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1. Introduction
1.1 Introduction
1.2 Objectives of the study
1.3 Methodology
1.4 Significance of the Study
1.5 Scheme of the Study
2. Currency Convertibility
2.1 Introduction
2.2 Convertibility of the Rupee
2.3 Advantages And Disadvantages of
currency convertibility
3. Trade Account Convertibility
3.1 Meaning
3.2 Current Account convertibility
3.3 Capital Account Convertibility
3.4 Capital Account convertibility vs.
Current Account Convertibility
4. Capital Account Convertibility in India
4.1 Journey so far
4.2Present Status Of Capital Account
Liberalization
4.3 Progress through Capital Account
Convertibility
4.4 Advantages and Disadvantages of
Capital Account Convertibility
5. Role of IMF in Capital Account
Convertibility
6. Conclusion
7. Bibliography
Chapter 1
INTRODUCTION
Economic growth and development of a nation is always
coupled with the progress of its tradable sector. In times of
today all economies is finding themselves integrated to each
other in some or the other way through forces of liberalization
and globalization? In context of these sweeping
advancements capital account convertibility has been widely
persuaded by developed and developing countries around the
world. India too is persistently poignant on the path of
liberalization, by opening up its markets & loosening its
controls over economic & financial matters.
CAC refers to the freedom of converting local financial assets
into foreign financial assets & vice versa at market
determined rates of exchange. It refers to the elimination of
restraints on international flows of a countrys capital
Accounts facilitating full currency convertibility & opening of
the financial system.
Practically there is a mix & match of experiencing with the
countries those who have liberalized their capital account. All
developed countries have adopted full convertibility, but the
2008 crisis of USA & current turmoil of European Union have
raised several questions while China has written its success
story without full capital account convertibility. India has found
itself fairly successful in the matter with its gradualist
approach. Indias conduct & experiences with the liberalization
of capital account are the subject matter of elaboration.
Methodology
This project is only concerned with the secondary data
collection such as book references, journals, articles, RBI
website, and other web links.
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Chapter 2
CURRENCY CONVERTIBILITY
~4~
convertibility profitability of exports increases because market
foreign exchange rate is higher than the previous officially
fixed exchange rate. This implies that from given exports,
exporters can get more rupees against foreign exchange (e.g.
US dollars) earned from exports. Currency convertibility
especially encourages those exports which have low import-
intensity.
2. Encouragement to import substitution:
Since free or market determined exchange rate is higher than
the previous officially fixed exchange rate, imports become
more expensive after convertibility of a currency. This
discourages imports and gives boost to import substitution.
3. Incentive to send remittances from abroad:
Thirdly, rupee convertibility provided greater incentives to
send remittances of foreign exchange by Indian workers living
abroad and by NRI. Further, it makes illegal remittance such
hawala money and smuggling of gold less attractive.
4. A self balancing mechanism:
Another important merit of currency convertibility lies in its
self-balancing mechanism. When balance of payments is in
deficit due to over-valued exchange rate, under currency
convertibility, the currency of the country depreciates which
gives boost to exports by lowering their prices on the one
hand and discourages imports by raising their prices on the
other.
In this way, deficit in balance of payments get automatically
corrected without intervention by the Government or its
Central bank. The opposite happens when balance of
payments is in surplus due to the under-valued exchange rate.
5. Specialisation in accordance with comparative
advantage:
Another merit of currency convertibility ensures production
pattern of different trading countries in accordance with their
comparative advantage and resource endowment. It is only
when there is currency convertibility that market exchange
rate truly reflects the purchasing powers of their currencies
which is based on the prices and costs of goods found in
different countries.
Since prices in competitive environment reflect that prices of
those goods are lower in which the country has a comparative
advantage, this will encourages exports. On the other hand, a
country will tend to import those goods in the production of
which it has a comparative disadvantage. Thus, currency
~5~
convertibility ensures specialisation and international trade on
the basis of comparative advantage from which all countries
derive benefit.
6. Integration of World Economy:
Finally, currency convertibility gives boost to the integration of
the world economy. As under currency convertibility there is
easy access to foreign exchange, it greatly helps the growth of
trade and capital flows between the countries. The expansion
in trade and capital flows between countries will ensure rapid
economic growth in the economies of the world. In fact,
currency convertibility is said to be a prerequisite for the
success of globalisation.
~6~
limited amounts on the black market. When a nations
currency is nonconvertible, it tends to limit the countrys
participation in international trade as well as distort its
balance of trade. Thus it is unable to acquire the foreign
capital it needs to achieve improvements in productivity,
income and human welfare among its people.
