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                                  Current Account
The term current account usually refers to the current account of the balance of payments
(BOP) and contains the import and export items of goods and services as well as transfer
payments including net investment income. The current account is often presented
alongside the capital account and financial account of the BOP which contains data about
short and long-term capital flows. Long-term capital flows are also known as foreign
direct investment (FDI). Often, the capital account and the financial account are both
referred to as the capital account. The BOP balances by means of a balancing account
which allows for changes in official reserve assets.

When it is talked about most, the current account will be either in large surplus (export
receipts exceeding import payments) or substantial deficit (import payments exceeding
export receipts). Generally it is a significant current account deficit (rather than a surplus)
that is perceived to be a problem requiring action, but the current (trading) and capital
(largely financial) accounts are inter-related and a persistent capital surplus can (by
raising the exchange rate above the level it would otherwise reach) cause a current
account deficit.

If action to address a substantial current account deficit is taken, then the more obvious
measures to consider include:

      encouraging depreciation of the exchange rate (e.g. by cutting interest rates or by
       currency intervention of one kind or another).
      import restrictions, quotas or duties (though the reduction in imports caused by
       these measures, by appreciating the domestic currency, may be offset by a
       reduction in exports, with the net result being little or no change in the current
       account balance).
      measures to promote exports e.g. encouraging arms sales abroad (though these
       measures may also result in an increase in imports due to an appreciated domestic

Less obvious but more effective methods to reduce a current account deficit include
measures that increase domestic savings (or reduced domestic borrowing), including a
reduction in borrowing by the national government.

It should be noted that a Current Account deficit is not always a problem. The "Pitchford
Thesis" states that a current account deficit does not matter if it is driven by the private
sector. This theory has held true particularly for the Australian economy which is always
in deficit, yet has experienced economic growth for the past 14 years (1991-2005).

Key drivers of the current account

The items in the current account (e.g. perhaps especially imports and exports of goods)
are sensitive to international price differentials (the differences between the prices of
goods in different countries), to the rise and decline of industries (e.g the emergence of

the Japanese automobile industry 20 years ago, and the decline of the US steel industry at
the same time), and to differential economic growth rates (e.g. with a country being likely
to experience a deteriorating current account balance if its economy is growing more
rapidly than other countries).

The theory of purchasing power parity deals with the relationships between price levels
(and changes of price levels) in competing countries, and is relevant in any discussion of
the stability and likely trajectory of a current account balance, because the price pressures
that may be operating will find their expression primarily (though not exclusively) in the
traded goods area (within the current account).

Structural influences on the BOP and the current account

Countries can experience structural features or trends in their BOP's that will influence
the current account. For example, the USA in recent years has enjoyed large capital
account surpluses that may, depending on your beliefs about the key drivers of the US
BOP, have caused their large current account deficits. Again the rise of China as a global
competitor has caused a large bilateral deficit between the USA and China (i.e. China
selling to the USA more than it buys from it) and this is likely a structural feature of trade
between the two countries that will persist for years to come. Finally, some countries (e.g
Malaysia and at times much of South East Asia) have been perceived as attractive
locations for direct investment; they have had corresponding capital account surpluses,
and resultant tendencies to experience trade and current account deficits or increase in
foreign exchange reserves.

                Capital account convertibility and banks
R. S. Raghavan 15 april 2002

AS RECENT newspaper articles and headlines indicate the subject of capital account
convertibility/full convertibility of the rupee excites everyone's imagination. The few
observations are however, in order. The fact that is the march to convertibility has been
measured and even the latest announcements in the budget do not indicate the arrival of
the full convertibility regime. The movement in the external sector fits into a broad
pattern into which macro-economy has been falling into.

The Government is withdrawing from many economic areas. For instance, there has been
a general reduction of all types of subsidies. At another level interest rates are left to be
determined by the market. There is no overt attempt to stabilise the Indian rupee that has
been depreciating year after year.

Globalisation issues concerning financial sector merit far more serious attention than
what the present literature would seem to indicate. The key topic today ought to be risk
management. That will include a substantial amount of technological support. That will

be the greatest challenge for all bank managements as and when full convertibility

However, as of today the subject of risk management in all banks in India (barring
perhaps foreign banks) remains only on paper. The convertibility factor should impact
not only on the business-NRI deposits for instance but much more so on the profitability
of banking operations. Obviously risk factors ought to figure prominently in the scheme
of preventive measures.

An interesting scenario in which banks can accept deposits in India in any currency from
anywhere in the world is possible under a full convertibility regime. The crucial
determinant will be the usual "swap cost'' that is the cost of converting a currency into
another currency depending on the current exchange rate at the material time. The other
important thing would be the comparative interest rates in India as well in other deposit
exporting countries.

What is called arbitrage, the process in which opportunities in interest or exchange rate
differentials are exploited will become quite common. Individual depositors too can make
use of those opportunities. In short we will be headed for a scenario where violent swings
in interest and exchange rates are possible. How will Indian banks be prepared to deal
with the scenario?

Banks should realise that the years of insulated economy are a thing of the past. The
Resever Bank of India will not protect exchange risks. It is obvious that exchange risks
on any transactions will solely be on the bank concerned.

No bank with the business approach can shy away from this risk but highly profitable
business. On the positive side it does give Indian banks an opportunity to move up
towards international standards in managing risks.

The risk perceptions in all activities whether it is on resources or liabilities side of the
balance sheet or deployment of resources or assets need to be comprehended. And such
risks need to be identified, quantified and as part of our routine, one needs to constantly
monitor to contain such risks to desired levels. For instance, in today's exchange dealings,
risk in terms of exposures, whether it is currency-wise or open position in individual or
total dealings — all banks need to document and control at any point of time. Likewise,
in the sphere of credit, a bank may lend to a company abroad — however, within Indian
banks have lost heavily in so many sectors for varied reasons and one of these is
attributable to poor knowledge of the borrowing unit; if we do not have the wherewithal
to know of entities here, what to say of avenues elsewhere in the world?

Again, take the example of exposure between inter banks today: how about innumerable
unreconciled entries in inter branch, clearing transactions in the books of the banks
branches. Periodically, these are being written off and managements do not feel shy of
touching their bottomlines for the inefficiency all around. Reconciliation itself is yet to be
perceived as a necessity by bank staff and here is the risk factor. On this item alone, if the

RBI is to prescribe risk weight, not many banks could afford `capital' to cover......!! Such
is the plight of the banks in India today!

