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  1. 1. CURRENT ACCOUNT CONVERTIBILITY OF INDIAN RUPEES A PROJECT REPORT Submitted to the faculty of Management In partial fulfillment of requirements for the degree of Post Graduate Diploma In Foreign Trade SINHGAD BUSINESS SCHOOL SUBMITTED BY MANISH NAGAR PGDFT II SEM SBS - 1100041
  2. 2. ` CERTIFICATEThis is to certify that the project entitled “CURRENT ACCOUNTCONVERTIBILITY OF INDIAN RUPEES” has been carried out byMANISH NAGAR under my guidance in partial fulfillment of the requirementfor the degree of Post Graduate Diploma In Foreign Trade during academic year2011-2012. GUIDE DIRECTORMrs. Prashant pawar Mrs. M.S.Sathe .2
  3. 3. ACKNOWLEDGEMENT I take this opportunity to express my deep sense of gratitude and indebt-ness to Mrs.prashant pawar under whose able guidance the present work hasbeen completed. I am very thankful devotion of help and Suggestions. I am also thankful to my whole teacher staff for their direct indirectsupport to me. Manish nagar3
  4. 4. IndexSr. pg.noNo.1 Introduction 52 Convertibility why? 73 What does current account convertibility means? 84 Types of convertibility 95 Types of accounts 136 Impacts of current and capital account convertibility 147 Benefits of current and capital account convertibility 168 Convertibility on Current Account 199 Current Situation on Current Account 2110 Path that lead to Current Account Convertibility 2211 Necessary reforms, policies and pre-conditions 2912 Limitations 4813 Conclusion 494
  5. 5. Introduction Each country has its own currency through which both national andinternational transactions are performed. All the international businesstransactions involve an exchange of one currency for another. For example, Ifany Indian firm borrows funds from international financial market in US dollarsfor short or long term then at maturity the same would be refunded in particularagreed currency along with accrued interest on borrowed money. It means thatthe borrowed foreign currency brought in the country will be converted intoIndian currency, and when borrowed fund are paid to the lender then the homecurrency will be converted into foreign lender’s currency. Thus, the currencyunits Of a country involve an exchange of one currency for another. The priceof one currency in terms of other currency is known as exchange rate. The foreign exchange markets of a country provide the mechanism ofexchanging different currencies with one and another, and thus, facilitatingtransfer of purchasing power from one country to another. With the multiplegrowths of international trade and finance all over the world, trading in foreigncurrencies has grown tremendously over the past several decades. Since theexchange rates are continuously changing, so the firms are exposed to the riskof exchange rate movements. As a result the assets or liability or cash flows of a5
  6. 6. firm which are denominated in foreign currencies undergo a change in valueover a period of time due to variation in exchange rates. This variability in thevalue of assets or liabilities or cash flows is referred to exchange rate risk. Sincethe fixed exchange rate system has been fallen in the early 1970s, specifically indeveloped countries, the currency risk has become substantial for manybusiness firms. As a result, these firms are increasingly turning to various riskhedging products like foreign currency futures, foreign currency forwards,foreign currency options, and foreign currency swaps. Convertibilityessentially means the ability of residents and non-residents toexchange domestic currency for foreign currency, without limit,whatever is the purpose of the transactions.6
  7. 7. Convertibility: why?Externally inconvertible currencies may be of rather limited value to theirholder. An exported item from a developing country to the USSR, for example,may be paid for in rubles or the currency of a country that has ratified ArticleVIII. The proceeds may be used to purchase goods anywhere.In considering possible import suppliers, therefore, a developing country willhave some interest in directing its importers to those countries that will havesome interest in directing its importers to those countries whose inconvertiblecurrencies are in large supply. This is, of course, a case of trade discriminationthat is condemned by traditional theory. This means that goods are not beingpurchased from the cheapest source. Recent economic writing has, however,reopened the question in view of the continued existence of inconvertiblecurrencies. Where it is profitable on the export side to trade with countriesmaintaining inconvertible currencies, and the government wishes to encourageimports from those countries to offset its credit balances, it will utilize itsexchange distribution mechanism to limit the availability of convertibleexchange where there are alternative suppliers of the same type of goods ininconvertible currency countries.7
  8. 8. What exactly does current account convertibility of rupee means? Current Account Convertibility means that rupee can now be freelyconvertible into any foreign currencies for acquisition of assets like shares,properties and assets abroad. Further, the banks can accept deposits in anycurrency. At present, Indian rupee was partly convertible on current account. Itprovided flexibility to buy or sell foreign exchange for specific activities likepayments for trade related activities, interest payments, remittances, businessexpenses etc. Further, an individual was allowed to buy shares worth $ 25,000per anumn only. India has come a long way from the FERA, 1947 to FERA,1973 and now to FEMA, 2000. It has seen the days from non-convertibility ofmoney to partial convertibility of money. Now, after the instructions from thePM, the finance minister Mr. P. Chidambaram said that RBI and centre shallannounce steps for greater convertibility of rupee. This reform shall mean a lotfor our country’s development and growth plus it shall mark a new era in termsof globalization and liberalization. For an economy which was so close, such astep is indeed a landmark – a mile stone achieved.8
  9. 9. Types of convertibility9
  10. 10. Current account convertibilityCurrent account is defined as including the value of trade in merchandise,services, investment, income and unilateral transfers. Current accountconvertibility, being essential to the development of multilateral trade, threeapproaches to current account convertibility has been adapted by developingcountries. These are the pre-announcement, by-product, and front-loadingapproaches. Each approach is distinguished by the importance it attaches toconvertibility relative to other economic objectives.Capital account convertibilityCapital account includes transactions of financial assets. Its convertibility refersto the freedom to convert local financial assets into foreign assets in any formand vice versa at market-determined rates of exchange. Capital controlsnormally restrict or prohibit cross-border movement of capital. Thus, controlson capital movements include prohibitions: need for prior approval;authorization and notification; multiple currency practices; discriminatory taxes;and reserve requirements or interest penalties imposed by the authorities thatregulate the conclusion or execution of transactions. The coverage of theregulations would apply to receipts as well as payments and to actions initiatedby non-residents and residents.10
