INDIAS FOREIGN TRADE

WILL FULL CAPITAL ACCOUNT CONERTABILITY CORRECT INDIAS BOP DEFICIT

Antariksh Bhandari - 3250 Himanshu Mangtani - 3021

CONTENTS
Abstract Introduction Capital Account Convertibility - Advantages and Disadvantages World Wide Scenario South Asian Crisis, 1997 Capital Account Convertibility With Reference To Various Countries (USA, China, India) RBIs Stand On Capital Account Convertibility Tarapore Committee Report Future Plans For India Will Capital Account Convertibility Correct Bop Deficit Conclusion Bibliography 1 1 2 3-4 4-5 5-8

9 10-11 12-13 13 14 14

ABSTRACT
After the success of the current account convertibility, the next step to liberalization of the Indian market is fuller capital account convertibility (CAC). In this report we will take example of US and China, the former a developed country with no capital control and the latter a developing country which has adopted capital controls as examples to see what would be the policy for India. The report will look into the CAC, past experiences and a roadmap for Indias implementation if it should.

INTRODUCTION
The economic growth and development of a country is synonymous with the progress of its tradable sector. With the integration of economies, the world finds itself combined to each other as the forces of Liberalization, Globalization and privatization take place. In India, after the liberalization of trade in 1991, the next step is the full convertibility of the capital account as a means fuller liberalization than before. Capital Account Convertibility (CAC) refers to the freedom of converting local financial assets into foreign financial assets and vice versa at market determined rates of exchange. It refers to the elimination of restraints on international flows on a countrys capital account, facilitating full currency convertibility and opening of the financial system. It is associated with changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by the rest of the world. Like everything, CAC has scores of benefits but it involves a cost that can be disruptive to the economy. The process of capital account liberalization is therefore, managed with farthest prudence given that such a step cannot be reversed easily. Today CAC is considered as a sign of a country being developed. All developed countries have moved towards fully liberalized capital accounts. For example: A resident of UK can buy property in the US at the current exchange rate and sell property in the US at the current exchange rate.

CAPITAL ACCOUNT CONVERTIBILITY ADVANTAGES AND DISADVANTAGES

Advantages of CAC are as follows Increased capital inflows - With the removal of capital controls, countries will see a flood of investments from other countries. This has happened to all the countries that have adopted CAC. For e.g.: Japan Higher choice of investments - Residents and companies alike will be allowed to invest abroad giving them giving them greater avenues and instruments to invest in.

Reduce disguised capital flows - Even with capital controls, investment in countries abroad takes place due to current account convertibility. By opening up the capital account, disguised capital flows can be reduced greatly if not removed altogether. Greater financial efficiency and innovation - Introduction of CAC in the AEs has led to the innovation of various financial instruments and the choice in investing has led to greater efficiency in distribution and returns received. Reduced cost of capital - CAC has allowed people to invest more. This increase in the supply of capital has led to the reduction of cost of capital. This is because supply is greater than demand.

Disadvantages of CAC are as follows Export of domestic savings - Opening up of the capital account will allow the residents to shift savings to countries where they can get higher returns for their investments. This could potentially reduce the liquidity in the making it harder for the government to form policies Exchange rate volatility - The continuous flow of capital in and out of the country make the exchange rate volatile. In case of sudden outflows, the country could face sudden depreciation of the currency value. Requires huge structural reforms - CAC cannot be adopted without structural reforms of the countrys economy. It would leave the country at risk. It has happened to many countries like UK, France etc., which have adopted CAC. Harder policy creation - The volatility of the financial market makes it harder for policy creators to make policies sue to the rapidly changing market.

WORLDWIDE SCENARIO
Though the term Capital Account Convertibility (CAC) was coined by the RBI in 1997, capital account liberalization has been happening since the collapse of the Bretton Woods System in 1973. All the Advanced Economies (AEs) have removed all capital controls and adopted CAC. Other countries had tried it but brought back capital controls after they started facing serious economic problems.

Table showing the list of Countries adopting CAC

In this report we will be looking at two countries United States of America and China and the condition they are in today and as an example to India and how their example can be used to better Indias cause.