And to the role of auditors: our practices/style of management in different fields seem to
have been `exported' to the U.S.! For decades, the balance sheets of banks carry
qualifications, remarks on reconciled status or for that matter, non-compliances.
Gradually, the relative importance is lost sight of and it becomes a routine.

And that is how we have come to see the plight of UTI and other financial institutions. It
is not any single controller or agency which matters but if the business is controlled in so
many dimensions by many agencies all of them must act in their spheres. In the U.S.,
such coordination exists and still risks do create problems.

The Basle Committee, at the international level, is constantly trying to review and update
in emerging situations. In conclusion, time is short for banks in India to gear themselves
and first, they must take serious steps to usher in ALM and Risk Management which the
RBI has been preaching.

                  What is capital account convertibility?
There is no formal definition of capital account convertibility (CAC). The Tarapore
committee set up by the Reserve Bank of India (RBI) in 1997 to go into the issue of CAC
defined it as the freedom to convert local financial assets into foreign financial assets and
vice versa at market determined rates of exchange. In simple language what this means is
that CAC allows anyone to freely move from local currency into foreign currency and

How is CAC different from current account convertibility?

Current account convertibility allows free inflows and outflows for all purposes other
than for capital purposes such as investments and loans. In other words, it allows
residents to make and receive trade-related payments — receives dollars (or any other
foreign currency) for export of goods and services and pay dollars for import of goods
and services, make sundry remittances, access foreign currency for travel, studies abroad,
medical treatment and gifts etc. In India, current account convertibility was established
with the acceptance of the obligations under Article VIII of the IMF’s Articles of
Agreement in August 1994.

Can CAC coexist with restrictions?

Contrary to general belief, CAC can coexist with restrictions other than on external
payments. It does not preclude the imposition of any monetary/fiscal measures relating to
forex transactions that may be warranted from a prudential point of view.

Why is CAC such an emotive issue?

CAC is widely regarded as one of the hallmarks of a developed economy. It is also seen
as a major comfort factor for overseas investors since they know that anytime they
change their mind they will be able to re-convert local currency back into foreign
currency and take out their money.

In a bid to attract foreign investment, many developing countries went in for CAC in the
80s not realising that free mobility of capital leaves countries open to both sudden and
huge inflows as well as outflows, both of which can be potentially destabilising. More
important, that unless you have the institutions, particularly financial institutions, capable
of dealing with such huge flows countries may just not be able to cope as was
demonstrated by the East Asian crisis of the late nineties.

Following the East Asian crisis, even the most ardent votaries of CAC in the World Bank
and the IMF realised that the dangers of going in for CAC without adequate preparation
could be catastrophic. Since then the received wisdom has been to move slowly but
cautiously towards CAC with priority being accorded to fiscal consolidation and financial
sector reform above all else.

In India, the Tarapore committee had laid down a three-year road-map ending 1999-2000
for CAC. It also cautioned that this time-frame could be speeded up or delayed depending
on the success achieved in establishing certain pre-conditions — primarily fiscal
consolidation, strengthening of the financial system and a low rate of inflation. With the
exception of the last, the other two pre-conditions have not yet been achieved.

What is the position in India today?

Convertibility of capital for non-residents has been a basic tenet of India’s foreign
investment policy all along, subject of course to fairly cumbersome administrative
procedures. It is only residents — both individuals as well as corporates — who continue
to be subject to capital controls. However, as part of the liberalisation process the
government has over the years been relaxing these controls. Thus, a few years ago,
residents were allowed to invest through the mutual fund route and corporates to invest in
companies abroad but within fairly conservative limits.

Buoyed by the very comfortable build-up of forex reserves, the strong GDP growth
figures for the last two quarters and the fact that progressive relaxations on current
account transactions have not lead to any flight of capital, on Friday the government
announced further relaxations on the kind and quantum of investments that can be made
by residents abroad. These relaxations are to be reviewed after six months and if the

experience is not adverse, we may see further liberalisation and in the not-too-distant
future full CAC.

     Capital Account Convertibility in India- Special Feature
Convertibility of a currency implies that a currency can be transferred into another
currency without any limitations or any control. A currency is said to be fully convertible,
if it can be converted into some other currency at the market price of that currency. If
currency has to be convertible, it shall not be subjected to these restrictions.

Current account convertibility refers to currency convertibility required in the case of
transactions relating to exchange of goods and services, money transfers and all those
transactions       that     are     classified    in      the      current      account.

On the other hand, capital account convertibility refers to convertibility required in the
transactions of capital flows that are classified under the capital account of the balance of

At present, Indian rupee is partly convertible on current account. In 1997, the Tarapore
Committee on Capital Account Convertibility (CAC), constituted by the Reserve Bank,
had indicated the preconditions for Capital Account Convertibility. The three crucial
preconditions were fiscal consolidation, a mandated inflation target and, strengthening of
the financial system..

India adopted a gradualist approach while initiating a process of gradual capital account
liberalisation in the early 1990s. In 2003, the RBI Governor outlined issues related to
capital              account             convertibility              in             India

Prime Minister Manmohan Singh on 18th March 2006 said there was merit in India
moving towards fuller capital account convertibility. He asked Finance Minister and the
Reserve Bank of India to revisit the subject and come out with a road map on capital
account        convertibility         based           on        current        realities

In response to Prime Minister's statement, Reserve Bank of India on 20th March 2006,
announced Committee to set out Roadmap towards Fuller Capital Account Convertibility

      Capital account convertibility — Carefully-calibrated
                        approach needed
The move towards capital account convertibility calls for a conservative and cautious
approach, buttressed by carefully marshalled facts

INDIA's foreign exchange reserves have crossed the $100-billion mark. This is no
surprise, if one looks at the continuous increase in the last 50 months or so, though the
rate of growth has been phenomenal over the last one-and-half years. However, the very
crossing of the $100-billion mark has triggered debate whether the time is ripe for the
country to go in for capital account convertibility (CAC).

The crossing of the $100-billion mark in India's forex reserves has triggered a debate on
whether the time is ripe for the country to go in for capital account convertibility.

Interestingly, the debate on CAC, which began a few years ago, was silenced by the
South-East Asian currency crisis of July 1997. Those who advocate full convertibility in
capital account list out the possible benefits for the country, including greater confidence
levels of global investors in India, the present feel-good factor and strong macro
economic parameters of the nation, the reducing NPA levels and so on.