  11. 11. To begin with let’s understand the concept of currency convertibility. Currencyconvertibility may be defined as the freedom to convert one currency into otherinternationally accepted currencies. Thus in a CAG regime the country placesno exchange controls or restrictions on foreign exchange transactions. There aretwo forms of convertibility – convertibility for current international transactionsand the convertibility for international capital movements. While India is still toopt for full Capital Account Convertibility, the government has made the rupeeconvertible on the current account. This implies that companies and residentIndians can make and receive payments for import/export of goods and servicesand be able to access foreign currency for travel, education, medical or otherdesignated purposes. Though there is no formal definition of CAC, the TaraporeCommittee provides some clarity in this regard as it defines the same as - thefreedom to convert local financial assets into foreign financial assets and viceversa at market determined rates of exchange. In other words, Capital accountconvertibility means that the home currency can be freely converted into foreigncurrencies for acquisition of capital assets abroad. Thus, implementation of thecapital account convertibility regime will allow Indian residents to invest,disinvest or transact in any property or assets/liability of any country, convertone currency to another or move funds anywhere in the world, solely guided bydiscretion of the concern individual or company & not restricted by law.11
  12. 12. External and internal convertibilitywhen all holdings of the currency by non-residents are freely exchangeable intoany foreign (non- resident) currency at exchange rates within the officialmargins than that currency is said to be externally convertible. All paymentsthat residents of the country are authorized to make to non-residents may bemade in any externally convertible currency that residents can buy in foreignexchange markets. And if there are no restrictions on the ability of a country touse their holdings of domestic currency to acquire any foreign currency andhold it, or transfer it to any nonresident for any purpose, that country’s currencyis said to be internally convertible. Thus external convertibility is the partialconvertibility and total convertibility is the sum of external and internalconvertibility.TYPES OF ACCOUNTS:12
  13. 13. Current Account: A record of all international transactions for goods and services. Thecurrent account combines the transactions of the trade account and the servicesaccount. Merchandise Trade Account: A record of all international transactionsfor goods only. Goods include physical items like autos, steel, food, clothes,appliances, furniture, et alServices Account:A record of all international transactions for services only. Services includetransportation, insurance, hotel, restaurant, legal services, Consulting, et al13
  14. 14. Impacts of current and capital account convertibilityImpact on corporate sectorHowever, it is interesting to note the impact which such free flow of currencywould have on Indian corporate. In the last two–three years we have beenwitnessing the growing phenomena of India Inc. being on the acquisition spreeabroad. In 2002 while Indian companies acquired 49 companies the same hasgrown to around 100 with total money used for the same increasing from US $1800 mn to US $ 2300 mn during the same period. The trend which was earlierrestricted to certain sectors like information technology has now spread acrossthe industries whether it is automobile, pharmaceuticals, auto-ancillary, ITES(IT Enabled Services) and so on. In the overseas markets Indian companies arebuying out even bigger size companies in order to become a globally efficientcompany and thus tackle the global competition successfully. Also Theacquisition drive in 2005 was not restricted to traditional US and UK but Indiancompanies went to countries as diverse as Australia, Romania, Germany,Bulgaria, South Africa etc. Ushering of CAC regime would facilitate theprocess of globalization of India Inc. as a whole. This is because so far Indiancompanies have been predominantly utilizing the proceeds from the overseasissues like ECB (External Commercial Borrowing), FCCB (Foreign CurrencyConvertible Bonds) to finance their overseas buyout. However, this indirect14
  15. 15. route has been delaying the actual acquisition process and the consequentintegration of the acquired entity with the rest of the business of the acquiringcompany. But if there no restriction on foreign currency availability for Indiancompany then it would substantially boost their financial flexibility. They canexpedite the process of International acquisition once the target company isidentified. Thus, overseas buy outs would be very fast and efficient which inturn would reduce the time period required to enjoy benefit of the acquisitiondone.Increasing globalizationMaking the overseas acquisition hassle free would also provide an impetus tothe entire process of Indian companies truly becoming global size with morenumber of companies opting for it which were restrained so far due to limitedaccess to international funds. In fact this could be high time for Indiangovernment to speed up the CAC reforms since there are several US companiesgoing bankrupt in the recent months whereas Indian companies has not takenthe advantage of it so far. Thus creation of more conducive environment & freeexchange of currencies would create a policy background which would enableIndian companies to acquire overseas companies more aggressively goingforward.Benefits of current and capital account convertibility15
  16. 16. Apart from the above mentioned benefits Indian corporate sector would alsoenjoy certain benefits in the long term. In this entire procedure companies withhigh focus on exports & globalization would benefit immensely. Thus the toprung companies from the software, textile, pharma, auto, auto componentsindustries having growing and substantial export revenues would have addedadvantage. This is due to the fact that it would result into hassle free movementof the currencies which would ensure that they can more efficiently utilize theoverseas earnings. Also this will simplify the investment diversification processfor Indian companies as they will have greater choice of parking their surplusfunds with global investment venues at their disposal. So not only Indiancitizens but corporate India will also have wider investment options and canspread their investment across various countries.OVERVIEW OF THE FOREIGN EXCHANGE MARKET IN INDIA16
