Capital Account Conv

7/27/2019 Capital Account Conv

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CERTIFICATE

This is to certify that Minal Garud (Roll No. 11053) has submitted

this report relating to Capital Account Convertibility as a partial

fulfillment of the course, entitled Business Environment I for the

Masters Programme in International Business (2002-2004) of the

Symbiosis Institute of International Business-Pune.

[Academic Coordinator]


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INDEX

INDEX.............................................................................................2Executive Summary .......................................................................3Introduction....................................................................................5

Advantages Of CAC.......................................................................8Developing countries Perspective..................................................9Disadvantages of CAC.................................................................12Factors Influencing CAC...............................................................13Inflation Rate ................................................................................13Financial Sector Reform...............................................................14Current Account Balance..............................................................15Foreign Exchange Reserves........................................................16

Strategy Towards CAC.................................................................17Preconditions of TATAPORE Committee.....................................18History Of CAC in India.................................................................19Current Trends of India:................................................................21Conclusion....................................................................................29Bibliography..................................................................................30

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achievements as far as Recommendation of Tarapore Preconditions are

concerned. It also critically looks the experience of developing countries in

CAC. It also critically evaluates the Strategy for moving towards the full

capital account Convertibility and concludes that Capital account convertibility

is not destination but a journey where the path has no fixed laid down rules.

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Introduction

When we talk of convertibility we mean the ease of conversion of a currency

to be exchanged for another currency. Convertibility can be differentiated as

current account and the capital account. When people have the freedom to

switch over from one currency to another for the purpose of buying goods and

services, then we say that current a/c convertibility is in force. On the other

hand, if people are allowed to change currency in order to buy capital assets

such as bonds, shares and property, then the nation has capital account

convertibility (CAC) in force.

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Major Components of Balance of Payments:

1) Current account

2) Capital account

The current account transactions are classified into two broad categories:

Merchandise / Visible

Invisible

1. Travel

2. Transportation

3. Insurance

4. Investment income

5. Government

6. Miscellaneous

7. Transfer payments-official

8. Transfer payments-private

The capital account transactions are classified into three main categories:

Private capital:

All the loans and borrowings did by the private agencies like FDIs etc.

These transactions are further divided into two categories viz.

1. Long term:

All the loans and borrowings whose maturity period is more than one

year.

2. Short term:

All the loans and borrowings whose maturity period is less than oneyear.

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Advantages Of CAC

A large number of different arguments have been advanced for capital

account liberalisation.

1. CAC maximizes efficiency in the worlds use of capital, a scarce resource.

Capital account liberalization reduces interest rate differentials across

currencies and countries, and thereby reduces international differences in the

cost of capital. As a consequence, investment becomes more efficient. This

argument is identical to standard arguments on the gains from free trade in

goods and services.

2. CAC gives individuals freedom to dispose of their income and wealth as

they see fit. In a liberal democracy, property owners should be free to

dispose of their assets as and where they wish, provided that this does to

involve illegal activities or tax avoidance or evasion. In particular, capital

market controls prevent Individuals from diversifying their asset portfolios.

Abolition of controls facilitates risk reduction.

3.Monetary policy- As capital markets are forward looking, the possibility of

large inward or outward capital flows imposes an element of constraint ongovernment policies, requiring that these be feasible over the longer term.

This discipline is a means for obtaining commitment to sound policies from

governments, which may be subject to short term electoral or other political

pressures.

4. Financial market discipline intense capital mobility puts greater burdens

on a country to ensure that its financial system is well supervised and

regulated. If countries are to compete in free international capital markets,

they will be required to conform to international standards with regard to

reporting and to financial regulation.

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Developing countries Perspective

The 1990s were marked by two major events in international financial

markets in the context of emerging market economies.

1) One was the rapid increase in international private capital flows,

2) The occurrence of financial crises, beginning first with Mexico in

December 1994 and its accompanying contagion effects and the

recent crisis in East Asia and Russia.

The two events are related in that a surge in capital flows was followed by

sudden reversals leading to a financial crisis in the receiving country,

accompanied by problems in the region because of herding behavior in

international markets. Many believe that an open account is an invitation to a

crisis and are of the opinion that a closed capital account will avert disaster.