In such arguments, there has been no mention about `the appropriate figure' of forex
reserves considered the safe level for any country. The other way of looking at the issue
is: What is it that present foreign exchange market lacks that CAC is going to
dramatically change? What could be the downside risk and its implications, if the adverse
effects of being part of a global financial system hit us? For this, it is necessary to
understand the major change ushered in the exchange control law four years ago.

The old law on foreign exchange — the Foreign Exchange Regulation Act, 1973 —
controlled all the foreign exchange transactions, regardless of the quantum. Unmindful of

the expensive international travel costs, it allowed only up to $250 per day and many
transactions required the blessings of the RBI, some capital account transactions
requiring multiple approvals at different stages. The law had draconian penal provisions
and was quasi-criminal in nature. The Foreign Exchange Management Act, 1999
(FEMA) changed the very focus of the exchange control law. From one of `controlling'
and `permitting', it was conceived of as a piece of legislation `to facilitate' external
payments and promote the orderly development of the foreign exchange market.

It drastically diluted the penal provisions and is just another civil law now. It seeks to
`manage' the exchange control transactions by exception: that is, according to their nature
— current or capital account. The forex balance was around $35 billion in June 1999,
which has since grown over three times (see Table).

Current account transactions were generally free to be carried out even with bankers, and
the RBI does not interfere with them. Only a very few current account transactions are
regulated specifically by Rules made for them. There is virtually no business or trade
payment, in current account that is regulated by the RBI today.

Payment towards technical know-how in foreign exchange alone is regulated. This again,
is intended for the knowledge of the RBI and a very substantial quantum of these
payments is under automatic approval. In fact, there is a specific mandate by the RBI to
bankers that current account transactions — barring the few regulated ones — shall be
permitted regardless of their monetary or percentage ceiling limits.

For instance, Business Travel Quota (BTQ) is permissible up to $25,000 per year. The
Finance Minister recently announced that any Indian citizen can now remit or take
outside India $25,000 per year for any purpose. Thus, virtually, there is current account

Capital account transactions continue to be regulated under the FEMA, but with one
important difference. The best parts of capital account transactions are put under
automatic route, subject to minimum necessary safeguards. Even these have been
progressively liberalised in the last four years.

Foreign direct investment, barring a few strategic industries to arrest possible speculation
(like real estate trading), is put on automatic route, with most of the sectors permitted to
have 100 per cent foreign equity participation. The foreign portfolio investment by FIIs is
already convertible.

The external commercial borrowings (ECB) no longer require the RBI or Ministry
approval up to a staggering $50 million. The various multiple approvals that borrowers
were required to take six years before are no longer required; nor are the long list of end-
use restrictions on such ECB. Now, corporates can avail of ECB for any general business
purposes, with the exception of investment in real estate or stock market. These two
exceptions are needed to avoid speculative deals, which would unsettle the economy.
With world-class Indian companies opting for ventures abroad — as joint ventures or

wholly-owned subsidiaries — overseas direct investments (ODI) are allowed without
RBI permission, under automatic route, subject to minimum conditions intended for

Here, again, the RBI, keeping pace with the market demands, had initially permitted
Indian entities to invest 25 per cent of the net worth of investing companies; this was
increased to 50 per cent two years ago. This has since been increased up to 100 per cent
or entire net worth of investor companies.

The overall financial ceiling of $100 million has also been removed, as announced by the
Prime Minister, Mr Atal Bihari Vajpaye, at the recent NRI meet. Likewise, even under
NRI deposits account, initially, different amounts were allowed to be repatriated for
different purposes.

These restrictions were removed early this year, to freely permit repatriation for
educational, medical purposes or remittance of sale proceeds of immovable property in
India by such NRIs up to $1 million, every year.

If one looks at the merits of business-related capital account transactions in foreign
exchange, as available now, no one is really complaining that they are restricted by
exchange control for these transactions at all. Stated another way, how many corporate
are frequenting the RBI for either ECB or ODI, beyond the very liberal limits already
permitted? Interestingly, capital transactions exceeding these already high ceilings,
though not under automatic route, are still considered by the RBI, on merit and disposed
of depending on the need.

Thus, insofar as capital account transactions are concerned, the regulations are not
restrictions, but necessary safeguards for the economy, in general, or the particular entity
proposing such transaction, and the benefits of capital account convertibility in major
business transactions are thus already in place.

The formal regime of capital account convertibility, when in place, will additionally
allow all residents — companies or individuals or other entities — to invest, disinvest or
transact in any property or assets/liability of any country, convert one currency to another
or move funds anywhere in the world, according to their personal choice, unrestricted by

Given the population, diversity, financial system and other priorities peculiar to India,
why are we so eager to usher in full CAC with its marginal benefits? On the contrary, the
downside could be devastating.

There is no absolute `comfortable' foreign exchange figure; nor is market sentiment
predictable. Global financial markets are volatile, and subject to the influence of several
factors — political, country, economic, and so on. Rogue speculators cannot be
eliminated from the system, which will gain at the cost of the country. If that happens, as
happened in the South-East Asian countries six-and-a-half years ago, it will wipe out

years of development and unsettle the overall economy; the cure for this will only be
doubly painful. The move towards CAC thus calls for a conservative, cautious and
calibrated approach, buttressed by carefully marshalled facts and clinical analysis of data
on the global and local markets.

The RBI has the necessary expertise in this area, and, the Tarapore Committee report
could be a guiding factor. Undoubtedly, the RBI has done an excellent job in managing
our forex reserves, particularly that of short-term foreign currency loans and, more
recently, by tactfully honouring its commitment of $5 billion to RIBs without affecting
the market in any way.

As a market regulator, the RBI is saddled with the high responsibility of maintaining
safety and liquidity of the currency reserve. And when it comes to the timing of CAC,
despite the liberal and free advice from all corners, the RBI will likely usher it in at a
time it considers appropriate, and probably without too much fuss.

        Should India pursue capital account convertibility?
FULL capital account convertibility is again being actively discussed with the accretion
of large foreign exchange reserves. There is no specific definition of capital account
convertibility (CAC). But the Tarapore Committee (1997) defines CAC as "the freedom
to convert local financial assets into foreign financial assets and vice-versa at market
determined rates of exchange". In other words, CAC implies complete mobility of capital
across countries.

