CURRENCY CONVERTIBILITY

What is Convertibility? Convertibility means the system where any thing can be converted into any other stuff without any question asked about the purpose

What is BoP?

Balance of payment (BoP) is a statistical statement that summarizes, for a specific period, transactions between residents of a country and the rest of the world. BoP positions indicate various signals to businesses. BoP comprises current account, capital account and financial account.

Signals that the BoP account of a country gives out. For example, large current account transactions indicate towards openness of an economy. This was the case with India as reduction in trade restrictions and duties led to increase in both exports and imports after 1991. Also large capital account transactions may indicate well-developed capital markets of an economy.

Capital and current account balances for India were quite stable between 1991 and 2001. After 2001, primarily because of increased exports of IT services and transfers, current account balance went into surplus. But due to increasing imports and an increasing oil bill, it started deteriorating after 2004 and went into deficit.

Sound fundamentals and a large untapped market coupled with a deregulated regime allowed foreign investors to invest in India, thereby increasing capital inflows after 2000. However, the global meltdown has led to an outflow of capital, which has led to a sudden fall in the capital account balance after 2007.

Reserves were built up over the years mainly because of capital inflows. But a recent deficit in current account and capital outflow led to a fall in 2008-09.

Healthy BoP positions or surplus in capital and current account keeps confidence in the economy and among investors. However, healthy BoP positions may be different for different countries. For example, surplus in current account is often more important for developed countries than surplus in capital account as most of them have sufficient capital to fund their investments. On the other hand, developing countries like India may place more importance on capital account as reserves and funding for investment is crucial for them at present.

Large balances often attract foreign investors into an economy, thus bringing in precious foreign exchange. Often credit ratings are based on BoP positions, thereby affecting the flows of credit to businesses. Businesses can make predictions about exchange rates by studying BoP positions. A healthy BoP position can signal domestic currency appreciation, hence encouraging businesses to engage in future contracts accordingly. Also, the BoP position influences the decisions of policy makers, which are crucial for any business.

India’s BoP

India presently has a deficit in its current account of BoP, which has increased substantially after reforms in 1991. In 1991-92, current account deficit was $1,178 million, which rose to $17,403 million in 2007-08, and accounted for $36,469 million for the last three quarters of 2008. After the reforms in 1991, India’s position of merchandise trade (exports and imports of goods) kept on deteriorating, but its position on invisibles (services, current transfers etc) improved during the period. However, one of the major factors for increasing current account deficit in the last few years has been a rising oil import bill. Some countries like Japan and Germany have current account surpluses, while the USA and UK have deficits.

India has done fairly well on the capital account side. In 2007-08 it had a capital account surplus of $108,031 million. In the same year it increased its foreign exchange reserves by $92,164 million, which provided stability to the economy. Foreign investments have increased manifold since 1991, peaking in 2007-08 to $44,806 million.

India’s overall current account and capital account deficit is $20,380 million for April–December 2008, which is expected to rise to a figure between $25 and 30 billion by the year ending March 31, 2009. There has been dip in reserves from $309,723 million in March 2008 to $253,000 million in March 2009. Reasons for this are portfolio flows

from foreign institutional investors and the appreciation of the US dollar. But this may not pose a significant threat to the Indian economy and businesses because of large pool of reserves that are still providing enough cushion. However, some businesses like those related to equities and realty are hit when outflows from these sectors occur. Not only is there fall in asset prices and erosion of investment value, but economic activity also gets reduced in these sectors.

However, recent profitability/growth numbers have indicated signs of a revival. Also political change and expected stability might bring in foreign exchange and may improve India’s capital account position and reserves. This may lead to the appreciation of the Indian rupee and may affect exporters and importers accordingly. At the same time, reserves infuse stability into the system, which in turn has positive effects on businesses and investments.

Current account convertibility refers to currency convertibility required in the case of transactions relating to exchange of goods and services, money transfers and all those transactions that are classified in the current account.

On the other hand, capital account convertibility refers to convertibility required in the transactions of capital flows that are classified under the capital account of the balance of payments.

What is capital account convertibility?

There is no formal definition of capital account convertibility (CAC). The Tarapore committee set up by the Reserve Bank of India (RBI) in 1997 to go into the issue of CAC defined it as the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. In simple language what this means is that CAC allows anyone to freely move from local currency into foreign currency and back.

Current account convertibility

Current account convertibility refers to freedom in respect of Payments and transfers for current international transactions. In other words, if Indians are allowed to buy only foreign goods and services but restrictions remain on the purchase of assets abroad, it is only current account convertibility. As of now, convertibility of the rupee into foreign currencies is almost wholly free for current account i.e. in case of transactions such as trade, travel and tourism, education abroad etc.

The government introduced a system of Partial Rupee Convertibility (PCR) (Current Account Convertibility) on February 29,1992 as part of the Fiscal Budget for 1992-93.

PCR is designed to provide a powerful boost to export as well as to achieve as efficient import substitution. It is designed to reduce the scope for bureaucratic controls, which contribute to delays and inefficiency. Government liberalized the flow of foreign exchange to include items like amount of foreign currency that can be procured for purpose like travel abroad, studying abroad, engaging the service of foreign consultants etc. What it means that people are allowed to have access to foreign currency for buying a whole range of consumables products and services. These relaxations coincided with the liberalization on the industry and commerce front which is why we have Honda City cars, Mars chocolate and Bacardi in India.

Components of Current Account

Covered in the current account are all transactions (other than those in financial items) that involve economic values and occur between resident non-resident entities. Also covered are offsets to current economic values provided or acquired without a quid pro quo. Specifically, the major classifications are goods and services, income, and current transfers.

Goods and services

Goods

General merchandise covers most movable goods that residents export to, or import from, non residents and that, with a few specified exceptions, undergo

changes in ownership (actual or imputed).

STRUCTURE AND CLASSIFICATION

Goods for processing covers exports (or, in the compiling economy, imports) of goods crossing the frontier for processing abroad and subsequent re-import (or, in the compiling economy, export) of the goods, which are valued on a gross basis before and after processing. The treatment of this item in the goods account is an exception to the change of ownership

principle.

Repairs on goods covers repair activity on goods provided to or received from non residents on ships, aircraft, etc. repairs are valued at the prices (fees paid or received) of the repairs and not at the gross values of the goods before and after repairs are made.

Goods procured in ports by carriers covers all goods (such as fuels, provisions, stores, and supplies) that resident/nonresident carriers (air, shipping, etc.) procure abroad or in the compiling economy. The classification does not cover auxiliary services (towing, maintenance, etc.), which are covered under transportation.

Nonmonetary gold covers exports and imports of all gold not held as reserve assets (monetary gold) by the authorities. Nonmonetary gold is treated the same as any other

commodity and, when feasible, is subdivided into gold held as a store of value and other (industrial) gold.

Services

Transportation covers most of the services that are performed by residents for nonresidents (and vice versa) and that were included in shipment and other transportation in the fourth edition of the Manual. However, freight insurance is now included with insurance services rather than with transportation. Transportation includes freight and passenger transportation by all modes of transportation and other distributive and auxiliary services, including rentals of transportation equipment with crew.

Travel covers goods and services—including those related to health and education—acquired from an economy by non resident travelers (including excursionists) for business and personal purposes during their visits (of less than one year) in that economy. Travel excludes international passenger services, which are included in transportation. Students and medical

patients are treated as travelers, regardless of the length of stay. Certain others—military and embassy personnel and non resident workers—are not regarded as travelers. However, expenditures by non resident workers are included in travel, while those of military and embassy personnel are included in government services

Communications services covers communications transactions between residents and nonresidents. Such services comprise postal, courier, and telecommunications services (transmission of sound, images, and other information by various modes and associated

maintenance provided by/for residents for/by non residents).

Construction services covers construction and installation project work that is, on a temporary basis, performed abroad/in the compiling economy or in Extra territorial enclaves by resident/non resident enterprises and associated personnel. Such work does not include that undertaken by a foreign affiliate of a resident enterprise or by an unincorporated site office that, if it meets certain criteria, is equivalent to a foreign affiliate.

Insurance services covers the provision of insurance to non residents by resident insurance

enterprises and vice versa. This item comprises services provided for freight insurance (on goods exported and imported), services provided for other types of direct insurance (including life and non-life), and services provided for reinsurance.

Financial services (other than those related to insurance enterprises and pension funds) covers financial intermediation services and auxiliary services conducted between residents and nonresidents. Included are commissions and fees for letters of credit, lines

of credit, financial leasing services, foreign exchange transactions, consumer and business credit

services, brokerage services, underwriting services, arrangements for various forms of hedging instruments, etc. Auxiliary services include financial market operational and regulatory services, security custody services, etc.

Computer and information services covers resident/non resident transactions related to hardware consultancy, software implementation, information services (data processing, data base, news agency), and maintenance and repair of computers and related

equipment.

Royalties and license fees covers receipts (exports) and payments (imports) of residents and non-residents for (i) the authorized use of intangible non produced, nonfinancial assets and proprietary rights—such as trademarks, copyrights, patents, processes, techniques,

designs, manufacturing rights, franchises, etc. and (ii) the use, through licensing agreements, of produced originals or prototypes—such as manuscripts, films, etc.

Other business services provided by residents to nonresidents and vice versa covers merchanting and other trade-related services; operational leasing services; and miscellaneous business, professional, and technical services.

Personal, cultural, and recreational services covers (i) audiovisual and related services and (ii) other cultural services provided by residents to non-residents and vice versa. Included under (i) are services associated with the production of motion pictures on films or video tape, radio and television programs, and musical recordings. (Examples of these services are

rentals and fees received by actors, producers, etc. for productions and for distribution rights sold to the media.) Included under (ii) are other personal, cultural, and recreational services—such as those associated with libraries, museums—and other cultural and sporting activities.

Government services i.e. covers all services (such as expenditures of embassies and consulates) associated with government sectors or international and regional

organizations and not classified under other items.

Income

Compensation of employees covers wages, salaries, and other benefits, in cash or in kind, and includes those of border, seasonal, and other non-resident workers (e.g., local staff of embassies).