South East Asian Crisis 1997

The East Asian region was characterized by high rates of growth since the 1980s which had accelerated to a range of 7 to 10 per cent in the 1990s accompanied by high investment rates which averaged around 30 percent through the 1980s (except in the Philippines) and kept well above 30 per cent of GDP and above 40 per cent in Malaysia and Thailand in the 1990s. There were moderate deficits in the general government budget ranging between 0.3 per cent of GDP and 3 per cent of GDP. Malaysia recorded deficit of 4 per cent of GDP during the 1980s, but rapidly consolidated its position and moved into fiscal surplus since 1994. Thailand recorded fiscal surpluses all through the 1990s

The East Asian economies faced a serious currency crisis during 1997-1999. It began in Thailand without much early warning signals in late June 1997 and afflicted other countries such as Malaysia, Indonesia and South Korea, and lasted up to the last quarter of 1998. It came as a surprise, not only because of the large number of countries affected and the speed of the spreading crisis from one country to another, but also because of the fact that before the crisis many countries had been showing healthy signs: long periods of impressive growth rates, responsible government fiscal policies, and steady investments. The key weaknesses were the large inflow of short-term capital, and the fact that most of the affected countries had high current account deficits and overvalued exchange rates. This episode was a major shock to countries embarking upon rapid capital account liberalization and raised doubts about the benefits of liberalization of capital account without certain macroeconomic and prudential policy prerequisites. The major macroeconomic causes for the crisis were identified as: current account imbalances with concomitant savings, investment imbalance, overvalued exchange rates, high dependence upon potentially short-term capital flows and huge portfolio flow composition of foreign investment. These factors were exacerbated by maturity mismatches, currency mismatches, moral hazard behavior of lenders and borrowers, excessive leveraging, herd behavior of markets and predatory speculation, and the sharp appreciation of the US dollar. The crisis period witnessed reversals of policies towards capital account by these countries.

UNITED STATES OF AMERICA

The United States had adopted to liberal policies with regard to capital account in the post war period but they introduced capital controls on account of speculative outflows in the 1960s. The government also introduced the following Controls which were later eliminated from 1974 onwards after the breakdown of the Bretton Woods System. Interest Equalization Tax, 1963. Voluntary Guidelines limiting foreign lending and investment, 1965. Voluntary guidelines limiting foreign direct investment, 1968.

Since, then, the United States has followed a liberal capital regime with limited controls mainly pertaining to security concerns.

As we can see in the graph, before 1975 the Debt-GDP Ratio was reducing but soon after US adopting to introduction of Capital Controls and eliminating Bretton Woods System. Their DebtGDP Ratio started to increase considerably which led to a slight downfall in 1990s but soon after the Global Economic Crisis, 2008 the ratio is rising considerably and this rise is even more than the 1970s and 1980s. This increase in the Debt-GDP ratio brings out the following A low debt-to-GDP ratio indicates an economy that produces a large number of goods and services and probably profits that are high enough to pay back debts but US is in-turn just opposite of this as they have a high Debt-GDP ratio. Inefficiency of capital coming to the country. Risk increases as the US government would have to pay more to the corporates, organizations and governments from whom they have taken debt from. Reduce spending which will in-turn have pressure on the economy of country. There is no identifiable critical level of debt at which a fiscal crisis may become likely.

CHINA
China has been following a policy of gradualist economic reforms since 1978. A closed economic system was rapidly opened to trade and investment. China allowed Yuan to be fully convertible under current account in December 1996. There are however extensive restrictions on inflows and outflows of money for capital account transactions. On July 21, 2005 China abandoned its 8 year peg to the US dollar and moved to a managed floating exchange rate regime. China continues to take steps to create market infrastructure and financial instruments for a floating currency. They introduced an inter-bank foreign currency trading system in early 2005. They also introduced new financial products to hedge against currency appreciation such as forwards. China has taken steps to liberalize controls on capital movements to increase the depth and liquidity in foreign exchange markets. It has continued to expand the program that allows FIIs to buy shares in locally listed companies. Chinese residents and institutional investors have also increasingly allowed to acquire overseas assets. But, China still maintains extensive controls on outflow of capital than it does on inflows. The country remains reticent to open capital account partly due to its weak financial system and the need to substantially strengthen regulations and prudential supervision. The authorities have recently announced that China will push ahead with Yuan convertibility STEP BY STEP. Yuan convertibility is a systematic project and has to accommodate the nation macroeconomic and financial reform. The Chinese government realizes that capital account liberalization is in the countrys best long term interests and moving in this direction is inevitable. In the last few years, China has announced the following liberalization measures on capital flows.

SEQUENCE OF MEASURES TAKEN BY CHINA

YEAR 2001 2002 2004 2005 2006 2007 2010 2011 2012 2013

MEASURES Resident corporates list overseas; Resident individual buy B-shares QFII scheme Approved corporates lend abroad; emigrants transfer limited assets abroad. Nonresidents issue RMB bonds in China (Panda Bonds) QDII Scheme; eliminate approval and expand financing sources for ODI Expand QDII institutions; raise QDII quota; residents issue RMB bonds offshore. Approved central/foreign bank invest in Chinese bond market; resident corporates borrow abroad. R-FDI scheme; R-QFII scheme. QFII quota increased to $80 billion; R-QFII quota increased to RMB200 billion; quotas on central banks/SWF removed. R-QFII Eligible institutions expanded; restrictions on asset allocation eased.