The rationale behind full capital account convertibility is efficient allocation of global
capital which not only equalises the rates of return of capital across countries but also
increases the level of output and equitable distribution of level of income.

The Tarapore Committee had suggested such preconditions as a reduction in gross fiscal
deficit as a percentage of GDP from 4.5 in 1997-98 to 4.0 in 1998-99 and further to 3.5 in
1999-2000; a mandated rate of inflation on an average 3-5 per cent for the three-year-
period 1997-98 to 1999-00; a fully deregulated interest rate structure by 1997-98; and a
reduction of non-performing assets as percentage of total advances to 12 per cent by
1997-98, 9 per cent by 1998-99 and 5 per cent by 1999-2000.

But none of these preconditions has been met in its specified time period. The
performance of these indicators has not been satisfactory in recent years. For example,
the gross fiscal deficit as a percentage of GDP stood at 5.9 per cent in 2002-03. The
annual inflation rate was 4.6 per cent between 1997-98 and 2002-03. The non-performing
assets of scheduled commercial banks as a percentage to total advance have declined to
only 10.40 per cent in 2001-02. Interest rates have not been deregulated completely. The
bank deposit rates, the provident fund rate and all long-term interest rates are still
administered by the government.

The whole host of capital account transactions has been liberalised or deregulated in the
recent past. It has been argued that for most business and personal transactions the rupee
is practically fully convertible. Further, in cases where specific permission is required for
transactions above a monetary ceiling, it is generally received easily. The authorities have
also declared that they will continue to pursue this deregulation policy further.

However, it is not immediately possible to:

                                  -term external borrowings, and

deposits and idle assets in response to market developments or exchange rate

Such liberalisation would cause extreme domestic financial vulnerability as the Asian
crisis taught us. It should be realised that free mobility of capital has affected many
countries, including Mexico, East Asia, Russia and so on. However strong the economic
fundamentals of developing countries, free flow of global capital inevitably sows the
seeds of financial crises.

Excessive inflows of capital results in exchange rate appreciation and thereby affect the
competitiveness of the host country in the international goods market, on the one hand,
and widens the trade deficit by increasing imports, on the other. The central bank's
intervention to avoid these effects causes problems and affects the independent monetary
policy operation.

Full capital account convertibility may encourage arbitrage operation. It is so because
banks, non-banking financial institutions and individual borrowers will prefer to borrow
global capital cheap which would not only increase the external debt burden of the
country but also encourage the functioning of the "black economy" and financial
instability because of the heavy investment in physical and financial assets.

Full capital account convertibility often provides wrong signals to the international
investors about the host country's economic fundamentals. Since the international
investors are concerned about their profit maximisation rather than productive
investment, they mobilise their funds for higher returns which may results in moral
hazard and adverse selection problems and thereby destabilise the financial system and
cause great loss to the host country.

Foreign capital is neither necessary nor desirable for India. It is so because the voluntary
savings in India generated according to the time preference of the economic agents is
mostly sufficient for the gross domestic investment and growth. The high real rates of
interest promotes both financial and total savings and private sector capital formation by
facilitating the accumulation of finance necessary for undertaking investments.

However, the cumulative net impact of the real rate of interest on investment is positive
because its effect operating through financial intermediation and complementarity
outweigh its cost effect. Therefore, any reduction in interest rates affects both savings and
investment. The proper utilisation of domestic savings at appropriate interest rates
structure is sufficient to put the Indian economy on a higher growth path.

For this, needed is coordination among such economic agents as households, corporates,
banks, and the Government, which, in turn, depends on confidence and expectation about
the future economic activity. In contrast to Arrow-Debrew's model of coordination
success in a competitive environment, coordination failure is very much prevalent in the
present uncertain milieu.

                            Current Account Deficit
The Indian economy has transformed itself from a current account surplus status of $3.3
billion during the April-June 2004 period to a deficit $6.2 billion during the comparative
period this fiscal according to the Reserve Bank of India’s preliminary balance of
payments data. This means the economy is once again absorbing savings from the rest of
the world.

A current account deficit shows the extent to which a country is consuming more than it
is producing and to the extent that the rest of the world is willing to finance its over-
consumption, there is nothing bad about a deficit per se.

The reasons for this are manifold. First, a record-high merchandise trade deficit during
the quarter has more than offset the smaller invisible surplus (which includes earnings
from software exports and remittances from Indians working overseas), resulting in a
wider current account deficit.

India's trade deficit is widening owing to strong domestic demand and high crude oil
prices. The trade deficit lingered throughout the previous fiscal touching an all time high
of $ 11.8 billion in the third quarter of fiscal 2005. The deficit in the fourth quarter fell
slightly to $ 11.53 billion.

Second, the capital account recorded a smaller surplus of $7.4 billion during the April-
June ’05 period significantly lower than the average of $12 billion in the previous two
quarters. A smaller increase in portfolio inflows during the period was the key reason for
the decline in the surplus on the capital account.

Third, the current account for the last quarter of the fiscal ended with a marginal surplus
of $ 159 million. This was on account of higher net invisibles of $ 7.2 billion for the year-
end and $ 11.69 billion for the fourth quarter. The capital account remains in surplus due
to net foreign direct investment into India, positive foreign institutional investment, and
higher recourse to external commercial borrowings and short-term credit.

According to a JP Morgan forecast, the wider-than-expected current account deficit
during the April-June 2005 quarter will put upward pressure on their full year deficit
forecast which presently stands at $10.1 billion (or 1.3% of GDP), and reinforces their
bearish outlook on the rupee.

Economic think tank NCAER has said interest rates will soon climb, with Indian
economy's macro indicators gradually worsening, which is reflected in higher current
account deficit, inflation and untamed fiscal deficit.

"Just when this will begin to happen is not immediately clear but it is certain that interest
rates will soon start to climb, even if only gradually," NCAER said in its publication

It its recent report, the Institute of Economic Growth has also predicted an upward
pressure on interest rates along with higher inflation.

