Economic Environment ProjectOn

GROUP 1

ABHISHEK KUMAR KHARE (ROLL NO: EPGP-04B-002)

MANOJ BENEDICT (ROLL NO: EPGP-04B-049)

MURALI KRISHNAN P (ROLL NO: EPGP-04B-055)

NAGESH KUMAR (ROLL NO: EPGP-04B-056

Instructor: Prof. Leena Mary Eepan Prof. Sthanu S Nair

Capital Account Convertibility

Contents

Objective.......................................................................................................................................................3

What is Capital Account Convertibility (CAC).....................................................................................................3

Why Capital Account Convertibility (CAC).........................................................................................................4

Pre-Conditions for Capital Account Convertibility................................................................................................5

Arguments For and Against Capital Account Convertibility..................................................................................7

Implications Of Capital Account Convertibility on Indian Economy........................................................................8

Experience of Capital Account Convertibility - Global Experience.........................................................................9

RBI’s Stand on Capital Account Convertibility – India Context............................................................................13

Views of Various Official Committees on CAC – India Context...........................................................................13

Roadmap for India for Capital Account Convertibility – Our Views......................................................................15

Reference....................................................................................................................................................18

Objective

Currency convertibility refers to the freedom to convert the domestic currency into other internationally accepted currencies and vice versa. Convertibility in that sense is the obverse of controls or restrictions on currency transactions. Through this project we attempt to study the history of Capital Account Convertibility policies and implementations mostly focusing on the India Context. This project intents to address the below set of questions.

Definition of capital account convertibility and its key differences with current account convertibility. The major arguments for and against capital account convertibility of Indian rupee in the backdrop

of worldwide experience in implementing CAC. Pre-conditions that India needs to meet before introducing capital account convertibility Implications of capital account convertibility for Indian economy RBI’s stand on this issue Various studies done so far by Official Committees. Propose a road map for India for reaching the goal of capital account convertibility.

What is Capital Account Convertibility (CAC)

A foreign currency transaction can be of two types: Current Account and Capital Account. While the former denotes transactions for normal trade and some specified non-trade purposes (e.g. medical treatment, education expenses abroad), capital account transactions are only for investment purposes.

A working definition of capital account convertibility (CAC) is ‘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. CAC can be, and is, coexistent with restrictions other than on external payments. It also does not preclude the imposition of monetary/fiscal measures relating to foreign exchange transactions which are of a prudential nature. As the definition indicates, capital account convertibility is compatible with prudential restrictions. Temporary measures to insulate an economy from macroeconomic disturbances caused by volatile capital flows are in accord with an open capital account.

A capital account refers to capital transfers and acquisition or disposal of non-produced, financial assets, and is one of the two standard components of a nation's balance of payments. The other being the current account, which refers to goods and services, income, and current transfers. 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.

Restricted CAC implies existence of capital control. This section discusses a few aspects of capital control per se. Capital controls can be imposed on:

• Direction of Capital flows (Inflows or Outflows) • Type of capital Flows (FDI/FPI/Portfolio Debt or Equity)

• Maturity of capital flows (Short-term/Medium-term/Long-term) • Sectoral destination of capital flows (Financial/Real estate/Infrastructure etc)

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 ino 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.

A Pictorial Representation of the differences between Capital Account and Current Account is below.

Why Capital Account Convertibility (CAC)

As per the two-gap approach to development, developing countries were assumed to face scarcity of capital. The analysis shows that developing countries should be net borrowers in the development process. Capital flows were welcome as far as they eased the foreign exchange constraint by borrowing externally on the government account. Today dismantling capital controls is also welcomed to relieve liquidity constraints. The advantage is seen in the optimal levels of investment that can be reached by the free access to global savings both by the government and private market participants.

As per modern theory of International finance, which emphasizes the risk in international financial markets, if the price of bearing risk differes across countries, then there are welfare gains in trading in international

markets. The welfare gains are seen in risk diversification by economic agents. Risk diversification can not only take place by holding a portfolio of different domestic assets, but also by diversifying internationally.

capital account provides opportunities for inter-temporal consumption smoothing. Time and liquidity constraints differ across countries. This would mean that aging economies tend to post excess savings and hence a surplus in the balance of payments on current account which they will run down later in the form of net inflows. A country suffering from a temporary shock will prefer to run a current account deficit to smooth consumption over time. Trade in financial assets would thus relieve liquidity constraints. The more integrated a developing country is with world markets, the greater will be the possibility to reap the dynamic advantages of financial intermediation. Benefits from improved international competition leading to the breaking up of the oligopolistic structure and a more efficient domestic financial system by intensifying competition between financial intermediaries is seen as one of the positive outcomes of capital account liberalization.

