Crucial Policy Measures of BOP:
The package of reforms initiated many policy measures. Two such policy measures brought significant changes in the balance of payment situation in India. These policy measures are discussed below:
Foreign Exchange Policy:
Since early seventies India. had adopted flexible exchange rates system. The guiding principle for monetary authorities was to allow the exchange rate to move in alignment with macro economic fundamentals. However, in general, countries prefer to limit exchange rate movement within the ceiling of movements that affect the fundamentals. India had large capital inflows soon after the adoption of the market based exchange rate system in 1993. The inflows surpassed the current account deficits and excess supply conditions prevailed in the foreign exchange market. This posed a new challenge for the government in devising monetary and exchange rate policies.
In such a state of affairs, a flexible exchange rate regime (i.e. allowing the nominal rate appreciate with large capital inflows) has the merits of insulating domestic economy from the inflows and containing inflation on account of an advantageous switchover from exchange rate to domestic prices. However, these gains have to be evaluated against the cost of weakening of external competitiveness. It certainly amounts to sacrifice of the external balance objective. Instead, if the aim is to prevent real appreciation of exchange rate and protect external competitiveness, there are four options or a mixture thereof available.
The central bank (RBI in case of India) intervenes in the foreign exchange market and then sterilizes the incremental liquidity generated. It thus keeps the monetary spreading out under check. This process has, however, quasi-fiscal costs associated with it and it also has the problem of inflating real interest rates which may tempt further capital inflows.
Trade restrictions are relaxed to permit capital flows supplement domestic saving. This has the potential of promoting economic growth. However, utmost care must be taken to ensure that it is the investment that increases and not the consumption. Otherwise, the debt servicing may go out of hand and become unsustainable. The authorities can relax restrictions on capital outflows. The advantage will be of better portfolio diversification for domestic residents as well as increased efficiency of the overall financial system. Often it develops further confidence thereby leading to bigger inflows.
The authorities can also reintroduce restrictions to control the swiftness of inflows. The restrictions could be in the form of increasing reserve requirements on non-resident deposits, tightening of norms for entities accessing global markets for private capital, higher withholding taxes on interest payments overseas, tapering. prudential standards on external loans, and insisting on end-use clauses.
Clearly, an open capital account not only limits the independence of authorities in the conduct of exchange rate policy but also exposes the economy to international fluctuations and shocks. Any plan of aiming at an exchange rate or the money stock may be counterbalanced by unexpected inflows, which affect the nominal exchange rate as well. The free floating exchange rate is certain to increase volatility and cause constant misalignment’s which could knock off balance the financial system, thereby eroding the reducibility of an independent monetary policy. Obviously, there has to be consistency with the economic fundamentals, and therefore it may become necessary to allow short-term nominal appreciation when there is excess supply, but the authorities must be geared up for aggressive interference, backed by likewise aggressive sterilization to shield the money objective. Long-term measures to preserve external competitiveness may include increasing fiscal concessions, softer export credit etc.
These have to be constantly weighed against the possible losses due to higher debt servicing burden in the event of depreciation. This way, the exchange rate regime has to play an active role in the conduct of exchange rate policy.
In August 1994, India opted for current account convertibility (CAC). CAC is also applicable to foreign investors (both direct and portfolio), non-resident depositors and resident corporate contraction of external commercial borrowings (ECB). Controls, however, exist on resident individuals and corporate bodies to send capital abroad as also on inflows and outflows of capital associated with banks and non-bank financial entities. International experience with CAC has shown that, more often, liberalization of the capital account attracts large capital inflows. Such inflows can lead to real appreciation in the exchange rate and erode the effectiveness of domestic monetary policy. In addition, open capital account inflicts monstrous pressure on the financial system and brings out its weaknesses into sharper focus. Any move to Capital Account Convertibility asks for a very strong discipline from the financial system and warrants early removal of infirmities in the system.
As defined by the Committee on Capital Account, Capital Account Convertibility (CAC) refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. The Committee realized that there could be certain weaknesses in the system and that the entrenchment of preconditions can be had only after a period of time. The Committee therefore called for a phased implementation of CAC over a three year period i.e. phase I (1997-98), Phase II (1998-99) and Phase III (1999-2000).
The implementation of measures meant for each phase was based on a careful and constant monitoring of certain precondition signposts and also certain important attendant variables. These variables were. identified from the lessons of the .international experiences and the specifics of Indian situations. The Committee suggested that fiscal consolidation; a mandated inflation target and strengthening of financial system should be considered as the vital precondition signposts for CAC in India.
To organize the financial system for CAC, the committee made many suggestions. All suggestions aimed at creating a level playing field among various participants in the financial system. They sought to remove market segmentation and extend uniform treatment to resident and non-resident liabilities, to introduce more stringent capital adequacy standards and prudential standards for effective supervisory systems and give greater autonomy to banks and financial institutions. The Committee recognized that even after finishing the third phase capital controls on. a number of items would be necessary. It therefore advised that at the end of three year phasing, there should be a stock taking of the progress on the preconditions/ signpost as well as the impact of the measures suggested by the Committee. CAC is a thus a continuous activity and more measures can be undertaken in the light of the experience acquired.