Capital account liberalisation in a large emerging economy: An Analysis of onshore-offshore arbitrage

In this paper, we decipher the openness of India's capital account by calculating the covered interest parity (CIP) deviations between the onshore-offshore rupee market. India is a country with an elaborate and comprehensive system of capital controls covering all kinds of international financial transactions. This has led to a thriving offshore rupee market of non-deliverable currency forward (NDF) contracts. We analyse more than 20 years (1999- 2020) of daily return differentials in the NDF market vis-a-vis the onshore spot market, estimate structural breaks in CIP deviations and connect these sub-periods to the patterns of changes in de-jure capital control actions announced by the Indian authorities. We also estimate no-arbitrage bands around the CIP using a Self-Exciting Threshold Autoregressive (SETAR) model. We find that on average over the duration of our sample period the capital controls broadly restrict capital outflows more than they restrict capital inflows. We also find that over time India has become more financially integrated with the rest of the world, though the process of capital account opening has not been a continuous and smooth one. This is reflected in large variations in CIP deviations across the period, and in recent times, smaller deviations and narrowing no-arbitrage bands that capture the transactions costs and the degree to which the capital controls are binding.