  17. 17. During the early 1990s, India embarked on a series of structural reforms in theforeign exchange market. The exchange rate regime, that was earlier pegged,was partially floated in March 1992 and fully floated in March 1993. Theunification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and was an important step in the progresstowards total current account convertibility, which was achieved in August1994. Although liberalization helped the Indian forex market in various ways, itled to extensive fluctuations of exchange rate. This issue has attracted a greatdeal of concern from policy-makers and investors. While some flexibility inforeign exchange markets and exchange rate determination is desirable,excessive volatility can have an adverse impact on price discovery, exportperformance, sustainability of current account balance, and balance sheets. Inthe context of upgrading Indian foreign exchange market to internationalstandards, a well- developed foreign exchange derivative market (both OTC aswell as Exchange-traded) is imperative With a view to enable entities to managevolatility in the currency market, RBI on April 20, 2007 issued comprehensiveguidelines on the usage of foreign currency forwards, swaps and options in theOTC market. At the same time, RBI also set up an Internal Working Group toexplore the advantages of introducing currency futures. Current Account17
  18. 18. It refers to currency convertibility required in the case of transactions relating toexchange of goods and services, money transfers and all those transactions thatare classified in the current account.In Short, Current account includes all transactions, which give rise to or use ofour National incomeCurrent Account TransactionsAll imports and exports of merchandiseInvisible Exports and Imports (sale/purchase of services Inward privateremittances (to & fro)Pension payments (to & fro)Government Grants (both ways)18
  19. 19. Convertibility on Current AccountIndia is fully convertible on the current account A full convertibility meansmovement of funds in & out of India without any restrictions &permissions.Provides full freedom to both residents and non-residents to tradein goods/services. RBI has placed a cap in creation of a capital asset In India,most current account transactions have been freed from controls over the years.Current account convertibility refers to freedom in respect of Payments andtransfers for current international transactions. In other words, if Indians areallowed to buy only foreign goods and services but restrictions remain on thepurchase of assets abroad, it is only current account convertibility.Liberalization of current account transactions leading to current accountconvertibility a compositional shift in capital flows away from debt- to non-debt-creating flows strict regulation of external commercial borrowings,especially short-term debt discouraging volatile elements of flows fromnonresident Indians gradual liberalization of outflows disintermediation of thegovernment in the flow of external assistance Introducing a market-determinedexchange rate regime19
  20. 20. Dual exchange rate systemLiberalised Exchange Rate Management System involving dual exchange ratesystem was instituted in March 1992 The dual exchange rate system wasessentially a transitional stage leading to the ultimate convergence of the dualrates made effective from March 1, 1993 Two rates of exchange: Official rate ofexchange & Market rate of exchange 60% of the export earnings could beconverted at the free market determined rate. (which was around Rs.28) Thebalance 40% of the earnings should be sold to RBI through authorised dealersat the Official rate of exchange. (generally higher at Rs.32)Full convertibility of the current accountThis unification of exchange rates brought about the era of market determinedexchange. Rate regime of rupee, based on demand and supply in the forexmarket.Liberalize the access to foreign exchange for all current businesstransactions including travel, education, medical expenses, etc.Under ArticleVIII of the IMF’s Articles of Agreement in August 1994.20
  21. 21. Current Situation on Current AccountIndia is fully convertible on the current accountProvides full freedom to bothresidents and non-residents to trade in goods/services. RBI has placed a cap increation of a capital asset21
  22. 22. Path that lead to Current Account ConvertibilityEconomists understand that capital mobility, fixed exchange rates and interestrates autonomy cannot exist together in any economy. The effects of monetaryand fiscal policy in an open economy depend on capital mobility. Underfloating exchange rates, monetary policy is a powerful tool for policy.Developing countries that seek to manage all three of the ingredients throughpolicy often attempt (like India) to adopt a ‘moving peg’ system that correctsexchange rates through a series of time lagged steps. The problem in this22
  23. 23. approach is that the central bank (the RBI, for example) has to interveneperiodically in the market to buy or sell dollars to prop up the current exchangerate. Resident Indians are allowed to invest abroad without any limits. NonResident Indians (NRI) [now a very wide term] is allowed to repatriate proceedsof their assets sold in India. Permitted allowances for business travel, education,health, etc., are extremely generous. The ceilings on corporate investmentsabroad or in joint ventures are very liberal, as also for securing external debt. In2005-2006, repatriation from India in the form of interest and dividendpayments as well as profits of corporate was in excess of US$10 billion, thehighest figure ever in the last five decades. Thus, in most respects, there isalmost total current account flexibility. It is, however, true that the Indian rupeeis still not an ‘international’ currency, that is, it cannot be bought and sold in theexchange market. Up to 1991, when India faced a major foreign exchangecrisis, there had been very rigid controls on both the external capital as well asthe current account. The liberalization process that started after 1991 and theterms of the IMF conditionality helped to relieve the current accounttransactions and the resulting growth and investments in the economyaugmented the forex reserves of the country. The improvements encouraged thegovernment to set up a committee in 1997 to spell out a road map for the fullconvertibility of the rupee. First was that gross fiscal deficit as a percentage ofGDP should go down from 4.5% budgeted for 1997-98 to 3.5% by 2000.Thegross fiscal deficit, on the other hand, increased to 5.9% in 2002-2003? It only23
