Capital account convertibility

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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.[1] It is sometimes referred to as capital asset liberationor capital

account convertibility

In layman's terms, 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.[citation needed] CAC is mostly a guideline to changes of ownership in foreign or domestic financial assets and liabilities. Tangentially, it covers and extends the framework of the creation and liquidation of claims on, or by the rest of the world, on local asset and currency markets.[2]

History
CAC was first coined as a theory by the Reserve Bank of India in 1997 by the Tarapore Committee, in an effort to find fiscal and economic policies that would enable developing Third World countries transition to globalized market economies.[3] However, it had been practiced, although without formal thought or organization of policy or restriction, since the very early 90's. Article VIII of the IMFs Articles of Agreement is agreed by most economists to have been the basis for CAC, although it notably failed to anticipate problems with the concept in regard to outflows of currency. However, before the formalization of CAC, there were problems with the theory. Free flow of assets was required to work in both directions. Although CAC freely enabled investment in the country, it also enabled quick liquidation and removal of capital assets from the country, both domestic and foreign. It also exposed domestic creditors to overseas credit risks, fluctuations in fiscal policy, and manipulation. [4] As a result, there were severe disruptions that helped to contribute to the East Asian crisis of the mid 90's. In Malaysia, for example, there were heavy losses in overseas investments of at least one bank, in the magnitude of hundreds of millions of dollars. These were not realized and identified until a reform system strengthened regulatory and accounting controls.[5] This led to the Tarapore Committee meeting which formalized CAC as utilizing a mixture of free asset allocation and stringent controls.[4]

Tenets
CAC has 5 basic statements designed as points of action: [6]

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.

Application
In most traditional theories of international trade, the reasoning for capital account convertibility was so that foreign investors could invest without barriers. Prior to its implementation, foreign investment was hindered by uneven exchange rates due to corrupt officials, local businessmen had no convenient way to handle large cash transactions, and 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. Due to the low exchange rates and lower costs associated with Third World nations, this was expected to spur domestic capital, which would lead to welfare gains, and in turn lead to higher GDP growth. The tradeoff for such growth was seen as a lack of sustainable internal GNP growth and a decrease in domestic capital investments.[7] When CAC is used with the proper restraints, this is exactly what happens. The entire outsourcing movement with jobs and factories going overseas is a direct result of the foreign investment aspect of CAC. The Tarapore Committee's recommendation of tying liquid assets to static assets (i.e., investing in long term government bonds, etc) was seen by many economists as directly responsible for stabilizing the idea of capital account liberalization.

Controversy
Despite changes in wording over the years, and additional safeguards, there is still criticism of CAC by some economists. American economists, in particular, find the restriction on inflows to Third World countries being invested in improvements as negative, since they would rather see such transactions put to direct use in growing capital.

What is capital account convertibility? There is no formal definition of capital account convertibility. The Tarapore committee set up by the Reserve Bank of India (RBI) in 1997 to go into the issue of capital account convertibility defined it as the freedom to convert local financial assets

into foreign financial assets and vice versa at market determined rates of exchange. In simple language what this means is that capital account convertibility allows anyone to freely move from local currency into foreign currency and back. How is capital account convertibility 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 trade-related 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. Can capital account convertibility coexist with restrictions? Contrary to general belief, CAC can coexist with restrictions other than on external payments. It does not preclude the imposition of any monetary/fiscal measures relating to forex transactions that may be warranted from a prudential point of view. Why is capital account convertibility such an emotive issue? CAC is widely regarded as one of the hallmarks of a developed economy. It is also seen as a major comfort factor for overseas investors since they know that anytime they change their mind they will be able to re-convert local currency back into foreign currency and take out their money. In a bid to attract foreign investment, many developing countries went in for CAC in the 80s not realising that free mobility of capital leaves countries open to both sudden and huge inflows as well as outflows, both of which can be potentially destabilising. More important, that unless you have the institutions, particularly financial institutions, capable of dealing with such huge flows countries may just not be able to cope as was demonstrated by the East Asian crisis of the late nineties. Following the East Asian crisis, even the most ardent votaries of CAC in the World Bank and the IMF realised that the dangers of going in for CAC without adequate preparation could be catastrophic. Since then the received wisdom has been to move slowly but cautiously towards CAC with priority being accorded to fiscal consolidation and financial sector reform above all else.