Predictions of inflation, higher current account deficit in the coming months and higher
interest rates along with a bearish outlook for the rupee may be a cause for worry. When
the current account deficit becomes large - as in the case of the US- the rest of the world
becomes anxious about the country’s ability to service the deficit, with grave
consequences for its long-term sustainability

Exchange Rate Management: An Emerging Consensus?- Part I
Speech of Dr. Bimal Jalan, Governor, Reserve Bank of India delivered on the 14th
August 2003, at the 14th National Assembly of Forex Association of India in

11. A frequently discussed question is about Capital Account Convertibility (CAS), i.e.
when is India going to move to full CAC? As you are aware, we have already liberalized
and deregulated a whole host of capital account transactions. It is probably fair to say that
for most transactions which are required for business or personal convenience, the rupee
is, for all practical purposes, convertible. In cases, where specific permission is required
for transactions above a high monetary ceiling, this permission is also generally
forthcoming. It is also the declared policy of the Government and the RBI to continue
with this process of liberalization. In this sense, Capital Account Convertibility continues
to be a desirable objective for all investment and business related transactions and India
should be able to achieve this objective in not too distant a future.

12. There are, however, two areas where we would need to be extremely cautious – one is
unlimited access to short-term external commercial borrowing for meeting working
capital and other domestic requirements. The other area concerns the question of
providing unrestricted freedom to domestic residents to convert their domestic bank
deposits and idle assets (such as, real estate), in response to market developments or
exchange                                rate                              expectations.

13. In respect of short-term external commercial borrowings, there is already a strong
international consensus that emerging markets should keep such borrowings relatively
small in relation to their total external debt or reserves. Many of the financial crises in the
1990s occurred because the short-term debt was excessive. When times were good, such
debt was easily accessible. The position, however, changed dramatically in times of
external pressure. All creditors who could redeem the debt did so within a very short
period, causing extreme domestic financial vulnerability. The occurrence of such a
possibility has to be avoided, and we would do well to continue with our policy of
keeping access to short-term debt limited as a conscious policy at all times – good and

14. So far as the free convertibility of domestic assets by residents is concerned, the
issues are somewhat more fundamental. It has to do with the differential impact of
"stock" and "flows" in determining external vulnerability. The day-to-day movement in
exchange rates is determined by "flows" of funds, i.e. by demand and supply of spot or
forward transactions in the market. Now, suppose the exchange rate is depreciating
unduly sharply (for whatever reasons) and is expected to continue to do so for the near
future. Now, further suppose that domestic residents, therefore, decide – perfectly
rationally and reasonably – that they should convert a part or whole of their stock of
domestic assets from domestic currency to foreign currency. This will be financially
desirable as the domestic value of their converted assets is expected to increase because
of anticipated depreciation. And, if a large number of residents so decide simultaneously
within a short period of time, as they may, this expectation would become self-fulfilling.
A         severe         external         crisis       is        then        unavoidable.

15. Consider India’s case, for example. Today, our reserves are high and exchange rate
movements are, by and large, orderly. Now, suppose there is an event which creates
external uncertainty, as for example, what actually happened at the time of the Kargil or
the imposition of sanctions after Pokhran, or the oil crises earlier. Domestic stock of bank
deposits in rupees in India is presently close to US $ 290 billion, nearly three and a half
times our total reserves. At the time of Kargil or Pokhran or the oil crises, the multiple of
domestic deposits over reserves was in fact several times higher than now. One can
imagine what would have had happened to our external situation, if within a very short
period, domestic residents decided to rush to their neighbourhood banks and convert a
significant    part    of    these    deposits     into    sterling,    euro    or    dollar.

16. No emerging market exchange rate system can cope with this kind of contingency.
This may be an unlikely possibility today, but it must be factored in while deciding on a
long term policy of free convertibility of "stock" of domestic assets. Incidentally, this
kind of eventuality is less likely to occur in respect of industrial countries with
international currencies such as Euro or Dollar, which are held by banks, corporates, and
other entities as part of their long-term global asset portfolio (as distinguished from
emerging market currencies in which banks and other intermediaries normally take a
daily     long    or    short    position   for    purposes     of    currency     trade).

17. Another issue, which has figured prominently in the current debate, relates to foreign
exchange reserves. As is well known, India’s foreign exchange reserves have increased
substantially in the past few years and are now among one of the largest in the world. The
fact that most of the constituents of India’s balance of payments are showing positive
trends – on the current as well as capital accounts – is a reflection of the increasing
competitiveness of the Indian economy and strong confidence of the international
community in India’s growth potential. For the first time after our Independence 56 years
ago, the fragility of the balance of payments is no longer a concern of policy makers. This
is a highly positive development and regarded as such by the country at large.

18. Nevertheless, there are two concerns that have been expressed by expert
commentators – one is about the "cost" of additional reserves, and second concerns the
impact of "arbitrage" in inducing higher inflows. So far as the cost of additional reserves
is concerned, it needs to be borne in mind that the bulk of additions to reserves in the
recent period is on account of non-debt creating inflows. India’s total external debt,
including NRI (Non-Resident Indian) deposits, has increased relatively slowly as
compared with the increase in reserves, particularly in the last couple of years. In fact,
India pre-paid more than $ 3 billion of external debt earlier this year. It may also be
mentioned that rates of interest paid on NRI deposits and multilateral loans in foreign
currency are in line with or lower than prevailing international interest rates.

19. On NRI rupee deposits, interest rates in the last couple of years have been in line with
interest rates on deposits by residents, and are currently even lower than domestic interest
rates. So far as other non-debt creating inflows (i.e., foreign direct investment, portfolio
investment or remittances) are concerned, such inflows by their very nature are
commercial in nature and enjoy the same returns and risks, including exchange rate risk,
as any other form of domestic investment or remittance by residents. The cost to the
country of such flows is the same whether they are added to reserves or are matched by
equivalent foreign currency outflow on account of higher imports or investments abroad
by residents. On the whole, under present conditions, it seems that the "cost" of
additional reserves is really a non-issue from a broader macro-economic point of view.

20. Indian interest rates have come down substantially in the last three or four years.
They are, however, still higher than those prevailing in the U.S., Europe, U.K. or Japan.
This provides an "arbitrage" opportunity to holder of liquid assets abroad, who may take
advantage of higher domestic interest rates in India leading to a possible short-term
upsurge in capital flows. However, there are several considerations, which indicate that
"arbitrage" per se is unlikely to have been a primary factor in influencing remittances or
investment decisions by NRIs or foreign entities in the recent period. Among these are :

The minimum period of deposits by NRIs in Indian rupees is now one year, and the
interest rate on such deposits is subject to a ceiling rate of 2.5 per cent over Libor. This is
broadly in line with one-year forward premium on the dollar in the Indian market
(interest rates on dollar deposits by NRIs are actually below Libor).