  24. 24. came down to 4.1% in 2005-06. It is targeted to come down to 3.8% in 2006-07,but still not close to the 3 % that is required by the Fiscal Responsibility BudgetManagement Act. There is also the concern about stated fiscal deficits that hadreached high levels, and have only recently started coming down. Anotherprecondition was that the annual rate of inflation should be in the 3% to 5%range. This has been maintained in India for over a decade and is close to 5%now. However, higher energy and commodity prices are likely to be a cause forconcern on this front. The third precondition was that the foreign exchangereserves of the country should be sufficient for six months’ imports.Phenomenal increases in foreign exchange reserves were seen after 1999-2000.In 2002-2003 alone, the reserves grew by US$21.3 billion. At present, foreignexchange reserves are equal to two years import cover. The final condition wasthat non-performing assets of banks should not be more than five percent of thedeposits. This is close to being reached. Soon after the submission of the reportin 1997, the East Asian crisis broke and there was rethinking on the issues offull convertibility. In fact, economists all over, including the IMF, startedadvocating a more gradual approach. The policy developments of thesubsequent years focused on gradual relaxations of the exchange rate regime,more oriented towards greater flexibility for trade and investment than formacroeconomic management of monetary or fiscal policy. The relaxations haveprogressively extended to most sectors of the economy, and for quite some timenow, there have been suggestions for clarity of policy in respect of CAC.24
  25. 25. The need for a clear road map at this stage arises from several considerations.The floating peg regime that the RBI is implementing is becoming untenable.As long as the RBI had significant quantities of government bonds to unload, itcould sterilize the liquidity caused by the buying of dollars by the release ofthese bonds into the market. As the stocks of these bonds ran out, a newmechanism of market sterilization bonds was thought up in 2004, by which theRBI continues the sterilization process through the issue of these instruments.As these are off the Consolidated Fund of India and do not enter into therevenue streams of the government, they do not add to the fiscal deficit, thoughthe interest on these is to be paid for by the budget and has, to that extent, afiscal implication. It is an ad-hoc measure intended to have a control overliquidity and hence over interest rates and inflation, but not a measure thatwould be able to be used long term. It has succeeded moderately in the last yeardue to lower needs of sterilization as current account flows turned negative lastyear. There is increasing exposure of firms to external currency borrowing andthis requires a stable currency regime to be in place urgently. When the centralbank intervenes in the currency market, it creates an illusion that the currency isnot volatile, and this encourages firms, banks and governments to be reckless indollar borrowing. Borrowers tend not to hedge currency risks. When the centralbank is no longer able to sustain this illusion, there are sharp currencymovements that inevitably hurt the borrowers. Sound policies require that thegovernment should not have dollar liabilities. In India, de facto dollar25
  26. 26. borrowing is taking place through devices such as bond issues by the Securitiesand Exchange Board of India (SEBI) or NRI deposits of banks. Since banks arenot allowed to bust, these are actually sovereign liabilities. It should make senseto allow Foreign Institutional Investors (FIIs) to access rupee borrowings and todiscourage firms from external borrowings until the currency regime and thecurrency derivatives are in good shape. But, at the moment, the reverse is thecase. The problem is exacerbated by the fact that the rupee is pegged to theUnited States dollar. Borrowers are encouraged by the belief that the dollar is asafe currency. As the rupee/dollar exchanges lurch into periods of volatility, itwould hurt the borrowers and the institutions significantly. Thirdly, progressiverelaxations of controls have led to anomalies in terms of opportunities forinvestments and repatriation. The slew of regulations on FDI, on investment inexternal primary markets, on internal fund flows etc require a complexregulatory policing that the banks, the RBI and SEBI are finding difficult tohandle. Several of these regulations have loopholes that are being exploited. Animportant example is the use of Participatory Notes in the financial markets.These are funds at the hands of FIIs that have been subscribed to by unknowninstitutions and individuals, and are in the nature of ‘hot’ money. Attempts toregulate them have not succeeded significantly; the RBI is worried aboutlikelihood of sudden outflows and of destabilizing effects. Managing therupee’s float within a system of limited convertibility and full interest rateautonomy has become a nightmare. The RBI has had a difficult time balancing26
  27. 27. capital inflows against the nation’s policy on money supply, interest rates,inflation, price stability and growth. CAC has therefore become a necessity. Thetiming is to India’s advantage with growing trade, expanding and transparentfinancial markets, and increasing integration with global markets. Fullconvertibility freely floating exchange rates would restore India’s autonomyover money supply, interest rates and growth.Changing International and Emerging Market PerspectivesThere is some literature which supports a free capital account in the Context ofglobal integration, both in trade and finance, for enhancing growth and welfare.The perspective on CAC has, however, undergone some change following theexperiences of emerging market economies (EMEs) in Asia and Latin Americawhich went through currency and banking crises in the 1990s.A few countriesbacktracked and re-imposed some capital controls as part of crisis resolution.While there are economic, social and human costs of crisis, it has also beenargued that extensive presence of capital controls, when an economy opens upthe current account, creates distortions, making them either ineffective orunsustainable. The costs and benefits or risks and gains from capital accountliberalization or controls are still being debated among both academics andpolicy makers. The IMF, which had mooted the idea of changing its Charter toinclude capital account liberalization in its mandate, shelved this proposal.2.527
  28. 28. these developments have led to considerable caution being exercised by EMEsin opening up the capital account. The link between capital accountliberalization and growth is yet to be firmly established by empirical research.Nevertheless, the mainstream view holds that capital account liberalization canbe beneficial when countries move in tandem with a strong macroeconomicpolicy framework, sound financial system and markets, supported by prudentialregulatory and supervisory policies.28
