Capital Account convertibility in its entirety would mean that any individual, be it Indian or Foreigner will be allowed to bring in any amount of foreign currency into the country. Full capital account convertibility also known as Floating rupee means the removal of all controls on the cross-border movement of capital, out of India to anywhere else or vice versa.
Capital account convertibility or CAC refers to the freedom to convert local financial assets into foreign financial assets or vice versa at market-determined rates of interest. If CAC is introduced along with current account convertibility it would mean full convertibility.
Complete convertibility would mean no restrictions and no questions. In general, restrictions on foreign currency movements are placed by developing countries which have faced foreign exchange problems in the past is to avoid sudden erosion of their foreign exchange reserves which are essential to maintain stability of trade balance and stability in their economy. With India’s Forex reserves increasing steadily, it has slowly and steadily removed restrictions on movement of capital on many counts.
Capital account convertibility means that an investor is allowed to move freely from the local currency to a foreign currency. India has limited capital account convertibility to prevent shocks to the capital account and maintain a stable exchange rate, by stipulating sectoral norms that ensure a lock-in period for investments.
The press notes simplify the method for calculating FDI and broadly state that as long as Indian promoters hold a majority stake (more than 51 per cent) in any operating-cum-investing company, it can bring investment up to 49.9 per cent through FDI. This company would be treated as an Indian company and it can invest through a joint venture in any other company that may be engaged in industries in which FDI has a sectoral limit.
Several companies like retailer Pantaloon and media house UTV have restructured their organizations to raise FDI in their businesses through step-down joint ventures — FDI is prohibited in multi-brand retail and is restricted to 26 per cent for media
In one sweep, therefore, any sectoral cap of 49 per cent and below has become meaningless in so far as downstream investment by a company with foreign investment below 50 per cent and qualifying as an Indian owned and controlled company,” the DEA argued in a letter, sources said.
“Such a company can apply for cable TV operations (49 per cent cap), FM broadcasting license (20 per cent cap), licensed defense items manufacture (26 per cent cap), printing news papers (26 per cent cap) up linking TV news channels (26 per cent cap) etc. Whether this stance has been approved as such or is an unintended liberalisation is not clear,” the DEA letter said..
Objectives of Full Capital Account Convertibility
- Economic Growth: The introduction of FCAC will help in the economic development of the country through capital investment in the country. This lead to employment generation in the country, infrastructure development, global competition etc.
- Improvement in Financial Sector: There would be improvement in the financial sector as huge capital flow into the system, which will help the companies to perform better. It will boost liquidity into the system.
- Diversification of Investment: It will also help in the diversification of investments by ordinary people, wherein they can invest abroad without any restriction and diversify their portfolio.
Risks involved in Full Capital Account Convertibility
Market risks such as interest rate and foreign exchange risks become more complex as financial institutions and corporates gain access to new securities and markets, and foreign participation changes the dynamics of domestic markets. For instance, banks will have to quote rates and take unhedged open positions in new and possibly more volatile currencies. Similarly, changes in foreign interest rates will affect banks’ interest sensitive assets and liabilities. Foreign participation can also be a channel through which volatility can spill-over from foreign to domestic markets.
Credit risk will include new dimensions with cross-border transactions. For instance, transfer risk will arise when the currency of obligation becomes unavailable to borrowers. Settlement risk (or Herstatt risk) is typical in foreign exchange operations because several hours can elapse between payments in different currencies due to time zone differences. Cross-border transactions also introduce domestic market participants to country risk, the risk associated with the economic, social, and political environment of the borrower’s country, including sovereign risk.
With FCAC, liquidity risk will include the risk from positions in foreign currency denominated assets and liabilities. Potentially large and uneven flows of funds, in different currencies, will expose the banks to greater fluctuations in their liquidity position and complicate their asset-liability management as banks can find it difficult to fund an increase in assets or accommodate decreases in liabilities at a reasonable price and in a timely fashion.
Risk in derivatives transactions become more important with capital account convertibility as such instruments are the main tool for hedging risks. Risks in derivatives transactions include both market and credit risks. For instance, OTC derivatives transactions include counterparty credit risk. In particular, counterparties that have liability positions in OTC derivatives may not be able to meet their obligations, and collateral may not be sufficient to cover that risk. Collecting and analyzing information on all these risks will become more challenging with FCAC because the number of foreign counterparts will increase and their nature change.
Operational risk may increase with FCAC. For instance, legal risk stemming from the difference between domestic and foreign legal rights and obligations and their enforcements becomes important with fuller capital account convertibility. For instance, differences in bankruptcy codes can complicate the assessment of recovery values. Similarly, differences in the legal treatment of secured transactions for repos can lead to unanticipated loss.
Regulatory issues include the risk of regulatory arbitrage as differences in regulatory and supervisory regimes among countries may create incentives for capital to flow from countries with higher standards to those with lower ones. FCAC can also bring a proliferation of new instruments and market participants, complicating the task of financial supervisors and regulators. The entry of large and complex institutions operating in different countries will increase the need for cooperation and coordination between domestic regulatory and supervisory agencies and also with their foreign counterparts.
Challenges in adopting Full Capital Account Convertibility
- Risk Management
- Interest Rate & Liquidity Risk Management
- Derivative Risk Management
To better manage liquidity risk, the report recommends that banks monitor their liquidity position at the head/corporate office level on a global basis, including both at the domestic and foreign branches. In addition the liquidity positions should be monitored for each currency.
Regarding market risk, the report recommends that banks adopt a duration gap analysis and consider setting appropriate internal limits on their interest rate risk exposures. The Tarapore report also suggests that the RBI link the open position limits to banks capacity to manage foreign exchange risk as well as their unimpaired Tier I capital.
Banks will require more derivatives instruments to mitigate the possible risks from fuller capital account convertibility. These should include interest rate futures and options, credit derivatives, commodity derivatives, and equity derivatives, which are not effectively available to banks at the moment. The RBI should, however, put in place the appropriate infrastructure, including a robust accounting framework; a robust independent risk management framework in banks, including an appropriate internal control mechanism; appropriate senior management oversight and understanding of the risks involved; comprehensive guidelines on derivatives, including prudential limits wherever necessary; and appropriate and adequate disclosures. prudential limits wherever necessary; and appropriate and adequate disclosures.