorsed in favour of free trade in capital. But this objective was questioned two times, with support of Keynes – once in the 1990 crisis and the other during the global financial crisis. Shri Kanungo is of the view that “there is no universally acceptable policy prescription” when it comes to capital trade since every nation has its own “idiosyncrasies” that it must cater to.

The foreign exchange management policy hinges on two factors – the quantity of foreign exchange available and the exchange rate.

FERA and its History

The war-time exchange was controlled through FERA, 1947, but the acute shortage of 1960s and other factors demanded a more stringent regulation through FERA, 1973. The remittances from Indian diaspora and the impact of green revolution coupled with FERA improved the situations related to the external sector. Two observations that Shri Kanungo makes is: firstly, liberalization (in forex) did not bring any significant changes and secondly, though the world followed the floating exchange system, Indian rupee was pegged first to pound sterling and later to many other currencies. Three landmarks mentioned by him are: (a) Adoption of market determined exchange rate system, (b) Commitment to conform to Article 8 of the IMF charter and (c) Enactment of FEMA in 1999.

Preamble Shri Kanungo remember the preamble of FEMA, 1999 which is an Act that was passed with the objective of facilitating external trade and payments and for promoting the orderly development and maintenance of foreign exchange market in India.

What are FERA and FEMA?

Foreign Exchange Regulation Act (FERA) and Foreign Exchange Management Act (FEMA) are statutory requirements, which were enacted by the parliament of India to conserve India’s foreign exchange reserves. The primary difference between FERA and FEMA is that FERA was enacted to facilitate all the payments and other foreign exchange activities in India. FEMA has the responsibility of ensuring that there is the orderly management of foreign exchange market in the country.

Current and Capital Accounts

The statute mandates that there shall be no restrictions regarding current account except some undesirable transactions that can be used to dress capital account transactions. Shri Kanungo hopes to develop a system to capture data similar to merchandise trade to help understand policy actions.

The statute provides that the Reserve Bank will regulate the capital account transactions. Most of the policy actions are related to the capital account due to the evolving macroeconomic conditions.

Difference between current account and capital account

The current and capital accounts represent two halves of a nation’s balance of payments.

  • Current account represents a country’s net income over a period of time

  • Capital account records the net change of assets and liabilities during a particular year

Capital Account – In Detail.

Through the 1970s to the 1994 Madrid Declaration, there was a strong advocacy of full capital account convertibility.

Three factors determine the issue: (a) pre-conditions for opening of capital account, (b) The cost and effectiveness of capital account and (c) monetary policy implications of an open capital account.

There are three conditions to be discussed for capital account liberalisation: price stability, fiscal stability and stability of the financial markets and institutions.

Hierarchy – First, capital flows for real sector has priority over flows in the financial sector. Second, equity related capital inflows have preference over debt inflows.

Investments and Investors

Huge investments are required for the physical and social infrastructure order. There is an emergence of new class of investors: venture capital and private equity funds. These investments constitute 35-40% of the FDI flows. The role of VC and PE funds is taken up by the mediators and potential growth industries. Shri Kanungo ponders if there is a need to consider private equity investment in its totality and see if a modulation of policy regime is warranted.

The major amount of funds for start-ups has been coming through foreign investment, mostly venture capital or private equity funds.

Capital outflows had always been for direct investment. There is no differentiated policy for equity and debt outflows. Creation of overseas assets by resident Indians goes as a credit entry in the international investment position.

Foreign Exchange markets.

The forex market determines the exchange rate. The rupee saw levels of 64 to a dollar, depreciated to around 75 per dollar and later to 68+ to a dollar. The cause for the change has been a change in the capital flows.

The primary function of deviations is to hedge against future uncertainties. But they can also be used as instruments of speculation. Shri Kanungo maintains that the approach towards the markets will be to provide an agent who has exposure to the rupee so that they can speculate well to avoid losses.

What is difference between REER and NEER ? 

Nominal Effective Exchange Rate (NEER)  – weighted geometric average of the bilateral nominal exchange rates of the home currency in terms of foreign currencies

Real Effective Exchange Rate (REER) – weighted average of NEER adjusted by the ratio of domestic price to foreign prices

Nationalization of the Rupee
A currency is international or reserve currency when it is widely held by non-residents and used to settle international transactions. The advantage is that it enables borrowing in one’s own currency, but the disadvantage is that the county that supplies the currency has the obligation to supply it to meet the global demand. Over the years, investors have shown interest in the Rupee. The regulatory framework will strive to make the markets accessible to all non-residents with a Rupee exposure.

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