Capital Acnt Convertibility

8/6/2019 Capital Acnt Convertibility

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Made by:-

Surbhi Harpalani

ACKNOWLEDGEMENT


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I, Surbhi Harpalani, owe my sincere

thanks to DU Board for giving us this

opportunity and for giving us this kind of

exposure to face the corporate world

outside.

I would also like to thank my mentor

Mrs. Chavi Mittal for also for providing me

such a nice topic and for always being

their for me throughout this project , for

guiding me and providing me all the help

that was required by me.

CONTENTS


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o Introduction

o What is Capital account convertibility?

o Difference b/w Current & Capital account

o How is Capital account convertibility different from

current account convertibility?o How does easing of capital controls benefit economies?o Advantages

o Costs/disadvantages

o Preconditions

o Why India went in for CAC?

o Lessons from countrys experiences

o Steps towards CAC in India

o Recommendations of Tarapore Committee

o How far has India moved towards CAC?

o Lessons dawn from Indias approach to Capital Account

Capitalization /Liberalizationo Experiences of other countries

o What is the position of CAC in India today?

o

Pitfalls of easing of controlso Conclusion

INTRODUCTION

In India, the foreign exchange transactions(transactions in dollars, yen, or any other currency)are broadly classified into two accounts: currentaccount transactions and capital account transactions.


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If an Indian citizen needs foreign exchange of smalleramounts, say $3,000, for travelling abroad or foreducational purposes, she/he can obtain the same

from a bank or a money-changer. This is a currentaccount transaction. But, if someone wants to import

plant and machinery or invest abroad, and needs alarge amount of foreign exchange, say $1 million, theimporter will have to first obtain the permission ofthe Reserve Bank of India (RBI). If approved, this

becomes a capital account transaction. This meansthat any domestic or foreign investor has to seek the

permission from a regulatory authority, like the RBI, before carrying out any financial transactions orchange of ownership of assets that comes under thecapital account. Thus, the rules regulate currencyconversion for foreign entities that want to invest in

India and Indians who want to invest overseasmaking the Indian rupee only partially convertible.

What is Capital Account

Convertibility????

In a countrys balance of payments, the capitalaccount features transactions that lead to changes in


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the overseas financial assets and liabilities. Theseinclude investments abroad and inward capital flows.Capital account convertibility implies the freedom to

convert domestic financial assets into overseasfinancial assets at market determined rates.

It can also imply conversion of overseas financialassets into domestic financial assets. Broadly, itwould mean freedom for firms and residents to freely

buy into overseas assets such as equity, bonds, property and acquire ownership of overseas firms besides, free repatriation of proceeds by foreigninvestors. It is associated with the changes ofownership in foreign/domestic financial assets andliabilities and embodies the creation and liquidationof claims on, or by the rest of the world

Difference b/w Current and

Capital Account

Basis Current

account

Capital

AccountComponents Includes all Consits of all


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transactions whichgive rise to or usenational income:

Merchandise

imports andexports

Invisible exportsand imports.

short term andlong term capitaltransactions.

Examples Importrefrigerators,

Import insuranceservices

Export steel

Export software

Receiveremittances froma sibling inEngland

Send abroad to achila attending

college in NewZealand

Capital Inflows:

If an Indiancompany takes aloan from an

American bank If a UK Company

invests in afactory in Indiathis is classifiedas Foreign DirectInvestment (FDI)

When foreigners

buy shares inIndian companiestheir investmentshows up as

portfolioinvestment on thecapital account

Capital Outflows:

TATAs purchased Tetleyand Daewoo

It is where we(Indianhouseholds & firms)invest in global


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assets.and global portfolio invest inIndian assets.

Convertibilty aspect Today,India has

Current AccountConvertibilty in thesense that you arefree to buy foreignexchange for the

purpose of importinggoods and services.In other words the

Rupee is notconvertible oncurrent account.

Today the rupee is

not fully convertibleon the capitalaccount as there existrestrictions onmoney that comes into buy assets in Indiaon that goes out ofIndia to acquire

assets abroad.

How is Capital Account

Convertibility different from

current account convertibility?

