CAPITAL ACCOUNT CONVERTIBILITY

SUBMITTED TO: DR. MANMINDER SINGH SUBMITTED BY: MONIKA JHANIYA IM-2K7-55

CAPITAL ACCOUNT CONVERTIBILITY

Capital Account Convertibility is a feature of a nation's financial regime that centers on the ability to conduct transactions of local financial assets into foreign financial assets freely and at market determined exchange rates. It is sometimes referred to as Capital Asset Liberation or CAC.
(Report of the Committee on Capital Account Convertibility, RBI, 1997)

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.

full capital account convertibility allows local currency to be exchange for foreign currency without any restriction on the amount. This is so local merchants can easily conduct transnational business without needing foreign Currency exchanges to handle small transactions. CAC is mostly a guideline to changes of ownership in foreign or domestic financial assets and liabilities.

How is CAC different from current account convertibility?

Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. In other words, it allows residents to make and receive traderelated payments receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts etc. In India, current account convertibility was established with the acceptance of the obligations under Article VIII of the IMFs Articles of Agreement in August 1994.

WHY CAPITAL ACCOUNT CONVERTIBILITY?

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 any time they want to and take their money away. At the same time, capital account convertibility makes it easier for domestic companies to tap foreign markets. Greater access for resident companies to foreign capital and debt markets reduce cost of capital.

DIFFERENCE BETWEEN CAPITAL AND CURRENT ACCOUNT

Capital Account
A capital account refers to capital transfers and acquisition or disposal of non-produced, non-financial assets. E.g. purchase/sell of property, ownership in a firm etc. Capital account convertibility allows free movement from local currency into foreign currency and back.

Current Account
A current account refers to goods and services, income, and current transfers. E.g. export/import of goods and services. Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans.

Tenets
CAC has 5 basic statements designed as points of action: All types of liquid capital assets must be able to be exchanged freely, between any two nations in the world, with standardized exchange rates. The amounts must be a significant amount (in excess of $500,000). Capital inflows should be invested in semi-liquid assets, to prevent churning and excessive outflow. Institutional investors should not use CAC to manipulate fiscal policy or exchange rates. Excessive inflows and outflows should be buffered by national banks to provide collateral.

BENEFIT OF CAC

Capital account convertibility would benefit countries because it would provide nations with huge funds, which would boost economic growth. It would improve a country's financial system as it would have better access to the world financial markets. This would further lead to people of that nation occupying and acquiring international securities and assets and thereby increasing the prosperity for the country. Companies would be able to issue global depository receipts without taking permission from their central banks.

CONT..

This would ensure more freedom and better control by companies is managing funds on the global level. This will also enable the citizens to make financial capital transfers to other countries, maintain foreign currencies, take loans from people who are not relatives etc. The world would become a common playground for banks and financial institutions as they would be able to borrow and invest in overseas markets. Transactions in foreign currencies would also further boost trade and relations between nations. One of the biggest benefits would be transactions in gold amongst financial institutions and banking systems would be allowed.

EVOLUTION OF CAC IN INDIA ECONOMIC AND FINANCIAL SCENARIOS:

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.

REASONS FOR THE INTRODUCTION OF CAC IN INDIA:

The logic for the introduction of complete capital account convertibility in India, according to the recommendations of the Tarapore Committee, is to ensure total financial mobility in the country. 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.

There already exists a great amount of freedom in transacting foreign currencies. Any further relaxations would render the Indian economy susceptible to the kind of crisis faced by the other developing countries. Why then is the government interested in introducing Capital Account Convertibility??? The UPA government, since its inception, had has been pursuing the policies of liberalization and privatization, which underscore its commitment to neo-liberalism. the government is unwilling to change course and is in essence pursuing the same policies as the NDA. A policy like Capital Account Convertibility is a reflection of this. Such policies solely benefit the rich business houses, investors in the stock markets and those who control the international finance markets. The prime minister and the finance minister are more than eager to serve the vested interests of these classes.

PROBLEMS WITH CAC

During the good years of the economy, there are huge inflows of foreign capital, but during the bad times there is an enormous outflow of capital under herd behaviour. Misallocation of capital inflows. Export of domestic savings. Entry of foreign banks can create an unequal playing field. Full capital account convertibility exposes an economy to extreme volatility on account of hot money flows.

DANGERS OF FULL CAC

A free capital account could lead to the export of domestic savings Capital convertibility could lead to exchange rate volatility of the Rupee resulting in macroeconomic instability caused through the risk of rapid and large capital outflows as well as inflows. The CAC would not suit an economy like India, undergoing the process of structural reforms, which needs controls and regulations for some more foreseeable future.

ASIAN CRISIS

Started in July 1997 in Thailand Indonesia, South Korea and Thailand most affected Hong Kong, Malaysia, Laos and Philippines had second level effect All these known as Asian Tigers

SOME LESSONS FROM THE CURRENCY CRISES IN EMERGING MARKET ECONOMICS

The Mexican crisis in 199495 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. 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. In 1998, Russia faced a serious foreign exchange crisis due to concerns about its fiscal situation and had to introduce a series of emergency measures, including re-intensification of capital controls and the announcement of a debt moratorium. Russia has lifted the last remaining restrictions on the rouble on July 1, 2006 clearing the way for making its currency fully convertible. The rouble's exchange rate will continue to be linked to a bi-currency basket and will be managed by the central bank

Argentina embarked on a currency board arrangement pegged to US dollar from April 1991 up to January 2002 which coupled with Argentina's persistent inability to reduce its high public and external debts, caused a recession-turned-depression during 1998-2001. This led Argentina to abandon the peg in January 2002, first devaluing and later floating its currency. 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 crisisagain beginning 2000 due to a combination of economic and noneconomic actors.

HOW DOES CAPITAL A/C 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 limit 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.

FDI IS PROHIBITED IN THE ACTIVITIES/SECTORS

Retail Trading (except single brand product retailing) Lottery Business including Government /private lottery, online lotteries,etc. Gambling and Betting including casinos etc. Business of chit fund Nidhi company Trading in Transferable Development Rights (TDRs) Real Estate Business or Construction of Farm Houses Manufacturing of Cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes Activities / sectors not opened to private sector investment including Atomic Energy and Railway Transport (other than Mass Rapid Transport Systems).

CONCLUSION :
The Prime Ministers recent announcement has refocused attention on the issue of full capital account convertibility. The country has steadily eased controls since 1991 and for many areas the restrictions are no longer binding. Nonetheless, some restrictions do remain, especially of resident outflows. The new Tarapore Committee needs to think about the gains from removing the remaining restrictions against the macroeconomic vulnerabilities that remain.

THANK YOU