  29. 29. Capital Account Convertibility: Necessary Reforms, Policies andPre-Conditions • Fiscal Policy, Monetary Policy, Sterilization and Exchange Rate PolicyCountry experience with capital flows shows that financial integration boostsgrowth by increasing investment and consumption and reduces volatility ofconsumption with the increased opportunities for risk diversification and inter-temporal consumption smoothing. However, large capital flows also lead torapid monetary, expansion, inflation, and real exchange rate appreciation. Theappropriate design of macroeconomic policy is extremely important in anintegrated world. Country experiences and the growing literature on the policyresponse to a surge in capital flows shows that counter cyclical measures suchas tight monetary and fiscal policies and flexibility in the exchange rate areessential to mange private capital flows. Other structural measures pertaining tothe financial sector, regulation, supervision and capital controls are discussedelsewhere in this paper.Fiscal ControlSound macroeconomic polices are a basic pre-requisite for capital accountconvertibility. The experience of the Southern Cone countries shows that fiscaldeficits emerge as one of the important factors accounting for success or failureof liberalization programs. The experience has shown that government finances29
  30. 30. and tax efforts need to be sufficiently strong to prevent the need for domesticfinancial repression. Taxes on financial intermediation encourage capitaloutflows and are no substitute for tax receipts. There is an urgent need in manyDeveloping countries to broaden the tax base. Fiscal control is needed so thatmonetary policy can be assigned to the external objective. (Mundell, 1962). Inthe absence of fiscal control, monetary policy is assigned to internal balance,which can only be achieved with the aid of capital controls to insulate thecountry from international capital movements. The aim of policy should be toassign fiscal policy to attain internal balance and monetary policy to attainexternal balance. Sound government finances would help in the achievement ofthis objective. The experience of Singapore and Indonesia has shown thatmanipulating the flow of liquidity into the banking system using governmentexcess savings partly frees the interest rate from demand management so that itCan be used for exchange rate management. High stocks of domestic publicdebt approaching unsustainable levels raises the chances of capital flight asdomestic investors fear a default on domestic debt. Keeping these factors inmind, it is essential to control the fiscal deficit and finance it with a minimalrecourse to the inflation tax. Financing of the deficit through issuance of bondsis problematic with an open capital account if it undermines the credibility ofthe country servicing domestic debt. Fiscal discipline gives a signal to investorsas to the health of the economy. Moreover, if the fiscal situation is not undercontrol, Central Bank polices can become ineffective because of the lack of30
  31. 31. fiscal discipline. Country experiences demonstrate the perverse effects thatsustained fiscal imbalances can have in the context of an open capital account.In the 1990s, the Brazilian government ran persistent fiscal deficits thatencouraged expectations of continued inflation and high interest rates thatreinforced capital inflows into Brazil. The Brazilian experience alsodemonstrates the ambiguities generated by a federal system in terms of fiscalpolicy. While the Brazilian federal deficit dramatically deteriorated in1993-1994, there was doubt as to whether it accurately reflected the fiscalpositions of the states. Consequently, when the state of Minas Gerais ran intofiscal difficulties in 1998, it generated a national crisis as investors worried thatit was merely a prelude to further harmful disclosures. The large inflows intoBrazilduring the 1990s in the midst of this unsure fiscal environment suggests thatpush factors (i.e. falling interest rates in advanced countries) may havepredominated over pull factors (i.e. domestic reform, improved macroeconomicperformance). It might also suggest an investor euphoria driven by the signingof the North American Free Trade Agreement in 1993 that stimulated flows tothe Latin America as a whole. As will be discussed later, the presence of anelaborate capital control regime was unable to offset the negative effects of thisstructural imbalance. In India, another country with a federal structure,continued fiscal imbalances are currently placing greater pressure on thecountry’s external accounts. Increasing fiscal imbalances leading up to Kenya’s31
  32. 32. first democratic elections in late 1992, along with other factors, hindered thecountry’s ability to induce inflows of capital despite its open capital account.Those countries that have successfully liberalized the capital account – such asArgentina, and Chile have all, with the exception of Colombia, shown a highdegree of fiscal discipline. Malaysia managed to attract capital inflows overalong period because of prudent fiscal policy.Monetary PolicyThe degree of financial integration also has implications for the conduct ofmonetary policy. For some countries greater financial integration will impairtheir ability to run independent monetary policies. As we move to a seamlesscapital market very few interest rates will be determined domestically apartfrom interest rates at the very short end. Attempts to depart from theinternational structure of interest rates may result in very large and possiblyvolatile capital flows exerting speculative pressure on exchange rates.Movements in exchange a rate because of independent monetary polices maycause increases in the currency risk component of interest rates. Monetarypolicy may therefore in some countries have to passively adopt the monetarypolicy of a large financial trading partner, than confronting volatile and harmfulExchange rate pressures. These are the conditions in a perfectly integratedfinancial world. In the intermediate stage of international financial integration aCentral Bank does have some control over monetary policy to avoid32
  33. 33. macroeconomic instability caused by large capital flows. Some of the optionsfor managing capital flows in the short run are:• To buy up reserves but sterilize the intervention by selling an equal value of Domestic currency bonds.• To increase the cash reserve ratio applying to bank deposits credits from Abroad and swap operations.• Monetary policy support through a tax on inflows. A pre-requisite for the success of sterilization policy is the move from direct to Indirect instruments of monetary policy. In some countries problems can occur Because of the lack of depth in the money and government securities market. In some small African economies problems can arise because of limiting Structural factors and the size of the economy. While open market operations Are necessary conditions for managing private capital flows, for countries withless developed financial sectors it may be more effective to stay with directtools of monetary policy? Uganda, for example, finds its capacity to sterilizeinflows heavily constrained by the lack of sufficient monetary instruments andthe thinness of the market. We need to open the debate on financialintermediation of international flows in this scenario. Even with open marketoperations, sterilization is not without costs. This policy is designed to mitigatethe impact of capital inflows on money supply leading to inflationary pressures,exchange rate appreciation and controlling the domestic money stock. Some ofthe costs of sterilization are discussed below.33