~7~
(or direction) of the Indian rupee in relation to other
currencies.
Also affecting convertibility is a series of customs regulations
restricting the import and export of rupees. Legally, foreign
nationals are forbidden from importing or exporting rupees;
Indian nationals can import and export only up to 7,500 at a
time, and the possession of 500 and 1,000 rupee notes
in Nepal is prohibited. In 2014 India allowed to take 500
and 1,000 rupee notes to be taken to Nepal.
RBI also exercises a system of capital controls in addition to
intervention (through active trading) in currency markets. On
the current account, there are no currency-conversion
restrictions hindering buying or selling foreign exchange
(although trade barriers exist). On the capital account, foreign
institutional investors have convertibility to bring money into
and out of the country and buy securities (subject to
quantitative restrictions). Local firms are able to take capital
out of the country in order to expand globally. However, local
households are restricted in their ability to diversify globally.
Because of the expansion of the current and capital accounts,
India is increasingly moving towards full de facto convertibility.
There is some confusion regarding the interchange of the
currency with gold, but the system that India follows is that
money cannot be exchanged for gold under any
circumstances due to gold's lack of liquidity;[citation
needed] therefore, money cannot be changed into gold by the
RBI. India follows the same principle as Great Britain and the
US.
Reserve Bank of India clarifies its position regarding the
promissory clause printed on each banknote:
"As per Section 26 of Reserve Bank of India Act, 1934, the
Bank is liable to pay the value of banknote. This is payable on
demand by RBI, being the issuer. The Bank's obligation to pay
the value of banknote does not arise out of a contract but out
of statutory provisions. The promissory clause printed on the
banknotes i.e., "I promise to pay the bearer an amount of X" is
a statement which means that the banknote is a legal tender
for X amount. The obligation on the part of the Bank is to
exchange a banknote for coins of an equivalent amount."
~8~
was exchanged at 12a 10ps (or 50 old pence per rupee).
Effectively, the rupee bought 1s 4d (or 15 per sterling) during
1899-1914.
Thereafter, both the rupee and the sterling gradually declined
in worth against the U.S. dollar due to deficits in trade, capital
and budget. In 1966, the rupee was devalued and pegged to
the dollar. The peg to the pound was at 13.33 to a pound
(approx. 40 rupees to 3), and the pound itself was pegged
to US$4.03. That means officially speaking the USD to INR rate
would be closer to 4. In 1966, India changed the peg to dollar
at 7.50.
~9~
Advantages
~ 10 ~
Indian markets, the offshore centers are gaining the
trading business. Making the rupee fully convertible
will enable these trades to happen in India, helping
national markets with improved liquidity, better
regulatory purview and reduced dependence and
risks from offshore market participants.
~ 11 ~
Improved financial system: The Tarapore
committee, which was tasked with assessing the full
convertibility of the rupee, has noted these benefits
after full rupee convertibility, including:
Disadvantages
~ 12 ~
keep their exchanges rates lower to retain the low-
cost advantage. Once the regulations on exchange
rates go away, India risks losing its competitiveness
in the international market. (For more, see: The
Reasons Why China Buys U.S. Treasury Bonds.)
Chapter 3
~ 13 ~
1. Trading account helps to know gross profit or loss.
~ 14 ~
delays and inefficiency. Government liberalized the flow of
foreign exchange to include items like amount of foreign
currency that can be procured for purpose like travel abroad,
studying abroad, engaging the service of foreign consultants
etc. What it means that people are allowed to have access to
foreign currency for buying a whole range of consumables
products and services. These relaxations coincided with the
liberalization on the industry and commerce front which is why
we have Honda City cars, Mars chocolate and Bacardi in India.
~ 15 ~
Non-monetary gold covers exports and imports of all gold
not held as reserve assets (monetary gold) by the authorities.
Non-monetary gold is treated the same as any other
commodity and, when feasible, is subdivided into gold held as
a store of value and other (industrial) gold.
Services
Transportation covers most of the services that are
performed by residents for non residents (and vice versa) and
that were included in shipment and other transportation in the
fourth edition of the Manual. However, freight insurance is
now included with insurance services rather than with
transportation. Transportation includes freight and passenger
transportation by all modes of transportation and other
distributive and auxiliary services, including rentals of
transportation equipment with crew.
Travel covers goods and servicesincluding
those related to health and educationacquired from an
economy by non resident travellers (including excursionists)
for business and personal purposes during their visits (of less
than one year) in that economy. Travel excludes international
passenger services, which are included in transportation.
