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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 
Current Account

A capital account refers to 
A current account refers to
capital transfers and goods and services,
acquisition or disposal of income, and current
non-produced, non-financial transfers. E.g. export/import
assets. E.g. purchase/sell of of goods and services.
property, ownership in a
firm etc. 
Current account

Capital account convertibility allows free
convertibility allows free inflows and outflows for all
movement from local purposes other than for
currency into foreign capital purposes such as
currency and back. 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