The Indian debate is quick to blame domestic policy even for external shocks. Thus, it was argued that there was something fundamentally flawed with Indian economy because it was running an overall balance of payment deficit for two years. Never mind that current account deficit (CAD) was only about 1 per cent of GDP and outflows were largely due to external shocks continuing since end of 2024. This created rupee weakness that led to further outflows in a self-fulfilling cycle.
Since 1990s reform, set of analysts had been arguing for full capital account convertibility to cut bureaucratic tangles that ostensibly kept capital away. But periodic global financial crises would throw cold water on these recommendations. Strangely, global shock-induced outflows have now become an opportunity to ask for more concessions to foreign capital. Argument is that foreign capital is essential to finance CAD and raise investment. All kinds of concessions have to be rolled out to attract foreigners, who are seen as only hope.
Is it domestic or foreign policy that is creating shocks? One reason why people even listen to argument is that Indian policies being criticised have protected economy from worst consequences of external shock-led volatility. In August, I was speaking at a Bank of Indonesia conference in a session on integrated policy frameworks and adaptive policy tools. Since their economy has suffered ills of being 'too open too fast' to foreign capital flows, they understand how necessary it is to use multiple policy tools to moderate global volatility.
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Since 2000s, financial crises have originated in advanced economies (AEs). Fluctuating global risks have aggravated surges and suddenly halted capital flows to emerging markets (EMs). They have had to cope with these shocks without help from an outdated international financial architecture.
The East Asian crisis especially hit a few EMs, who had followed IMF advice to more fully liberalise capital flows. Short-term foreign debt became very costly to service under steep currency depreciations. However, they gained from globalisation and were committed to it, so they undertook major market supportive financial and legal reform. They reduced short-term foreign debt, slowed down capital account convertibility and did well in 2000s. AEs, however, did not adopt any of then prevailing reform suggestions such as hedge fund transparency, prudential regulation or investors' bail-in. Had they done so, string of crises that originated in AEs may have been mitigated.
After 2008 global crisis, Indonesia added exchange rate, capital flow and macro prudential policy to its flexible inflation targeting. But in 2010s, they liberalised foreign investment in local currency (LCY) bonds, which were pushed as being free of currency risk. But large interest rate volatility followed during US Fed pronouncements on early reversal of quantitative easing led capital to flee EMs.
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Reforms to reduce transaction costs for foreign fixed income investors are required, but fully open doors are best avoided. What is ideal share of foreign capital? Bond market in absolute size and as percentage of GDP is much larger in India compared to Indonesia, but share of foreign investors is much larger in latter. Even so, bond markets are underdeveloped in India. Issuances of debt are just 13 per cent of equity while global averages are 25-30 per cent.
In Indonesia share of foreign investors in bond market was 32.6 per cent during 2013 taper on. 10-year yield shot up to 15.14 per cent in July. By 2026 Q1 foreign share had fallen to 12.6 per cent and 10-year yield rose much less, from 1.8 per cent in February, to 7.8 per cent in June. In India foreign investor share was only 1.3 per cent and 10-year yields rose to 8.3 per cent in July 2013. In 2026 Q1, share had risen only marginally to 2.5 per cent (higher at 6.8 per cent for fully accessible route). 10-year G-Sec rate averaged 6.86 per cent. Central bank was forced to raise repo rates more in Indonesia - 175 and 100bps. In India, changes in two periods were only 50 and 0 bps.
Depreciation of Indonesian Rupiah exceeded that of rupee, even though they raised interest rates relatively more. Diverse ownership lowers level of interest rates, but capping share of foreign investors as percentage of domestic market lowers interest rate volatility. Ideal share seems to be above India's, but below Indonesian level to reduce interest rate level as well as volatility and support domestic cycle.
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The final word: Diverse ownership is helpful, but tail must not wag dog. Reforms to reduce transaction costs for foreign fixed income investors are required, but fully open doors are best avoided. Higher volatilities in 2013 compared to 2026Q1 demonstrate that above threshold of development and with critical buffers, an integrated policy framework can counter global shocks.
Multiple instruments are required to reduce exchange rate volatility. Markets remain nervous due to continued geo-economic stress and perceived vulnerability to oil shocks. But success of FCNR(B) should give the important lesson that there are ways to get foreign capital without making concessions that could create excess volatility. Ammunition is available to break self-fulfilling fears of depreciation so that real exchange and interest rates can be near equilibrium, growth supporting levels despite external shocks.
Tags: #ForeignCapital #Rupee #CAD #FCNRB #RBI #AshimaGoyal #CapitalFlows #FII #ExchangeRate #IndonesianLesson