Investment income covers receipts and payments of income associated, respectively, with residents’ holdings of external financial assets and with residents’ liabilities to nonresidents. Investment income consists of direct investment income, portfolio investment income, and other investment income. The direct investment component is divided into income on equity

(dividends, branch profits, and reinvested earnings) and income on debt (interest); portfolio investment income is divided into income on equity (dividends) and income on debt (interest); other investment income covers interest earned on other capital (loans, etc.) and,

in principle, imputed income to households from net equity in life insurance reserves and in pension funds.

Current transfers

Current transfers are distinguished from capital transfers, which are included in the capital and financial account in concordance with the SNA treatment of transfers. Transfers are the offsets to changes, which take place between residents and nonresidents, in ownership of real resources or financial items and, whether the changes are voluntary or compulsory, do not involve a quid pro quo in economic value.

Current transfers consist of all transfers that do not involve (i) transfers of ownership of fixed assets; (ii) transfers of funds linked to, or conditional upon, acquisition or disposal of fixed assets; (iii) forgiveness, without any counterparts being received in return, of liabilities by creditors. All of these are capital transfers.

Current transfers include those of general government (e.g., current international cooperation between different governments, payments of current taxes on income and wealth, etc.), and other transfers (e.g., workers’ remittances, premiums—less service charges, and claims on non-life insurance). A full discussion of the distinction between current transfers and capital transfers.

WHY ARE BOP STATISTICS IMPORTANT ? Balance of Payments statistics (at least estimates of major items) are regularly compiled, published and are continuously monitored by companies, banks, and government agencies. Often we find a news headline like "announcement of provisional US balance of payment figures sends the dollar tumbling down". Obviously, the BOP statement contains useful information for financial decision matters. In the short-run, BOP deficits or surpluses may have an immediate impact on the exchange rate. Basically, BOP records all transactions that create demand for and supply of a currency. When exchange rates are market determined, BOP figures indicate excess demand or supply for the currency and the possible impact on the exchange rate. Taken in conjunction with recent past data, they may confirm or indicate a reversal of perceived trends. Further, as we will see later, they may signal a policy shift on the part of the monetary authorities of the country, unilaterally or in concert with its trading partners. For instance, a country facing a current account deficit may raise interest rates to attract short-term capital inflow to prevent depreciation of its currency. Or it may otherwise tighten credit and money supply to make it difficult for domestic banks and firms to borrow the home currency to make investments abroad. It may force exporters to realize their export earnings quickly, and bring the foreign currency home. Movements in a country's reserves have implications for the stock of money and credit circulating in the economy. Central

bank's purchases of foreign exchange in the market will add to the money supply and vice versa unless the central bank "sterilizes" the impact by compensatory actions such as open market sales or purchases. Countries suffering from chronic deficits may find their credit ratings being downgraded because the markets interpret the data as evidence that the country may have difficulties in servicing its debt.

Finally, BOP accounts are intimately connected with the overall saving-investment balance in a country’s national

Brief history

During the period 1950-1951 until mid-December 1973, India followed an exchange rate regime with Rupee linked to the Pound Sterling, except for the devaluations in 1966 and 1971. When the Pound Sterling floated on June 23, 1972, the Rupee’s link to the British units was maintained; paralleling the Pound’s depreciation and effecting a de facto devaluation.

On September 24, 1975, the Rupee’s ties to the Pound Sterling were broken. India conducted a managed float exchange regime with the Rupee’s effective rate placed on a controlled, floating basis and linked to a “basket of currencies” of India’s major trading partners.

In early 1990s, the above exchange rate regime came under severe pressures from the increase in trade deficit and net invisible deficit, which led the Reserve Bank of India (RBI) to undertake downward adjustment of Rupee in two stages on July 1 and July 3, 1991. This adjustment was followed by the introduction of the Liberalized Exchange Rate Management System (LERMS) in March 1992 and hence the adoption of, for the first time, a dual (official as well as market determined) exchange rate in India. However, such system was characterized by an implicit tax on exports resulting from the differential in the rates of surrender to export proceeds.

Subsequently, in March 1993, the LERMS was replaced by the unified exchange rate system and hence the system of market determined exchange rate was adopted. However, the RBI did not relinquish its right to intervene in the market to enable orderly control.

Currrent Account convertibility –Pros and Cons

Current account convertibility opens up the domestic economy to foreign capital. Foreign capital augments investible resources of the home country and facilitates faster growth.Cost of capital for domestic firms is lowered and access to global capital markets is enhanced. Just as there is gains from international trade in goods and services, there are gains from trade in financial assets. It allows residents to hold globally diversified portfolios improving their risk return trade off. It lowers the funding cost for resident borrowers.

Economists talk of capital output ratio. In order for the GDP to grow at 8-9 percent, 25 percent more investment is required. Twenty to 25 percent of the country’s gross icome should be invested in various infrastructural assets. India’s investment rate has not been more than 20-25 percent of GDP at best of times. The remaining five to six percent must come from foreign investments otherwise we will not be able to achieve a high growth rate. Our savings rate should be 32-34 percent but in actuality it is only 26 percent. The gap has to be filled by foreign investment.

Take the case of Japan, Scandinavia, Europe—there the opportunities for investment are limited. They are looking for more attractive investments abroad which will give say, eight percent return as against the three percent they get in their own country. So money is lying idle in those countries. Developing countries are short of funds, therefore, the opening up of capital account does augment the investible resources of the home country. Our companies can access the capital and their cost of capital will come down. If we are to rely only on domestic capital, the cost would be high. Some investments will simply not be undertaken.

Export and import of goods and services is good for the welfare of all countries engaged in it. For example, software services from India, we do it much better than developed countries. But we have to import a lot of goods either because other countries produce it better. Then why not apply the same logic to capital.The major fear is not only about foreigners investing here but what if domestic investors start investing abroad. But why should they do it. As a wise investor, who will be tempted to invest abroad and earn three percent when the same investment can yield eight percent in the domestic market. Why should you park your investments abroad if the rate of return is low? Rate of return on investment has come to two percent in Japan.

In India it is 4.6 percent. Unless e are fearing a massive crisis—either a political or economic collapse, the fear about capital account convertibility is not justified. Our political system is working well, government is functioning well, no major political crises is also foreseen? We also do not expect an economic crisis as in Thailand. Foreign capital in India constitutes a very small part of the total capital. Particularly short term capital that has a maturity of six month. That constitutes a much small portion. Even if all of that leaves tomorrow, Indian economy is not going to collapse. Our total foreign debt as a percentage of GDP is very small. Short term debt component in that is still smaller. So this fear about taking foreign capital away from India if capital account convertibility comes is totally unjustified. Today India and China offer the best investment opportunity globally in manufacturing, services and infrastructure. Because of wrong policies in power, roads, ports, investments are not flowing in.Current account convertibility also means, competition among financial intermediaries, improves efficiency, cuts transaction costs, deepen financial markets.

Specialisation in financial services guided by core competence may be increased, increasing allocative efficiency. Capital account convertibility imposes certain disciplines on federal,state governments and policy makers. Domestic tax regimes and

other fiscal parameters must coverge to international standards to prevent capital flight from home. Competition is the best way to increase efficiency in public sector banks and other private banks. Our banking sector requires a dose of competition. Banks, investment companies, mutual funds and insurance sector will only benefit from competition.Capital accounts convertibility will also lead to specialization in products offered by banks. It also puts a cap on uncontrolled budget deficits, uncontrolled government expenditure thereby putting certain discipline in the Finance Ministry.

Large deficits show up on current account as debits and running up large current account deficits will lose the confidence of foreign investors in meeting our liabilities.When there is current account deficit, it means imports are more than exports. In normal situations it should not exceed 1.5-2 % of GDP. Anything beyond that is not sustainable and quite dangerous also. In Thailand, the current account deficit for three years was nine percent of GDP.If we have to keep current account under control then budget deficits should also be under control. They must raise more resources by way of taxation not by way of borrowing. Borrowing creates problems for the future as interest burden will increase. Large deficits will also lead to depreciation of currency.Imposes discipline on domestic macro economic policy making. Monetary policy must work within the constraints of uncovered interest rate regime must be in tandem with what is happening and cannot be arbitrary.

Right now the country’s capacity to attract foreign capital is substantial. Once the capital account is convertible then the monetory policy, interest rate policy, fiscal policy must converge to international standards a there cannot be any undue restriction on flow of money. What is the governmen’t attitude to the issue? 1) We must be able to follow our own monetory policy. 2)We must have exchange rate stability 3)Our currency, financial markets should be reasonably linked to foreign markets. But the fact is that a country cannot enjoy all three of them, only two. For eg. If you want freedom with monetary policy and foreign market linkages then exchange rate will not be quite stable. If you want stable exchange rates and linkage with rest of the world, the country cannot have an independent monetary policy. So current account deficits puts restrictions on the ability of government to run independent policies.

Financial markets will become volatile with interest rates, exchange rates fluctuating every minute. Banks, companies, individuals will have to learn to live with it. Financial derivatives have been evolved to manage these volatilities. Financial products to hedge the risks have to be in place. When foreign capital flows freely in the country in times of a political or economic crisis it can be taken back as freely by investors. In crisis times, every investor is not rational. They follow a herd mentality. The remedy for this is prudent economic management, prudent political management, but keeping political capital out is not the answer.

We have partial capital mobility? At present there are NRI, FCNR bank accounts and FII investments coming in. Will capital account convertibility bring more of those? No according to Jagdish Bhagavati. In China controls on capital and current account has not affected the flow of FDI. Why don’t we selectively open up sectors for foreign investors as China. Some say it is our labor laws and lack of infrastructure that is keeping foreign investment away and not capital controls.In the case of exchange rate, many countries have tied their currency to the US $ at fixed rate of exchange. Argentina, Hongkong, and China have done that. We have a market determined rate. Exchange rate will be fixed between $ and Rs by a Currency Board, a controversy that is yet to be settled. Many economists say if you want to have a stable current account what is required is a fixed exchange rate.In capital account convertibility regime, the risk of contagion of inevitable. If some thing goes wrong in Pakistan then investors panic and get away from India even if India is doing well. They might take the view that the entire South Asia is unsafe. This is what happened in the East Asian Crisis. South Korea and Malaysia were doing fine unlike Thailand but investors panicked and withdrew from all similar countries. Nobody can guarantee that even if inflation rates are moderate, budget deficits are low, current account deficit is low, then no crisis will occur. If neighbouring countries are not performing well, then investors might panic about a similar situation occurring in India.