One of the most persuasive arguments for capital account liberalization is that

globalization has come to stay and that developing countries need to be part

of the growing financial integration of countries around the globe in world

financial markets. Liberalization in the industrialized countries was a response

to the changing realities of the world economy and proceeded in the generalbackground of a move towards flexible exchange rates in 1973. Significant

developments in the world economy spurred this process and created the

compulsions to liberalize.

A situation arose in which domestic banks in industrialized countries faced

competition from international financial markets and governments had to face

the risk of evasion of restrictions on the capital account as the growth of

offshore banks provided alternative opportunities for meeting the needs of

global nature of business. The growth in communications, computers and

electronically based payment technology have reduced the cost of collecting,

processing and executing transactions which further fostered the process of

liberalization. It led to the development of more sophisticated financial

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products, which have expanded hedging, and investment opportunities and

transactions that transcend international boundaries.

The process of liberalization accelerated in the 1980s and 1990s and as of

June 1995, all industrial countries had eliminated controls on both inflows and

outflows of capital. The forces, which led to liberalization in the industrialized

world, are increasingly relevant for developing countries too. Compulsions for

liberalization are generated by the financial intermediation possibilities offered

by offshore centers as an alternative to heavily regulated and still developing

financial onshore markets. They offer attractive opportunities to those

countries in need of investment finance to sustain high rates of growth.

There is also the recognition that globalization has come to stay because of

the increased internationalization of business opportunities and the

development in information and transaction technologies. It is also accepted

that if countries are convertible on the current account, capital controls are

porous and ineffective. With increasing financial integration of the developing

countries with financial markets in the industrialized world, opening the capital

account becomes unavoidable, as a country cannot remain isolated.

If countries do not plan for an orderly integration with the world economy, the

world will integrate with them in a manner which gives them no control over

events. Thus, the question is not whether a country should or should-not

move to capital account convertibility but whether an orderly or a disorderly

transition is desired.

It has made it easier for countries to finance budget deficits and current

account positions, and has improved the investment, funding and hedging

opportunities of the private sector. This should in theory lead to inter-temporal

consumption smoothing. The costs of this process are because financial

integration still has to go a long way till we observe the law of one price.

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Interest rate differentials cause large and sometimes speculative movements

of capital. This has in the case of some countries heightened credit, liquidity

and moral hazard risks facing financial authorities, increasing the need for

international solutions to problems of prudential stability. The experience of

countries that liberalized the capital account starting from a weak initial base

and inadequate conditions, end up in a financial crisis. Costs of liberalization

also include the risk of capital flow reversals and herding behavior in

international financial markets. The experience has also raised concerns

about international financial stability in the absence of prudential regulations

and restrictions. Today it is recognized that although a liberalized capital

account has certain benefits for developing countries it also has certain costs,

therefore making liberalization a more complicated procedure. The costs of

liberalization are acknowledged but their existence cannot reverse the

globalization process.

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Disadvantages of CAC

1. Macroeconomic Policy:

Capital account liberalisation complicates the conduct of

macroeconomic policy, essentially by constraining the level of the

domestic interest rate. This is just the counterpart of the

macroeconomic discipline argument advanced as a benefit from

liberalisation.

2. Exchange Rate Management:

Many developing countries are committed to pegged exchange rate

regimes. The viability of this type of regime is underpinned by capital

account controls. The Asian Crisis has shifted the majority view in the

Economics profession towards a strong preference for floating rate

regimes, but that transition requires a degree of central bank

independence, which can currently only be an aspiration in many

developing countries.

3. Taxation:

A characteristic of many poor developing countries is that they have a

relatively narrow tax base. Capital market liberalisation has the potential to

further reduce the tax base. This is first because it is difficult to tax

overseas earnings, and this makes it attractive to countries to prohibit the

export of domestic capital

4 There is empirical evidence that countries with capital controls tend to

exhibit relatively high inflation resulting in lower real interest rates, and

hence real service costs, on domestic debt. Capital account liberalisation

therefore entails either increases in explicit tax rates or reductions in

government expenditure

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Factors Influencing CAC

Fiscal Consolidation

Consolidating the states fiscal position has been a key component of

successful efforts to liberalize the capital account. This not only helps ensure

macroeconomic stability but also enhances the credibility of policy by easing

debt-servicing obligations. Large fiscal deficits may keep interest rates high

and thus contribute to interest rate differentials that induce large inflows of

more volatile, short-term capital. In itself, fiscal consolidation and Balance is

not enough to prevent crises (Thailand, Malaysia, Indonesia), but it has been

a necessary component of liberalization (Argentina, Chile, Uganda) and its

absence can lead to instability (Brazil).