Current account convertibility allows free inflows

and outflows for all purposes other than for capital


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purposes such as investments and loans. In other

words, it allows residents to make and receive trade-

related payments receive dollars (or any other

foreign currency) for export of goods and services

and pay dollars for import of goods and services,

make sundry remittances, access foreign currency for

travel, studies abroad, medical treatment and gifts

etc. In India, current account convertibility was

established with the acceptance of the obligations

under Article VIII of the IMFs Articles of

Agreement in August 1994.

How does easing of capital

controls benefit economies?

Once a country eases capital controls, typically, thereis a surge of capital flows. For countries that face

constraints on savings and capital can utilise suchflows to finance their investment, which in turnstokes economic growth.

The inflow of capital can help augment domestic


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resources and boost growth. Local residents would bein a position to diversify their portfolio of assets,which helps them insulate themselves better from the

consequences of any shocks in the domesticeconomy.

For global investors, capital account convertibilityhelps them to seek higher returns by sharing risks. Italso offers countries better access to global markets,

besides resulting in the emergence of deeper andmore liquid markets. Capital account convertibility isalso stated to bring with it greater discipline on the

part of governments in terms of reducing excessborrowings and rendering fiscal discipline.

With the wave of financial globalization, capitalaccount has been the center of attention forresearchers and policy makers. Most developingcountries have begun dismantling the restrictions oncapital account transactions with the objective ofachieving the traditional benefits of CAC identified

in the literature. Since most developing countries stillhave some kind of restrictions on capital accounttransactions, capital account openness is a matter ofdegree. In terms of theory, one of the primary aims ofincreasing the degree of capital account openness is


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to help countries to obtain the advantages ofimproved risk sharing and thereby lowering thevolatility in macroeconomic aggregates like output,

consumption and investment, which will, in turn, haswelfare enhancing effects. Developing countries, in

particular, appear to have benefited most from risksharing owing to their highly volatile nature ofincome and consumption dynamics. However,contrary to the expectations, the volatility of theseaggregates has increased in the aftermath of CACleading to crises in many countries at the end of the1990s. This led to a widespreaddebate regarding the costs and benefits of CAC.

Advantages:

Though countries have fears about plunging intoCAC, there exist a host of distinct advantages:

There would be more and more capital available to

the country, and the cost of capital would decline;


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just as there are gains from trade, there are

advantages to the free movement of capital, which

is, in a way, the freedom to trade in financial

assets;

the spreads of banks and non bank financial

institutions would come down due to growing

competition, rendering the financial system more

efficient;

tax levels would move closer to international levels

thereby reducing evasion and capital flight

the cost of government borrowing would fall in

response to lower interest rates, thus lowering the

fiscal deficit;

It would become quite difficult for a country to

follow unwise macroeconomic policies, because,

under CAC, markets would pre-emptorily punishimprudence.


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Costs/Disadvantages:

Critics have also spelled out a number of costsassociated with CAC. In the first place, an opencapitalaccount could lead to the export of domesticsavings, which for capital scarce developingcountries woulddisrupt the financing of domesticinvestment. Secondly, CAC could expose the

economy to larger macroeconomic instabilityemanating from the volatility of short-term capitalmovements and the risk of massive capital outflows.Thirdly, premature liberalisation (that is, if the speedand sequencing of reforms are not appropriate) could


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initially stimulate capital inflows that would lead toappreciation of real exchange rate and therebydestabilise an economy undergoing the fragile

process of transition and structural reform. Fourthly,because of higher capital inflows preceding CAC, theappreciating realexchange rate would shift resourcesfrom tradable to non-tradable sectors (such asconstruction, housing, hotels and tourism, etc.) andthis would happen in the backdrop of rising externalliabilities. Finally, a convertible capital account couldgenerate financial bubbles, especially throughirrational investment inreal estate and equity market financed byunrestrained foreign borrowing.

PRE-CONDITIONS

Generally, there are a number of prerequisites thatneed to be fulfilled prior to moving to CAC. One, a

prudent fiscal policy is an important element inachieving and maintaining capital convertibility.Large fiscal deficits that require financing throughmoney creation may destabilize the exchange rateand discourage both foreign and domestic

investment. Reliance on foreign loans with highinterest rates creates debt-management problems,reduces creditworthiness, and weakens an economysability to manage external shocks.