  34. 34. • Presumably capital flows into developing countries attracted by the higher rate Of return. If the capital flows are sterilized, the policy will prevent interest rateDifferential going down attracting further capital flows.• A policy of sterilization involves issuing domestic bonds to offset an increase In currency Flow, results in an increase in public debt.14• If the government does not issue domestic bonds, it will have to provide itsown currency leading to an increase in money supply and inflation. Theconsequent build up of reserves would mean the case of a poor country lendingabroad. If sterilization takes place through domestic bonds, the country canincur costs amounting to the difference between the interest paid on bonds athome and the interest received on foreign reserves. The costs of sterilizationpolicy have been clearly reflected in country experience. Both Colombia andChile experienced high sterilization costs that led them to move to a capitalControl regime. Other forms of sterilization through reserve requirements andtaxes on capital inflows are discussed elsewhere is this paper. They have beensuccessful in some countries (such as Chile, Colombia and Thailand) in alteringthe average maturity of the capital inflow, but not the total capital flow. Theexperience of Chile is particularly interesting in relation to the constraints onmonetary policy in a small, open economy with a liberalized capital account(see Annex 1 for a more detailed discussion of the Chilean experience). Theconflict between controlling domestic inflation (even with fiscal accounts inbalance) and preventing a sharp appreciation of the real exchange rate in the34
  35. 35. context of large capital inflows, prompted Chile to search for greater flexibilityof monetary policy through the implementation of controls on capital inflows.The Chilean controls appear to have provided a ‘wedge’ between domestic andinternational rates that provided greater scope for authorities to target domesticinflation, while avoiding the costs of sterilization (although it must be noted thatother costs were incurred, see Annex 1). The above measures can only be usedin the short-run. Their continuance can lead to agents developing new ways ofbypassing these regulations. In the long run, the only solution is to speed up thefinancial and overall reform, so that outflows can be liberalized so that the twoway movement of capital takes care of financial intermediation, without thenecessity for some of these measures. The process would be aided by a flexibleexchange rate policy. Monetary policy would get some autonomy in countrieswhere the conditions are right to operate an exchange rate band.Exchange Rate PolicyThe significance of a flexible exchange rate goes up for an economy with anopen capital account as the influence of international variables is transmittedmore quickly than in an economy with a relatively closed capital account. Whatis important for an open capital? This is the general case. The case study ofIndia illustrates that the huge stock of ad hoc treasury bills were available forsterilization without increasing the stock of public debt. Account management is35
  36. 36. that exchange rate policy should be flexible, with market participants bearingexchange risk instead of the balance sheet of a central bank. Furthermore, theResulting uncertainty from a flexible exchange rate may discourage short-termflows. Exchange rate uncertainty may discourage short-term flows. Themaintenance of a pegged exchange rate by the Thai authorities in the 1995-1997periods constrained policy making, discouraged hedging by market participantsand reinforced capital inflows. It also provided a fixed target for speculatorswho were quick to observe the inconsistency between an interest rate defense ofthe baht peg and the health of the financial sector. A further advantage ofallowing greater exchange rate flexibility is that the appreciation of theexchange rate is which is likely to occur through an appreciation of the nominalexchange rate and not through higher inflation. This gives room for pursuingautonomous monetary policy. It would force market participants to hedge theirpositions and this would be a beneficial development for foreign exchangemarket development. A drawback of a floating exchange rate regime is that itmay be associated with high volatility, which may damage the growth ofstrategic sectors like non-traditional exports. Country experience suggests thatas capital account convertibility has progressed, countries have adopted moreflexible exchange rate regimes. Of the countries surveyed in Annex 2,Colombia, Peru, Chile, Uganda, and Korea have all opted to introduce greaterflexibility into their exchange rate regime. Only, Argentina with its currencyboard regime and Malaysia, which pegged the ringgit to the dollar as part of its36
  37. 37. adjustment policy after the Asian crisis, have reverted to inflexible regimes. Theparticular nature of the Argentine and Malaysian experiences should be noted.Argentina sought credibility for its macroeconomic policy stance afterprolonged economic crises in the 1980s and the currency board was the surestMethod of acquiring this in international markets. Malaysia initiated its peggedregime in the context of a broad policy of capital controls on outflows, whichhelped ensure its maintenance. Thus, the general experience of capital accountliberalization is that a greater degree of exchange rate flexibility is required,even if this takes the form of a currency band which helps reduce the volatilityassociated with free floating regimes. It is for this reason that many countriessuch as Israel, Colombia, Chile and Mexico adopted an intermediate regime ofan exchange rate band. Exchange rate bands can be implemented in countriesthat have depth in the foreign exchange market and the market is welldeveloped so that two-way expectations can drive the exchange rate. It is anintermediate regime, in which monetary policy can be used for domesticobjectives most of the time and but will be assigned to the external objectivewhen necessary to avoid what might be a serious misalignment. Correction ofexchange rate misalignments cannot be safely left to the market. The choice ofan appropriate exchange rate involves a trade-off between the benefit oftargeting inflation and the external competitiveness of a country. Actual policywill have to be a mix of both these objectives as either extreme is harmful to acountry. Increased capital37