Investors in developed countries do not distinguish between well-managed strong emerging economies and ill-managed weak economies. For them all emerging economies are emerging economies. South Korea and Malaysia were doing fine but when things went wrong in Thailand and Indonesia investors withdrew from all the places.

Before we move to a full current account convertibility we need to have other pre-requisites. Government must bring down fiscal deficit, RBI should be given full control of monetary policy. RBI cannot be under the rule of Finance Ministry. RBI Governor should have full freedom to determine interest rates and cash reserve ratio. In developed countries, the Central Bank has full autonomy. In the US, the President cannot tell the Central Bank what to do with monetary policy. President cannot impeach the Central Bank Governor and he can be removed only if a fraud has been committed. So India also needs to have monetary authority full independent of the government.

Inflation rates are modes-4 percent to five percent. Our current account deficit at the worst of times has not been more than 2.5 to 3 percent of GDP. Foreign exchange reserves are more than adequate.

Our banking system is not fully in good shape especially with regard to non-performing assets. Some nationalized banks have huge NPA’s and they also face competition from foreign and domestic private banks. Some of the weaker nationalized banks may have to be bailed out by government. Financial regulation is fairly good under RBI and SEBI. Sometimes they control too much, they should actually control less. The Exchange Control Manual is voluminous one and I wonder whether bankers themselves have read

it fully. For eg. Forward foreign exchange contracts that were once allowed freely have been restricted to either importers or exporters and sometimes as in 1998, RBI said cancelled contracts cannot be recouped.

Somehow, RBI is under the impression that Indian companies do not know what to do with the facilities. On the other hand, RBI should spread knowledge about indulging in foreign exchange dealing and their negative consequences if something goes wrong. Company managements are responsible to their shareholders and therefore it can be assumed that they would not indulge in dealings that could result in a loss.

The banking sector is opening up in the country, the statutory liquidity ratio requirements have been done away with. Therefore, most of the pre-conditions for current account convertibility are present in Indian economy.

Now we have to over come the fear about a Thailand or Indonesia-like crisis occurring here. Nobody can give a 100 percent assurance that it will not happen. Our experience with foreign investments by and large has been good. Economy is dong well and we have the capacity to absorb large amounts of foreign capital.

Critics of full convertibility argue that there are other ways of attracting foreign capital than implementing full convertibility. If labor laws are reformed, improvements in infrastructure are made then FDI will automatically flow in. Therefore, don’t open up financial markets.

Impact on Balance of Payments

The deficits in trade and current accounts of the balance of payments widened significantly after 1993-94 . The current account deficit, as a proportion of GDP, rose from 0.5 per cent in 1993-94 to 1.7 per cent in 1995-96. The gap between domestic savings and investment required to support the accelerating growth momentum of the economy widened in the aftermath of reforms, including trade liberalisation. The increase in the current account deficit since 1993-94 reflects the availability of foreign savings, or external resources, to bridge this higher savings-investment gap. The magnitude of the deficit itself should be no cause for alarm as long as the deficit finances higher capital formation, and is sustained by capital inflows without compromising prudent management of India's external debt position. In fact, capital inflows during the years 1993-94 and 1994-95 have not only financed the current account deficits, but also led to a foreign currency assets build-up of US $14.4 billion from US $6.4 billion at the end of 1992-93 to US $20.8 billion at the end of 1994-95. Furthermore, the capital inflows have been preponderantly of the non-debt creating variety with net foreign borrowings constituting only about 20 per cent of the total capital inflows during 1993-95. External debt and debt service indicators have moved in a favourable direction, reflecting substitution, on a relatively large scale, of non-debt

creating foreign investment for other forms of debt-creating capital flows, especially since 1993-94.

Foreign investment flows continued to dominate the capital account inflows, which helped to mitigate the pressure on the overall balance of payments from the current account in 1995-96. External assistance and commercial credits remained subdued. Non-resident deposits were stable. Repayments to the International Monetary Fund peaked in 1995-96. Residual financing requirements were met by drawing down foreign currency assets from US$20.8 billion at end-March 1995 to US$15.9 billion by end-February 1996, as part of a policy to manage the balance of payments and to counter the periodic speculative pressures on the exchange rate of the rupee during the second half of 1995-96. The management of the foreign exchange situation in February and March 1996 brought about a turnaround in exchange market sentiments, and reserves grew by over US $1 billion to reach a level of US $17.0 billion by end-March 1996. The improvement in reserves since March, 1996 has also been supported by the stance of monetary policy announced by the RBI in early February 1996. The movements in the nominal exchange rate of the rupee were, on the whole, consistent with maintenance of the competitiveness of Indian products in international markets.

Developments on the trade account so far during 1996-97 have led to an easing of the pressure on the current account of the balance of payments. There are signs of a deceleration in the growth of foreign trade, particularly of imports. The current trend seems to indicate that the initial impact of trade liberalization, which resulted in very high growth rates in exports and imports during the last three years, is petering out and trade flows are reverting back to their normal trend determined by world demand and domestic activity. Export growth in 1996-97 is likely to be only about 8 to 10 per cent in US dollar terms compared to 18 to 21 per cent in the last three years. Similarly, import growth, which averaged about 29 per cent (on BOP basis) in the last two years, is likely to be only about 6 per cent in the current year. The sharp deceleration in the growth of imports of items other than petroleum and petroleum products is only partly explained by the slow-down in industrial growth. The improvement in the trade deficit brought about by the slow-down in imports will be largely offset by the anticipated decline in net invisible receipts. As a result, the current account deficit in 1996-97 is likely to decline to about US $4.9 billion or 1.4 per cent of GDP from US $5.4 billion (1.7 per cent of GDP) in 1995-96 (Figures 6.2 and 6.3

ACCOUNTS

General

When an Indian national or person of Indian origin residing in India leaves India for a foreign country (other than Nepal and Bhutan) for taking up employment, business or vocation outside India, or for any other purpose, indicating his intention to say outside India permanently or for an indefinite period, he becomes a person resident outside India. His bank account, if any, in India is designated as an Ordinary Non-resident Account (NRO Account). Such accounts can also be opened with funds remitted from abroad. . As funds in this type of account are non repatriable, they cannot be remitted abroad to the account holders or transferred to their NRE Accounts without the Reserve Bank’s prior permission. Interest earned on these deposits is not exempt from Indian Income-tax.

Type of Account

The accounts may be maintained in the form of savings or current or term deposit accounts. The accounts can also be opened jointly by non-residents with their close relatives resident in India and operations thereon by the resident account holders can be made freely. If an account is used only for the personal or business needs of the resident account holder, it may be opened jointly even with a person who is not a close relative but this needs prior permission of the Reserve Bank. Interest earned on balances in NRO Accounts is not exempt from Indian Income-tax instead Income-tax (at present @ 20%) is deducted at source i.e. at the time of payment of interest by the bank. Balance held in NRO Account can neither be repatriated nor any remittance in foreign currency is allowed without prior approval of Reserve Bank.

Operation of the Account

There are not many restrictions on the operation of this account and a number of credit and debit transactions can be made after filling up Form A4. The following credit transactions can be made :

(a) Proceeds of remittances received in any permitted form through normal banking channels.

(b) Proceeds of foreign currency notes/traveller cheques tendered by the account holder during his temporary visit to India.

(c ) Remittance by way of transfer from rupees accounts of non-resident banks.

(d) Legitimate dues in rupees of the account holder in India.

Certain credits to the accounts such as proceeds of foreign inward remittances, dividend and interest earned on shares/securities acquired with the Reserve Bank’s permission (wherever necessary ) and held in India by the account holder, sale proceeds/maturity proceeds of shares/securities, surrender value of life insurance policies of the account holder and proceeds of cheques for small amounts upto specified limits can be made by banks without the Reserve Bank’ permission.

Following debit transactions can also be made after filling Form A4

(a) All local payments in rupees.

(b) Debits for investment and credits representing sale proceeds of investments may also be permitted by banks.

Withdrawals from these accounts can be freely made for local disbursements as well as for investments in Units of UTI, Government securities and National Plan/Savings Certificates, without prior approval of the Reserve Bank.

Change of Status from Resident to Non-resident Account vice versa

All resident accounts of a person with banks in India will automatically be treated ordinary non-resident accounts on his becoming non-resident.

Similarly NRO account may be redesignated as resident accounts on the account of holder becoming resident in India. It may be noted that residential status of a person will be determined as per the definition under Foreign Exchange Regulation AEligibility

Any person or entity residing outside India is entitled to open a NRO account with an authorised dealer or an authorised bank for transactions conducted in Indian Rupees.

Individuals or entities of Bangladeshi or Pakistani nationality or ownership require approval from the RBI.

Types of Accounts NRO accounts can be opened as current, savings, recurring or fixed deposit accounts. The RBI determines the rate of interest on these accounts and issues guidelines for opening, operating and maintaining them.

Joint Accounts with Residents/Non-residents Joint accounts are permitted with resident and non-residents.

Permissible Credits/Debits -

Credits -

Remittances from outside India through normal banking channels received in freely convertible foreign currency.

Any freely convertible foreign currency can be deposited into the account during the account holder's visit to India. Foreign currency exceeding USD 5000/- or its equivalent in the form of cash has to be supported by a Currency Declaration Form. Rupee funds must be supported by an Encashment Certificate, if they are funds brought from outside India.

Current income earned in India, such as rent, dividend, pension or interest. Even proceeds from sale of assets including immovable property acquired out of rupee or foreign currency funds or through inheritance. 

Debits -

All payments towards expenses and investments in India

Payment outside India of current income like rent, dividend, pension, interest etc. in India of the account holder.

Repatriation up to USD One million, per calendar year, for all bonafide purposes with the approval of the authorised dealer. 

Remittance of Assets -NRIs and PIO may remit upto USD One million per calendar year, out of balances held in the NRO account which could be acquired from the sale proceeds of assets acquired

in India out of rupee or foreign currency funds or by way of inheritance from a resident Indian, provided:

(a) Assets acquired in India out of rupee/foreign currency funds(i) Immovable property: NRIs and PIO may remit sale proceeds of immovable property purchased by them when they were resident or out of Rupee funds as NRI or PIO.(ii) Other financial assets: There is no lock-in period for remittance of sale proceeds of other financial assets

(b) Assets acquired by way of inheritance: Sale proceeds of assets acquired through inheritance can be remitted. No lock-in period applies here if the authorised dealer is satisfied that the proceeds are from inherited property.

