Benefits:

The cross-country experience with capital account liberalisation suggests that countries,
including those which have an open capital account, do retain some regulations influencing
inward and outward capital flows. The 2005 IMF Annual Report on Exchange Arrangement and
Exchange Restrictions shows that while there is a general tendency among countries to lift
controls on capital movement, most countries retain a variety of capital controls with specific
provisions relating to banks and credit institutions and institutional investors Even in the
European Community (EC), which otherwise allows unrestricted movement of capital, the EC
Treaty provides for certain restrictions.

There are other benefits to fuller capital account convertibility for financial
institutions, including increased diversification, greater access to capital, and
a broader range of risk management tools.

FCAC can be beneficial for a country as the inflow of foreign investment increases and the
transactions are much easier and occur at a faster pace. CAC also initiates risk spreading through
diversification of portfolios. Moreover, countries gain access to newer technologies which
translate into further development and higher growth rates.

Risks involved in Full Capital Account Convertibility

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.
Risk in derivatives transactions become 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.

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. 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.

Regulatory issues include the risk of regulatory arbitrage as differences in regulatory and
supervisory regimes among countries may create incentives for capital to flow from countries
with higher standards to those with lower ones. FCAC can also bring a proliferation of new
instruments and market participants, complicating the task of financial supervisors and
regulators. The entry of large and complex institutions operating in different countries will
increase the need for cooperation and coordination between domestic regulatory and supervisory
agencies and also with their foreign counterparts.

Challenges in adopting Full Capital Account Convertibility

• — 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
FCAC Timing and Phasing

A broad time frame of a five year period in three phases, eg. 2006-07 (Phase I), 2007-08 and
2008-09 (Phase II) and 2009-10 and 2010-11 (Phase III) may be considered. This enables to
undertake a stock taking after each Phase before moving on to the next Phase. The roadmap
should be considered as a broad time-path for measures and the pace of actual implementation
would no doubt be determined by the authorities’ assessment of overall macroeconomic
developments as also specific problems as they unfold. There is a need to break out of the
“control” mindset and the substantive items subject to capital controls should be separated from
the procedural issues. This will enable a better monitoring of the capital controls and enable a
more meaningful calibration of the liberalisation process.

Before the voyages of discovery, the earth was believed to be flat, such that people feared that
once one reached the end of the world, one would fall off the edge of the Earth. Soon, it was
discovered that the Earth was actually a sphere and one could safely go around it. However,
more recently, the Earth is said to be becoming flat again, a theory propounded by Thomas
Friedman in his bestseller book ‘The World is Flat’. The forces of Globalization and
Liberalization are cutting across borders, re-integrating the world towards a common goal of
development. The liberalization reforms which swept across the country in 1991 changed the
face of the Indian economy.

Thus, in the current stream of events, where globalization has become the ‘hot’ word and
financial liberalization is synonymous with ‘developed economies’, the key issue that is to be
considered, is whether India is ready to take the plunge towards Full Capital Account
Convertibility (FCAC).

Capital Account Convertibility (CAC) is the freedom to convert local financial assets into
foreign financial assets at market determined exchange rates. Referred to as ‘Capital Asset
Liberation’ in foreign countries, it implies free exchangeability of currency at lower rates and an
unrestricted mobility of capital. India presently has current account convertibility, which means
that foreign exchange is easily available for import and export for goods and services. India also
has partial capital account convertibility; such that an Indian individual or an institution can
invest in foreign assets upto $25000. Foreigners can also invest along the same lines. 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.

The First Tarapore Committee was set up by the RBI in 1997 to study the implications of
executing CAC in India. It recommended that the before CAC is implemented, the fiscal deficit
needs to be reduced to 3.5% of the GDP, inflation rates need to be controlled between 3-5%, the
non-performing assets (NPAs) need to be brought down to 5%, Cash Reserve Ratio (CRR) needs
to be reduced to 3%, and a monetary exchange rate band of plus minus 5% should be instituted.
However, most of the pre-conditions weren’t entirely fulfilled. Thus, CAC was abandoned for
the moment.
However, recently there has been a renewed optimism as some of the targets suggested by the
First Tarapore Committee have been achieved. Moreover, consolidation of banks, a strong
export front, large forex reserves amounting to $300 billion and high growth rates have also
instilled within, some hope. Thus, a Second Tarapore Committee was set up in 2006 to look into
the PM’s proposal to reevaluate the earlier stand. Although the report hasn’t been released yet,
the committee does plan to increase the threshold level for investments from $25000 to $200000
in 3 phases.

FCAC can be beneficial for a country as the inflow of foreign investment increases and the
transactions are much easier and occur at a faster pace. CAC also initiates risk spreading through
diversification of portfolios. Moreover, countries gain access to newer technologies which
translate into further development and higher growth rates.

Even though CAC seems to have many advantages, in reality, it can actually destabilize the
economy through massive capital flight from a country. Not only are there dangerous
consequences associated with capital outflow, excessive capital inflow can cause currency
appreciation and worsening of the Balance of Trade. Furthermore, there are overseas credit risks
and fears of speculation. In addition, it is believed that CAC increases short term FIIs more than
long term FDIs, thus leading to volatility in the system.

However, if we were to judge the implications of CAC in India, independent of its general pros
and cons, CAC may not be such a good idea in the near future. The instability in the international
markets due to the sub prime crisis and fears of a US recession are adversely affecting the entire
world, including India. Moreover, rising oil prices which touched $100 a barrel recently are also
fueling inflationary pressures in the economies, worldwide.

Not only is there instability in the international arena, but India’s domestic economy is also
going through ups and downs. The rising prices and the appreciation of the rupee are adversely
affecting India’s exports and the Balance of Trade. Moreover, the fiscal deficit has been highly
underestimated by ignoring the deficits of individual states and through issuance of oil bonds to
the public sector oil companies, making severe losses due to the heavy subsidies on oil. The
government is yet to compensate these companies and these deferred payments have been left
out from the deficit. Also, corruption, bureaucracy, red tapism and in general, a poor business
environment, are discouraging the inflow of investment. Poor infrastructure and socio-economic
backwardness act as deterrents to FDI inflow.

Hence, India still needs to work on its fundamentals of providing universal quality education and
health services and empowerment of marginalized groups, etc. The growth strategy needs to be
more inclusive. There is no point trying to add on to the clump at the top of the pyramid if the
base is too weak. The pyramid will soon collapse! Thus, before opening up to financial volatility
through the implementation of FCAC, India needs to strengthen its fundamentals and develop a
strong base.

Hence, India should either wait for a while or implement CAC in a phased, gradual and cautious
manner.