Capital Account Convertibility and India - Status


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Group presentation on CAC and India's Journey towards CAC

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Capital Account Convertibility and India - Status

  1. 1.  The freedom to convert the local financial assets into foreign financial assets and vice-versa at market determined rates of exchange. It is associated with the 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 - As per Report of the Committee on Capital Account Convertibility, RBI, 1997 Different from current account transaction  Indian citizen needs foreign exchange of smaller amounts, say $3,000, for travelling abroad or for educational purposes, she/he can obtain the same from a bank or a money-changer
  2. 2.  Implies progressive integration of the domestic financial system with international financial flows. Regarded as one of the hallmarks of a developed economy. Signals openness of the economy Comfort factor for overseas investors. Encourages global capital flows into the country Indian businesses - access to cheaper external credit (Global rates + Country risk) - without having to ask permission of the RBI. High Risk – High Gain – Good Times – Chance of huge inflows of foreign capital; Bad times – Chance of an enormous outflow of capital Chance of “export of domestic savings” - for capital scarce developing countries this could curb domestic investment Exposes an economy to extreme volatility on account of “hot money” flows
  3. 3. Pros: • Increases competition and reduces inefficiency; aids price discovery • Allows access to funds at global rates (plus country risk) • Disciplines domestic policy and exchange rate monitoring. • Integrates economy to global trade and capital flows. • Capital controls ineffective with open trade, human movement. • Natural direction of evolution for Developing economies (globalization)Cons: • No evidence linking improved growth to CAC (Bhagwati, Rodrik, Stiglitz) • Increases vulnerability to herd behavior, contagion, sentiment. • Downside exceeds upside – High Risk, High/Moderate Gain. • Reduces monetary, exchange rate autonomy for a nation.
  4. 4.  The East Asian currency crisis Q2 1997- Q4 1998) - Began in Thailand. Malaysia, Indonesia, South Korea and the Philippines. Macroeconomic causes: ◦ current account imbalances with concomitant savings-investment imbalance ◦ overvalued exchange rates, ◦ high dependence upon potentially short-term capital flows. Microeconomic imprudence - maturity mismatches, currency mismatches, ◦ moral hazard behaviour of lenders and borrowers and excessive leveraging. The Russian FX Crisis - Re-intensified capital controls and debt moratorium. CAC in 2006. The Mexican crisis -1994–95 - Overvalued Exchange Rate. Caused by short-term capital inflows. Similar Crisis – Brazil (post Asian Crisis), Argentina (removed peg in 2001), Turkey (1994)
  5. 5.  Tarapore Committee setup in 1996-97 - Capital Account Convertibility (CAC) Committee favored CAC as a goal to be achieved in 3 years (by 2000) – considered too aggressive target by economists (30 years avg by other liberalized nations) Established road map and benchmarks. Main issue areas: fiscal consolidation, inflation target, financial system, exchange rate management, Balance of Payments. Levels of Convertibility – ◦ Foreign Corporate – Reasonably High Degree ◦ NRI Individual– Full Convertibility (Tax Benefits) but with Procedural/Regulatory delays ( ◦ Non NRI Individual – Near Zero Convertibility ◦ Resident Individual – High Restrictions (relaxed by some extent) ◦ Resident Corporate – Medium Restrictions Targeted Parameters for CAC in 2000: ◦ Bring down Central government fiscal deficit from 4.5% in 1997-98 to below 3.5 % of GDP by 1999- 2000 ◦ Inflation to be reduced to World Average (3-5 % ) - RBI Key Objective should be to monitor and actively manage Inflation ◦ Financial system: CRR at 3%; Gross NPAs at 5%; Interest rate deregulation by 1998. ◦ BoP: “Sustainable” current account deficit; build up “adequate” reserves.
  6. 6.  1997 Asian crisis – major cause related to exchange rate fluctuations due not- regulated capital account . Rapid surge of capital outflow (short term loans etc).  Aftermath - Shift in international sentiment against CAC, Decreased IMF Focus and less pressure from USA/Developed Nations - Reduced momentum.  India - Steady liberalization continued, but not at the pace or with the commitment indicated by the Tarapore Committee.• Led to formation of 2nd Tarapore Committee in 2006 – For FCAC (Fuller CAC).  Objectives of Fuller CAC – ◦ to facilitate economic growth through higher investment by minimising the cost of both equity and debt capital; ◦ to improve the efficiency of the financial sector through greater competition, thereby minimising intermediation costs and ◦ to provide opportunities for diversification of investments by residents.  Idea was to streamline regulations – ◦ All non-residents should be treated equally ◦ Simplify rules for Residents.
  7. 7.  Current State: ◦ Strong BoP, High reserves. But is it enough security? ◦ Well “managed” floating exchange rate . Less volatility despite regulated capital flow. ◦ Increasingly efficient Financial markets. Much improved and improving, banking system. ◦ Mature Long-term government debt market, more efficient price discovery Risks - ◦ High Inflation (Compared to Global Standards) and External Debt (though under moderation and monitoring) ◦ Large fiscal deficit, High public debt - Govt focused on targeted reduction in phases. ◦ Pressure from Industry vs Uncertain Future ahead – prioritization.
  8. 8.  Don’t Rush In - Despite high reserves we need to worry about inflation. Also emerging economies need to take care of Exports competitiveness. Fiscal Management - Improving the quality of public expenditure, both current and capital. Aggregate fiscal adjustment must/should occur, but this will take time. Exchange Rate Mgmt - Suggestion from Tarapore Committee –Device different framework for exchange rate and monetary management. Nominal exchange rate needs to become a shock absorber, and the FX market needs to deepen. A Strong RBI - Supervision has improved; legal sanctions are stronger.RBI needs to move from a nanny to headmaster. Focus on Short Term Bank loans- RBI needs to closely monitor short term bank loan flows (an additional risk mitigation device as done in Chile in 1990’s). Finally – It’s a Judgment Call - Gains, both signaling and substantive, could be substantial, but are the risks manageable. Conditions seem ripe to put more full-blooded CAC back on the front-burner. We are in the right direction to reach the destination. But it pays to be cautious.