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Capital Account Convertibility and India - Status
   The freedom to convert the local
    financial assets into foreign financial
    assets and vice-versa at market
    determined rates of exchange. It is
    associated with the changes of
    ownership in foreign/domestic
    financial assets and liabilities and
    embodies the creation and
    liquidation of claims on, or by the rest
    of the world
         -     As per Report of the Committee on Capital
               Account Convertibility, RBI, 1997


   Different from current account
    transaction
       Indian citizen needs foreign exchange of smaller
        amounts, say $3,000, for travelling abroad or for
        educational purposes, she/he can obtain the same
        from a bank or a money-changer
Capital Account Convertibility and India - Status
   Implies progressive integration of the domestic financial system with
    international financial flows.
   Regarded as one of the hallmarks of a developed economy. Signals
    openness of the economy
   Comfort factor for overseas investors. Encourages global capital flows
    into the country
   Indian businesses - access to cheaper external credit (Global rates +
    Country risk) - without having to ask permission of the RBI.
   High Risk – High Gain – Good Times – Chance of huge inflows of
    foreign capital; Bad times – Chance of an enormous outflow of
    capital
   Chance of “export of domestic savings” - for capital scarce developing
    countries this could curb domestic investment
   Exposes an economy to extreme volatility on account of “hot money”
    flows
Pros:
     •   Increases competition and reduces inefficiency; aids price discovery
     •   Allows access to funds at global rates (plus country risk)
     •   Disciplines domestic policy and exchange rate monitoring.
     •   Integrates economy to global trade and capital flows.
     •   Capital controls ineffective with open trade, human movement.
     •   Natural direction of evolution for Developing economies (globalization)

Cons:
    •    No evidence linking improved growth to CAC (Bhagwati, Rodrik, Stiglitz)
    •    Increases vulnerability to herd behavior, contagion, sentiment.
    •    Downside exceeds upside – High Risk, High/Moderate Gain.
    •    Reduces monetary, exchange rate autonomy for a nation.
   The East Asian currency crisis Q2 1997- Q4 1998) - Began in Thailand. Malaysia, Indonesia,
    South Korea and the Philippines.

   Macroeconomic causes:

    ◦ current account imbalances with concomitant savings-investment imbalance

    ◦ overvalued exchange rates,

    ◦ high dependence upon potentially short-term capital flows.

    Microeconomic imprudence

    -   maturity mismatches, currency mismatches,

    ◦ moral hazard behaviour of lenders and borrowers and excessive leveraging.
   The Russian FX Crisis - Re-intensified capital controls and debt moratorium. CAC in 2006.

   The Mexican crisis -1994–95 - Overvalued Exchange Rate. Caused by short-term capital inflows.

   Similar Crisis – Brazil (post Asian Crisis), Argentina (removed peg in 2001), Turkey (1994)
   Tarapore Committee setup in 1996-97 - Capital Account Convertibility (CAC)
   Committee favored CAC as a goal to be achieved in 3 years (by 2000) – considered too
    aggressive target by economists (30 years avg by other liberalized nations)
   Established road map and benchmarks. Main issue areas: fiscal consolidation, inflation
    target, financial system, exchange rate management, Balance of Payments.
   Levels of Convertibility –
    ◦   Foreign Corporate – Reasonably High Degree
    ◦   NRI Individual– Full Convertibility (Tax Benefits) but with Procedural/Regulatory delays (
    ◦   Non NRI Individual – Near Zero Convertibility
    ◦   Resident Individual – High Restrictions (relaxed by some extent)
    ◦   Resident Corporate – Medium Restrictions
   Targeted Parameters for CAC in 2000:
    ◦ Bring down Central government fiscal deficit from 4.5% in 1997-98 to below 3.5 % of GDP by 1999-
      2000
    ◦ Inflation to be reduced to World Average (3-5 % ) - RBI Key Objective should be to monitor and
      actively manage Inflation
    ◦ Financial system: CRR at 3%; Gross NPAs at 5%; Interest rate deregulation by 1998.
    ◦ BoP: “Sustainable” current account deficit; build up “adequate” reserves.
   1997 Asian crisis – major cause related to exchange rate fluctuations due not-
        regulated capital account . Rapid surge of capital outflow (short term loans etc).
       Aftermath - Shift in international sentiment against CAC, Decreased IMF Focus
        and less pressure from USA/Developed Nations - Reduced momentum.
       India - Steady liberalization continued, but not at the pace or with the
        commitment indicated by the Tarapore Committee.
•       Led to formation of 2nd Tarapore Committee in 2006 – For FCAC (Fuller CAC).
       Objectives of Fuller CAC –
        ◦ to facilitate economic growth through higher investment by minimising the cost of both
          equity and debt capital;
        ◦ to improve the efficiency of the financial sector through greater competition, thereby
          minimising intermediation costs and
        ◦ to provide opportunities for diversification of investments by residents.
       Idea was to streamline regulations –
        ◦ All non-residents should be treated equally
        ◦ Simplify rules for Residents.
   Current State:
    ◦ Strong BoP, High reserves. But is it enough security?