Students and medical patients are treated as travellers,
regardless of the length of stay. Certain othersmilitary and
embassy personnel and non resident workersare not
regarded as travellers. However, expenditures by non resident
workers are included in travel, while those of military and
embassy personnel are included in government services
Communications service covers communications
transactions between residents and non residents. Such
services comprise postal, courier, and telecommunications
services (transmission of sound, images, and other
information by various modes and associated maintenance
provided by/for residents for/by non residents).
Construction services covers construction and installation
project work that is, on a temporary basis, performed
abroad/in the compiling economy or in extra territorial
enclaves by resident/non resident enterprises and associated
personnel. Such work does not include that undertaken by a
foreign affiliate of a resident enterprise or by an
~ 16 ~
unincorporated site office that, if it meets certain criteria, is
equivalent to a foreign affiliate.
Insurance service covers the provision of insurance
to non residents by resident insurance enterprises and vice
versa. This item comprises services provided for freight
insurance (on goods exported and imported), services
provided for other types of direct insurance (including life and
non-life), and services provided for reinsurance.
Financial services (other than those related to insurance
enterprises and pension funds) cover financial intermediation
services and auxiliary services conducted between residents
and non residents. Included are commissions and fees for
letters of credit, lines of credit, financial leasing services,
foreign exchange transactions, consumer and business credit
services, brokerage services, underwriting services,
arrangements for various forms of hedging instruments, etc.
Auxiliary services include financial market operational and
regulatory services, security custody services, etc.
Computer and information services covers resident/non
resident transactions related to hardware consultancy,
software implementation, information services (data
processing, data base, news agency), and maintenance and
repair of computers and related equipment.
Royalties and license fees covers receipts
(exports) and payments (imports) of residents and non-
residents for (i) the authorized use of intangible non produced,
nonfinancial assets and proprietary rightssuch as
trademarks, copyrights, patents, processes, techniques,
designs, manufacturing rights, franchises, etc. and (ii) the use,
through licensing agreements, of produced originals or
prototypessuch as manuscripts, films, etc.
Other business services provided by residents to
non residents and vice versa cover merchanting and other
trade-related services; operational leasing services; and
miscellaneous business, professional, and technical services.
Personal, cultural, and recreational
services covers (i) audio visual and related services and (ii)
other cultural services provided by residents to non-residents
and vice versa. Included under (i) are services associated with
the production of motion pictures on films or video tape, radio
and television programs, and musical recordings. (Examples of
these services are rentals and fees received by actors,
producers, etc. for productions and for distribution rights sold
~ 17 ~
to the media.) Included under (ii) are other personal, cultural,
and recreational servicessuch as those associated with
libraries, museumsand other cultural and sporting activities.
Government services i.e. covers all services (such
as expenditures of embassies and consulates) associated with
government sectors or international and regional
organizations and not classified under other items.
2. Income
Compensation of employees covers wages,
salaries, and other benefits, in cash or in kind, and includes
those of border, seasonal, and other non-resident workers
(e.g., local staff of embassies).
Investment income covers receipts and payments of income
associated, respectively, with residents holdings of external
financial assets and with residents liabilities to non residents.
Investment income consists of direct investment income,
portfolio investment income, and other investment income.
The direct investment component is divided into income on
equity (dividends, branch profits, and reinvested earnings)
and income on debt (interest); portfolio investment income is
divided into income on equity (dividends) and income on debt
(interest); other investment income covers interest earned on
other capital (loans, etc.) and, in principle, imputed income to
households from net equity in life insurance reserves and in
pension funds.
3. Current transfers
Current transfers are distinguished from capital transfers,
which are included in the capital and financial account in
concordance with the SNA treatment of transfers. Transfers are
the offsets to changes, which take place between residents
and non residents, in ownership of real resources or financial
items and, whether the changes are voluntary or compulsory,
do not involve a quid pro quo in economic value.
Current transfers consist of all transfers that do not involve
(i) Transfers of ownership of fixed assets;
(ii) Transfers of funds linked to, or conditional
upon, acquisition or disposal of fixed assets; (iii)
forgiveness, without any counterparts being received
in return, of liabilities by creditors. All of these are
capital transfers.
Current transfers include those of general government (e.g.,
current international cooperation between different
governments, payments of current taxes on income and
~ 18 ~
wealth, etc.), and other transfers (e.g., workers remittances,
premiumsless service charges, and claims on non-life
insurance).