Outside of NRI deposits, investments by Foreign Institutional Investors (FIIs) in debt

funds is subject to an overall cap of only $ 1 billion in the aggregate. In other words, the
possibility of arbitrage by FIIs in respect of pure debt funds is limited to this low figure
of $ 1 billion (excluding investments in a mix of equity and debt funds).

Interest rates and yields on liquid securities are highly variable abroad as well as in India,
and the differential between the two rates can change very sharply within a short time
depending on market expectations. It is interesting to note that the yield on 10 year
Treasury bills in the U.S. had risen to about 4.4 per cent as compared with 5.6 per cent on
Government bonds of similar maturity in India at the end of July 2003. Taking into
account the forward premia on dollars and yield fluctuations, except for brief period,
there is likely to be little incentive to send large amounts of capital to India merely to take
advantage of the interest differential.

RBI Committee to set out Roadmap towards Fuller Capital
Account    Convertibility-    20th    March       2006
Economic reforms in India have accelerated growth, enhanced stability and strengthened
both external and financial sectors. Our trade as well as financial sector is already
considerably integrated with the global economy. India's cautious approach towards
opening of the capital account and viewing capital account liberalisation as a process
contingent upon certain preconditions has stood India in good stead.

Given the changes that have taken place over the last two decades, however, there is
merit in moving towards fuller capital account convertibility within a transparent
framework. There is, thus, a need to revisit the subject and come out with a roadmap
towards fuller Capital Account Convertibility based on current realities. In consultation
with the Government of India, the Reserve Bank of India has appointed a committee to
set    out    the   framework     for   fuller    Capital    Account       Convertibility.

The Committee consists of the following:

i. Shri S.S Tarapore Chairman
ii. Dr. Surjit S. Bhalla Member
iii. Shri M.G Bhide Member
 iv. Dr. R.H. Patil Member
v. Shri A.V Rajwade Member
vi. Dr. Ajit Ranade Member

The terms of reference of the Committee will be:

i. To review the experience of various measures of capital account liberalisation in India,

ii. To examine implications of fuller capital account convertibility on monetary and

exchange rate management, financial markets and financial system,

iii. To study the implications of dollarisation in India of domestic assets and liabilities
and internationalisation of the Indian rupee,

iv. To provide a comprehensive medium-term operational framework, with sequencing
and timing, for fuller capital account convertibility taking into account the above
implications and progress in revenue and fiscal deficit of both centre and states,

v. To survey regulatory framework in countries which have advanced towards fuller
capital account convertibility,

vi. To suggest appropriate policy measures and prudential safe- guards to ensure
monetary and financial stability, and

vii. To make such other recommendations as the Committee may deem relevant to the

Technical work is being initiated in the Reserve Bank of India. The Committee will
commence its work from May 1, 2006 and it is expected to submit its report by July 31,

The Committee will adopt its own procedures and meet as often as necessary. The
Reserve Bank of India will provide Secretariat to the Committee.

              There are three benefits to India from CAC
Economic Times in June 1997

First, Rates of return on debt and equity in India are high by world standards. With
convertibility, foreign money will come into India to arbitrage this differential away and
reduce these rates of return: i.e., the cost of capital faced by the companies of India in
equity and debt financing will drop. At a lower cost of capital, more investment projects
would be viable, which would generate a faster pace of investment and growth in the

Second, With convertibility, Indians would be able to diversify their portfolios
internationally. Instead of being constrained to only hold Indian real estate, equity and
debt, we will reduce our risk by diversifying internationally. This means that in a bad
year in India, when Indian financial assets generate a poor return, foreign assets owned
by Indians would continue to generate good returns. This reduction in the variability of
returns would make Indians happier since they face less risk, and help stabilise India's

Convertibility means that the households and firms of India are not forced to meet each
other through India's financial system. The GDR market is one example of the
alternative: here Indian firms chose to meet with foreign investors through the markets
outside India. This market arose in response to weaknesses of existing markets in India.
With convertibility, it will be possible for Indian firms to interact with Indian households
in (say) the markets of Singapore. This would provide alternatives for India's households
and firms, generate competition for India's financial industry, and elevate the urgency of
reforms in the financial sector. For example, if derivatives on the dollar--rupee start
trading in Singapore or Chicago, convertibility means that we in India would be able to
use them.

The foreign exchange market will especially be in the spotlight, since all these increased
flows of funds will have to go through the dollar-rupee market. An illiquid dollar-rupee
market will display spurious volatility under such pressures. Hence, institutional
development of India's foreign exchange market should precede convertibility. The two
key approaches for this are (a) transition of the spot market away from the inter-bank
market to modern screen-based trading that is widely accessible all over the country, and
(b) transition away from the inter-bank dollar-rupee forward market to a modern dollar-
rupee futures market without entry barriers. These approaches would transform the
quality of the foreign exchange market.

CAC also has important ramifications for taxation. Convertibility opens up new avenues
for a narrowing of the tax base, and hence upgrades the priority of a harmonization of
taxation in India with international standards.

Third, CAC puts new pressures upon macroeconomic management of the economy, in
the sense that poor macroeconomic policies will swiftly generate large outflows of funds,
and price volatility. Financial markets will constantly monitor economic policy; this will
constrain the behaviour of policymakers, and diminish the likelihood of irresponsible
policy choices. CAC also brings up the specter of a significant macroeconomic crisis if
irresponsible policies are adopted.


                      Source: RBI Press Release dated June 3, 1997

A committee on capital account convertibility, setup by the Reserve Bank of India (RBI)
under the chairmanship of former RBI deputy governor S.S. Tarapore to "lay the road
map" to capital account convertibility. At the moment it is still a report and central bank
has      to      accept     the       recommendations         of       the      committee.

The five-member committee has recommended a three-year time frame for complete
convertibility by 1999-2000. The highlights of the report including the preconditions to
be    achieved      for   the   full    float    of    money      are    as    follows:-


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.

A consolidated sinking fund has to be set up to meet government's debt repayment needs;
to be financed by increased in RBI's profit transfer to the govt. and disinvestment

Inflation rate should remain between an average 3-5 per cent for the 3-year period 1997-

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%

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

External sector policies should be designed to increase current receipts to GDP ratio and
bring down the debt servicing ratio from 25% to 20%

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.