    ◦ Well “managed” floating exchange rate . Less volatility despite regulated capital flow.

    ◦ Increasingly efficient Financial markets. Much improved and improving, banking system.

    ◦ Mature Long-term government debt market, more efficient price discovery

   Risks -
    ◦ High Inflation (Compared to Global Standards) and External Debt (though under
       moderation and monitoring)
    ◦ Large fiscal deficit, High public debt - Govt focused on targeted reduction in phases.
    ◦ Pressure from Industry vs Uncertain Future ahead – prioritization.
   Don’t Rush In - Despite high reserves we need to worry about inflation. Also
    emerging economies need to take care of Exports competitiveness.

   Fiscal Management - Improving the quality of public expenditure, both current and
    capital. Aggregate fiscal adjustment must/should occur, but this will take time.
   Exchange Rate Mgmt - Suggestion from Tarapore Committee –Device different
    framework for exchange rate and monetary management. Nominal exchange rate
    needs to become a shock absorber, and the FX market needs to deepen.
   A Strong RBI - Supervision has improved; legal sanctions are stronger.RBI needs to
    move from a nanny to headmaster.
   Focus on Short Term Bank loans- RBI needs to closely monitor short term bank
    loan flows (an additional risk mitigation device as done in Chile in 1990’s).
   Finally – It’s a Judgment Call - Gains, both signaling and substantive, could be
    substantial, but are the risks manageable.

   Conditions seem ripe to put more full-blooded CAC back on the front-burner. We
    are in the right direction to reach the destination. But it pays to be cautious.
Capital Account Convertibility and India - Status

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Capital Account Convertibility and India - Status