Remittance of assets out of NRO account by a person resident outside India other than NRI/PIO A foreign national who is not a citizen of Pakistan, Bangladesh, Nepal or Bhutan and who

has retired as an employee in India,

has inherited assets from a resident Indian, or

is a widow residing outside India and has inherited assets of her deceased husband who was a resident Indian can remit upto USD one million per calendar year on production of documentary evidence to support the acquisition by way of inheritance or legacy of assets to the authorised dealer.

Restrictions -The above facility of repatriation from sale of immovable property is not extended to citizens of Pakistan, Bangladesh, Sri Lanka, China, Afghanistan, Iran, Nepal and Bhutan. Remittance of sale proceeds from other financial assets is not extended to citizens of Pakistan, Bangladesh, Nepal and Bhutan.

Foreign Nationals of non-Indian origin on a visit to India Foreign nationals of non-Indian origin are permitted to open a NRO account (current/savings) on their visit to India with funds remitted from outside India through normal banking channels or by foreign exchange brought to India. The balance in the NRO account is converted by the bank into foreign currency for payment to the account holder when he leaves India, provided the account was maintained for less than six months. The account should not be credited with any local funds during the term, except for interest accrued on it.

Grant of Loans/ Overdrafts by Authorised Dealers/ Bank to Account Holders and Third parties -Loans to NRI account holders and to third parties is granted in Indian Rupees by authorised dealers (banks) against the security of fixed deposits provided:

The loans are utilised only for meeting the borrower's personal requirements or for business and not for agricultural/plantation /real estate or relending activities

RBI regulations pertaining to margin and rate of interest will apply

All norms and considerations which apply to loans to trade and industry will apply to loans and facilities granted to third parties.

The authorised dealer/bank may allow an overdraft to the account holder subject to his commercial discretion and compliance with the interest rate directives.

Change of Resident Status of Account holder -

(a) From Resident to Non-resident When a resident Indian leaves India for taking up employment or for carrying on business outside India, his existing account is designated as a Non-Resident (Ordinary) Account, except in the case of persons shifting to Bhutan and Nepal. For the latter, the resident accounts do not change to NRO accounts.

(b) From Non-Resident to Resident NRO accounts may be re-designated as resident rupee accounts once the account holder returns to India for taking up employment, or for carrying on business or for any other purpose indicating his objective to stay in India for an uncertain period. Where the account holder is only on a temporary visit to India, the account continues to be treated as non-resident during the visit.

Treatment of Loans/ Overdrafts in the Event of Change in the Resident Status of the Borrower -In case of a resident Indian who had availed of loan or overdraft facilities while resident in India and who subsequently becomes a NRI, the authorised dealer may at its discretion allow the loan facility to continue. In this case, payment of interest and repayment of loan may be made by inward remittance or out of bonafide resources in India.

Payment of funds to Non-resident/Resident Nominee The amount payable to a non-resident nominee from the NRO account of a deceased account holder is credited to the NRO account of the nominee.

Facilities to a person going abroad for studies - Students going abroad for studies are treated as Non-Resident Indians (NRIs) and are eligible for all the facilities enjoyed by NRIs. All loans availed of by them as residents in India will continue to be extended as per FEMA regulations. 

International Credit Cards Authorised dealers are allowed to issue International Credit Cards to NRIs and PIO, without the permission of the RBI. Such transactions can be made by inward remittance or out of balances held in the cardholder's FCNR/NRE/NRO Accounts.

Income Tax The remittances, after payment of tax are allowed to be made by the authorised dealers on production of a statement by the remitter and a Certificate from a Chartered Accountant in the formats prescribed by the Central Board of Direct Taxes, Ministry of Finance, Government of India.

NRE ACCOUNT

What’s an NRE account?

A Non-Resident External (NRE) account is a bank account that’s opened by depositing foreign currency at the time of opening a bank account. This currency can be tendered in the form of traveler’s checks or notes.

 

Account Highlights:--

Savings / Current or Term Deposits accounts in Indian Rupees can be opened. Minimum period of NRE Term deposit is one year and maximum period is 3 years. The balances in these accounts can be repatriated outside India at any time. Transfer to / from other NRE / FCNR Account is possible. Accounts in the name of 2 or more NRI's are permitted. Nomination facility is available. Interest earned on deposit is exempted from Indian Income Tax. Balances in the accounts are free from wealth Tax. Gifts to close relatives in India from balances in the account are exempted from gift tax. NRE Account can be operated by resident in terms of Power of Attorney for Local

payments. Local disbursements from accounts can be made freely. Loans / Overdrafts can be availed against the security of Term Deposits. Premature withdrawals are allowed. Interest for such withdrawals is paid one percent

less than the rate payable for the period of deposit held. Standing instructions for local payments are accepted. Term Deposits will be allowed to be continued till maturity at the contracted rate on

return to India and re-designated as resident account. The depositor runs the risk of depreciation in Rupee against foreign currencies.

Schemes available under NRE Account:

Fixed Deposit (Simple Interest Deposit). Recurring Deposit (Monthly Interest Deposit). Muthukkuvial Deposit (Reinvestment Plan). Pearl Deposit (Reinvestment Plan with Compound Interest Payment).

FCNR ACCOUNT

Non-Resident Indians can open accounts under this scheme. The account should be opened by the non-resident account holder himself and not by the holder of power of attorney in India.

These deposits can be maintained in 5 designated currencies i.e. U.S. Dollar (USD), Pound Sterling (GBP) and Euro, Australian Dollar (AUD) & Canadian Dollar (CAD).

These accounts can only be maintained in the form of terms deposits for maturities of minimum 1 year to maximum 5 years.

These deposits can be opened with funds remitted from abroad in convertible foreign currency through normal banking channel, which are of repatriable nature in terms of general or special permission granted by Reserve Bank of India.

These accounts can be maintained with our branches, which are authorised for handling foreign exchange business. (List of branches authorised for handling foreign exchange business linked at the end).

Funds for opening accounts under PNB Global Foreign Currency Deposit Scheme or for credit to such accounts should be received from: -

- Remittance from outside India or- Traveller Cheques/Currency Notes tendered on visit to India. International Postal Orders cannot be accepted for opening or credit to FCNR accounts.- Transfer of funds from existing NRE/FCNR accounts.

If remittance is received in any currency other than USD, GBP, Euro, AUD & CAD, it will be converted into one of the designated currencies of remitter’s choice at the risk & cost of the depositor.

Rupee balances in the existing NRE accounts can also be converted into one of the designated currencies at the prevailing TT selling rate of that currency for opening of account or for credit to such accounts.

Advantages of FCNR (B) Deposits

- Principal alongwith interest freely repatriable in the currency of your choice.- No Exchange Risk as the deposit is maintained in foreign currency.- Loans/overdrafts in rupees can be availed by NRI depositors or 3rd parties against the security of these deposits. However, loans in foreign currency against FCNR (B) deposits in India can be availed outside India through our correspondent Banks.- No Wealth Tax & Income Tax is applicable on these deposits.- Gifts made to close resident relatives are free from Gift Tax.- Facility for automatic renewal of deposits on maturity and safe custody of Deposit Receipt is also available.

Payment of Interest

Interest on FCNR (B) deposits is being paid on the basis of 360 days to a year. However, depositor is eligible to earn interest applicable for a period of one year if the deposit has completed a period of 365 days.

For deposits upto one year, interest at the applicable rate will be paid without any compounding effect. In respect of deposits for more than one year, interest can be paid at intervals of 180 days each and thereafter for remaining actual number of days. However, depositor will have the option to receive the interest on maturity with compounding effect in case of deposits of over one year.

What is Capital Account convertibility????

Capital Account Convertibility (CAC) means freedom to convert domestic financial assets into overseas financial assets at market-determined rates. Simply put, the regime of full convertibility allows any Indian resident to go to a foreign exchange dealer or bank and freely convert rupees into dollars, pounds or Euros to acquire assets abroad. The overseas assets can be anything; equity, bonds, property or ownership of overseas firms.

It refers to the abolition of all limitations with respect to the movement of capital from India to different countries across the globe. In fact, the authorities officially involved with CAC (Capital Account Convertibility) for Indian Economy encourage all companies, commercial entities and individual countrymen for investments, divestments, and real estate transactions in India as well as abroad. It also allows the people and companies not only to convert one currency to the other, but also free cross-border movement of those currencies, without the interventions of the law of the country concerned.

Capital Account convertibility in its entirety would mean that any individual, be it Indian or Foreigner will be allowed to bring in any amount of foreign currency into the country. Full convertibility also known as Floating rupee means the removal of all controls on the cross-border movement of capital, out of India to anywhere else or vice versa. Capital account convertibility or CAC refers to the freedom to convert local financial assets into foreign financial assets or vice versa at market-determined rates of interest. If CAC is introduced along with current account convertibility it would mean full convertibility.

Complete convertibility would mean no restrictions and no questions. In general, restrictions on foreign currency movements are placed by developing countries which have faced foreign exchange problems in the past is to avoid sudden erosion of their foreign exchange reserves which are essential to maintain stability of trade balance and stability in their economy. With India’s forex reserves increasing steadily, it has slowly and steadily removed restrictions on movement of capital on many counts.

The last few steps as and when they happen will allow an Indian individual to invest in Microsoft or Intel shares that are traded on NASDAQ or buy a beach resort on Bahamas or sell home or small industry and invest the proceeds abroad without any restrictions.

Components of Capital Account: -

1. Foreign Investment(FDI, FII)2. Banking Capital (NRI Deposits)3. Short term credit 4. External Commercial Borrowings(ECB)

Accounting of total inflow and outflow of Funds is as follows: -

Increase in foreign ownership of domestic assets – Increase of domestic ownership of foreign assets = FDI + Portfolio Investment + Other investments.

FDI: - At present, there are limits on investment by foreign financial investors and also caps on FDI ceiling in most sectors, for example, 74% in banking and communication, 49% in insurance, 0% in retail, etc.

Need for Capital Account Convertibility: -

1. Capital account convertibility is considered to be one of the major features of a developed economy. It helps attract foreign investment. It offers foreign investors a lot of comfort as they can re-convert local currency into foreign currency anytime they want to and take their money away.