Inflation Rate

Among central bankers there is an increasing belief that an inflation rate in

the low, single-digit range is a desirable objective of policy. The achievement

of this policy will require central banks to have greater independence and

insulation from populist pressures. With an increasingly integrated world

economy and low inflation rates in the industrial countries, it is necessary for

developing countries to break inflationary expectations and achieve inflation

rates not far out of line with those in the industrial countries. High rates of

inflation are destabilizing and require high nominal and real rates of interest,

which have negative real effects and could reinforce capital inflows (Brazil).

Conversely, artificially maintained low interest rates could induce large net

outflows of capital.

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Financial Sector Reform

A central component of any policy directed at promoting capital account

liberalization is the reform and restructuring of the financial sector to avert

inefficient allocations of capital. In an environment of liberalized capital flows,

weaknesses of the financial system can cause macroeconomic instability and

crises (Thailand, Indonesia, Kenya). The choice is therefore between a

careful reform of the financial system before or during the process of

liberalization, and emergency reforms after a crisis. Banking systems remain

weak in many developing countries, burdened either by interest rate controls

or mandated lending to favored groups or firms. In addition, many systems

have very high reserve requirements relative to international levels. Reducingthese requirements diminishes the effectiveness of monetary policy in the

absence of indirect policy tools. Thus, the development of indirect tools such

as open market operations and interest rates should become a key objective

of policy. Reform must also encompass improved accounting standards,

increased monitoring and surveillance of bank risk exposure, and prudential

standards that conform to international standards (Basle Committee).

Monetary Policy

The development and deepening of financial markets following reform, also

changes the context in which monetary policy is conducted. A move from

direct monetary policy controls to indirect controls is desirable, as it avoids

distortions in financial intermediation and is more flexible for policy purposes.

In addition, the development of indirect controls also enables the central bank

to more effectively carry out sterilization operations in capital inflow episodes.

Appreciation of the exchange rate due to capital inflows diverts investment

away from the tradable sector. Sterilization is needed to deal with this or it

can be combined with other instruments such as reserve requirements, taxes

or a partial liberalization of outflows.

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Exchange Rate PolicyExchange rate policy becomes even more central to policymaking concerns

with moves towards capital account convertibility. Authorities must decide on

the optimal degree of exchange rate flexibility with an aim to prevent either

unsustainable appreciations of the real exchange rate that can undermine

competitiveness or expensive interest rate defenses of fixed rates and/or

costly sterilization operations. The balance between these considerations is

complex, although there is a general belief that exchange rate regimes have

to be more flexible under capital account convertibility.

Current Account Balance

Current account deficits are commonly found in developing countries,

reflecting the use of global savings to achieve desired levels of growth and

investment. Experience suggests that prudent limits must be set on

expanding deficits. The counterpart of current account deficits are expanding

external liabilities, and as the deficit rises debt servicing begins to account for

an increasing proportion of external earnings that could be otherwise used to

increase imports. Thus, high current account deficits may constrain growth by

retarding imports as well as leading to fears of contraction and/or crisis.

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Foreign Exchange Reserves

With capital account convertibility, the level of international reserves becomes

a key consideration for policymakers. Reserves help to cushion the impact of

cyclical changes in the balance of payments and help offset unanticipated

shocks, which can lead to reversals of capital flows. Reserves also help

sustain confidence in both domestic policy and exchange rate policy. The

optimal level of reserves is of course contingent on a country specific

circumstances, including its balance of payments, exchange rate regime and

access to international finance. Indicators of reserve adequacy should be

derived from measures of import cover and debt servicing. Another important

ratio to monitor is the ratio of short-term debt and portfolio stocks to reservesto guard against sudden depreciation.