Phased liberalisation of capital controls

The Committee's recommendations for a phased liberalisation of controls on capital
outflows over the three year period which have been set out in detail in a tabular form in
Chapter        4       of        the      Report,       inter        alia,       include:-

(i) Indian Joint Venture/Wholly Owned Subsidiaries (JVs/WOSs) should be allowed to
invest up to US $ 50 million in ventures abroad at the level of the Authorised Dealers
(ADs) in phase 1 with transparent and comprehensive guidelines set out by the RBI. The
existing requirement of repatriation of the amount of investment by way of dividend etc.,
within a period of 5 years may be removed. Furthermore, JVs/WOs could be allowed to
be set up by any party and not be restricted to only exporters/exchange earners.

ii) Exporters/exchange earners may be allowed 100 per cent retention of earnings in
Exchange Earners Foreign Currency (EEFC) accounts with complete flexibility in
operation of these accounts including cheque writing facility in Phase I.

iii) Individual residents may be allowed to invest in assets in financial market abroad up
to $ 25,000 in Phase I with progressive increase to US $ 50,000 in Phase II and US$

100,000 in Phase III. Similar limits may be allowed for non-residents out of their non-
repatriable assets in India.

iv) SEBI registered Indian investors may be allowed to set funds for investments abroad
subject to overall limits of $ 500 million in Phase I, $ 1 billion in Phase II and $ 2 billion
in Phase III.

v) Banks may be allowed much more liberal limits in regard to borrowings from abroad
and deployment of funds outside India. Borrowings (short and long term) may be subject
to an overall limit of 50 per cent of unimpaired Tier 1 capital in Phase 1, 75 per cent in
Phase II and 100 per cent in Phase III with a sub-limit for short term borrowing. in case
of deployment of funds abroad, the requirement of section 25 of Banking Regulation Act
and the prudential norms for open position and gap limits would apply.

vi) Foreign direct and portfolio investment and disinvestment should be governed by
comprehensive and transparent guidelines, and prior RBI approval at various stages may
be dispensed with subject to reporting by ADs. All non-residents may be treated on part
purposes of such investments.

vii) In order to develop and enable the integration of forex, money and securities market,
all participants on the spot market should be permitted to operate in the forward markets;
FIIs, non-residents and non-resident banks may be allowed forward cover to the extent of
their assets in India; all India Financial Institutions (FIs) fulfilling requisite criteria should
be allowed to become full-fledged ADs; currency futures may be introduced with screen
based trading and efficient settlement system; participation in money markets may be
widened, market segmentation removed and interest rates deregulated; the RBI should
withdraw from the primary market in Government securities; the role of primary and
satellite dealers should be increased; fiscal incentives should be provided for individuals
investing in Government securities; the Government should set up its own office of
public debt.

viii) There is a strong case for liberalising the overall policy regime on gold; Banks and
FIs fulfilling well defined criteria may be allowed to participate in gold markets in India
and abroad and deal in gold products

               Capital account convertibility is a challenge
                               4 Sep, 2006
MUMBAI: A five-year roadmap to take India to fuller rupee convertibility doesn't appear
optimistic in its timeframe, analysts say, because some of the key recommendations will
challenge the government and may not find favour with the central bank.

The road map, released recently, was drawn up by an expert panel appointed by the
central bank and outlines a three-phase plan extending to 2010-11 to allow greater
movement      of    capital    in    and     out    of    the   local    currency.

The panel recommended that before achieving fuller capital account convertibility the
central bank needed a more transparent exchange rate policy, the government should
lower its stakes in state-run banks and measures should be taken to discourage overly
high               investment             by               foreign             funds.

The panel also said the government should put its finances in order and start running
revenue surpluses after wiping out the revenue deficit by 2009, a suggestion, analysts say,
the    government       will    find      challenging     to     meet     by     2010-11.

"There are recommendations that the panel has made which cannot be met in the five-
year timeframe and could take longer," said Indranil Pan, chief economist at Kotak
Mahindra                                                                     Bank.

Public finances are a case in point. The country runs a revenue deficit and a high fiscal
deficit, making it vulnerable to shocks when foreign capital is allowed to enter and leave

The combined deficit of the governments was 7.7% of GDP in 2005-06, one of the
highest in the world. Indian law stipulates fiscal deficit must fall by 0.3 percentage points
a year until 2009 and while it has shrunk recently this is due more to high growth than
budget                                                                             discipline.

Rupee has been convertible on current account since 1994, meaning it can be changed
freely into foreign currency for purposes like trade-related expenses. But it cannot be
converted      freely    for    activities    like    acquiring     overseas     assets.

Fuller convertibility is expected to facilitate double-digit growth through higher
investment and improve efficiency in financial sector through greater competition.

But analysts say the panel's suggestion that government's share in state-run banks should
fall to 33% from 51% will fall foul of the ruling coalition's communist allies. The
communists, whose main backers are trade unions, fear loss of state control will lead to
job                                                                                  cuts.

"It will not happen with communist parties as allies," said A Balasubramaniam, chief
investment         officer     at          Birla          Sun        Life       MF.

"Probably the government would make the state-run banks stronger, may be through
mergers, to face competition when fuller convertibility comes in."

The report also said industrial houses should be allowed to set up private sector banks. "I
don't see it happening immediately," said R Sreesankar, head of research at IL&FS

 Capital Account Convertibility: Neo-liberalism’s New Threat
                          to India
                                                                      Amitayu Sen Gupta
                                                                    Shouvik Chakraborty
April 02, 2006

ON the inaugural function of the 16th Asian Corporate Conference (March 18, 2006), the
prime minister Dr Manmohan Singh, stated that there is merit in India’s moving forward
towards fuller Capital Account Convertibility. In an immediate response, the RBI set up a
committee under the Chairmanship of Mr S S Tarapore to pave the way for the Capital
Account Convertibility. This article provides a basic analysis of the problems involved
with the issue of Capital Account Convertibility in India.


In India, the foreign exchange transactions (transactions in dollars, pounds, or any other
currency) are broadly classified into two accounts: current account transactions and
capital account transactions. If an 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. This is a “current account transaction”. But, if
someone wants to import plant and machinery or invest abroad, and needs a large amount
of foreign exchange, say $1 million, the importer will have to first obtain the permission
of the Reserve Bank of India (RBI). If approved, this becomes a “capital account
transaction”. This means that any domestic or foreign investor has to seek the permission
from a regulatory authority, like the RBI, before carrying out any financial transactions or
change of ownership of assets that comes under the capital account. Of course there are a
whole range of financial transactions on the capital account that may be freed form such
restrictions, as is the case in India today. But this is still not the same as full capital
account convertibility.