China also had record current account surplus and its official external debt was modest. The focus on attracting certain forms of FDI on an integrated, geographically-targeted basis and gradual opening up of financial sector has also helped in attracting stable capital inflows into China. China had committed to open the external sector to foreign investment as part of WTO accession with substantive liberalization to by 2007. This looming deadline has forced Chinese government to accelerate steps to strengthen reforms in the banking system.

INDIA
The term Capital Account Convertibility (CAC) is credited to RBI who coined the term in 1997. India has moved from a closed economy in 1991 when they adopted the policy of LPG (Liberalization, Privatization and Globalization) along with economic restructuring and policy reforms. India today has moved towards complete current account convertibility which has had a positive impact on the foreign reserve and has contributed majorly on the growth of the Indian economy. There is a slow move towards CAC but there has been serious reconsideration after the East Asian crisis of 1997. The Tarapore committee was tasked by the RBI to create a plan for Indias move towards CAC but implementation could not take place to the volatility of the world financial market.

DEBT OF USA, CHINA AND INDIA

RBIS STAND ON CAPITAL ACCOUNT CONVERTIBILITY

Two major committees were set by RBI to look into this issue under S.S.Tarapore. First committee submitted its report in 1997 and laid the road map and preconditions to be met to achieve Full capital account convertibility in three year time frame. But the East Asian crisis in 1997, put the issue on back burner as the international opinion on Full capital account convertibility turned negative. Again after years of solid economic growth the Indian government started looking into CAC. Already many of the recommendations of Tarapore I had been acted upon and in 2006 Tarapore II committee was formed by RBI. This committee recommended moving toward CAC in three phases leading to complete CAC by 2011. Another High powered committee set up under Ministry of Finance in 2007 for making Mumbai an IFC also echoed the sentiments of Tarapore-II and recommended achieving the goal in a time bound manner (18-24 months). Off late (2011 onwards) high inflation and fiscal deficit in Indian economy have been major issue facing the policy makers and fresh reforms need to be infused to achieve high economic growth.

Tarapore Committee Report

A committee on capital account convertibility was setup by the Reserve Bank of India (RBI) under the chairmanship of former RBI deputy governor S.S. Tarapore to "lay the road map" to capital account convertibility. In 1997, the Tarapore Committee had indicated the preconditions for Capital Account Convertibility. The committee had recommended a three-year time frame for complete convertibility by 19992000. The highlights of the report including the preconditions to be achieved for the full float of money are as follows Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5 per cent in 199798 to 3.5% in 1999-2000. A consolidated sinking fund has to be set up to meet government's debt repayment needs; to be financed by increased in RBI's profit transfer to the govt. and disinvestment proceeds. Inflation rate should remain between an average 3-5 per cent for the 3-year period 19972000. Gross NPAs of the public sector banking system needs to be brought down from the present 13.7% to 5% by 2000. At the same time, average effective CRR needs to be brought down from the current 9.3% to 3% RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a neutral Real Effective Exchange Rate RBI should be transparent about the changes in REER

External sector policies should be designed to increase current receipts to GDP ratio and bring down the debt servicing ratio from 25% to 20%

Four indicators should be used for evaluating adequacy of foreign exchange reserves to safeguard against any contingency. Plus, a minimum net foreign asset to currency ratio of 40 per cent should be prescribed by law in the RBI Act.

Table showing the Pre conditions for CAC The Asian crisis in 1997 gave a new perspective to capital account convertibility. Countries like India and China which had capital account regulations in place were able to ride the crisis more effectively. This led the policy makers to put the recommendations of First Tarapore committee report on the back burner for few years. But after high growth phase of Indian economy the policy makers again started looking into CAC. A second committee was set up under the chairmanship of S.S.tarapore with many notable champions of CAC on board and referred to as Tarapore committee II. The committee followed the same approach as before and recommended to progressively achieve CAC in three phases: Phase I (2006-07), Phase II (2007-09) and Phase III (2009-11) giving time in between each phase to take stock of the situation before they moved forward. The major recommendations of Tarapore II are set out below Removal of overall external commercial borrowings (ECBs) ceiling of $ 22 billion and removal of restrictions on end-use of ECBs. Limits on corporate investments abroad be doubled from the current limit of 200 per cent of net worth. Banks be allowed to borrow overseas up to 50 per cent of paid-up capital and reserves in Phase I, which amount can be raised to 75 per cent in Phase II and 100 per cent in Phase III. As against the current limit of $ 25,000, individuals be allowed to remit abroad (annually) up to $ 50,000 in Phase I, $ 100,000 in Phase II and $ 200,000 in Phase III.

Currently only NRIs are allowed to invest in companies listed on Indian stock exchanges. The committee recommends extension of this facility to all non-residents (through SEBI registered entities such as mutual funds and other portfolio management schemes). FIIs be prohibited from raising money through Participatory Notes (PNs).