  38. 38. Mobility limits the possibility of targeting the real exchange rate and thereforeallowing the exchange rate to fluctuate within a band is a desirable policy. Acredible announcement by the authorities that they will intervene to keep theexchange rate within the band will encourage market corrections or limitationsto the misalignments without diverting monetary policy from its domesticobjectives. Refraining from intervening continually in the market willdiscourage complacent traders who prevent market corrections through theirbehavior. At the margin of the band, as part of official policy, the central bank isexpected to intervene but not necessary as market can carry out the correctivespeculation. With this policy the central bank can allow the market to work andyet keep the surprise element in its policy. The central bank can also from timeto time review its own choice of the equilibrium exchange rate and signal amajor change is warranted by its own intervention and moving the parity aroundwhich the exchange rate is fluctuating. Whether countries opt for a managedfloating exchange rate regime or an exchange rate band depending upon theirown circumstances, flexibility of the exchange rate is necessary with an opencapital account.38
  39. 39. • Sequencing Current and Capital Account LiberalizationMcKinnon (1973 and 1982) Frenkel (1982) and Edwards (1984) made a casefor liberalizing the capital account following the opening of the current accountand the domestic financial system. According to McKinnon if the oppositesequencing were followed, excessive capital inflows would result in asubstantial appreciation of the real exchange rate, which would thenHamper the opening up of the current account. Arguments for a simultaneousopening of the current and capital account have been advanced by Little,Scitovsky, and Scot, (1970), Michaely, (1986) and Krueger (1984).Since many developing economies have signed Article VIII agreements with theIMF, the issue of sequencing current and capital account liberalization needsfurther qualification as to the time period between current and capital accountliberalization as the capital account can be porous because of a liberalizedcurrent account. It also needs to focus on the type of restrictions needed on thecurrent account to avoid the loss of capital in the transition stage.Inflation RateAmong central bankers there is an increasing belief that an inflation rate in thelow, single-digit range is a desirable objective of policy. The achievement ofthis policy will require central banks to have greater independence and39
  40. 40. insulation from populist pressures. With an increasingly integrated worldeconomy and low inflation rates in the industrial countries, it is necessary fordeveloping countries to break inflationary expectations and achieve inflationrates not far out of line with those in the industrial countries. High rates ofinflation are destabilizing and require high nominal and real rates of interestwhich have negative real effects and could reinforce capital inflows (Brazil).Conversely, artificially maintained low interest rates could induce large netoutflows of capital.Financial Sector ReformA central component of any policy directed at promoting capital accountliberalization is the reform and restructuring of the financial sector to avertinefficient allocations of capital. In an environment of liberalized capital flows,weaknesses of the financial system can cause macroeconomic instability andcrises (Thailand, Indonesia, and Kenya). The choice is therefore between acareful reform of the financial system before or during the process ofliberalization, or emergency reforms after a crisis. Banking systems remainweak in manyDeveloping countries burdened either by interest rate controls or mandatedlending to favored groups or firms. In addition, many systems have very highreserve requirements relative to international levels. Reducing these40
  41. 41. requirements diminishes the effectiveness of monetary policy in the absence ofindirect policy tools. Thus, the development of indirect tools such as openmarket operations and interest rates should become a key objective of policy.Reform must also encompass improved accounting standards, increasedmonitoring and surveillance of bank risk exposure, and prudential standards thatconform to international standards (Basle Committee).Monetary PolicyThe development and deepening of financial markets following reform, alsochanges the context in which monetary policy is conducted. A move from directmonetary policy controls to indirect controls is desirable, as it avoids distortionsin financial intermediation and is more flexible for policy purposes. In addition,the development of indirect controls also enables the central bank to moreeffectively carry out sterilization operations in capital inflow episodes.Appreciation of the exchange rate due to capital inflows diverts investmentaway from the tradable sector when in persists for a long time. Sterilization isneeded to deal with this or it can be combined with other instruments such asreserve requirements, taxes or a partial liberalization of outflows. In smalleconomies the financial markets lack of depth and it may be feasible to rely onmore direct monetary policy tools.41
  42. 42. Exchange Rate Policy Exchange rate policy becomes even more central to policymaking concernswith moves towards capital account convertibility. Authorities must decide onthe optimal degree of exchange rate flexibility with an aim to prevent eitherunsustainable appreciations of the real exchange rate that can underminecompetitiveness or expensive interest rate defences of fixed rates and/or costlysterilization operations. The balance between these considerations is complex,although there is a general belief that exchange rate regimes have to be moreFlexible under capital account convertibility.Current Account BalanceCurrent account deficits are commonly found in developing countries, reflectingthe use of global savings to achieve desired levels of growth and investment.Experience suggests that prudent limits must be set on expanding deficits. Thecounterpart of current account deficits are expanding external liabilities, and asthe deficit rises debt servicing begins to account for an increasing proportion ofexternal earnings that could be otherwise used to increase imports. Thus, highcurrent account deficits may constrain growth by retarding importsas well asleading to fears of contraction and/or crisis.42
  43. 43. Foreign Exchange ReservesWith capital account convertibility, the level of international reserves becomes akey consideration for policymakers. Reserves help to cushion the impact ofcyclical changes in the balance of payments and help offset unanticipatedshocks, which can lead to reversals of capital flows. Reserves also help sustainconfidence in both domestic policy and exchange rate policy. The optimal levelof reserves is of course contingent on a country’’ specific circumstances,including its balance of payments, exchange rate regime and access tointernational finance. Indicators of reserve adequacy should be derived frommeasures of import cover and debt servicing. Another important ratio to monitoris the ratio of short-term debt and portfolio stocks to reserves to guard againstsudden depreciation.Lowering tariff barriersReforming the trade regime to make it more open to the international economyis part of the structural reforms that should precede CAC. High tariffs, inaddition to their allocative inefficiency, encourage direct investment in theeconomy that is not directed towards export markets, but rather towards ‘tariff43
