Capital account

convertibility
Issues and concerns
 What is C.A.C
In its report on capital account convertibility to
the Reserve Bank of India, the Tarapore
Committee provided a succinct and subtle
definition: Capital Account Convertibility
refers to the freedom to convert local
financial assets into foreign financial assets
and vice versa at market determined rates of
exchange. 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.
 IMF’s ROLE IN C.A.C
Convertibility is an IMF clause that all the member countries must
adhere to in order to work towards the common goals of the
organization. However CONVERTIBILITY per se can be looked into
from various perspectives and incorporated accordingly by the
member nations. An economy can choose to be (a) partially
convertible on CURRENT ACCOUNT (b) partially convertible on
CAPITAL ACCOUNT (c) fully convertible on current account and (d)
fully convertible on capital account.
It is important to state here that “The IMF’s mandate is conspicuous
on current account convertibility as current account liberalization is
among the IMF’s official purposes outlined in its Articles of
Agreement, but it has no explicit mandate to promote capital
account liberalization. Indeed, the Articles give the IMF only limited
jurisdiction over the capital account however the IMF has given
greater attention to capital account issues in recent decades, given
the increasing importance of international capital flows for
macroeconomic stability and exchange rate management in many
countries. Thus there is no official binding over any member state to
opt for FULL CAPITAL ACCOUNT CONVERTIBILTY but it has been
a constant component of the IMF’s advisory reports on member
countries.
 The rationale for opening the
capital account
Dismantling capital controls generates economic
benefits through

Increased opportunities for trade and cross-border

portfolio diversification in both assets and liabilities.
It also imposes macroeconomic discipline on national
governments.
Allowing assets and liabilities portfolio diversification
across borders enables a country's borrowers to access
lower borrowing costs and its savers to earn higher
yields.
Moreover, competition among financial
Intermediaries will squeeze intermediation margins; as a
result, costs of funds to borrowers will decrease and
returns to lenders will rise.
 INDIA AND CAC
Though the rupee had become fully convertible on
current account as early as 1991, the RBI has been
adopting a cautious approach towards full float of the
rupee, particularly after the 1997 south-east Asian
currency crisis. While there has been a substantial
relaxation of foreign exchange controls during the last 10
years, the current account convertibility since 1994
means that both resident Indians and corporate have
easy access to foreign exchange for a variety
of reasons like education, health and travel. They are
allowed to receive and make payments in foreign
currencies on trade account. The next logical step in the
same direction would be full convertibility, which would
remove restrictions on capital account.
STEPS TAKEN TOWARDS C.A.C
In 1997, the Tarapore committee took on the
convertibility question. And suggested a logical
framework to attain C.A.C. However the conventional
wisdom is that the report was buried after the East Asian
Crisis.
In 2006 with Prime Minister’s allegiance to CAC shown
at the CII summit in Mumbai the RBI reappointed the
TARAPORE committee to submit a report on C.A.C in
India.
In their report on C.A.C in 2006 the committee has listed
certain pre conditions for C.A.C in India to be achieved
over a time frame of 3 years.
 PRECONDITIONS
Fiscal Consolidation

i. Reduction in gross fiscal deficit (GFD) to GDP ratio to 3.5%.

ii. A consolidated sinking fund (CSF) to be set up to meet government's debt

repayment needs to be financed by increase in RBI's profit transfer to the
government and disinvestment proceeds.

Mandated Inflation Rate

iii. The mandated inflation rate should remain at an average 3-5% for the three-
year period.

Consolidation in the Financial Sector

iv. Gross non-performing assets (NPAs) of the banking sector (as a percentage
of total advances) to be brought down to 5%.

v. A reduction in the average effective Cash Reserve Ratio (CRR) for the
banking systemto 3%.
 Preconditions contd…….
Exchange Rate Policy

vi. RBI should have a Monitoring Exchange Rate Band of plus

minus 5% around a neutral Real Effective Exchange Rate (REER).
RBI should be transparent about the changes in REER.\

Balance of Payments Indicators

vii. Reduction in Debt Servicing Ratio to 20%.

