The freedom to convert the local financial assets into foreign financial assets and vice-versa at market determined rates of exchange. It is associated with the changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by the rest of the world

- As per Report of the Committee on Capital Account Convertibility, RBI, 1997

Different from current account transaction Indian citizen needs foreign exchange of smaller

amounts, say $3,000, for travelling abroad or for educational purposes, she/he can obtain the same from a bank or a money-changer

Implies progressive integration of the domestic financial system with international financial flows.

Regarded as one of the hallmarks of a developed economy. Signals openness of the economy

Comfort factor for overseas investors. Encourages global capital flows into the country

Indian businesses - access to cheaper external credit (Global rates + Country risk) - without having to ask permission of the RBI.

High Risk – High Gain – Good Times – Chance of huge inflows of foreign capital; Bad times – Chance of an enormous outflow of capital

Chance of “export of domestic savings” - for capital scarce developing countries this could curb domestic investment

Exposes an economy to extreme volatility on account of “hot money” flows

Pros:

• Increases competition and reduces inefficiency; aids price discovery

• Allows access to funds at global rates (plus country risk)

• Disciplines domestic policy and exchange rate monitoring.

• Integrates economy to global trade and capital flows.

• Capital controls ineffective with open trade, human movement.

• Natural direction of evolution for Developing economies (globalization)

Cons:

• No evidence linking improved growth to CAC (Bhagwati, Rodrik, Stiglitz) • Increases vulnerability to herd behavior, contagion, sentiment. • Downside exceeds upside – High Risk, High/Moderate Gain. • Reduces monetary, exchange rate autonomy for a nation.

The East Asian currency crisis Q2 1997- Q4 1998) - Began in Thailand. Malaysia, Indonesia,

South Korea and the Philippines.

Macroeconomic causes:

◦ current account imbalances with concomitant savings-investment imbalance

◦ overvalued exchange rates,

◦ high dependence upon potentially short-term capital flows.

Microeconomic imprudence

- maturity mismatches, currency mismatches,

◦ moral hazard behaviour of lenders and borrowers and excessive leveraging.

The Russian FX Crisis - Re-intensified capital controls and debt moratorium. CAC in 2006.

The Mexican crisis -1994–95 - Overvalued Exchange Rate. Caused by short-term capital inflows.

Similar Crisis – Brazil (post Asian Crisis), Argentina (removed peg in 2001), Turkey (1994)

Tarapore Committee setup in 1996-97 - Capital Account Convertibility (CAC)

Committee favored CAC as a goal to be achieved in 3 years (by 2000) – considered too aggressive target by economists (30 years avg by other liberalized nations)

Established road map and benchmarks. Main issue areas: fiscal consolidation, inflation target, financial system, exchange rate management, Balance of Payments.

Levels of Convertibility –

◦ Foreign Corporate – Reasonably High Degree

◦ NRI Individual– Full Convertibility (Tax Benefits) but with Procedural/Regulatory delays (

◦ Non NRI Individual – Near Zero Convertibility

◦ Resident Individual – High Restrictions (relaxed by some extent)

◦ Resident Corporate – Medium Restrictions

Targeted Parameters for CAC in 2000:

◦ Bring down Central government fiscal deficit from 4.5% in 1997-98 to below 3.5 % of GDP by 1999-2000

◦ Inflation to be reduced to World Average (3-5 % ) - RBI Key Objective should be to monitor and actively manage Inflation

◦ Financial system: CRR at 3%; Gross NPAs at 5%; Interest rate deregulation by 1998.

◦ BoP: “Sustainable” current account deficit; build up “adequate” reserves.

1997 Asian crisis – major cause related to exchange rate fluctuations due not-regulated capital account . Rapid surge of capital outflow (short term loans etc).

Aftermath - Shift in international sentiment against CAC, Decreased IMF Focus and less pressure from USA/Developed Nations - Reduced momentum.

India - Steady liberalization continued, but not at the pace or with the commitment indicated by the Tarapore Committee.

• Led to formation of 2nd Tarapore Committee in 2006 – For FCAC (Fuller CAC).

Objectives of Fuller CAC –

◦ to facilitate economic growth through higher investment by minimising the cost of both equity and debt capital;

◦ to improve the efficiency of the financial sector through greater competition, thereby minimising intermediation costs and

◦ to provide opportunities for diversification of investments by residents.

Idea was to streamline regulations – ◦ All non-residents should be treated equally

◦ Simplify rules for Residents.

Current State:

◦ Strong BoP, High reserves. But is it enough security?

◦ Well “managed” floating exchange rate . Less volatility despite regulated capital flow.

◦ Increasingly efficient Financial markets. Much improved and improving, banking system.

◦ Mature Long-term government debt market, more efficient price discovery

Risks -

◦ High Inflation (Compared to Global Standards) and External Debt (though under

moderation and monitoring)

◦ Large fiscal deficit, High public debt - Govt focused on targeted reduction in phases.

◦ Pressure from Industry vs Uncertain Future ahead – prioritization.

Don’t Rush In - Despite high reserves we need to worry about inflation. Also emerging economies need to take care of Exports competitiveness.

Fiscal Management - Improving the quality of public expenditure, both current and capital. Aggregate fiscal adjustment must/should occur, but this will take time.

Exchange Rate Mgmt - Suggestion from Tarapore Committee –Device different framework for exchange rate and monetary management. Nominal exchange rate needs to become a shock absorber, and the FX market needs to deepen.

A Strong RBI - Supervision has improved; legal sanctions are stronger.RBI needs to move from a nanny to headmaster.

Focus on Short Term Bank loans- RBI needs to closely monitor short term bank loan flows (an additional risk mitigation device as done in Chile in 1990’s).

Finally – It’s a Judgment Call - Gains, both signaling and substantive, could be substantial, but are the risks manageable.

Conditions seem ripe to put more full-blooded CAC back on the front-burner. We are in the right direction to reach the destination. But it pays to be cautious.