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Secondly, a sound monetary policy that complementsand is facilitated by fiscal discipline is anothercritical element, because excess liquidity expansion

will spill over into the external sector. Moreover, amarket-clearing exchange rate is essential to ensureexternal balance. Furthermore, to avoid wideexchange rate fluctuations, prudent macroeconomic

policies need to be coupled with adequateinternational reserves. An efficient and soundfinancial sector is an essential ingredient of capitalaccount convertibility, enabling banks to investcapital inflows prudently and weather shocks.Efficiency requires market-based monetaryinstruments and a liberal regulatory framework. Thesectors soundness depends on, among other things,effective banking supervision and observance of

prudential ratios.Finally, a well-functioning pricemechanism is essential to avoid distortions thatreduce the efficiency of resource allocation, affectcapital flows adversely and hinder growth. Thus,subsidies, tax concessions and price controls need to

be phased out.


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Why India went in for CAC???

India started its path towards CAC because movingtowards CAC was regarded as a mark of a developingcountry graduating into a developed country. Therewere many reasons given in favour of implementingCAC.

Greater Capital Mobility If CAC is allowed, it isargued that foreign fund inflows to the countrybecome easier thus increasing the availability of largecapital stock. Developing nations, which are usuallycapital-scarce, are blessed under unhindered mobility


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of capital and this capital can be used in long terminvestments thus raising the national income.

Access to global pool of savings Once the door toinvesting in international securities gets opened up,CAC will allow residents to hold internationallydiversified portfolios thereby reducing thevulnerability of income streams to shocks in thedomestic market.

Effective Financial Intermediation - Capital accountliberalization provides the domestic and foreignplayers more choice of financial products, firms, andmarkets. The resulting competition benefits theconsumer of financial services since the servicesoffered will become more efficient raising the bar toservice to international levels.

Check on Distortionary policies It is argued thatwith CAC in place, the economy comes undervigilant watch by foreign players. Thus anydistortionary policies taken by the Government will

be put under extreme scrutiny and it might lead to acurrency crisis if such policies elicit unfavorable

responses from such international players.


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LESSONS FROM COUNTRY

EXPERIENCES

The early 1990s witnessed a boom in capital flowsinternationally followed by thereversal of such flows especially in the second half ofthe 1990s. The first reversal occurred in theaftermath of Mexicos currency crisis in December

1994. It was, however, restricted to some LatinAmerican economies and capital flows resumed soonafter. The second reversal, which was more severe,came in 1997 and led to the East Asian crisis. Thiswas followed by the Russian default in August 1998,


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the Brazilian crisis in 1998-99 and by the collapse ofthe Argentine currency in 2001.

A number of lessons can be drawn from theexperiences of various currency crises in the pastsixteen years:

In the first place, liberalisation of the capitalaccount was gradual in most of the economies inthe run up to full convertibility, combined withstrengthened financial systems and prudentialregulations. Even after completely liberalisingthe capital account these countries continue toimpose certain capital controls.

Secondly, the gradual process of capital accountliberalization does not eliminate the risks of crisis

or pressures in the foreign exchange market. Theserisks, however, get minimized when an integratedapproach to reform is pursued involvingmacroeconomic stabilization and institutionalstrengthening. Along with other reform measures,another import lesson is that exchange rateflexibility is important while undertaking capital

account liberalization. Under a flexible exchangerate scenario, monetary policy flexibility can be aninstrumental mechanism to help maintain macro-economic stability.


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Thirdly, limiting fiscal imbalances and preventingexcessive build-up of domestic debt is essential toavoid chances of backtracking subsequent to

capital account liberalization. Though fiscalconsolidation may not by itself be a sufficientcondition to prevent crises, it has been a necessarycomponent of liberalization and its absence cancreate instability.

The fourth lesson from country experiences is that

avoiding real exchange rate misalignment couldminimize the impact of the crisis. This also callsfor pursuing autonomous monetary policy. It wouldforce market participants to hedge their positionsthat would be beneficial for forex marketdevelopment.

Rapid easing of capital controls and subsequent

backtracking seen in the case of many Asian andLatin American countries, clearly indicate the needfor a more cautious and calibrated approach, andensuring enough regulatory and prudentialsafeguards before moving towards capital accountliberalization.

Given the growing risks that are prevalent in aderegulated environment, it is important to focuson effective risk management strategies, improve

prudential supervision and develop proper


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reporting standards to meet the emergingchallenges.