~ 19 ~
convertibility, therefore, entails an understanding of the
current and capital accounts of BOP.
As such, the current account of the BOP comprises trade in
goods and services. In other words, the current account
balance takes into account exports, imports, and net foreign
income from unilateral transfers. The capital account of the
BOP, on the other hand, takes into account cross-border flow of
funds that are associated with financial or other assets in the
trading countries. For example, the direct and portfolio
investments made by foreign investors, in India, are captured
by the capital account balance of the BOP. The capital account
also encompasses foreign investments of Indian companies,
foreign aid and bank deposits of Non-resident Indians (NRI).
A currency is deemed convertible on the current account if it
can be freely converted into other convertible currencies for
purchase and sale of commodities and services. For example, if
the rupee is convertible on the current account an Indian firm
should be able to freely convert rupee into Yen (JPY) to
purchase mods from Japanese Company. Similarly, a German
company should be able to freely convert the mark (DM) into
rupee to pay an Indian software consultancy firm for its
services. It is evident that the ideal of free trade lies at the
heart of current account convertibility.
~ 20 ~
account transaction purposes was a main goal of Bretton
Woods and was reached, to a large extent, early on in the
system; however, the agreements to the IMF allowed more
flexibility with regard to the imposition of exchange controls on
capital account transactions. The flexibility was partly a result
of a prevailing feeling that short-run speculative capital flows
could be potentially destabilising and governments should
therefore have the freedom to resist them.
Owing to other reasons, developing countries have historically
not had convertible currencies. Typically, their currencies have
been partially convertible on the current account and the
capital of the BOP, the rationale for the choice being
embedded in the macroeconomic realities and the policy
perspectives of the countries concerned. In India, the rupee
was made convertible on the current account in August 1994.
However, the currency as yet has limited convertibility on the
capital account, and that indeed is the center of a countrywide
debate. What might be the rationale behind the
aforementioned choice: making rupee convertible on the
current account while maintaining exchange control for capital
account transactions? What, indeed, are the policy implications
of free capital mobility that is associated with capital account
and have full convertibility? Is India ready for full currency
convertibility?
~ 21 ~
the Tarapore Committee, is to ensure total financial mobility in
the country. It also helps in the efficient appropriation or
distribution of international capital in India. Such allocation of
foreign funds in the country helps in equalizing the capital
return rates not only across different borders, but also
escalates the production levels. Moreover, it brings about a fair
allocation of the income level in India as well.
Jumping into capital account convertibility game without
considering the downside of the step can harm the economy.
The Committee on Capital Account Convertibility (CAC)
or Tarapore Committee was constituted by the Reserve Bank
of India for suggesting a roadmap on full convertibility of
Rupee on Capital Account. The committee submitted its report
in May 1997. The committee observed that there is no clear
definition of CAC. The CAC as per the standards refers to the
freedom to convert the local financial assets into foreign
financial assets or vice versa at the market determined rates of
exchange.
The Tarapore committee observed that the Capital controls can
be useful in insulating the economy of the country from the
volatile capital flows during the transitional periods and also in
providing time to the authorities, so that they can pursue
discretionary domestic policies to strengthen the initial
conditions.
The CAC Committee recommended the implementation of
Capital Account Convertibility for a 3 year period viz. 1997-98,
1998-99 and 1999-2000. But this committee had laid down
some pre conditions as follows:
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
governments debt repayment needs; to be financed by
increased in RBIs 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
~ 22 ~
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.
~ 23 ~
The Second Tarapore Committee on Capital Account
Convertibility
Reserve Bank of India appointed the second Tarapore
committee to set out the framework for fuller Capital
Account Convertibility. The committee was established by
RBI in consultation with the Government to revisit the subject
of fuller capital account convertibility in the context of the
progress in economic reforms, the stability of the external
and financial sectors, accelerated growth and global
integration.
~ 24 ~
financial capital transfers to other countries within certain
limits, to take loans from non-relatives and others up to a
ceiling of $ 1 million, etc.
(c) Indian banks would be allowed to borrow from overseas
markets for short-term and long-term up to certain limits, to
invest in overseas money markets, to accept deposits and
extend loans denominated in foreign currency. Such facilities
would be available to financial institutions and financial
intermediaries also.
(d) All-India financial institutions which fulfil certain
regulatory and prudential requirements would be allowed to
participate in foreign exchange market along with
authorised dealers (ADs) who are, at present, banks. In a
later stage, certain select NBFCs would also be permitted to
act as ADs in foreign exchange market.