2. Capital account convertibility makes it easier for domestic companies to tap foreign markets. At the moment, India has current account convertibility. This means one can import and export goods or receive or make payments for services rendered. However, investments and borrowings are restricted.

3. It also helps in the efficient appropriation or distribution of international capital in India. Such allocation of foreign funds in the country helps in equalizing the capital return rates not only across different borders, but also escalates the production levels. Moreover, it brings about a fair allocation of the income level in India as well.

4. For countries that face constraints on savings and capital can utilise such flows to finance their investment, which in turn stokes economic growth.

5. Local residents would be in a position to diversify their portfolio of assets, which helps them insulate themselves, better from the consequences of any shocks in the domestic economy.

6. For global investors, capital account convertibility helps them to seek higher returns by sharing risks.

7. It also offers countries better access to global markets, besides resulting in the emergence of deeper and more liquid markets.

8. Capital account convertibility is also stated to bring with it greater discipline on the part of governments in terms of reducing excess borrowings and rendering fiscal discipline.

How does Capital Convertibility affect you?

As most of us know, resident Indians cannot move their money abroad freely. That is, one has to operate within the limits specified by the Reserve Bank of India and obtain permission from RBI for anything concerning foreign currency.

For example, the annual limit for the amount you are allowed to carry on a private visit abroad is $10,000: of which only $5,000 can be in cash. For business travel, the yearly limit is $25,000. Similarly, you can gift or donate up to $5,000 in a year.

The RBI raises the limit if you are going abroad for employment, or are emigrating to another country, or are going for studies abroad: the limit in both these cases is $100,000.

You are also allowed to invest into foreign stock markets up to the extent of $25,000 in a year.

For the average Indian, these 'limits' seem generous and might not affect him at all. But for heavy spenders and those with visions of buying a house abroad or a Van Gogh painting, it will mean a lot.

But with the markets opening up further with the advent of capital account convertibility, one would be able to look forward to more and better goods and services.

Evolution of CAC in India economic and financial scenarios:

In early 1990s India was facing foreign reserve crisis, the foreign reserves were only sufficient to pay off two weeks import; therefore India was forced to liberalize the economy. In 1994 August, the Indian economy adopted the present form of Current Account Convertibility, compelled by the International Monetary Fund (IMF) Article No. VII, the article of agreement. The primary objective behind the adoption of CAC in India was to make the movement of capital and the capital market independent and

open. This would exert less pressure on the Indian financial market. The proposal for the introduction of CAC was present in the recommendations suggested by the Tarapore Committee appointed by the Reserve Bank of India.

Currency Crisis in Emerging Market Economies (EME)

1. The East Asian currency crisis began in Thailand in late June 1997 and afflicted other countries such as Malaysia, Indonesia, South Korea and the Philippines and lasted up to the last quarter of 1998. 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. These macroeconomic factors were exacerbated by microeconomic imprudence such as maturity mismatches, currency mismatches, moral hazard behaviour of lenders and borrowers and excessive leveraging.

2. The Mexican crisis in 1994–95 was caused by weaknesses in Mexico's economic position from an overvalued exchange rate, and current account deficit at 6.5 per cent of Gross Domestic Product (GDP) in 1993, financed largely by short-term capital inflows.

3. Brazil was suffering from both fiscal and balance of payments weaknesses and was affected in the aftermath of the East Asian crisis in early 1998 when inflows of private foreign capital suddenly dried up. After the Russian crisis in 1998, capital flows to Brazil came to a halt.

4. Difficulties in meeting huge requirements for public sector borrowing in 1993 and early 1994, led to Turkey's currency crisis in 1994. As a result, output fell by 6 per cent, inflation rose to three-digit levels, the central bank lost half of its reserves, and the exchange rate depreciated by more than 50 per cent. Turkey faced a series of crisis again beginning 2000 due to a combination of economic and noneconomic factors.

Some Lessons from Currency Crisis in Emerging Market Economies: -

1. Most currency crises arise out of prolonged overvalued exchange rates, leading to unsustainable current account deficits. As the pressure on the exchange rate mounts, there is rising volatility of flows as well as of the exchange rate itself. An excessive appreciation of the exchange rate causes exporting industries to become unviable, and imports to become much more competitive, causing the current account deficit to worsen.

2. Large unsustainable levels of external and domestic debt directly led to currency crises. Hence, a transparent fiscal consolidation is necessary and desirable, to reduce the risk of currency crisis.

3. Short-term debt flows react quickly and adversely during currency crises. Receivables are typically postponed, and payables accelerated, aggravating the balance of payments position.

4. Domestic financial institutions, in particular banks, need to be strong and resilient. The quality and proactive nature of market regulation is also critical to the success of efficient functioning of financial markets during times of currency crises.

Existing challenges to FCAC: -

1. Market risks such as interest rate and foreign exchange risks become more complex as financial institutions and corporate gain access to new securities and markets, and foreign participation changes the dynamics of domestic markets. For instance, banks will have to quote rates and take unhedged open positions in new and possibly more volatile currencies. Similarly, changes in foreign interest rates will affect banks’ interest sensitive assets and liabilities.

2. Credit risk will include new dimensions with cross-border transactions. For instance, transfer risk will arise when the currency of obligation becomes unavailable to borrowers. Settlement risk (or Herstatt risk) is typical in foreign exchange operations because several hours can elapse between payments in different currencies due to time zone differences. Cross-border transactions also introduce domestic market participants to country risk, the risk associated with the economic, social, and political environment of the borrower’s country, including sovereign risk.

3. With FCAC, liquidity risk will include the risk from positions in foreign currency denominated assets and liabilities. Potentially large and uneven flows of funds, in different currencies, will expose the banks to greater fluctuations in their liquidity position and complicate their asset-liability management as banks can find it difficult to fund an increase in assets or accommodate decreases in liabilities at a reasonable price and in a timely fashion.

4. Risk in derivatives transactions becomes more important with capital account convertibility as such instruments are the main tool for hedging risks. Risks in derivatives transactions include both market and credit risks. For instance, OTC derivatives transactions include counterparty credit risk. In particular, counterparties that have liability positions in OTC derivatives may not be able to meet their obligations, and collateral may not be sufficient to cover that risk. Collecting and analyzing information on all these risks will become more challenging with FCAC because the number of foreign counterparts will increase and their nature change.

5. Operational risk may increase with FCAC. For instance, legal risk stemming from the difference between domestic and foreign legal rights and obligations and their enforcements becomes important with fuller capital account convertibility.

6. Adequate prudential regulation and supervision, and developed capital markets will also be key in addressing the challenges from FCAC. Prudential regulation and supervision will need to encompass the existing and new risks associated with FCAC. In addition, developed capital markets with adequate liquidity, infrastructure, and

market discipline are necessary to provide market participants with the relevant risk management instruments.

60:40 CONVERSION RATIO TILL 1992 AND LERMS (LIBERALISED EXCHANGE RATE MANAGEMENT SYSTEM)

A market channel in which the exchange rate is determined by market forces of supply and demand of foreign exchange where access if free for all transactions (other than those specified as not free).

An official channel where the exchange rate continues to be determined by RBI on the base of the value of rupee in relation to the basket of currencies and fixed, but access to the market is restricted.

With view to giving effect to the PCR. RBI introduced a system called the Liberalized Exchange Rate Management System (LERMS) effective from 1st March 1992.

Till 1st March 1992 all foreign exchange remitted into India was implicitly handed over to RBI by Authorized Dealers (ADs) and then RBI made a Foreign exchange available for approved purpose. Under new system, the RBIs retention ratio has been reduced from 100% to 40% of all foreign exchange remittances received with effect from 1.3.1992. The ADs apply the official exchange rate in calculating the value of rupees to be paid to the remitter for this 40% and surrender the exchange to the RBI. The remaining 60% of the value of the remittance is purchased by AD at a market-determined exchange rate. AD s, retain this 60% portion for sale to other AD s, authorized broker or buyer of foreign exchange.

TARAPORE COMMITTEE

1. EstablishmentThe first Tarapore committee report on capital account convertibility (CAC), which came out in May 1997, wanted CAC to be phased in over three years (1997-2000)

The five-member committee has recommended a three-year time frame for complete convertibility by 1999-2000. The highlights of the report including the preconditions to be achieved for the full float of money are as follows:- 

2. Pre-Conditions Set By Tarapore Committee :

        Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5 per cent in 1997-98 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 1997-2000

        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%.

TARAPORE COMMITTEE -II

In the Year 2006 under Manmohan Singh Government the Tarapore Committee reappointed to give suggesstion on adoption of Fuller Capital Account Convertibility (FCAC). The Committee has given the following recommendation and the whole process was divided into 3 phases :

Phase – I (2006-07)Phase- II (2007-09)Phase – III (2009-11)

The difficulty is that PNs have come to dominate FII inflows in recent years — in 2005-06, they accounted for around 80% of all incremental FII inflows. It is the sheer magnitude of PN-related inflows that raises concerns

Tarapore-II makes wide-ranging recommendations on the strengthening of the banking sector. At times, it appears to over-step its brief. It is one thing to argue that government’s holdings in public sector banks should be brought down to 33% as this would help banks augment their capital

ACTUAL V/S PROJECTION

India has not achieved the targetted pre-condition directed by the Tarapore Committee. This shows that still India is much behind from achieving the FCAC because India has not achieved the pre-condition itself. It is compared in the below part as how Indias position is different from the targetted figures for the economy.

FULLER CAPITAL ACCOUNT CONVERTIBILITY

CONCEPT :

Capital Account convertibility in its entirety would mean that any individual, be it Indian or Foreigner will be allowed to bring in any amount of foreign currency into the country.Full convertibility also known as Floating rupee means the removal of all controls on the cross-border movement of capital, out of India to anywhere else or vice versa.

Capital account convertibility or CAC refers to the freedom to convert local financial assets into foreign financial assets or vice versa at market-determined rates of interest . If CAC is introduced along with current account convertibility it would mean full convertibility.

Complete convertibility would mean no restrictions and no questions. In general, restrictions on foreign currency movements are placed by developing countries which have faced foreign exchange problems in the past is to avoid sudden erosion of their foreign exchange reserves which are essential to maintain stability of trade balance and stability in their economy. With India’s Forex reserves increasing steadily, it has slowly and steadily removed restrictions on movement of capital on many counts.