Current Situation
Thus, Tarapore Committees recommendations have mostly not been implemented, since the prescribed conditions were not met. Time-frame wise, it is clear that the committees suggestions and recommendations were premature by at least 10 years, if not more. On the following counts on which India performed as recommended by the Committee Trade and External Sector Reserves Adequacy Gross NPA of Public Sector Banks.

The following observations came out from the study of the subject with respect to Roadmap to Capital Account convertibility Globalization of world economy is a reality and opening up of financial market is inevitable and unavoidable process. Its suggested that emerging economies workout and orderly liberalization of the capital account instead of reforming under duress after crisis hit the economy. The main impediments in the way of capital account convertibility are the weak initial conditions related to the health and development of the financial sector and problems related to asset liability management of the banking system. Of crucial importance are measures addressing bank soundness, interest risk management, hard budget constraints for public enterprises, the oligopolistic structure of the banking industry and market segmentation. Without underlying changes in the structure of the financial system, macroeconomic and financial instability is a predictable consequence of moves towards capital account liberalization.

FUTURE PLANS FOR INDIA

PHASE I - ECONOMIC STABILITY The starting of capital account convertibility will happen only once India is economically stable. This phase will last for 3-5 years and another 2 years to take stalk of the current situation and to be absolutely sure for the economy to be stable. Some of the key factors in this phase are Fiscal Consolidation. Current Account Balance. Inflation Rate. Foreign Exchange Reserves. Reforms.

Fiscal Consolidation - It includes those strategies that are aimed at minimizing debt and curtailing accumulation of more debt. Some of the ways in which fiscal consolidation can be done are Budget cuts and reduce spending. Increase in revenue. Increase exports and reduce imports.

Current Account Balance - India currently has a current account deficit of 6.3% of the GDP which needs to be brought down to 3-4%. This can be done through increased exports and reduced imports. Inflation Rate - The aim of the government should be to bring down the inflation rate to 4% which is the ideal rate for growth. Foreign Exchange Reserves - India currently has a forex reserve of 282 million dollars. Before anything else can be done India has to make sure that it has considerable reserves to absorb any shocks it might face during the transitionary period or at times of capital flight. Reforms - Major structural and economic reforms have to be made to accommodate the continuous inflow and outflow of capital. Also care should be taken regarding the financial instruments that come into the market. This phase will end once India has achieved economic and political stability and the structural reforms begin.

 PHASE II - STRUCTURAL REFORMS

The aim at the end of Phase II will be have structural reforms such that they are able to compete with the international market. This will include change in policy and technology and bring them up to international standards. This phase will be of 2-3 years with 1 year kept as buffer to try out and ensure that the reforms remain intact. Technological standards are a major factor influencing the inflow of capital. It will also be needed to ensure the smooth flow of the capital.

PHASE III REMOVAL OF ALL REGULATIONS

This will be the last phase leading to full Capital Account Convertibility. This phase will aim at removing all inhibitions and trade barrier as well to lead to capital account liberalization. This will include introduction of maximum percent FDI in majority of the sectors. Up to 75% FDI in those sectors like retail.

WILL CAC CORRECT BOP DEFICIT

With the financial crisis in the US, developing countries like Brazil, China, India etc. have been seeing increased levels of investments. But with the US coming back, India has been seeing a flight of investments especially in FIIs. Removal of the capital controls combined with easy investment policy will definitely help in bringing in capital inflows which can correct the BOP deficit. The use capital inflows to correct BOP deficit is a wrong practice and should be discontinued because in the future when the investment has to be paid back, it will put a bigger burden on the capital account and the countrys foreign reserve. Taking the example of china we see that liberalization of the capital is not the only method of correcting BOP deficit and it India should take a leaf out of chinas book and explore all other avenues before taking such a drastic and risky avenue.

FDI OF USA CHINA AND INDIA

CONCLUSION
Through the experiences of various countries we have seen that Capital Account Convertibility has been a success in the case of developed countries and a failure for the rest. As we have seen in the case of the Argentinian Crises of 1999 and South East Asia crisis of 1997, going into full CAC without proper preparation is not consequence and even if preparations are made, a crisis is highly possible. India will have to implement CAC at some point in the future, the only choice we have in how we do it. Either we implement the changes ourselves or be mandated to do so by the IMF. It would be better to do it ourselves were India can adopt the policies it likes. India will have to retain some Capital Control measures to ensure that history does not repeat itself, but it will not happen anytime soon. India has a long and tough road ahead of itself but the end will definitely be good.

BIBLIOGRAPHY
mrv.net.in rbidocs.rbi.org.in pd.cpim.org bloomberg.com www.iie.com/publications/papers www.imf.org www.igef.cuhk.edu.hk ideas.repec.org