Capital account

convertibility
Issues and concerns
 INTRODUCTION
• Capital Account Convertibility is
a monetary policy that centers
around 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.
 HISTORY
CAC was first coined as a theory by
the Reserve Bank of India in 1997 by
the Tarapore Committee.

Objective: to find a fiscal and economic

policy that would enable developing Third
World countries transition to
globalized market economies.
 HISTORY
The Tarapore Committee’s definition:

Capital Account Convertibility refers to the

freedom to convert local financial assets
into foreign financial assets and vice versa
at market determined rates of exchange.
It is associated with 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.
Current account:

• For e.g. If an Indian citizen needs foreign exchange of

smaller amounts, say $1,000, for going abroad or for
educational purposes, she/he can obtain the same from a
bank or a money-changer. This is a “current account
transaction”.

Capital account:

Suppose, one wants to import plant and machinery or

invest abroad, and needs a large amount of foreign
exchange, say $2 million, the importer will have to first
obtain the permission of the Reserve Bank of India (RBI). If
approved, this becomes a “capital account
transaction”.
Causes behind CAC implementation:

Prior to its implementation,

Foreign investment was hindered by uneven exchange

rates due to corrupt officials and local businessmen.

They had no convenient way to handle large cash

transactions.

National banks were disassociated from fiscal exchange

policy and incurred high costs in supplying hard-currency
loans for those few local companies that wished to do
business abroad.
 Objectives of CAC

• To facilitate economic growth through higher

investment by minimizing the cost of both equity
and debt capital;

• To improve the efficiency of the financial sector

through greater competition thereby minimizing
intermediation costs and

• To provide opportunities for diversification of

investment by residents .
 IMF’s ROLE IN C.A.C
According to IMF an economy can choose to be

• (a) partially convertible on CURRENT ACCOUNT

• (b) partially convertible on CAPITAL ACCOUNT

• (c) fully convertible on current account and

• (d) fully convertible on capital account.

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, 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.
 INDIA AND CAC
Though the rupee had become fully convertible on
current account as early as 1991, the RBI has been
adopting a cautious approach towards full float of the
rupee, particularly after the 1997 south-east Asian
currency crisis. While there has been a substantial
relaxation of foreign exchange controls during the
last 10 years, the current account convertibility since
1994 means that both resident Indians and corporate
have easy access to foreign exchange for a variety
of reasons like education, health and travel. They are
allowed to receive and make payments in foreign
currencies on trade account. The next logical step in
the same direction would be full convertibility, which
would remove restrictions on capital account.
 PRECONDITIONS
for full CAC
• Fiscal Consolidation

i. Reduction in gross fiscal deficit (GFD) to GDP ratio to 3.5%.

ii. A consolidated sinking fund (CSF) to be set up to meet

government's debt repayment needs to be financed by increase
in RBI's profit transfer to the government and disinvestment
proceeds.

• Mandated Inflation Rate

iii. The mandated inflation rate should remain at an average 3-
5% for the three-year period.

• Consolidation in the Financial Sector

iv. Gross non-performing assets (NPAs) of the banking sector
(as a percentage of total advances) to be brought down to 5%.

v. A reduction in the average effective Cash Reserve Ratio

(CRR) for the banking system to 3%.
 Preconditions contd…….
• Exchange Rate Policy

vi. RBI should have a Monitoring Exchange Rate Band of plus

minus 5% around a neutral Real Effective Exchange Rate (REER).
RBI should be transparent about the changes in REER.

• Balance of Payments Indicators

vii. Reduction in Debt Servicing Ratio to 20%.

• Adequacy of Foreign Exchange Reserves

viii. Reserves should not be less than six months of imports.

ix. The short -term debt and portfolio stock should be lowered to
60% of level of reserves.

x. The net foreign exchange assets to currency ratio

(NFA/Currency) should be prescribed by law at not less than 40%.
 STATUS OF INDIA W.R.T the
PRECONDITIONS
Preconditions Current Status
i Almost achieved
ii Not achieved
iii Achieved
iv Not achieved (5.84% for the nationalized banks in FY
2004)
v Not achieved (currently 5%)
vi Not achieved
vii Achieved
viii Achieved
ix Achieved
x Achieved (there is no legal restriction)
 PROS OF C.A.C for INDIA
• It allows domestic residents to invest abroad and have a
globally diversified investment portfolio, this reduces risk and
stabilizes the economy..

• Our NRI Diaspora will benefit tremendously if and when CAC

becomes a reality. The reason is on account of current
restrictions imposed on movement of their funds. As the
remittances made by NRI’s are subject to numerous restrictions
which will be eased considerably once CAC is incorporated.

• It also opens the gate for international savings to be invested in

India. It is good for India if foreigners invest in Indian assets —
this makes more capital available for India’s development.
 Pros contd…………
• Controls on the capital account are rather easy to evade
through unscrupulous means. Huge amounts of capital are
moving across the border anyway. It is better for India if
these transactions happen in white money. Convertibility
would reduce the size of the black economy, and improve law
and order, tax compliance and corporate governance.

• Most importantly convertibility induces competition against

Indian finance. Currently, finance is a monopoly in mobilizing
the savings of Indian households for the investment plans of
Indian firms. No matter how inefficient Indian finance is,
households and firms do not have an alternative, thanks to
capital controls. Exactly as we saw with trade liberalization,
which consequently led to lower prices and superior quality of
goods produced in India, capital account liberalization will
improve the quality and drop the price of financial
intermediation in India.
 Cons of C.A.C for INDIA
• During the good years of the economy, it might experience huge inflows
of foreign capital, but during the bad times there will be an enormous
outflow of capital under “herd behavior” . For example, the South East
Asian crisis.

• There arises the possibility of misallocation of capital inflows. Such capital

inflows may fund low-quality domestic investments, like investments in
the stock markets or real estates, and desist from investing in building up
industries and factories, which leads to more capacity creation and
utilization, and increased level of employment.

• An open capital account can lead to “the export of domestic savings” (the
rich can convert their savings into dollars or pounds in foreign banks or
even assets in foreign countries), which for capital scarce developing
countries would curb domestic investment. Moreover, under the threat of
a crisis, the domestic savings too might leave the country along with the
foreign ‘investments’, thereby rendering the government helpless to
counter the threat.
 Cons cont……..
• International finance capital today is “highly volatile”, i.e. it
shifts from country to country in search of higher
speculative returns. In this process, it has led to economic
crisis in numerous developing countries. Such finance
capital is referred to as “hot money” in today’s context. Full
capital account convertibility exposes an economy to
extreme volatility on account of “hot money” flows.
 conclusion
It does seem that the Indian economy has the competence of bearing the strains
of free capital mobility given its fantastic growth rate and investor confidence.
Most of the pre-conditions stated by the TARAPORE committee have been well
complied to through robust year on year performance in the last five years
especially. The forex reserves provide enough buffer to bear the immediate flight
of capital which although seems unlikely given the macroeconomic variables of
the economy alongside the confidence that international investors have leveraged
on India.
However it must not be forgotten that C.A.C is a big step and integrates the
economy with the global economy completely thereby subjecting it to
international fluctuations and business cycles. Thus due caution must be
incorporated while taking this decision in order to avoid any situation that was
faced by Argentina in the early 80’s or by the Asian economies in 1997-98.
Thank you