CAPITAL ACCOUNT CONVERTIBILTY & SOME ISSUES

What is Convertibility?

CONVERTIBILITY
Current Account convertibility: refers to currency convertibility required in the case of transactions relating to exchange of goods and services, money transfers and all those transactions that are classified in the current account.

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.

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.

CAPITAL ACCOUNT CONVERTIBILITY

Freedom to residents to convert local financial assets into foreign assets, and/or to take on foreign liabilities and invest proceeds in India or abroad. Freedom to non residents to create rupee assets or liabilities and alter them . In other words, I would be free to keep money in a Swiss Bank! And, say, Microsoft could issue a rupee bond in the Indian market.

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.

Capital Account Transactions

FDI and FII FDI Foreign Direct Investment

Asserts controlling stake with inclination to control.a firm.

FII

Stock Market / Securities market based investment with no inclination to control

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.

Recommendations by Tarapore Committee

Raise the annual limit for the amount you are allowed to carry on a private visit abroad from $25000 presently to $100000. Permission to invest into foreign stock markets up to the extent of $25,000 in a year. Banning the Participatory Notes to avoid/reduce money laundering.

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

Asian Crisis (2)

Until 1997, Asia attracted almost half of total capital inflow to developing countries. These economies maintained high interest rates attractive to foreign investors. Received a large inflow of hot money and experienced a dramatic run-up in asset prices. Thailand, Malaysia, Indonesia, the Philippines, Singapore, and South Korea experienced high, 8-12% GDP growth rates in the late 1980s and early 1990s. This achievement was broadly acclaimed by economic institutions including the IMF and World Bank, and was known as part of the Asian economic miracle.

Asian Crisis (3)

Productivity did not increase ! In 1994, Western investors lost confidence in securities in East Asia and began to pull money out, creating a domino effect. Large Current Account Deficits Large External Borrowings Russia, Brazil and US pulled-out investments from Asia

Asian Crisis (4)

Role of IMF was controversial Currencies weakened by 50% or more Stock markets crashed by 75% Interest Rates roofed up to 40% or even 500% Depression Unemployment

IMF Views

One of the objectives of IMF is to promote CAC ! Basic objective of IMF is to bailout economies in crisis related to BoP IMF urged India 3 times in 2005 to be liberal on Capital Account

Contrary Views on objectives of IMF

Indian Approach

Partial CAC Slow approach Policy watch after every move Current Account Improvements Productivity Improvements Democratic pressures positive