Free movement of capital have add on benefits like , flow of technology and intellectual property. The free movement of capital is expected to bring about convergence of interest rates and tax rates and structures. A liberalized capital account is also seen as way to discipline domestic policies.

The declining effectiveness of capital controls may be another reason for removing them. Growing tradeintegration and the presence of multinationals provides opportunities for financial integration even if controls on capital account transactions are in place.

Pre-Conditions for Capital Account ConvertibilityFiscal consolidation: States fiscal position is a key factor in deciding to liberalize the financial markets and polices including capital account convertibility. This ensures macroeconomic stability and also the credibility of the policy by easing debt servicing obligations. Large fiscal deficits may keep interest rates high and thus contribute to interest rate differentials that induce large inflows of more volatile, short-term capital.

Inflation rate: It is generally believed that an inflation in single digit is a desirable policy objective. This requires central banks to be independent and insulated from populist pressures. High rates of inflation are destabilizing and require high nominal and real rates of interest which have negative real effects and could reinforce capital inflows

Financial Sector Reforms: In an environment of liberalized capital flows, weaknesses of the financial system can cause macroeconomic instability and crises. The choice is therefore between a careful reform of the financial system before or during the process of liberalization, or emergency reforms after a crisis. Banking systems remain weak in many developing countries, burdened either by interest rate controls or mandated lending to favored groups or firms. In addition, many systems have very high reserve requirements relative to international levels. Reform must also encompass improved accounting standards, increased monitoring and surveillance of bank risk exposure, and prudential standards that conform to international standards (Basle Committee)

Monetary Policy: The development and deepening of financial markets following reform, also changes the context in which monetary policies conducted. A move from direct monetary policy controls to indirect controls is desirable, as it avoids distortions in financial intermediation and is more flexible for policy purposes. In addition, the development of indirect controls also enables the central bank to more effectively carryout sterilization operations in capital inflow episodes. Appreciation of the exchange rate due to capital

inflows diverts investment away from the tradable sector when in persists for a longtime. Sterilization is needed to deal with this or it can be combined with other instruments such as reserve requirements, taxes or a partial liberalization of outflows.

Exchange Rate Policy: This is another factor central policy making concerns towards CAC. Authorities must decide on the optimal degree of exchange rate flexibility with an aim to prevent either unsustainable appreciations of the real exchange rate that can undermine competitiveness or expensive interest rate defenses of fixed rates and/or costly sterilization operations.

Current Account Balance: Current account deficits are common with developed countries, basically reflecting the global savings to achieve the growth and investment. Experience suggests that prudent limits must be set on the expanding deficits. As the deficit raises the debt servicing begins to account for an increasing proportion of external earnings that could be otherwise used to increase imports.

Foreign Exchange Reserves: With capital account convertibility, the level of international reserves becomes a key consideration for policymakers. Reserves help to cushion the impact of cyclical changes in the balance of payments and help offset unanticipated shocks, which can lead to reversals of capital flows. Reserves also help sustain confidence in both domestic policy and exchange rate policy.

Prudential Norms : The implementation of effective prudential norms in the financial sector is a central requirement for CAC. Given the weaknesses of financial systems in developing countries, authorities should consider moving beyond the prudential standards defined. Tighter prudential norms may be in the form of steeper capital requirements for banks with higher levels of non-performing loans. Norms should be set with the aim of ensuring the stability, solvency and liquidity of the financial system and not watered down to ensure the survival of weaker institutions.

Supervision: An essential precondition for capital account convertibility is the establishment of an effective supervisory regime that has the capacity to monitor developments in the financial sector and to enforce its regulations and directives. Weak financial institutions need to be quickly identified, provisions made for losses and prudential standards enforced. The consequences of lax supervision are magnified in the presence of CAC since the linkage between the domestic and international financial systems are far closer and instabilities arising in one can quickly lead, for the individual country, to a domestic financial crisis and/or an external funding crisis. Establishing an effective and efficient supervisory institution is a long-term project that reinforces the need for gradualism in introducing CAC.

Lowering of tariff Barriers: Reforming the trade regime to make it more open to the international economy is part of the structural reforms that should precede CAC. High tariffs, in addition to their allocative inefficiency, encourage direct investment in the economy that is not directed towards export markets, but rather towards ‘tariff jumping’. Lowering tariffs is therefore linked to the promotion of a diversified export base.