(e) Banks and financial institutions would be allowed to
operate in domestic and international markets and they
would also be allowed to buy and sell gold freely and offer
gold denominated deposits and loans.
~ 25 ~
on or by the remaining world. It enables relaxation of the
Capital Account, which is under tremendous pressure from
the commercial sectors of India. Along with the financial
capitalists, the reputed commercial firms in India jointly
derive and enjoy the benefits of the CAC policy, which
speculate the stock markets through investments. In fact,
the CAC policy in India is pursued primarily to gain the
speculator's and the punter's confidences in the stock
markets.
However, CAC does not serve the purposes of the real
sectors of Indian economy, like eradication of poverty,
escalation of the employment rates and other inequalities.
In spite of CAC being present in Indian economy, there will
be a co-existence of financial crises. Despite several
benefits, CAC has proved to be insufficient in solving the
Indian financial crises, the complete solution of which lies in
having a regulated inflow of capital into the economy.
Unlike current account convertibility, capital account
convertibility does not come without a downside. But before
we discuss the downside it will be in order to point out that
reservations have been expressed about the most important
contribution of capital account convertibility, that is, its role
in better allocation of global savings. It has been pointed out
that often capital movement is guided by considerations
such as tax savings which improve the returns to the
investor but does not contribute to increased productivity.
Secondly, neither open capital account constitute sufficient
conditions to ensure capital flows into a country nor do
capital flows, in absence of appropriate institutional
framework in the receiving country, contribute to growth
and welfare. On the other hand, it has been argued that free
capital accounts were not necessary for the phenomenal
growth recorded by countries in the diverse parts of the
world. As Jagdish Bhagwati observes in his celebrated 1998
paper, After all, China and Japan, different in politics and
sociology as well as historical experience, have registered
remarkable growth rates. Western Europes return to
prosperity was also achieved without capital account
convertibility. Elsewhere in the same paper he remarks, 7
Substantial gains (from capital account convertibility) have
been asserted, not demonstrated, and most of the payoff
can be obtained by direct equity investment.
~ 26 ~
Views of Bretton woods institutions
It is also important to note the significant shift in the view of
Bretton Woodss institutions on capital account
liberalization. IMF, which was a strong votary of capital
account liberalization in the pre global financial crisis period,
adopted a new institutional view in December 2012 on
capital account liberalization and the management of capital
flows. The institutional view recognizes that 8 full capital
accounts liberalization may not be an appropriate goal for
all countries at all times, and that under certain
circumstances capital flow management measures can have
a place in the macroeconomic policy toolkit. It has done
much to change the public image of the Fund as a
doctrinaire proponent of free capital mobility. The Fund thus
now endorses, though in a limited way, the perspective of
many emerging and developing countries. The IMF now
recognizes that capital flows carry risks, and that the
liberalization of capital flows before nations reach a certain
threshold of financial and institutional development can
accentuate those risks. It also acknowledges that under
certain circumstances, cross-border capital flows should be
regulated to avoid the worst effects of capital flow surges
and sudden stops. It further says that nations that are the
source of excessive capital flows should pay more attention
to the potentially negative spillover effects of their
macroeconomic policies. Finally, the IMF notes that its new
view on capital flow management may be at odds with other
international commitments, such as in trade and investment
treaties that restrict the ability to regulate cross-border
finance. The World Bank has also advocated the use of
capital control measures as a last resort to help mitigate a
financial crisis and stabilize macroeconomic developments.
It may be contextual to recall that when the Asian crisis
broke out, some economists advocated imposition of
temporary capital controls as a policy tool to steer the
affected economies out of the crisis. In fact Malaysia did
precisely this to check deepening of the crisis with success.
However at that time it was considered an unorthodox and
anti-market policy prescription. But in September 2008,
when Iceland faced a similar crisis, capital controls
implemented through stringent exchange control regulations
were a key component of the policy package. As pointed
out, the use of capital controls in times of currency and
~ 27 ~
banking crisis is now part of the accepted wisdom. It may
also be noted that India has been using capital controls to
effectively manage the flows. While on the subject, let me
point out that imposition of capital controls by one country
can have significant negative externality; it can generate a 9
flight of capital from other similarly situated countries for
fear of capital controls there too.