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Strategy Towards CAC

Country experiences suggest that there are three strategies for opening the

capital account and that it is practical and feasible to be at different points

along the spectrum leading to a fully convertible capital account.

1). The opening up of the capital account based on distinctions between

residents and non-residents (an approach followed by India30 and South

Africa). In both these cases the assumption seems to be that outflow of

capital by residents can cause a crisis since opening up is more cautious for

the resident sector. There is some basis for this. In the 1994 Mexican crisis

domestic residents moved out of Tesobonos first setting a signal for FIIs.

However, as country experiences shows that FIIs are equally likely to exit

from a country based on their perceptions about the economy

ii. Opening first the inflow side and later liberalizing outflows (same as (i) but

the opening up is not restricted between residents and non-residents. After

liberalization of inflows and outflows, management of the open capital

account with the aid of price instruments (when required) that are designed to

alter the maturity structure of inflows and their impact on monetary and

exchange rate policy (an approach followed by Chile, Colombia and

Malaysia).

The experience of these three economies points to the importance of overall

supportive policies to make these controls work.

iii. A big bang approach that simultaneously liberalizes controls on inflowsand outflows (an approach followed by Argentina, Peru and Kenya).

The country experiences suggests that either option (i) or (ii) is Preferable for

most developing countries. Each country has to decide on the degree of

capital account convertibility based on its own conditions. If a country decides

on a given degree of CAC, over time it should move towards greater

openness consistent with its overall reform process.

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History Of CAC in India

India, after independence, opted for a model of development characterized by

What was then perceived as self-reliance. Hence, till the early eighties,

external financing was confined to external assistance through multilateral

and bilateral sources, mostly on concessional terms to or through

Government.

The onset of the nineties, however, saw the impact of the Gulf crisis on India.

Combined with the large fiscal deficits of the eighties and political

uncertainties, repercussions of this development in the Gulf resulted in drying

up of commercial sources of financing and in what could be described as asevere liquidity crisis in the balance of payments. While successfully meeting

the Gulf crisis through an adjustment programme, it was decided to

simultaneously launch upon a comprehensive programme of structural reform

of which the external sector was on component.

Policy Framework For Liberalisation

The broad approach to reform in the external sector after the Gulf crisis was

laid out in the Report of the High Level Committee on Balance of Payments

chaired by Dr. C. Rangarajan. The Committee recommended the introduction

of a market-determined exchange rate regime while emphasizing the

need to contain current account deficit within limits. The Report of the

High Level Committee on Balance of Payments, while providing the basic

framework for policy changes in external sector, encompassing exchange

rate management and, current and capital account liberalisation also

indicated the transition path. Accordingly, the Liberalised Exchange Rate

Management System involving dual exchange rate system was instituted in

March 1992, no doubt, in conjunction with other measures of liberalisation in

the areas of trade, industry and foreign investment. The dual exchange rate

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system was essentially a transitional stage leading to the ultimate

convergence of the dual rates made effective from March 1, 1993 .

This unification of exchange rates brought about the era of market

determined exchange rate regime of rupee, based on demand and supply in

the forex market. It also marks an important step in the progress towards

current account convertibility, which was finally achieved in August 1994 by

accepting Article VIII of the Articles of Agreement of the International

Monetary Fund. The appointment of a 14 member Expert Group on Foreign

Exchange (Sodhani Committee) in November 1994 was a follow up step to

the above measures, for the development of the foreign exchange market in

India. Many of the subsequent actions were based on this Report. Tarapore

Committee on Capital Account Convertibility, 1997, appointed by the Reserve

Bank of India, had recommended a number of measures while inviting

attention to several preconditions.

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Current Trends of India:

External Debt:

Sr No CountryExternalDebt

IndebtnessClassification

1 Brazil 245 Severe

2 Russian Federation 174 Moderate

3 Mexico 167 Less

4 China 154 Less

5 Indonesia 150 Severe

6 Argentina 148 Severe

7 Korea. Rep. 130 Less

8 Turkey 102 Moderate9 Thailand 96 Moderate

10 India 94 Less

#source: World economic report,2000

Going by a number of indicators, India's external debt situation is far better

today than it was during the balance of payments (BoP) crisis of 1991. While

the absolute size of foreign debt is important, more relevant is the weight this

debt imposes on the economy. And, on that count, the burden has becomelighter and lighter, even as the stock of outstanding has remained more or

less constant.