Diversified Export Base: A diversified export base helps cushion the economy from sudden terms of trade or other shocks that may emerge from dependence on a narrow range of exports, Such shocks have immediate effects upon the current account and with a loss of confidence in the country’s capacity to meet debt repayments or sustain the current rate of capital inflows, may drive a capital account crisis as well. Developing countries have traditionally been vulnerable to such shocks to the export sector, often arising from dependence on primary commodity exports.

Arguments For and Against Capital Account Convertibility Full CAC has both pros and cons. [5]

The beneficial effects include the following: It leads to more inflow of capital into domestic financial system. Thus firms have access to more

capital, and this reduces their cost of capital(i.e. COC). A reduced COC induces firms to invest more, expand more and thus output, employment and income expand in medium- to long-run.

Full CAC leads to freedom to trade in financial assets. Investors can choose from a wider range of financial products across multiple countries.

Entry of foreign financial institutions results in eventual efficiency in domestic financial system, since such entry increases the number of players in the market, and fosters competition. In some cases,the market could see a transition from the near-monopoly to near-perfectly competitive market. In order to survive stiffer competition, (domestic) firms are forced to become more efficient. This also ensures compliance with international standards of reporting,

disclosure and best practices. As a consequence of full CAC, tax levels converge to international levels. As more capital flows in, domestic interest rates are reduced, thus cost of government’s domestic

borrowing is reduced, and so fiscal deficit shrinks.

However, the other side of the coin has the following ill-effects: An open capital account causes an export of domestic savings abroad, to more attractive destinations.

In capital-starved countries, such outbound savings-flight can be ill afforded. Increased capital inflows also lead to appreciation of real exchange rate. It shifts resources from tradable to non-tradable sectors.

Premature liberalization and CAC lead to an initial stimulation of capital outflows, which by appreciating the real exchange rate, destabilizes the economy.

Another possible side-effect is generation of financial bubbles. A sudden burst could replicate the Asian crisis once again.

The often cited argument against CAC is concerning movements of short-term capital. It is considered to be extremely volatile, highly sensitive to domestic and/or international economic, political and financial events, and once such an event starts, the extent increases as in a chain-reaction – such investors invest their capital only lured by the prospect of short-term ‘windfall gains’ precipitated by interest-rate differentials (in most cases). And once some investors withdraw their capital, the herd mentality is displayed – other ‘arms-length’ investors also follow suit and withdraw their money. This is known as ‘capital flight’. Once capital flight takes place, international investors lose confidence on the host country’s economy. Creditworthiness diminishes, too. And the most dangerous consequence of capital flight is that the government has to deploy its Forex Reserves to the investors who withdraw the capital, and this brings the domestic economy to a highly vulnerable state. This may well start a financial disruption and/or currency crisis.

The upsides of CAC for INDIA are summarized below,

• CAC could facilitate the Indian need to attract global capital as we need to augment our domestic savings with external savings to boost out investment rates

• Ordinary Indian residents would get an increased choice of investment, which could enhance their welfare. Further, by offering a diverse global market for investment purposes, an open capital account permits domestic investors to protect the real value of their assets through risk reduction

• Capital controls, it is often found, are not very effective, particularly when current account is convertible, as current account transactions create channels for disguised capital flows and thereby distorting trade.

• An open capital account could bring with it greater financial efficiency, specialization and innovation by exposing the financial sector to global competition.

The downsides of CAC for INDIA are summarized as below,

• A free capital account could lead to the export of domestic savings, which for capital scarce developing countries like India could be ruinous. Given the fact that one hand we seem to invite FDI – i.e. import foreign savings into India, any step that could lead flight of domestic capital is highly contradictory to the national policy of attracting higher savings through FDI route into India.

• 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. Moreover, such speculative capital flows may make domestic monetary policy virtually ineffective. Also one needs to understand that India imports approximately 75% of her crude requirements. Given the fact that the oil prices have been well above the USD 60 per barrel and extremely volatile, any volatility in the FE position of India could result in soaring energy prices. This could upset the economy and have a debilitating impact on inflation within India.

• 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.

Implications Of Capital Account Convertibility on Indian Economy India did not engage in ‘big bang’ liberalization. The full policy implications of this broad position were worked out through a steady pace of numerous reforms initiatives in the 1992-2004 period. The present framework of tariffs, restrictions against FDI and restrictions against portfolio flows implies that the reforms agenda on the current account, on FDI and on portfolio flows remains incomplete as of 2004.

Looking back, these goals have been achieved to a significant extent:

1. Net debt flows were at roughly 1% of GDP in both 1992-93 and 2003-04. Gross debt flows actually dropped sharply, from 13.5% of GDP in 1992-93 to 10.6% in 2003-04.