In India, the Tarapore committee had laid down a three-year road-map ending 19992000 for CAC. It also cautioned that this time-frame could be speeded up or delayed depending on the success achieved in establishing certain pre-conditions primarily fiscal consolidation, strengthening of the financial system and a low rate of inflation. With the exception of the last, the other two pre-conditions have not yet been achieved. the position of capital account convertibility in todays India Convertibility of capital for non-residents has been a basic tenet of Indias foreign investment policy all along, subject of course to fairly cumbersome administrative procedures. It is only residents both individuals as well as corporates who continue to be subject to capital controls. However, as part of the liberalisation process the government has over the years been relaxing these controls. Thus, a few years ago, residents were allowed to invest through the mutual fund route and corporates to invest in companies abroad but within fairly conservative limits. Buoyed by the very comfortable build-up of forex reserves, the strong GDP growth figures for the last two quarters and the fact that progressive relaxations on current account transactions have not lead to any flight of capital, on Friday the government announced further relaxations on the kind and quantum of investments that can be made by residents abroad. These relaxations are to be reviewed after six months and if the experience is not adverse, we may see further liberalisation and in the not-toodistant future full CAC.
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How are capital a/c convertibility and current a/c convertibility different? 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 trade-related 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. 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 anytime 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. At the moment, India has current account convertibility. This means one can import and export goods or receive or make payments for services rendered. However, investments and borrowings are restricted. But economists say that jumping into capital account convertibility game without considering the downside of the step could harm the economy. The East Asian economic crisis is cited as an example by those opposed to capital account convertibility. Even the World Bank has said that embracing capital account convertibility without adequate preparation could be catastrophic. But India is now on firm ground given its strong financial sector reform and fiscal consolidation, and can now slowly but steadily move towards fuller capital account convertibility. What is the Tarapore Committee? The Reserve Bank of India has appointed a committee to set out the framework for fuller Capital Account Convertibility. The Committee, chaired by former RBI governor S S Tarapore, was set up by the Reserve Bank of India in consultation with the Government of India to revisit the subject of fuller capital account convertibility in the context of the progress in economic reforms, the stability of the external and financial sectors, accelerated growth and global integration. Economists Surjit S Bhalla, M G Bhide, R H Patil, A V Rajwade and Ajit Ranade were the members of the Committee. The Reserve Bank of India has also constituted an internal task force to re-examine the extant regulations and make recommendations to remove the operational impediments in the path of liberalisation already in place. The task force will make its recommendations on an ongoing basis and the processes are expected to be completed by December 4, 2006. The Task Force has been set up following a recommendation of the Committee. The Task Force will be convened by Salim Gangadharan, chief general manager, incharge, foreign exchange department, Reserve Bank of India, and will have the following terms of reference:

Undertake a review of the extant regulations that straddle current and capital accounts, especially items in one account that have implication for the other account, and iron out inconsistencies in such regulations. Examine existing repatriation/surrender requirements in the context of current account convertibility and management of capital account. Identify areas where streamlining and simplification of procedure is possible and remove the operational impediments, especially in respect of the ease with which transactions at the level of authorized entities are conducted, so as to make liberalisation more meaningful. Ensure that guidelines and regulations are consistent with regulatory intent. Review the delegation of powers on foreign exchange regulations between Central Office and Regional offices of the RBI and examine, selectively, the efficacy in the functioning of the delegation of powers by RBI to Authorised Dealers (banks). Consider any other matter of relevance to the above.

The Task Force is empowered to devise its work procedure, constitute working groups in various areas, co-opt permanent/special invitees and meet various trade associations, representative bodies or individuals to facilitate its work. It will make recommendations on an ongoing basis to rectify the anomalies and remove operational impediments. The processes are expected to be completed by December 4, 2006. How does capital a/c convertibility affect the customers? 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. Customers 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. how will it affect Non-Resident Indians? Capital account convertibility may NRIs as it will help remove all shackles on movement of their funds. Currently, NRIs have to produce a whole lot of documents and certificates if they want to buy a house in India (for which the lock-in period is 10 years, meaning they can't take their money back overseas if they sell the house after having owned it for less than 10 years), or send money to India from their overseas accounts. ---------------*****************-------------------------******************----------How far has India moved towards capital account convertibility? Capital account convertibility is in vogue in terms of freedom to take out proceeds relating to FDI, portfolio investment for overseas investors and NRIs besides leeway for firms to invest abroad in JVs or acquisition of assets, and for residents and mutual funds to invest abroad in stocks and bonds with some restrictions. India seems to be taking the approach that easing of capital controls would be marked by removal of capital outflow restrictions on NRIs first, corporates next, followed by banks and freedom for residents in the last stage. How does easing of capital controls benefit economies? Once a country eases capital controls, typically, there is a surge of capital flows. For countries that face constraints on savings and capital can utilize such flows to finance their investment, which in turn stokes economic growth. The inflow of capital can help augment domestic resources and boost growth. Local residents would be in a position to diversify their portfolio of assets, which helps them insulate themselves better from the consequences of any shocks in the domestic economy. For global investors, capital account convertibility helps them to seek higher returns by sharing risks. It also offers countries better access to global markets, besides resulting in the emergence of deeper and more liquid markets. Capital account convertibility is also stated to bring with it greater discipline on the part of governments in terms of reducing excess borrowings and rendering fiscal discipline.