STEPS TOWARDS CAC IN

INDIA

India started liberalizing its capital account as part ofcomprehensive economic reforms initiated in theearly 1990s that reversed its 40-year experiment withcentrally planned development. The hallmark of thereform process has been a gradual, cautious approachthat has been carefully phased and sequenced

across the economy. As a result, India has come along way from its pre-1991 highly restrictiveexchangecontrol regime. With gradual liberalization of bothForeign Direct Investment (FDI) and portfolio


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investment, the rupee has been made convertible forforeign investors. However, some controls remain in

place to varying degrees for both foreign and

domestic corporates and individuals, with residentcorporates facing a more liberal regime than residentindividuals.In India, the current account convertibility wasachieved in August 1994 by accepting Article VIII oftheArticles of the International Monetary Fund (IMF).It was the Tarapore Committee on Capital AccountConvertibility that defined the framework for forexliberalization in May 1997. This Committee hadchalked out three stages, to be completed by 1999-2000. It had indicated certain signposts to beachieved for the introduction of CAC. The three most

important of them were: fiscal consolidation, amandated inflation target and strengthening of thefinancial system. However, the timetable wasabandoned in the wake of the 1997-98 Asianfinancial crisis.In April, 2006 a committee was formed again underthe chairmanship of former Deputy Governor of the

Reserve Bank of India (RBI) Mr. S. S. Tarapore torevisit the issue of CAC and suggest a road map forit.The committee proposed that India shift to FullerCapital Account Convertibility (FCAC) in five years


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beginning 2006/07. In its report submitted to the RBIon July 31, 2006, the committee suggested that the

proposed regime be embraced in three phases2006-

07 (phase I), 2007-08 and 2008-09 (phase II) and2009-10 and 2010-11 (phase III).The committee has

pointed out that the concomitants for a move to fullerCAC would be fiscalconsolidation, setting ofmedium-term monetary policy objectives,strengthening of the banking system,maintaining an appropriate level of current accountdeficit as well as reserve adequacy.

Recommendations of Tarapore

Committee:

The centre and states should graduate from the

present system of computing fiscal deficit toa new measure of Public Sector BorrowingRequirement (PSBR). Substantial part of the revenue surplus of the centreshould be earmarked for meeting the repaymentliability under the centres market borrowing

programme, thereby reducing the gross borrowingrequirement. Revenue deficits of the states should be eliminated

by 2008-09 and fiscal deficits of thestates should be reduced to 3 percent of GDP.


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To strengthen the banking system, the minimumshare of the government/RBI in the capitalof Public Sector Banks (PSBs) should be reduced

from 51 percent (55 percent for State BankOf India) to 33 percent. All commercial banks should be subject to a singlelegislation and all banks, including state owned

banks, be incorporated under the Companies Act. The RBI should evolve policies to allow, on merit,industrial houses to have stakes in Indian

banks or promote new banks. The limits for banks overseas borrowing should belinked to their paid-up capital and freereserves, and not to unimpaired tier I capital at

present, and raised to 50 percent in phase I,75 percent in phase II and 100 percent in phase III.

To make Indian corporates compete in the globalarena on an equal footing, the limits forcorporate investments abroad should be raised in

phases from 200 per cent of net worth to400 per cent. Other than Non-Resident Indians (NRIs) who areallowed to invest in companies on Indian

bourses, all individual non-residents should beallowed to invest in the Indian marketsthrough Sebi-registered entities. Non-resident corporates should be allowed to investin the Indian stock markets through Sebi-registered


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entities, including mutual funds and portfoliomanagement schemes. Apart from multilateral institutions being allowed to

raise rupee bonds in India, other institutions/corporate should also be permitted toraise such bonds (with an option to convert intoforeign exchange), subject to an overall ceiling,which should be slowly raised. The annual limit of remittance by individuals toopen foreign currency accounts overseas beraised to US$ 50,000 in phase one from the currentlevel of $25,000 and further raised toUS$ 100,000 in phase two and US$ 200,000 in phasethree. The limit for mutual funds to invest overseas should

be increased from the present level of

US$ 2 billion to US$ 3 billion in phase one, to US$ 4billion in phase two and to US$ 5 billion in phasethree and these facilities should be available to SEBIregistered portfoliomanagement schemes apart from mutual funds.