Annual repayments of loans and interest as a percentage of current receipts

the debt service ratio which was as high as 35 per cent in 1990-91 has

fallen to 13 per cent today. Debt as a percentage of the gross domestic

product has nearly halved since the early 1990s. And the short-term debt to

GDP ratio, which crossed 10 per cent in 1990-91 and precipitated the BoP

crisis of that year, has been held under 3 per cent.

India is now been classified by the World Bank as a "less" indebted country.

In absolute terms as well, India's position has improved globally. In the mid-

1990s, India was the third largest debtor in the world; today it is ranked ninth.

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All this has taken place in spite of the fact that new loans are increasingly

being raised on commercial rather than concessional terms, as was the

practice for decades. This improvement should be attributed both to a

cautious policy on foreign borrowings (which includes annual caps on

commercial loans which would not have been possible if the rupee was fully

convertible) and to the steady growth in current receipts in the BoP.

Fiscal deficit

Year (As% of GDP)

1994-95 4.7

1995-96 4.2

1996-97 4.1

1997-98 4.8

1998-99 5.11999-2000 5.4

2000-2001 5.7

2001-2002 5.7

#Source: RBI Bulletin-2002

If India has achieved its CAC targets on adequacy of reserves and inflation

there are couple of gray areas. Fore most among them is the Tarapore panel

recommended a GFD/GDP ratio of 3.5% this should be accompanied by

states fiscal deficit. This is one area where things have gone haywire. The

revised estimated of GFD/GDP in 2000-01 was 5.1% and Budget estimate for

2001-02 was 4.7%. Against this the actual for 2000-01 were 5.7% and revised

estimate for 2001-02 also 5.7%. The budget estimate for 2003 has been

5.3%.

The slowdown in economic growth has been exacerbated by the intractability

of high fiscal deficits, says Economic survey. The deleterious effects of such

a high impact on the economy has been made worse by similar levels of

deficits been made worse by the similar level of deficits recorded by the state

government.

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Interest rate

Deregulation of interest rates is one of the recommendations of the

Committee. RBI has introduced deregulations of interest rates both in

advances and deposits in phased manner. Except for savings deposits the

interest rates for all other deposits are deregulated. A similar exercise has

been adopted for lending also. Maximum lending rate during 1001-92 was at

19% when inflation was 13.7%and now it is 11.50 %. PLR has been

converted to benchmark rate for banks rather than treating it as minimum

rate. Phased deregulation of interest rates suggested in the road map has

been achieved.

Inflation

TC suggested that the mandated inflation rate should be an average of 3-5%.

Movement of inflation rate is an imp indicator of macroeconomic stability. The

point-to-point annual inflation rate in 2001-02 was 5%. It started decling after

2001 and recorded a low of 1.3% in Jan 2002.

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Financial Reforms:

The second generation of reforms in the financial sector has been initiated

with important measures being taken up to strengthen the health of the

banking sector by

1) Monitoring capital adequacy norms

2) Setting up guidelines for risk mgmt in banks

3) Facilitating recapitalisation of banks.

This being positive sides of the activities of the regulator, banking sector on

whole is still struggling to get over NPA problem. The committee has

suggested gross NPAs to be at 5% by year 2000 when its position in 1997

was 13.7%. The expectation is that with implementation of various reforms

contemplated in finance sector the NPAs can be brought down to 5%in 3 ys.

51710

4655

2357

53033

4761

2614

54773

6039

3071

0%

20%

40%

60%

80%

100%

1998-99 1999-01 2000-01

NPA of SCBs

Foreign

Private

Public

#Souce: RBI bulletin 2001

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But in reality the picture is different. The gross NPAs of SCBs do not indicate

very positive trends. In absolute terms the gross NPAs have increased. The

only satisfying features is fall in % terms. Now gross NPAs are likely to grow

up as the duration of treating a NPA might come down to 90 days in absolute

terms. Apart from accumulation of NPAs several sources of vulnerability

exists in the market such as stock market scams. The structure of financial

system is changing and supervisory and regulatory regimes are experiencing

the difficulties of accommodating changes. Certain weak links in banking and

non-banking financial sector are clearly visible such as:

1) Poor legal system that cannot enforce on erring parties

2) Labor laws that do not permit quick settlement of industrial disputes.