2. Trade integration has gone up sharply, with gross current account flows rising from 25% of GDP in 1992-93 to 35% in 2003-04.

3. FDI and portfolio flows have gone up sharply. India has fared particularly well in the institutional transformation of the equity market, which helped Indian equities obtain acceptance in global portfolios. The experience with FDI flows, while showing strong growth rates when compared with the initial conditions, lags that of other Asian countries, both in absolute terms and when expressed as per cent to GDP.In an open-economy, these three aspects of policy are closely intertwined with the currency regime. India has been in a quest for openness in trade, FDI and portfolio flows, while continuing to have capital controls in most other respects, and trying to have both an independent monetary policy and a pegged exchange rate. There was a very strong consensus about the usefulness of extensive trading by the central bank on the currency market in implementing currency policy. Indeed, issues about the currency regime were not debated in the 1992-2002 period.

As a consequence, India’s experience with capital flows is deeply intertwined with India’s experience with the currency regime. Capital flows have shaped the currency regime, and the currency regime has shaped capital flows.

Openness on the trade account, FDI and portfolio flows has given economic agents opportunities to express speculative views about currency movements, and thus thrown up new problems in the implementation of pegging. India differs from China in the importance of portfolio flows. Portfolio flows involve robust inflows and outflows. For example, in 2003-04,portfolio inflows were only 1.67 times bigger than portfolio outflows, and gross portfolio flows amounted to 7 per cent of GDP.

Difficulties faced by the central bank in implementing the currency regime have continually influenced the pace of removal of controls on capital flows. In particular, there has been significant policy volatility with respect to debt flows, ranging from periods with government sponsored offshore borrowing to periods with sharp restrictions upon offshore borrowing.

Similarly, policies on outward capital flows have been ambivalent, and have lacked the consistent direction of reform that was found on the current account, on FDI and on portfolio flows. The implementation of the currency regime has led to large capital outflows in the form of reserves accumulation by the RBI. This was particularly the case in 2003-04, when 4.9% of GDP left the country in this fashion. The total outward flow was larger than this when we take into account other policy tools such as pre-payment of official debt, which were used in 2003-04.

One of the key goals of the reforms of the 1990s was to augment domestic GDP growth by attracting FDI and portfolio flows. In 2003-04, the total net capital inflows of $20.5 billion were accompanied by an outward official capital flow of over $31.4 billion. This leads to concerns about whether this policy framework has succeeded in serving the interests of accelerating GDP growth. India has undoubtedly reaped microeconomic benefits from the new presence of FDI and foreign investors on the equity market. However, a sustainable macroeconomic framework for a current account deficit, and augmenting domestic investment using foreign capital, is not yet in place.[4]

Experience of Capital Account Convertibility - Global Experience 1. Argentina

In the 1970s and 1980s, Argentina experienced severe hyperinflation that had completely undermined the credibility of monetary policy and subverted economic growth. The Convertibility Plan of 1991 sought to regain monetary control and credibility by establishing a currency board that prevented the monetization of the fiscal deficit and ensured the complete liberalization of international payments and transfers on both current and capital account. In conjunction with this radical restructuring of monetary and payments policy, Argentina pursued a policy of trade liberalization, privatization, deregulation, fiscal consolidation and initiatives to improve the operation and prudential supervision of the financial system.

Argentina accepted Article VIII obligations in 1968. However, current and capital account transactions were both liberalized simultaneously in 1991,completing a process that had begun in 1989. Financial sector reform continued throughout the period and was pushed even further during the Mexican crisis of 1994-95, when authorities required capital adequacy ratios that went beyond those specified by the Basel Committee, increased liquidity and encouraged increased foreign participation.

Result :: Argentina was able to attract large inflows of private capital in the aftermath of this radical reform program. Foreign direct investment and portfolio flows reached 11 percent of GDP in 1993,

compared with less than 1 percent in 1990. Real GDP growth averaged more than 7 percent in the three years following the convertibility plan while consumer price inflation declined dramatically to 4 percent in 1994. After a recession in 1995, growth quickly resumed [6]

2. Kenya

Kenya experienced a severe economic crisis in the late 1980s, fuelled by a dramatic decline in the price of two of its main commodity exports, tea and coffee, that resulted in widening fiscal and current account deficits and a shortage of foreign exchange. Growth slowed while inflation accelerated. Kenya in the late 1980s was characterized by a highly regulated financial system and highly controlled payments and trade regimes. The financial system was poorly supervised and a clientelistic political system generated pressures to grant credits to favored groups and firms.