Though the debate on capital account convertibility has
moderated and its advocacy qualified, it is generally
accepted that sooner or later all countries have to be there
and the question is when, how and at what pace. Are there
preconditions to be created so that the benefits of capital
account convertibility outweigh the costs, as Tarapore
Committee advocated or should we rush to it in anticipation
of the Promised Land and leave it to the financial markets to
discipline economic management into good behavior? Is the
slow progress to capital account convertibility a case of
undesirable procrastination or wisely heeding the
precautionary principle as Arvind Subramanian puts it? This
leads me to examine the Indian situation
~ 28 ~
Mankiw observes, Economists are famous for disagreeing
with one another, and indeed, seminars in economics
departments are known for their vociferous debate. But
economists reach near unanimity on some topics, including
international trade. Promoting free trade has been a stated
global policy priority during the post second world war
period. Article VIII; sub-section 2 of the Articles of
Agreement of the IMF states that ......no member shall,
without the approval of the Fund, impose restrictions on the
making of payments and transfers for current international
transaction. Similarly, the objectives of WTO include,
providing a forum for negotiating and monitoring further
trade liberalisation. Though, every now and then, we come
across modern mercantilism in objections to imports, these
are often driven by political considerations and not based on
economic logic. Be that as it may, India accepted the Article
VIII obligation as early as in 1994 and has been an active
member of the WTO. So the public policy view on free trade
in goods and services or current account convertibility is
settled.
What about capital account convertibility? Capital account of
the balance of payments comprises a summary of cross
border transactions in assets. Assets in the context of
international transactions mean investment assets: equity,
debt, immovable property or any combination or hybrid of
these. Thus capital account convertibility would mean that
there is no restriction on conversion of the domestic
currency into a foreign currency to enable a resident to
acquire any foreign asset or on conversion of a foreign
currency to the domestic currency to enable a non-resident
to acquire a domestic asset. Assets are diverse. If a foreign
company sets up an Indian subsidiary, say, to manufacture
automobiles or aircrafts that is also capital account
transaction and so is if a hedge fund buys treasury bills to
book a profit out of expected movement in interest rates.
Similarly capital flows may finance a metro project or fuel a
real estate boom. Therefore, capital flows cannot be viewed
as a homogeneous phenomenon with identical economic
consequences. Capital flows can be conceptually classified
into two broad categories. Those that imply long term
engagement without any incentive to exit at every
provocation and those that are motivated by disinterested
profit those that buy at every low and sell at every high, as
~ 29 ~
it were. Full capital account convertibility will open the door
to both without any discrimination. In this backdrop, is
capital account convertibility as much a public policy priority
as current account convertibility?
Chapter 4
JOURNEY SO FAR
~ 30 ~
relatively low level of economic reliance on rest of the world.
Therefore, for the first four decades after sovereignty in
1947, all economic policies were centered on regulation and
capital controls. Although there were intervallic reforms in
areas of foreign procurement, technology, travel, education,
exchange rate depreciation and easing of restrictions on
inflows. As these measures were narrow in scope so they
had little impact on inflows and outflows of foreign
exchange. Real liberalization was initiated in 1991 aftermath
balance of payment crises. On the basis of
recommendations made by Rangrajan Committee the
reforms in the external sector were initiated.
Recommendations included dismantling of trade restrictions,
transition to market determined exchange rates and gradual
opening of capital account. In 1997 a committee under
stewardship of S.S. Tarapore submitted its report on capital
Account Convertibility which provided the initial roadmap for
the liberalization of capital account transactions.
~ 31 ~
PRESENT STATUS OF CAPITAL ACCOUNT
CONVERTIBILITY
Foreign Direct
FDI is restricted in the following sectors:
a) Multi brand retailing.
b) Lottery (public, private, online), gambling, betting and
casino.
c) Chit funds and Nidhi Company.
d) Trading in Transferable Development Rights in real estate
business or construction of farm houses.
e) Manufacturing of Cigars, cheroots, cigarillos and
cigarettes, of tobacco or of tobacco substitutes
f) Atomic energy and Railway transport In rest other sectors
such as agriculture, mining, manufacturing, broadcasting,
print media, aviation, courier services, construction,
telecom, banking, insurance etc.; the limits of FDI range
from 26% to 100%. All the foreign operators have to abide
by the sectoral restrictions of the statutory regulators in
addition to FDI rules.
~ 32 ~
ADRs/ GDRs by Indian companies
Indian companies can raise additional finances abroad
through the issue companies of ADRs/ GDRs, in accordance
with guidelines issued by the Government of India. Unlisted
companies, which have not so far accessed the ADR/GDR
route for raising funds in the global market, would require
prior listing in the domestic market. Unlisted companies,
which have already issued ADRs/GDRs in the international
market, have to list in the domestic market on making profit
or within three years of such issue of ADRs/GDRs, whichever
is earlier. A Limited two way fungibility scheme is also
operationalised through the custodians of securities and
stock brokers under SEBI.