Capital account convertibility means that an investor is allowed to move freely from the local currency to a foreign currency. India has limited capital account convertibility to prevent shocks to the capital account and maintain a stable exchange rate, by stipulating sectoral norms that ensure a lock-in period for investments.

FDI Norms

The press notes simplify the method for calculating FDI and broadly state that as long as Indian promoters hold a majority stake (more than 51 per cent) in any operating-cum-investing company, it can bring investment up to 49.9 per cent through FDI. This company would be treated as an Indian company and it can invest through a joint venture in any other company that may be engaged in industries in which FDI has a sectoral limit.

Several companies like retailer Pantaloon and media house UTV have restructured their organizations to raise FDI in their businesses through step-down joint ventures — FDI is prohibited in multi-brand retail and is restricted to 26 per cent for media

In one sweep, therefore, any sectoral cap of 49 per cent and below has become meaningless in so far as downstream investment by a company with foreign investment below 50 per cent and qualifying as an Indian owned and controlled company,” the DEA argued in a letter, sources said.

“Such a company can apply for cable TV operations (49 per cent cap), FM broadcasting license (20 per cent cap), licensed defence items manufacture (26 per cent cap), printing news papers (26 per cent cap) up linking TV news channels (26 per cent cap) etc. Whether this stance has been approved as such or is an unintended liberalisation is not clear,” the DEA letter said..

OBJECTIVES

Economic Growth

The Introduction of FCAC will help in the economic development of the country through capital investment in the country. This lead to employment generation in the country, infrastructure development, global competition etc.

Improvement in Financial Sector

There would be improvement in the financial sector as huge capital flow into the sysytem, which will help the companies to perform better. It will boost liquidity into the system.

Diversification of InvestmentIt will also help in the diversification of Investment by ordinary people, wherein they can invest abroad without any restriction and diversify their portfolio.

RISK INVOLVED IN FCAC

Market Risk Credit Risk Liquidity Risk Derivative Transaction Risk Operational Risk

Market risks such as interest rate and foreign exchange risks become more complexas financial institutions and corporates gain access to new securities and markets, andforeign participation changes the dynamics of domestic markets. For instance, bankswill have to quote rates and take unhedged open positions in new and possibly morevolatile currencies. Similarly, changes in foreign interest rates will affect banks’interest sensitive assets and liabilities. Foreign participation can also be a channelthrough which volatility can spill-over from foreign to domestic markets.

Credit risk will include new dimensions with cross-border transactions. For instance,transfer risk will arise when the currency of obligation becomes unavailable toborrowers. Settlement risk (or Herstatt risk) is typical in foreign exchange operationsbecause several hours can elapse between payments in different currencies due totime zone differences. Cross-border transactions also introduce domestic marketparticipants to country risk, the risk associated with the economic, social, andpolitical environment of the borrower’s country, including sovereign risk.

With FCAC, liquidity risk will include the risk from positions in foreign currencydenominated assets and liabilities. Potentially large and uneven flows of funds, indifferent currencies, will expose the banks to greater fluctuations in their liquidityposition and complicate their asset-liability management as banks can find it difficultto fund an increase in assets or accommodate decreases in liabilities at a reasonableprice and in a timely fashion.

Risk in derivatives transactions become more important with capital accountconvertibility as such instruments are the main tool for hedging risks. Risks inderivatives transactions include both market and credit risks. For instance, OTCderivatives transactions include counterparty credit risk. In particular, counterpartiesthat have liability positions in OTC derivatives may not be able to meet theirobligations, and collateral may not be sufficient to cover that risk. Collecting andanalyzing information on all these risks will become more challenging with FCACbecause the number of foreign counterparts will increase and their nature change.

Operational risk may increase with FCAC.4 For instance, legal risk stemming fromthe difference between domestic and foreign legal rights and obligations and theirenforcements becomes important with fuller capital account convertibility. Forinstance, differences in bankruptcy codes can complicate the assessment of recovery

values. Similarly, differences in the legal treatment of secured transactions for reposcan lead to unanticipated loss.

Regulatory issues include the risk of regulatory arbitrage as differences in regulatoryand supervisory regimes among countries may create incentives for capital to flowfrom countries with higher standards to those with lower ones. FCAC can also bring aproliferation of new instruments and market participants, complicating the task offinancial supervisors and regulators. The entry of large and complex institutionsoperating in different countries will increase the need for cooperation andcoordination between domestic regulatory and supervisory agencies and also withtheir foreign counterparts

CHALLENGES IN ADOPTING FCAC

Risk Management Interest Rate & Liquidity Risk Management Derivative Risk Management

• To better manage liquidity risk, the report recommends that banks monitor theirliquidity position at the head/corporate office level on a global basis, including both atthe domestic and foreign branches. In addition the liquidity positions should bemonitored for each currency.

• Regarding market risk, the report recommends that banks adopt a duration gapanalysis and consider setting appropriate internal limits on their interest rate riskexposures. The Tarapore report also suggests that the RBI link the open positionlimits to banks’ capacity to manage foreign exchange risk as well as their unimpairedTier I capital.

• Banks will require more derivatives instruments to mitigate the possible risks fromfuller capital account convertibility. These should include interest rate futures andoptions, credit derivatives, commodity derivatives, and equity derivatives, which arenot effectively available to banks at the moment. The RBI should, however, put inplace the appropriate infrastructure, including a robust accounting framework; arobust independent risk management framework in banks, including an appropriateinternal control mechanism; appropriate senior management oversight andunderstanding of the risks involved; comprehensive guidelines on derivatives,including prudential limits wherever necessary; and appropriate and adequatedisclosures. prudential limits wherever necessary; and appropriate and adequatedisclosures.

FINANCIAL INTEGRATION: WHAT IT MEANS

The commonly accepted definition of Financial Integration [1] states that all potentialparticipants in a market:

Are subject to a single set of rules when dealing with financial products and/orservices.

Have equal access to this specific set of financial instruments/services. Are treated equally when they operate in the market.

Alternately, we can classify financial integration into two forms (USAID, 1998): Horizontal Integration:

This relates to the interlinking among domestic financial market segments. Vertical integration:

This refers to integration between domestic market and regional or internationalFinancial markets.

An integrated financial market is characterized by following traits: Financial markets are efficient (A market is called efficient if the rate prevailing

at any point of time reflects all the existing information available in the market). Rates are market-determined. Rates of Return are related to some benchmark/reference rate (such as LIBOR). There is resource flow from one segment of the market to others. Thus arbitrage

Opportunities are ruled out. Rates of various financial market segments tend to move in tandem.

The international financial system is in a state of introspection, jolted by several financial crises caused by violent capital movements over the last two decades. On their part, Indian policy-makers are also in a state of revisionism and are moving the country to greater capital account openness after several decades of extensive controls.

The proponents of full capital account convertibility advance these arguments in its favour:

1) An arbitrary (i.e. pre-capital mobility) distribution of capital among different nations is not necessarily efficient, and all countries, irrespective of whether they borrow or lend, stand to gain from the reallocation caused by freer capital mobility. National income goes up in the country experiencing capital outflows due to higher interest incomes, while that in the debtor country increases as the interest paid is less than the increase in output.

2) Capitalists in the labour-abundant economies tend to lose with a fall in the marginal productivity of capital, and the opposite happens in labour-scarce countries, so that developing nations, which are usually capital-scarce, are doubly blessed under unhindered mobility of capital — the inflow of capital raises the national income and produces a healthy, egalitarian impact on income distribution as well.

3) It is argued that if there is only a small correlation between the returns on investment in different countries, risk can be reduced by the ownership of income-earning assets across different countries. Free mobility of capital, thus, helps reduce the risks that each country is subjected to.

4) Finally, it is argued that when full capital account convertibility is in place, government profligacy and distortionary policies are likely to be followed by currency crises that threaten to make the government highly unpopular. Therefore, under capital account convertibility, the salubrious effects of capital mobility are magnified through a change in domestic policy in the right direction.

This rosy picture painted by traditional neo-liberal thinking is sullied when we look at what actually happened to developing nations that have gone the full-capital account convertibility way in the 1980s and 1990s.

1) In a widely quoted study, Dani Rodrik (1998) finds little evidence of any significant impact of capital account convertibility on the growth rate of a country. Worse, a 1999 World Bank survey of 27 capital inflow surges between 1976 and 1996 in 21 emerging market economies found that in about two-thirds of the cases, there was a banking crisis, currency crisis or twin crises in the wake of the surge.

2) Since the early 1970s, there have been several crises triggered by speculative capital movements: the Southern Cone financial crisis in the late 1970s; the Mexican crisis of 1994-95 and the `Tequila Effect'; the East Asian crisis of 1997; the collapse of the Brazilian real and its impact on the rest of Latin America; the Russian crisis of 1998 and the Argentine crisis of 2001.

Here are the theoretical counter-arguments why full convertibility is correlated with the crises and why, even otherwise, it is not such a good thing:

1) Contrary to the assumption of the neo-classical model, a large volume of capital inflows into developing countries has actually been used for speculative purposes rather than for financing productive investments.

2) Capital account convertibility exposes the economy to all sorts of exogenous impulses generated through financial channels, as domestic and foreign investors try to shift their funds into or out of a country. Since financial markets adjust very quickly, even minor disturbances may exacerbate into major ones.

3) Under flexible exchange rates, capital inflows lead to an appreciation of the domestic currency directly. On the other hand, in a fixed exchange rate regime, increased capital inflows lead to monetary expansion and price inflation (unless there is substantial unutilised capacity), which also causes a real appreciation. In both cases, therefore, capital inflows tend to cause a real appreciation and the possibility of swollen current account deficits because of cheaper imports and uncompetitive exports which, if not controlled in time, will lead to loss of confidence and capital flight.

4) Because of the massive volume and high mobility of international capital, it has been observed that the government tries to play it safe by keeping interest rates high, thus discouraging domestic private investment. The government also desists from spending on public investment because, through an expansion in government spending, it could send signals of impending increases in fiscal deficits that have the potential of destabilising capital markets and inducing capital flight.

Policy implications for India

The experience with liberalisation of inward capital flows in India has been similar to the economies of Latin America and East Asia, only the magnitude of these flows has not been large enough to cause serious macro and micro management problems.