The government significantly liberalized current and capital account transactions in 1991 when it introduced foreign exchange bearer certificates of deposits (FEBCs) that allowed the bearer to redeem them for foreign exchange for any external transaction. Kenya accepted Article VIII obligations in 1994. In 1995, remaining foreign exchange controls were eliminated and with a few exceptions all restrictions on the capital account were removed. Financial sector reforms were largely neglected.

Result :: Kenya's reform program failed to attract significant inflows of foreign capital or to prevent the country from experiencing another economic crisis. Growth declined, inflation accelerated and inconsistent policies generated by the country's first democratic elections in late 1992 resulted in an economic crisis in early 1993. The money supply expanded rapidly, resulting in a M2/GDP ratio that rose from 29.7 percent in 1990 to 37.1 percent in 1993. Pervasive weaknesses in the financial system exacerbated the crisis and prudential regulation and enforcement remained feeble as banks regularly breached legal reserve ratios [6]

3. Indonesia

In 1985, Indonesia initiated a reform program that was intended to reorient the economy away from its dependence on the oil sector and towards an internationally competitive industrial export sector that could help absorb the growing labour force. This objective required reform on a broad front, including the liberalization of direct investment flows to promote export diversification, maintenance of a competitive exchange rate, trade liberalization, improvements in monetary management and strengthening the financial sector.

Indonesia accepted Article VIII obligations to liberalize payments for current international transactions in 1988. On the capital account, Indonesia maintained selective controls on both capital inflows and outflows. The financial sector was reformed in phases from interest rate reform in the early 1980s to a greater emphasis on accounting standards and prudential regulation in 1995-96.

Result :: Indonesia initially seemed poised to weather the 1997 Asian financial crisis given its smaller current account deficit and decision to widen the trading band of the rupiah. Widespread

concerns about the soundness of the banking sector, however, renewed speculative pressure on the rupiah and after its forced float promptly collapsed in value. From an average rate of 2,342 against the US dollar in 1996 the rupiah traded at 10,013 in 1998 [6]

4. Brazil

In the early 1990s, the Brazilian economy was experiencing an inflationary spiral. A wide arsenal, including price and wage controls, freezing bank deposits, tighter monetary policy, tax increases and sequestering financial assets, was deployed unsuccessfully against it. Large fiscal funding requirements encouraged expectations of further inflation and raised the interest rate differential which, in conjunction with a stable exchange rate, induced large inflows. These inflows were further encouraged by a further liberalization of capital inflows.Brazil signed Article VIII in November 1999. Capital account liberalization has progressed in fits and starts over the course of the 1980s and 1990s since it has been complicated by the large imbalances that have led to periods of hyperinflation. Financial sector reform has also proceeded at a fitful pace, although Brazil already possesses a relatively sophisticated financial systemObservation: The Brazilian experience suggests that the lack of macroeconomic reforms (especially in terms of fiscal policy) can induce perverse outcomes with respect to inflationary expectations and capital inflows. In a context of high interest rate differentials and sophisticated financial markets, it is unlikely that capital controls will be able to effectively alter the scale of net inflows or their composition. The increase in controls have a temporary effect on the scale and composition of inflows, but that the effect is only temporary. [6]

5. India

After the economic crisis of 1991, India embarked on a liberalization process that has begun to reverse decades of inward-looking and interventionist policies. Industrial licensing has been abolished and trade barriers have been reduced. Over the course of the 1990s, a cautious and gradual move towards more capital account openness was underway, although considerable obstacles to full convertibility are still present. Signed Article VIII in August 1994, although some current account controls have been maintained that are consistent with these obligations. Capital account liberalization has proceeded at a gradual pace. The 1997 Tarapore Committee on Capital Account Convertibility recommended a cautious approach that seeks to establish the preconditions for liberalization on a sound footing. These include fiscal consolidation, an inflation target and, most importantly, the strengthening of the financial system. Consequently, more stable flows such as direct and portfolio investment have been liberalized first, followed by partial liberalizations of debt-creating flows, derivative transactions and capital outflows. Financial reform has continued concurrently.Observation :: India's experience illustrates the gradual approach to capital account liberalization. CAC has proceeded gradually in the context of a broad reform agenda that encompasses trade, competition and industrial restructuring. Emphasis has been placed on the reform of the financial system as a pre-condition for capital account liberalization. The Report of the Committee on Banking Reform has set out the large-scale reform agenda that is required. India's experience also reveals the effectiveness of the present control regime in preventing, along with other factors, a build-up of short-term external liabilities that could increase the country's vulnerability to externally-generated crises. In contrast to the countries affected by the Asian crisis, India also limits banking assets held in

real estate, foreign currency and equities. Thus, the balance sheets of Indian banks are not subject to the same degree of volatility.By effectively shifting the composition of inflows towards more stable, long-term flows, India can receive the benefits of capital account liberalization while limiting vulnerability while financial sector reforms proceed. [6]