  • 2. The freedom to convert the local financial assets into foreign financial assets and vice-versa at market determined rates of exchange. It is associated with the changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by the rest of the world - As per Report of the Committee on Capital Account Convertibility, RBI, 1997  Different from current account transaction  Indian citizen needs foreign exchange of smaller amounts, say $3,000, for travelling abroad or for educational purposes, she/he can obtain the same from a bank or a money-changer
  • 4. Implies progressive integration of the domestic financial system with international financial flows.  Regarded as one of the hallmarks of a developed economy. Signals openness of the economy  Comfort factor for overseas investors. Encourages global capital flows into the country  Indian businesses - access to cheaper external credit (Global rates + Country risk) - without having to ask permission of the RBI.  High Risk – High Gain – Good Times – Chance of huge inflows of foreign capital; Bad times – Chance of an enormous outflow of capital  Chance of “export of domestic savings” - for capital scarce developing countries this could curb domestic investment  Exposes an economy to extreme volatility on account of “hot money” flows
  • 5. Pros: • Increases competition and reduces inefficiency; aids price discovery • Allows access to funds at global rates (plus country risk) • Disciplines domestic policy and exchange rate monitoring. • Integrates economy to global trade and capital flows. • Capital controls ineffective with open trade, human movement. • Natural direction of evolution for Developing economies (globalization) Cons: • No evidence linking improved growth to CAC (Bhagwati, Rodrik, Stiglitz) • Increases vulnerability to herd behavior, contagion, sentiment. • Downside exceeds upside – High Risk, High/Moderate Gain. • Reduces monetary, exchange rate autonomy for a nation.
  • 6. The East Asian currency crisis Q2 1997- Q4 1998) - Began in Thailand. Malaysia, Indonesia, South Korea and the Philippines.  Macroeconomic causes: ◦ current account imbalances with concomitant savings-investment imbalance ◦ overvalued exchange rates, ◦ high dependence upon potentially short-term capital flows. Microeconomic imprudence - maturity mismatches, currency mismatches, ◦ moral hazard behaviour of lenders and borrowers and excessive leveraging.  The Russian FX Crisis - Re-intensified capital controls and debt moratorium. CAC in 2006.  The Mexican crisis -1994–95 - Overvalued Exchange Rate. Caused by short-term capital inflows.  Similar Crisis – Brazil (post Asian Crisis), Argentina (removed peg in 2001), Turkey (1994)
  • 7. Tarapore Committee setup in 1996-97 - Capital Account Convertibility (CAC)  Committee favored CAC as a goal to be achieved in 3 years (by 2000) – considered too aggressive target by economists (30 years avg by other liberalized nations)  Established road map and benchmarks. Main issue areas: fiscal consolidation, inflation target, financial system, exchange rate management, Balance of Payments.  Levels of Convertibility – ◦ Foreign Corporate – Reasonably High Degree ◦ NRI Individual– Full Convertibility (Tax Benefits) but with Procedural/Regulatory delays ( ◦ Non NRI Individual – Near Zero Convertibility ◦ Resident Individual – High Restrictions (relaxed by some extent) ◦ Resident Corporate – Medium Restrictions  Targeted Parameters for CAC in 2000: ◦ Bring down Central government fiscal deficit from 4.5% in 1997-98 to below 3.5 % of GDP by 1999- 2000 ◦ Inflation to be reduced to World Average (3-5 % ) - RBI Key Objective should be to monitor and actively manage Inflation ◦ Financial system: CRR at 3%; Gross NPAs at 5%; Interest rate deregulation by 1998. ◦ BoP: “Sustainable” current account deficit; build up “adequate” reserves.
  • 8. 1997 Asian crisis – major cause related to exchange rate fluctuations due not- regulated capital account . Rapid surge of capital outflow (short term loans etc).  Aftermath - Shift in international sentiment against CAC, Decreased IMF Focus and less pressure from USA/Developed Nations - Reduced momentum.  India - Steady liberalization continued, but not at the pace or with the commitment indicated by the Tarapore Committee. • Led to formation of 2nd Tarapore Committee in 2006 – For FCAC (Fuller CAC).  Objectives of Fuller CAC – ◦ to facilitate economic growth through higher investment by minimising the cost of both equity and debt capital; ◦ to improve the efficiency of the financial sector through greater competition, thereby minimising intermediation costs and ◦ to provide opportunities for diversification of investments by residents.  Idea was to streamline regulations – ◦ All non-residents should be treated equally ◦ Simplify rules for Residents.
  • 9. Current State: ◦ Strong BoP, High reserves. But is it enough security? ◦ Well “managed” floating exchange rate . Less volatility despite regulated capital flow. ◦ Increasingly efficient Financial markets. Much improved and improving, banking system. ◦ Mature Long-term government debt market, more efficient price discovery  Risks - ◦ High Inflation (Compared to Global Standards) and External Debt (though under moderation and monitoring) ◦ Large fiscal deficit, High public debt - Govt focused on targeted reduction in phases. ◦ Pressure from Industry vs Uncertain Future ahead – prioritization.
  • 10. Don’t Rush In - Despite high reserves we need to worry about inflation. Also emerging economies need to take care of Exports competitiveness.  Fiscal Management - Improving the quality of public expenditure, both current and capital. Aggregate fiscal adjustment must/should occur, but this will take time.  Exchange Rate Mgmt - Suggestion from Tarapore Committee –Device different framework for exchange rate and monetary management. Nominal exchange rate needs to become a shock absorber, and the FX market needs to deepen.  A Strong RBI - Supervision has improved; legal sanctions are stronger.RBI needs to move from a nanny to headmaster.  Focus on Short Term Bank loans- RBI needs to closely monitor short term bank loan flows (an additional risk mitigation device as done in Chile in 1990’s).  Finally – It’s a Judgment Call - Gains, both signaling and substantive, could be substantial, but are the risks manageable.  Conditions seem ripe to put more full-blooded CAC back on the front-burner. We are in the right direction to reach the destination. But it pays to be cautious.