Professional Documents
Culture Documents
Final Currency Convertibility
Final 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.
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.
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.
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.
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.
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.
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.
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.
TARAPORE COMMITTEE
1. Establishment
The 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:-
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)
Investment
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
Investment
magnitude of PN-related inflows that raises concerns
Relaxation
government’s holdings in public sector banks should be brought down to 33% as this
would help banks augment their capital
FII investment
FIIs’ debt
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.
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.
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 Investment
It will also help in the diversification of Investment by ordinary people, wherein they
can invest abroad without any restriction and diversify their portfolio.
Market risks such as interest rate and foreign exchange risks become more complex
as financial institutions and corporates 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. Foreign participation can also be a channel
through 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 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.
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.
Operational risk may increase with FCAC.4 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. For
instance, differences in bankruptcy codes can complicate the assessment of recovery
values. Similarly, differences in the legal treatment of secured transactions for repos
can lead to unanticipated loss.
Risk Management
Interest Rate & Liquidity Risk Management
Derivative Risk Management
• To better manage liquidity risk, the report recommends that banks monitor their
liquidity position at the head/corporate office level on a global basis, including both at
the domestic and foreign branches. In addition the liquidity positions should be
monitored for each currency.
• Regarding market risk, the report recommends that banks adopt a duration gap
analysis and consider setting appropriate internal limits on their interest rate risk
exposures. The Tarapore report also suggests that the RBI link the open position
limits to banks’ capacity to manage foreign exchange risk as well as their unimpaired
Tier I capital.
• Banks will require more derivatives instruments to mitigate the possible risks from
fuller capital account convertibility. These should include interest rate futures and
options, credit derivatives, commodity derivatives, and equity derivatives, which are
not effectively available to banks at the moment. The RBI should, however, put in
place the appropriate infrastructure, including a robust accounting framework; a
robust independent risk management framework in banks, including an appropriate
internal control mechanism; appropriate senior management oversight and
understanding of the risks involved; comprehensive guidelines on derivatives,
including prudential limits wherever necessary; and appropriate and adequate
disclosures. prudential limits wherever necessary; and appropriate and adequate
disclosures.
The commonly accepted definition of Financial Integration [1] states that all potential
participants in a market:
• Are subject to a single set of rules when dealing with financial products and/or
services.
• 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 international
Financial markets.
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.
************************ ***********************