  44. 44. jumping’. Lowering tariffs is therefore linked to the promotion of a diversifiedexport base.Diversified export baseA diversified export base helps cushion the economy from sudden terms oftrade or other shocks that may emerge from dependence on a narrow range ofexports. Such shocks have immediate effects upon the current account and witha loss of confidence in the country’s capacity to meet debt repayments orsustain the current rate of capital inflows, may drive a capital account crisis aswell. Developing countries have traditionally been vulnerable to such shocks tothe export sector, often arising from dependence on primary commodityexports. The process of promoting non-traditional exports can encompasspromotion of domestic firms through some kind of industrial policy or throughthe encouragement of foreign direct investment. In the latter case, it is essentialthat countries promote FDI in exportable sectors.Current account liberalization can lead to a de facto liberalization of the capitalaccount because it is possible for capital to leave through leads and lags.Kasekende et al. (1997) and Kimei et al. (1997) find evidence of significantcapital flows through current account transactions and foreign exchange bureausfor Uganda and Tanzania. Kahn (1991) found substantial evidence of capitalflight through the current account for South Africa. Some developing countries44
  45. 45. retain certain restrictions on the current account with Article VIII status.13 It ishowever difficult to gauge which restrictions achieve the objectives for whichThey have been set. This is an area for research. India maintained certainrestrictions on the current account with Article VIII status to avoid themovement of capital through the current account because controls on themovement of capital by the resident sector have not been liberalized. Hence,certain preventive measures were built into the regulations relating to currentaccount transactions. (In recent weeks some small steps have been made toliberalize this sector but the focus is still on micro management of exchangecontrols.) An attempt is made to capture the impact of opening of the currentaccount on the porosity of the capital account. Estimates of misinvoicing oftrade data based on partner country comparison of the country withindustrialized countries for a select sample of four countries is revealing.External Sector IndicatorsRecent developments in the balance of payment (BoP) indicate continuingresilience of the external sector even as the Indian economy is entering anexpansionary phase of the business cycle. There has been an emergence of acurrent account deficit (CAD) in 2004-05 and 2005-06 after surpluses in the45
  46. 46. preceding three years (2001-04). For a developing country like India, imports ofraw materials, intermediates, capital goods, technology and services hold thekey to scaling up growth in the medium-term. It is important to recognize thatcurrent BoP has significantly improved over 1990-91.Current Account DeficitSince the crisis of 1990-91, during which a CAD of 3 per cent of GDP turnedout to be unsustainable, the appropriate level of the CAD for India has been thesubject of considerable deliberation. The appropriate level of the CAD is adynamic concept and cannot be fixed in time, or cast in stone. The openness isbased on the increase in the current receipts to GDP ratio to 24.5 per cent in2005-06, which is substantially higher than the ratio of 8.0 per cent in 1990-91.Current receipts in 2005-06 pay for 95 per cent of current payments, up from 72per cent in 1990-91. Acceleration in the growth of current earnings economiseson the need to seek access to International financial markets and strengthens theability to run a higher CAD (and achieve higher growth) without encountering afinancing constraint. Stepping up the growth of current receipts is essential forsustaining a higher CAD. Viability of the CAD is a function of the availabilityof normal capital flows, as opposed to exceptional financing. Net capital flowshave regularly exceeded the CAD requirements by a fair measure, enabling46
  47. 47. large accretions to the reserves. During 2005-06, the CAD has been comfortablyfinanced by net capital flows with over US$ 15 billion added to the foreignexchange reserves. Compositional shifts in favour of foreign investment haveactually strengthened the economys absorptive capacity. The share of non-debtcreating flows in net capital flows has, in fact, risen from 1 per cent in 1990-91to nearly 50 per cent in 2004-05. The operating ‘viability’ criterion fordetermining the access to capital flows is the ability to service externalliabilities as embodied in a low ratio of debt service payments to currentreceipts. The debt service ratio (DSR) has fallen to as low as 10.2 per cent in2005-06 and the ratio of the external debt stock to GDP was a modest 15.8 percent. The DSR could safely be in the range of 10-15 per cent. If the ratio ofcurrent account deficit to GDP is regarded as the target variable, the ratio ofCurrent receipts to GDP can be regarded as the instrument variable.Accordingly, a sustainable current account deficit is dependent on the currentreceipts to GDP ratio. A rising current receipts to GDP ratio will enable a highercurrent account deficit which would enable a higher investment ratio. Given thepresent CR/GDP ratio of 24.5 per cent, the CR/CP ratio of 95 per cent and adebt service ratio in the range of 10-15 per cent, a CAD/GDP ratio of 3 per centcould be comfortably financed. Should the CAD/GDP ratio rise substantiallyover 3 per cent there would be a need for policy action.47
  48. 48. Limitation of the Study:The analysis will be purely based on the primary and secondary data. Theprimary data comprise only of feedback collected from retail investors. It willnot include institutional investors. The currency future is a new concept.48
  49. 49. ConclusionThe process of macro economic reforms which ushered in 1991 has evolvedslowly but steadily over the last one and half decade contributing for buildingstronger Indian economy. The next major step in this direction would be Indianopting for Capital Account Convertibility because it continues to be a desirableobjective for providing another growth impetus for Indian economy as wholeand Indian companies in particular. Though there are certain caveats like it maylead to aggressive moves by international players ( by exercising their financialmuscle) and further intensify the competition for domestic companies but acarefully drafted policy suitable to Indian requirement and steadyimplementation of it would minimize ill effects and maximize the gains.49
  50. 50. BibliographyReport of the RBI-SEBI standing technical committee on exchange tradedCurrency futures) 2008Recent Development in International Currency Market by: Lucjan T. Orlowski)Websites: paradise.comhttp://www.wikipedia.comhttp://www..com