Adequacy of Foreign Exchange Reserves

viii. Reserves should not be less than six months of imports.
ix. The short -term debt and portfolio stock should be lowered to
60% of level of reserves.
x. The net foreign exchange assets to currency ratio
(NFA/Currency) should be prescribed by law at not less than 40%.
 STATUS OF INDIA W.R.T the
PRECONDITIONS
Preconditions Current Status
i Almost achieved
ii Not achieved
iii Achieved
iv Not achieved (5.84% for the nationalized banks in FY
2004)
v Not achieved (currently 5%)
vi Not achieved
vii Achieved
viii Achieved
ix Achieved
x Achieved (there is no legal restriction)
 PROS OF C.A.C for INDIA
It allows domestic residents to invest abroad and have a
globally diversified investment portfolio, this reduces risk and
stabilizes the economy. A globally diversified equity portfolio
has roughly half the risk of an Indian equity portfolio. So, even
when conditions are bad in India, globally diversified
households will be buoyed by offshore assets; will be able to
spend more, thus propping up the Indian economy.
Our NRI Diaspora will benefit tremendously if and when CAC
becomes a reality. The reason is on account of current
restrictions imposed on movement of their funds. As the
remittances made by NRI’s are subject to numerous
restrictions which will be eased considerably once CAC is
incorporated.
It also opens the gate for international savings to be invested in
India. It is good for India if foreigners invest in Indian assets —
this makes more capital available for India’s development. That
is, it reduces the cost of capital. When steel imports are made
easier, steel becomes cheaper in India. Similarly, when inflows
of capital into India are made easier, capital becomes cheaper
in India.
 Pros contd…………
Controls on the capital account are rather easy to evade through
unscrupulous means. Huge amounts of capital are moving across
the border anyway. It is better for India if these transactions happen
in white money. Convertibility would reduce the size of the black
economy, and improve law and order, tax compliance and corporate
governance.
Most importantly convertibility induces competition against Indian
finance. Currently, finance is a monopoly in mobilizing the savings of
Indian households for the investment plans of Indian firms. No
matter how inefficient Indian finance is, households and firms do not
have an alternative, thanks to capital controls. Exactly as we saw
with trade liberalization, which consequently led to lower prices and
superior quality of goods produced in India, capital account
liberalization will improve the quality and drop the price of financial
intermediation in India. This will have repercussions for GDP growth,
since finance is the ‘brain’ of the economy.
 Cons of C.A.C for INDIA
During the good years of the economy, it might experience huge
inflows of foreign capital, but during the bad times there will be an
enormous outflow of capital under “herd behavior” (refers to a
phenomenon where investors acts as “herds”, i.e. if one moves out,
others follow immediately). For example, the South East Asian
countries received US$ 94 billion in 1996 and another US$ 70 billion in
the first half of 1997. However, under the threat of the crisis, US$ 102
billion flowed out from the region in the second half of 1997, thereby
accentuating the crisis. This has serious impact on the economy as a
whole, and can even lead to an economic crisis as in South-East Asia.
There arises the possibility of misallocation of capital inflows. Such
capital inflows may fund low-quality domestic investments, like
investments in the stock markets or real estates, and desist from
investing in building up industries and factories, which leads to more
capacity creation and utilisation, and increased level of employment.
This also reduces the potential of the country to increase exports and
thus creates external imbalances.
An open capital account can lead to “the export of domestic savings”
(the rich can convert their savings into dollars or pounds in foreign
banks or even assets in foreign countries), which for capital scarce
developing countries would curb domestic investment. Moreover,
under the threat of a crisis, the domestic savings too might leave the
country along with the foreign ‘investments’, thereby rendering the
government helpless to counter the threat.
 Cons cont……..
Entry of foreign banks can create an unequal playing field, whereby
foreign banks “cherry-pick” the most creditworthy borrowers and
depositors. This aggravates the problem of the farmers and the
small-scale industrialists, who are not considered to be credit-worthy
by these banks. In order to remain competitive, the domestic banks
too refuse to lend to these sectors, or demand to raise interest rates
to more “competitive” levels from the ‘subsidised’ rates usually
followed.
International finance capital today is “highly volatile”, i.e. it shifts
from country to country in search of higher speculative returns. In
this process, it has led to economic crisis in numerous developing
countries. Such finance capital is referred to as “hot money” in
today’s context. Full capital account convertibility exposes an
economy to extreme volatility on account of “hot money” flows.
 conclusion
It does seem that the Indian economy has the competence of bearing the strains
of free capital mobility given its fantastic growth rate and investor confidence.
Most of the pre-conditions stated by the TARAPORE committee have been well
complied to through robust year on year performance in the last five years
especially. The forex reserves provide enough buffer to bear the immediate flight
of capital which although seems unlikely given the macroeconomic variables of
the economy alongside the confidence that international investors have leveraged
on India.
However it must not be forgotten that C.A.C is a big step and integrates the
economy with the global economy completely thereby subjecting it to
international fluctuations and business cycles. Thus due caution must be
incorporated while taking this decision in order to avoid any situation that was
faced by Argentina in the early 80’s or by the Asian economies in 1997-98.
Thank you