External Commercial the ECB limit under the
automatic route is enhanced to USD 750 million
Borrowings (ECBs)/ Foreign (Circular No. 27 dated
September 23, 2011).
The maturity guidelines have also Currency Convertible
Bonds been revised (Circular No.64 January 05, 2012).
(FCCBs)
a) ECBs up to $20 million in a financial year should have a
minimum average maturity of three years.
b) ECBs of more than $20 million and up to $750 million or
equivalent should have a minimum average maturity of 5
years. c) Eligible borrowers under the automatic route can
raise Foreign Currency Convertible Bonds (FCCBs) up to USD
750 million or equivalent per financial year for permissible
end-uses.
d) Corporate in services like hotel, hospital and software,
can raise FCCBs up to USD 200 million or equivalent for
permissible end-uses during a financial but the proceeds of
the ECB should not be used for acquisition of land.
e) ECB / FCCB availed of for the purpose of refinancing the
existing outstanding FCCB should be viewed as part of the
limit of USD 750 million available under the automatic route.
Government Securities
NRIs and SEBI registered FIIs are permitted to purchase
Government Securities/ Treasury bills and corporate debt.
The details are as under:
1. On repatriation basis a Non-resident Indian can purchase
without limit,
~ 33 ~
a) Dated Government securities (other than bearer
securities) or treasury bills or units of domestic mutual
funds.
b) Bonds issued by a public sector undertaking (PSU) in
India. MANAGEMENT INSIGHT Vol. VIII, No. 2; December
2012 54
c) Shares in Public Sector Enterprises being disinvested by
GoI.
2. on non-repatriation basis
a) Dated Government securities (other than bearer
securities) or treasury bills or units of domestic mutual
funds.
b) Units of Money Market Mutual Funds in India.
c) National Plan/Savings Certificates. A SEBI registered FII
may purchase, on repatriation basis, dated Government
securities/ treasury bills, listed non-convertible debentures/
bonds issued by an Indian company and units of domestic
mutual funds either directly from the issuer of such
securities or through a registered stock broker on a
recognized stock exchange in India. The FII investment in
Government securities and corporate debt is subject to the
Investment limit. For the FIIs in Government securities
currently is USD 10 billion and limit in Corporate debt is USD
20 billion.
~ 34 ~
investment in bonds / non convertible debentures issued by
Indian companies in the infrastructure sector.
~ 35 ~
Capital account liberalization has been the strongest
medium in curbing such crisis. Depicted in the graph there is
an ongoing trade deficit from the year 1990-91, but a
positive capital account has provided cushion against all
odds and overall balance of payments are in surplus.
(2) Plenty of Foreign Currency Reserves: India has envisaged
a plentiful surge in its reserves. The liberalization of capital
account has helped country in recovering from reserve
shortage. The doting supply of dollars to Reserve Bank
exchequer is a healthy sign for economy, as reserves can be
utilized during the times of adversity.
(3) Efficiency in Financial System: Capital Account
Convertibility is incomplete without fiscal consolidation,
sound policies and financial prudence. RBI and Government
of India have been very conservative and watchful during
whole process of liberalization. This has improved total
financial performance of economy. Banks today have greater
access to additional capital (foreign borrowing), autonomy in
operations (easement of control by RBI) and intensive
competition (opening of private and foreign banks and Non
Banking Finance Corporations). There is larger room for
financial efficacy, specialization and innovation in financial
system.
(4) Development of Securities Market: Gush of Foreign
Institutional Investment (FII) has helped in multifold
enlargement of security market. The market capitalization of
BSE and NSE has significantly risen. Derivates, bonds,
commodities now constitute the major trading instruments
besides equity shares. Sensex (above 20,000) and Nifty
(above 6,000) touched new heights due to huge investment
in the listed stocks.
(5) Worldwide Presence and Friendly Relations with Trading
Counterparts: Flow of investment is a distinctive medium of
developing global relationships. Indian MNCs and service
organizations are conducting business operations in almost
140 countries across the globe. India is 19th largest
exporting country in the world according to 2011 estimates.
Indian IT services, handicrafts, cuisine and jewelry are world
famous and contribute to major chunk of revenue from
international operations. It all has become reality with the
financial liberalization. India is the founder member of WTO,
IMF and World Bank. It is a member of BRICS and G-20 at
WTO trade negotiations. Government has entered into
~ 36 ~
multilateral trade agreements and tax avoidance treaties
with the trading counterparts. Immigration norms have also
been untangled. All this has given a global presence to the
country and friendly relations too are in progress.