CAC and South-East Asian Crisis: A Note

The Asian Crisis of 1997-98 originated from Thailand. The Baht was at that time pegged with US Dollar. As dollar appreciated, so did Baht,and exports decreased, export competitiveness also reduced, leading to increased current account deficit and trade deficit. Thailand was heavily reliant on foreign debt – with its huge CAD being dependent on foreign investment to stay afloat. Thus there was an increased forex risk. As US increased its domestic interest rate, the investors started investing more in the US. It led to capital flight. Forex reserves rapidly depleted, and the Thai economy tumbled down. At this juncture, Thai government decided to dissociate Baht from the US currency and floated Baht. Concurrently, the export growth in Thailand slowed down visibly. Combination of these factors led to heavy demand for the foreign currency, causing a downward pressure on Baht. Asset prices also decreased. But, that time Thailand was dominated by “crony capitalism”, so credit was widely available. This resulted in hike of asset prices to an unsustainable level – and as asset prices fell, there was heavy default on debt obligations. Credit withdrawal started. This crisis spread to other countries as a contagion effect. The exchange markets were flooded with the crisis currencies as there were few takers. It created a depreciative pressure on the exchange rate. To prevent currency depreciation, the governments were forced to hike interest rates and intervene in forex markets, buying the domestic currencies with their forex reserves. However, an artificially high interest rate adversely affected domestic investment, which spread to GDP, which declined, and eventually economies crashed. In this backdrop, the most vicious argument offered by the opponents of full CAC had been the role of free currency convertibility. In the absence of any capital control, no restrictions were kept on capital outflow, and thus the herd behavior of investor led to economic cash of the entire region. [7]Thus the Asian currency has taught the following observations and lessons:

• Most currency crises arise out of prolonged overvalued X-rate regime. As the pressure on the X-Rate increases, there is an increased volatility of the capital flows as well as of the X-Rate itself. If the X-rate appreciates too high, the economy’s export sector becomes unviable by losing export-competitiveness at a global level. Simultaneously, imports become more competitive, thus CAD

• increases and becomes unsustainable after a certain limit. • Large and unsustainable levels of external and domestic debt had added to the crises, too. Thus, the

fiscal policies need to be more transparent and forward-looking. • During the crises, short term flows reacted quickly and negatively. Either receivables were postponed

by debtors and/or payables were accelerated by creditors. Thus BOP situation worsened. • Domestic financial institutions need to be strong and resilient to absorb and minimize the shocks so

that the internal ripple effect is least. • Gradual CAC is the safest way to adopt. However, even a gradual CAC can not fully eliminate the risk of crisis or pressure on forex market.

RBI’s Stand on Capital Account Convertibility – India ContextIn the post reform era (after 1992), full current account convertibility was achieved but the government and RBI have been cautious on the issue of Capital account convertibility. Two major committees were set by RBI to look into this issue under S.S.Tarapore. First committee submitted its report in 1997 and laid the road map and preconditions to be met to achieve Full capital account convertibility in three year time frame. But the East Asian crisis in 1997, put the issue on back burner as the international opinion on Full capital account convertibility turned negative. Again after years of solid economic growth the Indian government started looking into CAC. Already many of the recommendations of Tarapore-I had been acted upon and in 2006 Tarapore II committee was formed by RBI. This committee recommended moving toward FCAC in three phases leading to complete FCAC by 2011. Another High powered committee set up under Ministry of Finance in 2007 for making Mumbai an IFC also echoed the sentiments of Tarapore-II and recommended achieving the goal in a time bound manner (18-24 months). Off late(2011 onwards) high inflation and fiscal deficit in Indian economy have been major issue facing the policy makers and fresh reforms need to be infused to achieve high economic growth.The details of these committees and their recommendations are captured in the next section.