Based on the experience of other countries, the following issues are of concern for India:

1) Flexibility in exchange rate: To prevent a nominal appreciation because of the capital inflows, the RBI has been adding billions of dollars to its reserves; the foreign exchange reserves with the RBI are a whopping $69 billion.

2) However, intervening foreign currency purchases to stabilise the exchange rate and accumulation of forex reserves have implications for domestic monetary management, which can be seriously impaired by divided short-term monetary responses during a capital surge.

3) On the other hand, the option of a more flexible exchange rate would cause an appreciation in the value of the rupee, which may hurt exports.

4) Hence, the usual macroeconomic trilemma (Obstfield, M and A. M Taylor 2001) where only two of the three objectives of a fixed exchange rate — capital mobility and an activist monetary policy — can be chosen. Since the government has already liberalised inflows of capital to a large extent, the authorities could attempt to deal with this problem in one of the following ways: It could begin relaxing capital controls,

allowing individuals to exchange rupees for dollars. Indeed, some piecemeal measures in this direction have already been taken. But this, perhaps, is a risky proposition.

4) For one thing, the embrace of full convertibility is itself likely to bring more dollars into the country in the initial phase and add to the existing upward pressure on the rupee. More important, given the lack of regulatory capacity, such convertibility runs the risk of a future financial crisis that may scuttle the growth process.

5) Alternatively, the government could tap this opportunity to liberalise imports. Further liberalisation will stimulate imports and create the necessary demand for dollars, mopping up the excess supply of dollars and relieving the government of the burden of low-yielding foreign exchange reserves.

6) In as much as the imports are used as inputs for further exports, the move will kill two birds with one stone — it will relieve the upward pressure on the rupee, and bring the usual efficiency gains. In this regard, therefore, import liberalisation seems to be a distinctly better option.

7) Banking and capital market regulatory system: The relatively greater contribution of portfolio capital towards India's capital account, and the fact that these inflows could increase to significant levels in the future as India's financial markets get integrated globally, show that an important sphere of concern is their skilful management to facilitate smooth intermediation.

8) Banks intermediate a substantial amount of funds in India — over 64 per cent of the total financial assets in the country belong to banks. However, many Indian banks are undercapitalised, and their balance sheets characterised by large amounts of non-performing assets (NPAs).

9) Unless banking standards are duly brushed up, viable competition introduced and government interference reduced, it would be reckless to go in for full capital account convertibility, which requires flexibility, dynamism and foresight in the country's banking and financial institutions.

10) Transparency and discipline in fiscal and financial policies: It is well known that the last thing that a government wanting to gain the confidence of investors should do is to be fiscally imprudent. However, New Delhi does not seem to be paying heed to this consideration at all.

The ratio of gross fiscal deficit to GDP (including that of states) increased to 10.4 per cent in 1999-2000 from 6.2 per cent in 1996-97 and 8.5 per cent in 1998-99, and has hovered around the 10 per cent figure since then. Such high fiscal deficits can prove to be unsustainable and frighten away investors.

11) Hence, there is an immediate need for putting brakes on government expenditure, and until that has been satisfactorily done, opening up the capital account fully would carry with it a big risk of sudden loss of faith of investors and capital flight.

Caution on outflows

Whatever the apparent theoretical benefits of capital account convertibility, they have not yet been vindicated by the actual empirical evidence; rather, the experience of the countries in the developing world that have experimented with capital account convertibility has been that of increased market volatility and financial crises.

Moreover, at least a part of the large inflows of capital into India are a consequence of the recessionary conditions elsewhere. The country's macroeconomic fundamentals, though better than before, are not good enough to warrant long-lasting confidence from foreign investors. The reform process is not proceeding with adequate speed, banks are saddled with large volumes of non-performing assets, the financial system is not deep or liquid enough and the country ranks high in the list of corrupt nations.

Once the conditions in the rest of the world improve, and the interest rate differentials between India and the rest of the world narrow further, this capital may move on to greener pastures. Hence, one cannot bank on the continuous supply of foreign capital to finance whatever outflows occur from the country.

Therefore, we believe that India should be extremely cautious in liberalising capital outflows any further.

While it should leave no stone unturned to promote inward FDI, which, because of its very nature, is less susceptible to sudden withdrawals and also tends to promote productive use of capital and economic growth, it should be wary of short-term capital flows that have the potential to destabilise financial markets

The `slow and steady' stance that the RBI has taken towards capital account convertibility is to be appreciated.

It must be emphasised that only over time will the Indian economy be mature enough to be comfortable with full capital account convertibility — financial markets will deepen, macroeconomic and regulatory institutions grow more robust and the government will learn from past mistakes.

The Government would do well to focus at present on the fundamental processes of institutional development and policy reform because, in the long run, these would serve the country better than an early move towards full capital account convertibility.

Economists realize that directly jumping into fuller capital account convertibility without taking into consideration the downside or the disadvantages of the steps could harm the economy.

The East Asian economic crisis can be a classic example to cite for those who are opposed to fuller capital convertibility. The further question that should be raised is that why is India so desperate in pushing ahead with the liberalization agenda. So what if there have been enormous global developments and developments in the last few years. It should be bore in mind at the very outset that attracting greater capital inflow into the country can barely provide a reason for greater or full convertibility. Capital inflows in India are far in excess of what is needed to finance the current account of the balance of payments. According to the report,

‘During the 2005-2006, the current account deficit has been comfortably financed by the net capital flows with over U.S. $15 billion added to the foreign exchange reserves.

World Bank has said that embracing CAC without necessary precautions could be absolutely disastrous. At this stage of the country’s economic growth, fuller convertibility on capital account cannot be an objective per se, although it can be a step towards creating opportunities in achieving more goals of economic policies. The major hindrance to fuller convertibility of the rupee is the fiscal deficit of the centre and the states, which is around 10 percent of GDP, which is grossly high when we talk of opening a capital account. ‘Opening a country’s capital account when it has unsustainably high fiscal deficit can be likened to administering polio drops to a child suffering from high fever; it can prove fatal. It should be clearly bore in mind that until India reaches with a figure of 3 percent of GDP, it would be imprudent to give a sudden move to fuller convertibility of capital account and which is not insurmountable, so to say. Though the committee has emphasized on reducing fiscal deficit, as a necessary condition for fuller convertibility, it has not set a time-map for the same hitherto. Capital account convertibility should be treated as a process and not an event. The plan for further convertibility on capital account will depend, however on several factors, as well as on international developments. The most native but at the same time most fundamental argument put forward for CAC was that free markets are inherently better than restricted markets. Just as the government should eliminate barriers to trade, they should also eliminate barriers to the free flow of capital because doing so leads to better economic performance measured in growth, efficiency and stability. A second argument was that CAC enhances stability as countries trap into a diversified source of funds. CAC increases the welfare of domestic investors by allowing them to invest abroad and diversify risk. CAC is widely regarded as a prestige characteristic of an economy. It gives confidence to the foreign investors who are assured that anytime they change their mind, they can reconvert local currency back into foreign currency and take it out. Lots of people assume that a liberal capital account is, by itself, a desirable objective of economic policy.

Capital account liberalization leads to the availability of a larger capital stock to supplement domestic resources and thereby higher growth. To add, CAC allows residents to hold an internationally diversified portfolio, which reduces the vulnerability of income and wealth to domestic shocks. It is also argued that CAC has a disciplinary influence on domestic policies. It does not allow monetary policy to take on an excessive burden of the adjustments. At the same time CAC enhances the effectiveness of fiscal policy by:

a) Reducing real interest rate applicable to public sector borrowing

b) Bringing about an optimal combination of taxes through a reduction of the inflation tax and in the rate of other taxes to international levels with beneficial effect for tax revenues

c) Reducing crowding out effect in the access to funds.

On the face of it, CAC seems to be a panacea to all financial problems and bottlenecks. But there is hardly any empirical evidence and studies to support and substantiate the free flow of capital. Free mobility of capital exposes a country to both sudden and huge inflows as well as outflows of foreign capital, which can be potentially destabilizing the economic growth of a country. Thus, it is necessary for a country to have experienced institutions to deal with such huge flows.

“It may be recalled that in 1980s, many developing countries introduced CAC in a bid to attract foreign investments. After the disastrous experience of some East Asian Countries, developing countries ( India in particular) have become very cautious in adopting CAC”. It is an undisputable fact that in the arena of globalization, we have financial integration in the markets all over the world. But it should be bore in mind that before taking any quick decision about fuller CAC, one must properly understand the volatilities of these inflows. India has successfully avoided the trap so far and policy makers must remain cautious as regards to CAC. Jagdish Bhagwati’s interesting take on the risks of CAC becomes relevant when he says “cease and desist from moving rapidly to full convertibility until you have gained political stability, economic prosperity and substantial macroeconomic expertise- and not just transparency and better banking supervision..” Countries are exposed to great risk when they liberalize. But the people of the countries-----especially workers, small businesses, and the poor----have no way of protecting themselves against these risks. The argument that CAC allows residents to diversify risk by investing abroad focuses on the benefits for a small group of residents while it ignores the larger affects ion society as a whole. In late 1990s, Chile relaxed restrictions on domestic pension funds investing abroad. The pension funds then speculated against the national currency and deepened the BOP problems in the aftermath of the Asian crisis. Domestic pension funds and domestic investors were the main agents behind the massive capital flows. What is perhaps the most important argument against CAC can be stated in three words: it increases instability. CAC allows speculative capital to flood into a country. While the money flows in, the currency appreciates. The capital inflows may support short term growth, but they can also lead to an unsustainable expansion of consumption, and to changes in the structure of production. The most compelling case against CAC is that it leads to instability. Nonetheless CAC could be desirable if it led to a faster economic growth.

There is no doubt that economic indicators of Indian economy have improved quite a bit since 1997. But so far as fuller CAC is concerned India has yet to go a long way ahead. International experience shows that India should be very careful and calibrated while deciding towards fuller CAC.

In general, at this stage of the country’s development, CAC cannot be an objective per se but should be considered as a means to achieving more fundamental objectives of economic policy.

From what was a nebulous concept a decade ago, could become a reality soon. If satisfied the above cited problems, CAC could be the logical culmination of India 's journey towards globalization. It should be carefully determined about whether the risks involved in fuller convertibility of capital account seems to be greater than the rewards

we get from it. To the mind of the researcher at this stage of the country’s economic development, capital account convertibility cannot be a desired means per se, but India can step forward by the means of it to maximize more economic goals.