~ 37 ~
Investor sentiments are down. Individual portfolios are
making losses. Volatility and panic are the latest buzz words
for the Dalal Street.
Food inflation is constantly maintaining its double digit
levels causing a decline in domestic savings with banks. IIP
has fallen to the level of 3.5% from 8.1% of the previous
year. GDP growth in 2012- 13 is estimated at the aching
level of 6.5% while fiscal deficit is at 5.9%. Reserve Banks
Governor D. Subbarao said fiscal deficit in 1991 was 7% and
it is ruling at 5.9% in 2012.Is it an alarming signal? Because,
India was going through its meager times in 1991 and latest
GDP estimates too are worrisome. There are additional
doubts about Governments ability to trim subsidy level to
cut fiscal deficit, which could further increase the prices of
essential commodities. A new retro tax GAAR (General Anti
Avoidance Rule) is also proposed to be enacted in budget for
fiscal 2013. GAAR aims to target tax evaders, partly by
stopping Indian companies and investors from routing
investments through Mauritius or other tax havens for the
sole purpose of avoiding taxes. It has sparked an outcry
among foreign investors.
Thus the recent global turmoil, volatile capital flows and
economic instability have considerably heightened the
uncertainty surrounding the outlook for India, complicating
the conduct of monetary policy and external management.
The intensified pressures have necessitated stepped up
operations in terms of capital account management and
more active liquidity management with all instruments at
command of Reserve Bank. Therefore in this scenario, it is
suggested that India should adopt a go slow approach in
moves to liberalize capital account. Instead, it is important
for the country to be ready to deal with potentially large and
volatile outflows along with spillovers. In this context, there
is a need of maneuver for Reserve Bank to deal with present
serious matters by deployment of monetary policy
instruments, buying and selling operations of forex,
complemented by prudential restrictions and measures for
capital account management.
~ 38 ~
Capital account convertibility allows free mobility of Capital
into a country from the foreign investors. It allows to convert
the foreign exchange brought into as Capital to convert into
rupees at market determined rates , which makes the
investors encouraging. It allows the foreign investors to
easily move in and move out from an economy. This enables
the domestic companies to raise funds from abroad.
(2) Ability to invest in abroad easily:
Capital account convertibility allows the individuals of a
nation to invest in abroad by easily converting their rupees
into foreign exchange at the rates determined by the
Market. This enables those potential domestic investors to
acquire & own the assets in abroad.
(3) Improved access to global financial markets:
One can easily invest in the equity and debt markets of
another economy alongside a reduction in the cost of
capital.
Disadvantages:
(1) Easier access to Hawala money:
As it allows converting any foreign receipt into Indian
rupees at market determined rates there may be chance
that domestic economy will be flooded with foreign
exchange which in long run may damage the financial
health of an economy.
Chapter 5
~ 39 ~
Role of IMF in Capital Account Convertibility
~ 40 ~
market and the volatility of the dollar and rupee is bound
to increase. In Indias ace, our floating exchange rate
system will stand to benefit India unlike the fixed
exchange rate that was adopted by the South East Asian
countries.
Thus a decision of implementing CAC in India is a complex
one and has to take into account the multiplicity of
constraints and objectives at hand. It is necessary to focus
on the macroeconomic constraints as well as the
development objectives of CAC. The implication of CAC on
exchange rate policies in India has not been touched upon
yet. Hence factoring in the exchange rate and growth
consequences of CAC would be important before the final
implementation of CAC in India.
~ 41 ~
CONCLUSION
The volatile nature of capital inflow presents an alarming trend.
Liberalizing capital control may lead to huge dependence on
foreign portfolio capital. Need is to channelize the capital flow.
As recognized in the recent Tara pore Committee Report,
financial institutions ability to identify, measure, and manage
risk will also depend on the availability of instruments to
manage risk, the liquidity of financial markets and the quality of
market infrastructure, and level of market discipline. Key
segments of the Indian capital markets remain, however,
underdeveloped. The term money market is limited and
although there is a domestic yield curve for government
securities with maturities up to 30 years, its depth and liquidity
are limited. The Govt. had however stated that if the value of
the rupee depreciates to an unreasonable level in the free
market operations, the R.B.I. will intervene and control it. This
assurances certainly gives credence to the earnestness and
sincerity with which the full convertibility has been announced.
~ 42 ~
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~ 43 ~
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