Views of Various Official Committees on CAC – India ContextFirst CAC committee (Tarapore committee report 1997): [2]

A committee on capital account convertibility was setup by the Reserve Bank of India (RBI) under the chairmanship of former RBI deputy governor S.S. Tarapore to "lay the road map" to capital account convertibility. In 1997, the Tarapore Committee had indicated the preconditions for Capital Account Convertibility. The three crucial preconditions were fiscal consolidation, a mandated inflation target and strengthening of the financial systemThe five-member committee had recommended a three-year time frame for complete convertibility by 1999-2000. The highlights of the report including the preconditions to be achieved for the full float of money are as follows Pre-Conditions 1. Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5 per cent in 1997-98 to 3.5% in 1999-2000

2. A consolidated sinking fund has to be set up to meet government's debt repayment needs; to be financed by increased in RBI's profit transfer to the govt. and disinvestment proceeds. 3. Inflation rate should remain between an average 3-5 per cent for the 3-year period 1997-2000

4. Gross NPAs of the public sector banking system needs to be brought down from the present 13.7% to 5% by 2000. At the same time, average effective CRR needs to be brought down from the current 9.3% to 3%

5. RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a neutral Real Effective Exchange Rate RBI should be transparent about the changes in REER 6. External sector policies should be designed to increase current receipts to GDP ratio and bring down the debt servicing ratio from 25% to 20%

7. Four indicators should be used for evaluating adequacy of foreign exchange reserves to safeguard against any contingency. Plus, a minimum net foreign asset to currency ratio of 40 per cent should be prescribed by law in the RBI Act.

Second CAC committee (Tarapore committee report 2006): [2]

The Asian crisis in 1997 gave a new perspective to capital account convertibility. Countries like India and China which had capital account regulations in place were able to ride the crisis more effectively. This led the policy makers to put the recommendations of First Tarapore committee report on the back burner for few years. But after high growth phase of Indian economy the policy makers again started looking into CAC. Second CAC committee was again set under the chairmanship of S.S.tarapore with many notable champions of CAC on board and referred to as Tarapore committee II. This committee once again followed an approach much similar in spirit to that of the earlier committee. It began by reviewing the extent to which the earlier committee’s recommendations had been actually implemented. It then laid down a detailed time frame for achieving full convertibility and also drew out a new set of safety guidelines. Tarapore II is far more ambitious in the scope of its recommendations, and intends to take India quite a bit further along the road to full (or almost full) capital account convertibility. This it proposes to do progressively in three phases: Phase I (2006-07), Phase II (2007-09) and Phase III (2009-11). The major recommendations of Tarapore II are set out below:

(1) Removal of overall external commercial borrowings (ECBs) ceiling of $ 22 billion and removal of restrictions on end-use of ECBs.

(2) Limits on corporate investments abroad be doubled from the current limit of 200 per cent of net worth.

(3) Banks be allowed to borrow overseas up to 50 per cent of paid-up capital and reseves in Phase I, which amount can be raised to 75 per cent in Phase II and 100 per cent in Phase III.

(4) As against the current limit of $ 25,000, individuals be allowed to remit abroad (annually) up to $ 50,000 in Phase I, $ 1,00,000 in Phase II and $ 2,00,000 in Phase III.

(5) Currently only NRIs are allowed to invest in companies listed on Indian stock exchanges. The committee recommends extension of this facility to all non-residents (through SEBI registered entities such as mutual funds and other portfolio management schemes).

(6) FIIs be prohibited from raising money through Participatory Notes (PNs).

High Powered Committee (HPEC) set up under the Ministry of Finance , Government of India for making Mumbai an International Finance centre[3] submitted its report in 2007. In this report, the HPEC after considering the recommendations of the Tarapore-2 committee very carefully, recommended that full capital convertibility should be achieved with in a time bound period of the next

18-24 months and by no later than the end of calendar 2008. According to this committee report, time bound execution of Full capital account convertibility when executed along with its other recommendations would help to accommodate the accepted international consensus that a country moving to convertibility must have liquid and efficient financial markets and strong institutions and also export IFS more effectively after convertibility is achieved. [3]

Roadmap for India for Capital Account Convertibility – Our ViewsIndia - Key Macro Economic Indicators

(Source Deloitte Paper on getting to the Core Economic indicators of the Indian capital markets relevant for Foreign Institutional Investors, March 2012)

India’s Performance against the Pre-Conditions set by the Tarapore committee

The previous discussion clearly indicates the following:

• On the fiscal front, India has performed poorly. The fiscal deficit/GDP ratio has not been contained within the prescribed limit.

Average inflation rate has stayed higher than the recommended band. • Debt-servicing ratio has not at all responded to the recommendation. • Average effective CRR has remained much higher than the floor. • However, the gross NPA ratio of public sector banks has come down remarkably. • India’s external sector has registered positive performance. The exports/GDP ratio and import/GDP

ratio have gone up. CAD/GDP ratio has been contained within the 2-3% band on a continuous basis.