The fact that fuller convertibility has been a subject of fierce debate from past five years and the reasons in being so has been addressed throughout the course of this paper.

It has been also elaborated that the risks involved in fuller capital account convertibility are much more that the fruits we get from it.

For India is it not the right time to go for full convertibility. Taking into consideration of the Asian crisis, we need not touch the fire and set an example just like. It must be remembered that the move towards capital account convertibility calls for a conformist and cautious approach.

The Asian financial crisis sealed the fate of that recommendation but the FM has once again revived the issue.

There are five reasons why India should not rush into convertibility. First, as Prof Jagdish Bhagwati forcefully argued in his celebrated 1998 article: The Capital Myth: The Difference between Trade in Widgets and Dollars, persuasive empirical evidence on the benefits of full convertibility is lacking. Recent research shows that for countries with well-developed financial markets and stable macroeconomic environment, convertibility offers small positive growth effects.

But for countries with weak financial sectors and macroeconomic vulnerabilities, convertibility leads to greater instability in growth without dividend in terms of higher average rates. But even this and related research does not distinguish between limited convertibility in terms of openness to trade and foreign direct and portfolio investment and full-fledged convertibility. Therefore, we have no evidence showing positive benefits from a move from the limited to full convertibility, which is the question facing India today.

Second, on the fiscal front, India remains far from ideal conditions for convertibility. The average growth rate of almost 8% during 2003-04 to 2005-06 has led to increased tax revenues and some reduction in the deficit but not nearly enough. Moreover, we can scarcely be sure that the deficit will not return to the higher level if the GDP growth rate and therefore tax revenue growth revert to the previous trend as happened after 1996-97.

With interest payments on the debt amounting to more than 6% of the GDP, gross fiscal deficit of 8% and debt-to-GDP ratio of more than 90%, convertibility is bound to leave India vulnerable to a crisis. One hazard is that the government itself would be tempted to turn to lower-interest short-term external debt to finance its deficits and debt. Third, the financial sector is still insufficiently developed in India. Banks are predominantly in the public sector and credit markets relatively shallow. Insurance has barely been opened to the private sector with the foreign investment in it capped at 26%.

The debt and equity markets are thin and dominated by public sector FIs and FIIs. Because the Indian debt and equity markets are tiny in relation to the worldwide stakes of the FIIs, any time the latter begin to exit the Indian market, the financial markets go

into turmoil. Because few FIIs have the incentive to carefully gather detailed information on the future profitability of various firms, such exits are characterised by herd behaviour.

Fourth, India is still far from fully integrated on the trade front. For this reason, ensuring a competitive exchange rate is a high priority. A move to the capital-account convertibility is bound to bring more capital inflows initially and force an appreciation of the rupee.

If the appreciation ends up being large and persistent, it could put trade integration into jeopardy. Furthermore, even if the appreciation is only temporary, convertibility could hurt export growth by making the real exchange rate more volatile.

Finally, the embrace of full capital-account convertibility can place the ongoing reforms in other areas at grave risk. In the Indian political environment, building a consensus for even most straightforward reforms such as privatisation and trade liberalisation is an uphill task. Therefore, if capital account convertibility were to culminate in a crisis or even create greater volatility in growth, the cause of reforms would be set back.

The advocates of speedy convertibility sometimes make two counter arguments. First, the adoption of convertibility will speed up the reform, especially in the financial sector. For instance, giving individuals and firms access to the global markets may bring pressure on the domestic banks to become more competitive. Likewise, the possibility of a crisis may force the government to act more urgently on fiscal deficits and debt.

While these outcomes can indeed follow the embrace of convertibility, the opposite can also happen. Both the government and the firms will be tempted to quickly proceed to accumulate short-term external debt and rapidly move the economy towards a crisis.

T he question is largely empirical. On balance, the weight of the empirical evidence favours erring on the side of caution: whereas the countries that ended up in a crisis following the premature adoption of convertibility are many, those that reformed more speedily and smoothly on account of the premature embrace of convertibility are few.

The second argument in favour of moving rapidly to convertibility is that this will help India turn into a major financial centre in Asia. Given its vast pool of skilled labour force and rapidly developing information technology industry, India certainly has the potential to become such a centre. It is also true that full convertibility is a necessary condition for becoming a hub of financial activity. Yet, the argument is misleading.

Currently, the financial sector in India is heavily dominated by the public sector, which account for 70% of its assets. It is implausible that India would turn into a major financial centre in Asia without the reforms that give primacy to private sector in the financial markets. It is even more implausible that the government will relinquish its control of the financial markets overnight - just calculate the prospects of bank privatisation!

Though India must eventually adopt full convertibility, which is a defining characteristic of all mature modern economies, our arguments lean against the kind of approach the Tarapore Committee I recommended. We should instead stay the course on reforms including increasing the role of the private sector in financial markets without committing to a specific timetable for convertibility.

III.F. CAC: Cost – Benefit Analysis

Full CAC has both pros and cons. The beneficial effects include the following:

1) It leads to more inflow of capital into domestic financial system. Thus firms have access to more capital, and this reduces their cost of capital. A reduced COC induces firms to invest more, expand more and thus output, employment and income expand in medium- to long-run.

2) Full CAC leads to freedom to trade in financial assets. Investors can choose from a wider range of financial products across multiple countries.

3) Entry of foreign financial institutions results in eventual efficiency in domestic financial system, since such entry increases the number of players in the market, and fosters competition. In some cases, the market could see a transition from the near-monopoly to near-perfectly competitive market. In order to survive stiffer competition, (domestic) firms are forced to become more efficient. This also ensures compliance with international standards of reporting, disclosure and best practices.

4) As a consequence of full CAC, tax levels converge to international levels.

5) As more capital flows in, domestic interest rates are reduced, thus cost of government’s domestic borrowing is reduced, and so fiscal deficit shrinks.

However, the other side of the coin has the following ill-effects:

1) An open capital account causes an export of domestic savings abroad, to more attractive destinations. In capital-starved countries, such outbound savings flight can be ill afforded.

2) Increased capital inflows also lead to appreciation of real exchange rate. It shifts resources from tradable to non-tradable sectors.

3) Premature liberalization and CAC lead to an initial stimulation of capital outflows, which by appreciating the real exchange rate, destabilizes the economy.

4) Another possible side-effect is generation of financial bubbles. A sudden burst could replicate the Asian crisis once again.

5) But the oft-cited argument against CAC is concerning movements of short-term capital. It is considered to be extremely volatile, highly sensitive to domestic and/or international economic, political and financial events, and once such an event starts, the extent increases as in a chain-reaction – such investors invest their capital only lured by the prospect of short-term ‘windfall gains’ precipitated by interest-rate differentials (in most cases). And once some investors withdraw their capital, the herd mentality is displayed – other ‘armslength’ investors also follow suit and withdraw their money.

This is known as ‘capital flight’. Once capital flight takes place, international investors lose confidence on the host country’s economy. Creditworthiness diminishes, too.

And the most dangerous consequence of capital flight is that the government has to deploy its Forex Reserves to the investors who withdraw the capital, and this brings the domestic economy to a highly vulnerable state. This may well start a financial disruption and/or currency crisis.

It may be noted that full capital account convertibility doesn’t necessarily lead to a financial crisis, but it makes the country in question more susceptible to such crises. The symptoms of such financial vulnerability are: Inadequate capital base, large bad loans (NPA), inappropriate risk management techniques and (politically) connected lending.

Countries where such symptoms exist should exercise utmost caution while deciding whether or not to adopt Full CAC, since these are most vulnerable to any shock, and take more time to recover from any external threat.

III.G. CAC and South-East Asian Crisis: A Note

The Asian Crisis of 1997-98 originated from Thailand. The Baht was at that time pegged with US Dollar. As dollar appreciated, so did Baht, and exports decreased, export competitiveness also reduced, leading to increased current account deficit and trade deficit. Thailand was heavily reliant on foreign debt – with its huge CAD being dependent on foreign investment to stay afloat. Thus there was an increased forex risk.

As US increased its domestic interest rate, the investors started investing more in the US. It led to capital flight. Forex reserves rapidly depleted, and the Thai economy tumbled down. At this juncture, Thai government decided to dissociate Baht from the US currency and floated Baht. Concurrently, the export growth in Thailand slowed down visibly.

Combination of these factors led to heavy demand for the foreign currency, causing a downward pressure on Baht. Asset prices also decreased. But, that time Thailand was dominated by “crony capitalism”, so credit was widely available. This resulted in hike of asset prices to an unsustainable level – and as asset prices fell, there was heavy default on debt obligations. Credit withdrawal started.

This crisis spread to other countries as a contagion effect. The exchange markets were flooded with the crisis currencies as there were few takers. It created a depreciative pressure on the exchange rate. To prevent currency depreciation, the governments were forced to hike interest rates and intervene in forex markets, buying the domestic currencies with their forex reserves. However, an artificially high interest rate adversely affected domestic investment, which spread to GDP, which declined, and eventually economies crashed.

In this backdrop, the most vicious argument offered by the opponents of full CAC had been the role of free currency convertibility. In the absence of any capital control, no restrictions were kept on capital outflow, and thus the herd behavior of investor led to economic cash of the entire region.

Thus the Asian currency has taught the following observations and lessons:

1) Most currency crises arise out of prolonged overvalued X-rate regime. As the pressure on the X-Rate increases, there is an increased volatility of the capital flows as well as of the X-Rate itself. If the X-rate appreciates too high, the economy’s export sector becomes unviable by losing export-competitiveness at a global level. Simultaneously, imports become more competitive, thus CAD increases and becomes unsustainable after a certain limit.

2) Large and unsustainable levels of external and domestic debt had added to the crises, too. Thus, the fiscal policies need to be more transparent and forward looking.

3) During the crises, short term flows reacted quickly and negatively. Either receivables were postponed by debtors and/or payables were accelerated by creditors. Thus BOP situation worsened.

4) Domestic financial institutions need to be strong and resilient to absorb and minimize the shocks so that the internal ripple effect is least.

5) Gradual CAC is the safest way to adopt. However, even a gradual CAC cannot fully eliminate the risk of crisis or pressure on forex market.

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