RBI Announces Capital Account Restrictions For Residents :: Morgan Stanley Research

RBI Announces Capital
Account Restrictions For
Residents
Capital Account Restrictions: During the boom period
of 2004-07 when capital inflows were rising sharply RBI
had initiated gradual liberalization of capital account
transactions for the resident corporate sector and
individuals. The recent balance of payment stress has
pushed the central bank to reverse some of those
measures partially. The measures announced today
include:
 Outbound FDI limits: The limit for Overseas
Direct Investment (ODI) under the automatic
route for all fresh ODI transactions has been
reduced from 400% of the net worth of an
Indian Party to 100% of its net worth. This
reduced limit would also apply to remittances
made under the ODI scheme by Indian
Companies for setting up unincorporated
entities outside India in the energy and natural
resources sectors. This reduction in limit,
however, would not apply to ODI by Navratna
public sector undertakings (PSUs), ONGC
Videsh Limited and Oil India in overseas
unincorporated entities and incorporated
entities, in the oil sector.
 Outward remittances by individuals: The
limit for remittances by Resident Individuals
under the Liberalised Remittance Scheme
(LRS Scheme) has been reduced from USD
200,000 to USD 75,000 per financial year.
 Restrictions on application of outward
remittances: While current restrictions on the
use of LRS for prohibited transactions, such as,
margin trading and lottery would continue, use
of LRS for acquisition of immovable property
outside India directly or indirectly will,
henceforth, not be allowed.

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What has the trend been in capital outflows?
The big source of capital outflows from the country was ODI.
ODI flows have been slowing over the last few years. In the last
four quarters the total outflows have been US$7.1bn. While it is
unclear what will be the likely decline in ODI due to these
restrictions, assuming that it declines by 50%, it will help
reduce the BOP deficit by ~US$3.5bn annually.
Outward remittances from individuals have remained in the
range of US$1-1.2bn over the last two years, with outflows for
gifts, investment in debt /equity, maintenance of relatives and
studies abroad accounting for ~70% of total outflows (Exhibit
2). Assuming that outward remittances decline by 50%, it would
help reduce the BOP deficit by ~US$0.5bn.
Bottom-line: We believe the measures announced today are
likely to make a small difference to the balance of payments
trend in the near term. We expect India to remain exposed to
funding risks in the next few months as long as India’s current
account deficit remains higher than a more sustainable level of
2.5% of GDP and CPI inflation remains higher than 7%. We
believe as long as US Treasury yields keep rising, India will
continue to see currency depreciation pressures. We see
currency depreciation pressures as a symptom of domestic
imbalance caused by decline in savings (partly on account of
negative real rates). We believe that a sustainable fix to these
currency pressures will be to ensure higher real rates. While
the RBI has already taken tightening measures, a confused
message implying that the central bank may reverse those
measures soon has partly taken away the benefit of those
tightening measures.
What next? In the event of another round of quick rises in US
Treasury yields and if the currency pressures increase again
we believe the government and RBI could potentially take
following measures:
 Import tariffs on consumer goods: Comments from the
Finance Minister (Business Standard August 13) indicate
that the government may announce import tariff hikes on
non-essential imports (exhibit 3 gives the break up of
imports). The government yesterday increased the import
duty on gold and silver to 10% from 8%, marking the third
hike in this fiscal year.
 Dollar deposits for Non-resident Indians at special
rates: While the government has already indicated that
the state owned enterprises will be raising more dollar
debt, we believe the amount likely to be collected under
this route will be small. Hence, non-resident deposits
could be an alternative, which could help collect about
US$15 billion. Indeed, in a separate announcement today
the RBI has increased the incentive for domestic banks to
raise dollar deposits from non-residents by removing the
statutory liquidity ratio (SLR) and cash reserve ratio
requirements (CRR) on non resident deposits. However,
we believe that for the collection of a larger sum of
deposits it may need to launch a special deposit scheme
with more attractive interest rates.
 Explicit repo rate hike: As mentioned above the RBI may
have confused its tightening moves by indicating the
tightening is temporary. Hence, in the event of another of
quick rise in US Treasury yields, the RBI may need to hike
repo rate even if it’s just 25 bps rise to signal its tightening
intention more firmly.