Thus Tarapore Committee’s recommendations have mostly not been implemented, since the prescribed conditions were not met. Time-frame wise, it is clear that the committee’s suggestions and recommendations were premature by at least 10 years, if not more.

On the following counts on which India performed as recommended by the Committee:

• Trade and External Sector • Reserves Adequacy, and • Gross NPA of Public Sector Banks.

The following observations came out from the study of the subject with respect to Roadmap to Capital Account convertibility

(a) Globalization of world economy is a reality and opening up of financial market is inevitable and unavoidable process. Its suggested that emerging economies workout and orderly liberalization of the capital account instead of reforming under duress after crisis hit the economy.

(b) The main impediments in the way of capital account convertibility are the weak initial conditions related to the health and development of the financial sector and problems related to asset liability management of the banking system. Of crucial importance are measures addressing bank soundness, interest risk management, hard budget constraints for public enterprises, the oligopolistic structure of the banking industry, and market segmentation. Without underlying changes in the structure of the financial system, macroeconomic and financial instability is a predictable consequence of moves towards capital account liberalization.

(c) Macroeconomic stabilization and flexibility are required for a successful liberalization of the capital account. A successful capital account convertibility program requires the achievement of the following macroeconomic targets:

1. reductions in inflation levels to those prevailing in industrialized countries2. reductions in the gross fiscal deficit to gross domestic product ratio3. sufficiency of foreign exchange reserves4. sustainable current account deficits5. a stable and competitive exchange rate regime6. development of indirect instruments of monetary policy

(d) Liberalization of the capital account will be a gradual process accompanied by fiscal and financial reforms. International portfolio diversification requires skills in managing interest and exchange risk.

(e) Emerging economies like India, the supervisory and regulatory regimes need to be improved and brought up to international standards, which further reinforces the case for gradualism. Developing different segments of the financial market is dependent on a well-functioning money market.

(f) Sequencing current and capital account liberalization. Liberalization of the controls on the current account combined with a relatively closed capital account leads to the loss of capital through leads and lags in the current account. Some restrictions on the current account are needed in the transition phase to give the country time to reform without dealing with the problem of capital flight through this channel.

(g) The opening up of the capital account based on distinctions between residents and non-residents (an approach followed by India and South Africa). In both these cases the assumption seems to be that outflow of capital by residents can cause a crisis since opening up is more cautious for the resident sector. There is some basis for this. But country experiences shows that FIIs are equally likely to exit from a country based on their perceptions about the economy.

(h) Capital flight may be a problem for economies opening their capital accounts. The overall investment climate, political and economic instability, and asymmetric risk and information motivate capital flight. The porosity of the capital account emphasizes the need to bring about the necessary reforms to control unrecorded capital flows

(i) Capital account convertibility is consistent with some restrictions that can be used to insulate a country from macroeconomic instability in the face of large and volatile flows. Individual components of the capital account can be liberalized selectively while the sequencing of liberalization at each stage must explicitly take into consideration the individual circumstance of each country. Experiences of selected countries can serve as a guide to the outcome of some policy measures. The experience with capital controls in managing flows is useful and there are important lessons for countries contemplating liberalization. Restrictions on certain classes of institution, such as banks, pension funds and authorized dealers are generally effective.

(j) The need to constrain short-term inflows arises from the inability of financial systems in developing countries to intermediate capital from the short-end to the long-end and cannot therefore bear the risk of financial intermediation. The management and monitoring of short-term inflows must therefore be a central concern. Over time, as the financial sector becomes more sophisticated, the need to constrain short-term inflows should diminish.

Reference[2] “Liberalisation of Capital Account-Perils and possible safeguards”, D.M.Nachane, special arcticle, Economic and political weekly, September 8, 2007 (Instructor’s reference material)

[3] “Report on - Making Mumbai an International Financial Centre”, Ministry of Finance, Government of India, (Instructor’s reference material)

[4]India’s experience with capital flows: the elusive quest for a sustainable current account deficit (Instructor’s reference material)

[5] Capital account convertibility – a discussion paper on its impact on the Indian economy (Capital ReferenceMaterial.pdf)

[6] Issues in Capital Account Convertibility in Developing Countries, Benu Schneider, Overseas development Institute, June 2000

[7] Report of the committee on Fuller Capital Account Convertibility, RBI Doc, rbidocs.rbi.org.in

[8] Full Capital Account Convertibility : India’s readiness in the context of Financial Integration, Sulaga Bhattacharya,

[9] Economic Survey India 2011-12, indiabudget.nic.in