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How far has India moved

towards capital account

convertibility?

Capital account convertibility is in vogue in terms offreedom to take out proceeds relating to FDI,

portfolio investment for overseas investors and NRIsbesides leeway for firms to invest abroad in JVs oracquisition of assets, and for residents and mutualfunds to invest abroad in stocks and bonds with somerestrictions. India seems to be taking the approach

that easing of capital controls would be marked byremoval of capital outflow restrictions on NRIs first,corporates next, followed by banks and freedom forresidents in the last stage.


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Lessons drawn from Indias

approach to capital account

liberalization:One, capital account liberalization is regarded as

a process and not an event. Two, it is recognized that there may be links

between the current and capital accounts and,

hence, procedures should be intact to avoidcapital flows in the guise of current accounttransactions.

Thirdly, capital account liberalization ismaintained in line with other reforms. Thedegree and timing of capital accountliberalization need to be sequenced with other

reforms, such as strengthening of bankingsystems, fiscal consolidation, marketdevelopment and integration, trade liberalization,and the changing domestic and externaleconomic environments.


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Fourth, a hierarchy has been made with regard tothe sources and types of capital flows. The focusin India has been to liberalize inflows relative to

outflows, but all outflows related to inflows have been completely freed. Among the kinds ofinflows, FDI is preferred for stability, whileexcessive short-term external debt needs to beavoided. A separation is made betweencorporates, individuals, and banks. For outflows,the hierarchy for liberalization has beencorporates first, followed by financialintermediaries, and finally individuals. Forindividuals, residents are treated separate fromnonresidents, and nonresident Indians have aclear intermediate status between residents andnonresidents.

Fifth, the speed and sequencing of liberalizationis responsive to domestic developments, particularly in the monetary and financialsectors, and to the developing internationalfinancial architecture. As liberalization proceeds,administrative measures need to be lowered and

price-based measures should be increased, but

the freedom to change the mix and reimposecontrols should be available.


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Experience of some of the

countries

The initial experience has been that of animprovement in their balance of payments position.In Malaysia, Indonesia, Mexico and Argentina, thesurge in capital flows meant a widening of theircurrent accounts. Inflation was also subdued for sometime and the reserves were also bolstered.

But after the current account deficit could be notsustained, some of these countries introduced somecontrols. Mexico and Argentina reintroduced controlsin the 80s, while Chile also placed fetters after itfaced a crisis between 82 and 89. However, all ofthem subsequently opened up.


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What is the position of CAC in

India today?

Convertibility of capital for non-residents has been abasic tenet of Indias foreign investment policy allalong, subject of course to fairly cumbersomeadministrative procedures. It is only residents both

individuals as well as corporates who continue tobe subject to capital controls. However, as part of theliberalisation process the government has over theyears been relaxing these controls. Thus, a few yearsago, residents were allowed to invest through themutual fund route and corporates to invest incompanies abroad but within fairly conservative

limits.


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Pitfalls of easing of capital

controlsOne of the main problems an economy that has optedfor a free-float has to contend with is, the prospectsof outflow of what is termed as speculative short-term flows. Denomination of a substantial part oflocal assets in foreign currencies poses the threat of

outward flows and higher interest rates, which couldde-stabilise economies.

The volatility in exchange and interest rates in thewake of capital inflows can lead to unsound fundingand large unhedged foreign liabilities. This isespecially so for economies that go in for a free-float

without following prudent macro-economic policies,and ensuring financial reforms.


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Conclusion

India should be extremely cautious in liberalisingcapital outflows any further. It should leave no stoneunturned to promote inward FDI, which, because ofits very nature, is less susceptible to suddenwithdrawals and also tends to promote productive useof capital and economic growth. However, it should

be wary of short-term capital flows that have thepotential to destabilize financial markets. The 'slowand steady' stance that the RBI has taken towardscapital account convertibility is to be appreciated. Itmust be emphasized that only over time will theIndian economy be mature enough to be comfortable

with full capital account convertibility - financialmarkets will deepen, macroeconomic and regulatoryinstitutions grow more robust and the Governmentwill learn from past mistakes. The Governmentwould do well if it at present focuses on the


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fundamental processes of institutional developmentand policy reform because, in the long run, thesewould serve the country better than an early move

towards full CAC.

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