Capital account convertibility and India

According to the Tarapore Committee provided a succinct and subtle 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.

IMF’s Role in Capital Account Convertibility

Convertibility is an IMF clause that all the member countries must adhere to in order to work towards the common goals of the organization. However CONVERTIBILITY per se can be looked into from various perspectives and incorporated accordingly by the member nations. 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.

It is important to state here that “The IMF’s mandate is conspicuous on current account convertibility as current account liberalization is among the IMF’s official purposes outlined in its Articles of Agreement, but it has no explicit mandate to promote capital account liberalization. Indeed, the Articles give the IMF only limited jurisdiction over the capital account however the IMF has given greater attention to capital account issues in recent decades, given the increasing importance of international capital flows for macroeconomic stability and exchange rate management in many countries. Thus there is no official binding over any member state to opt for FULL CAPITAL ACCOUNT CONVERTIBILTY but it has been a constant component of the IMF’s advisory reports on member countries.

India and Capital Account Convertibility

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.

  • India to be achieved over a time frame of 3 years. In 1997, the Tarapore committee took on the convertibility question. And suggested a logical framework to attain Capital Account Convertibility. However the conventional wisdom is that the report was buried after the East Asian Crisis.
  • In 2006 with Prime Minister’s allegiance to Capital Account Convertibility shown  at the CII summit in Mumbai the RBI reappointed the TARAPORE committee to submit a report on Capital Account Convertibility in India.
  • In their report on Capital Account Convertibility in 2006 the committee has listed certain pre conditions for Capital Account Convertibility in

Preconditions

  • 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 systemto 3%.

  • 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%.

Pros of Capital Account Convertibility for India

  • It allows domestic residents to invest abroad and have a globally diversified investment portfolio, this reduces risk and stabilizes the economy. A globally diversified equity portfolio has roughly half the risk of an Indian equity portfolio. So, even when conditions are bad in India, globally diversified households will be buoyed by offshore assets; will be able to spend more, thus propping up the Indian economy.
  • Our NRI Diaspora will benefit tremendously if and when Capital Account Convertibility 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 Capital Account Convertibility 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. That is, it reduces the cost of capital. When steel imports are made easier, steel becomes cheaper in India. Similarly, when inflows of capital into India are made easier, capital becomes cheaper in India.
  • 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. This will have repercussions for GDP growth, since finance is the ‘brain’ of the economy.

Cons of Capital Account Convertibility 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” (refers to a phenomenon where investors acts as “herds”, i.e. if one moves out, others follow immediately). For example, the South East Asian countries received US$ 94 billion in 1996 and another US$ 70 billion in the first half of 1997. However, under the threat of the crisis, US$ 102 billion flowed out from the region in the second half of 1997, thereby accentuating the crisis. This has serious impact on the economy as a whole, and can even lead to an economic crisis as in South-East Asia.
  • 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 utilisation, and increased level of employment. This also reduces the potential of the country to increase exports and thus creates external imbalances.
  • 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.
  • Entry of foreign banks can create an unequal playing field, whereby foreign banks “cherry-pick” the most creditworthy borrowers and depositors. This aggravates the problem of the farmers and the small-scale industrialists, who are not considered to be credit-worthy by these banks. In order to remain competitive, the domestic banks too refuse to lend to these sectors, or demand to raise interest rates to more “competitive” levels from the ‘subsidised’ rates usually followed.
  • 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.
  • 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 Capital Account Convertibility 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.

About Abey Francis

Abey Francis is the founder of MBAKnol - A Blog about Management Theories and Practices - and he's always happy to share his passion for innovative management practices. You can found him on Google+ and Facebook. If you’d like to reach him, send him an email to: [email protected]

Leave a Reply

Your email address will not be published. Required fields are marked *


*

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>