3) Ineffective bankruptcy laws.

4) Poor corporate governance among business units.

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Balance of Payment

Selected Indicators of balance of payments (expressed as% of GDP)

1990-91 1997-98 1998-99 1999-00 2000-01

Exports 5.8 8.7 8.3 8.4 9.8

Imports 8.8 12.5 11.5 12.4 13

Trade Balance -3 -3.8 -3.2 -4 -3.1

Invisible Balance -0.1 2.7 2.2 3 2.6

Current account balance -3.1 -1.2 -1 -1.1 -0.5

External Debt 28.7 24.5 23.6 22.2 22.3

Debt Service Payments 2.8 3.2 2.6 2.5 2.9

Source: Indian economy survey, 2001

It is shocking to note that Indias share in international trade is 0.7%. Another

disturbing factor is that out of $1tn, annual flow of FDI across the globe,

annual outflow into the India are $3-4bn.

Current Account deficit in 2000-01 has narrowed down to 0.5% from 1.1%

deficit last year. Apart from subdued non-oil import demand, dynamism in

export performance and substantial increase in software services export are

the reasons for these significant improvements.

When we refer to current account deficit and few recommendations of CAC

committee many of the parameters are at satisfactory level in the external

sector

Reserves:Tarapore Committee ON CAC put the foremost step in direction of an

effective foreign exchange policy forward

1) Imports cover of not less than 6 months.

2) Reserves should not be less than 3 months of imports+50%of annual

debt services payment and one month of imports and exports taking

into account the possibility of lags.

3) 60% in the ratio of short-term debt and portfolio stocks to reserve.

4) Net foreign exchange assets to currency ratio should not be less than

40%.

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Policy for Utilization of Excess Reserves:

Piling up of foreign currency has opportunity costs. Direct financial cost of

holding reserves is the interest paid by the public and private sectors on

external liabilities. Therefore it is necessary that such reserves earn more

than the interest payments. At the same time RBI cannot let the dollars be in

the market, as it will appreciate the domestic currency. After making reserves

for volatile payments and exchange rate management, RBI should allow

domestic banks, financial institutions and Corporate to use these reserves

abroad.

Conclusion for reserve:Reserve adequacy should be judged in multi dimensional framework. It

should be viewed along with interest rate policy, exchange rate policy foreign

investment policy and overall macroeconomic policy. In Indian case the

current level of foreign exchange is adequate to carry forward the liberalized

capital account in form of more freedom to banks and financial institutions

and corporate entities to invest funds in international financial markets.

The need of the hour is to bring down the cost of keeping foreign exchange

reserves and at that same time protect domestic financial market from

International contagion.

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Conclusion

1. Capital account liberalization is not a choice. Globalization of the world

economy is reality that makes opening up of the capital account an

unavoidable process. It is prudent for developing countries to work out an

orderly liberalization of the capital account instead of reforming under duress

after a crisis has hit the country.

2. The main impediments in the way of capital account convertibility are the

weak initial conditions related to the health and development of the financial

sector and problems related to asset liability management of the banking

system. Of crucial importance are measures addressing bank soundness,

interest risk management, hard budget constraints for public enterprises,

Without underlying changes in the structure of the financial system,

macroeconomic and financial instability is a predictable consequence of

moves towards capital account liberalization.

3. As far as India is concerned it is incredulously getting clear that there is

considerable amount of work to be done at the national level to ensure thatthe preconditions for the freedom of capital movements are at its place.

Capital account certainly calls for bold visions and cautious implementation. It

is time that we move away from hoopla of CAC towards the strengthening of

financial systems that encompasses improvement in supervision and

prudential standards, framing sound monitory and fiscal policies that in

consonance with the chosen exchange rate regime .The results thus would

be more capital inflows and less volatility in markets irrespective of CAC.

4. We should remember that capital account convertibility is journey and not

a destination

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Bibliography

Analyst, Dec 2002

Treasury Management, Nov 2002

www.bankingindiaupdate.com www.financeclububs.org

www.odi.org.uk

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Capital Account Conv

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