By “Capital Account Convertibility” (or CAC in short), we mean “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. …” (Report of the Committee on Capital Account Convertibility,
RBI, 1997) Thus, in simpler terms, it means that irrespective of whether one is a resident
or non-resident of India one’s assets and liabilities can be freely (i.e. without permission
of any regulatory authority) denominated (or cashed) in any currency and easily
interchanged between that currency and the Rupee.


Several economists are of the view that the full Capital Account Convertibility (and
allowing the exchange rate to be market determined) has serious consequences on the
wellbeing of the country, and this may even lead to extreme sufferings of the common
masses. Some of the reasons are highlighted below.

              During the good years of the economy, it might experience huge inflows
      of foreign capital, but during the bad times there will be an enormous outflow of
      capital under “herd behaviour” (refers to a phenomenon where investors acts as
      “herds”, i.e. if one moves out, others follow immediately). For example, the South
      East Asian countries received US$ 94 billion in 1996 and another US$ 70 billion
      in the first half of 1997. However, under the threat of the crisis, US$ 102 billion
      flowed out from the region in the second half of 1997, thereby accentuating the
      crisis. This has serious impact on the economy as a whole, and can even lead to an
      economic crisis as in South-East Asia.

             There arises the possibility of misallocation of capital inflows. Such
      capital inflows may fund low-quality domestic investments, like investments in
      the stock markets or real estates, and desist from investing in building up
      industries and factories, which leads to more capacity creation and utilisation, and
      increased level of employment. This also reduces the potential of the country to
      increase exports and thus creates external imbalances.

             An open capital account can lead to “the export of domestic savings” (the
      rich can convert their savings into dollars or pounds in foreign banks or even
      assets in foreign countries), which for capital scarce developing countries would
      curb domestic investment. Moreover, under the threat of a crisis, the domestic
      savings too might leave the country along with the foreign ‘investments’, thereby
      rendering the government helpless to counter the threat.

             Entry of foreign banks can create an unequal playing field, whereby
      foreign banks “cherry-pick” the most creditworthy borrowers and depositors. This
      aggravates the problem of the farmers and the small-scale industrialists, who are
      not considered to be credit-worthy by these banks. In order to remain competitive,
      the domestic banks too refuse to lend to these sectors, or demand to raise interest
      rates to more “competitive” levels from the ‘subsidised’ rates usually followed.

             International finance capital today is “highly volatile”, i.e. it shifts from
      country to country in search of higher speculative returns. In this process, it has
      led to economic crisis in numerous developing countries. Such finance capital is
      referred to as “hot money” in today’s context. Full capital account convertibility
      exposes an economy to extreme volatility on account of “hot money” flows.

According to Joseph Stiglitz, the former Chief Economist at the World Bank and a Nobel
Laureate in 2001,

“Capital market liberalization entails stripping away the regulations intended to control
the flow of hot money in and out of the country- short term loans and contracts that are
usually no more than bets on exchange rate movements. This speculative money cannot
be used to build factories or create jobs- companies don’t make long term investments
using money that can be pulled out on a moment’s notice- and indeed, the risk that such
hot money brings with it makes long-term investments in a developing country even less
attractive.”- (Globalisation and its’ Discontents, 2002.)


Over the past two decades, under the diktat of the IMF-World Bank, several developing
countries have undertaken measures to open their capital account as part of a broader
process of financial liberalisation and international economic integration. Several
developing countries like Argentina, Kenya, Mexico and the South East Asia (Indonesia,
South Korea, Malaysia and Thailand) liberalized their capital accounts over the last few

The early 1990s experienced a boom in capital flows internationally followed by the
reversal of such flows especially in the second half of the 1990s. The first reversal
occurred in the aftermath of Mexico’s currency crisis in December 1994. It was,
however, limited to some Latin American economies and capital flows resumed soon
after. The second reversal, which was more severe and enduring, came in 1997 and
resulted in the East Asian crisis. This was followed by the Russian default in August
1998 and the Brazilian crisis in 1998-99, followed more recently by the collapse of the
Argentine currency in 2001 and the spate of corporate failures and accounting
irregularities in the USA in 2002. Needless to say, all the developing countries faced
major crisis due to such vagaries of finance capital, whereas the only gainers were the
handful of financers who control the flows of such capital.

But, these crises did not affect the Indian economy since India had regulations on capital
account. Even a conservative economist like Jagadish Bhagwati recognized this point
when he argued that “It is noteworthy that both India and China escaped the Asian
Financial crisis; (since) they did not have Capital Account Convertibility.” – (US House
of Representatives Committee on Financial Services, April, 2003).

                          WHO BENEFITS FROM “CAC”?

The class which benefits from the CAC primarily compromises the big business houses
and the finance capitalists, who invest in the stock market for speculations. The policies
like CAC are pursued mainly to gain the confidence of the speculators and punters in the
Stock Markets, and do not have any beneficial effects on the real sector of the economy,

like increasing the employment level, eliminating poverty and decreasing the inequality
gap. However, the irony is that under a crisis, the burden is borne primarily by the
common masses. This may come in the form of a sharper reduction in subsidies, less
investment for social welfare projects by the government and an increase in the
privatisation process. The foreign speculators and the domestic players may walk out of
the market (by converting their assets to foreign currency) and insulate themselves from
any damage.

                          BACKGROUND OF CAC IN INDIA

By August 1994, India was forced to adopt full current account convertibility under the
obligations of IMF’s article of agreement (Article No. VII). The committee on Capital
Account Convertibility, under Dr S S Tarapore’s chairmanship, submitted its report in
May 1997 and observed that international experience showed that a more open capital
account could impose tremendous pressures on the financial system. Hence, the
committee recommended certain signposts or preconditions for Capital Account
Convertibility in India. However, the agenda of Capital Account Convertibility was put
on hold following the South-East Asian crisis. Even the finance minister acknowledged
this point that “...the idea of Capital Account Convertibility was floated in 1997 by the
Tarapore Committee, but could not be implemented as the Asian Crisis cropped up”.
(The Hindu, March 25, 2006). The RBI over a period of time has accepted the point that
the South East Asian crisis was a bad example for Capital Account Convertibility and
that India had been insulated from the crisis because it had not allowed Capital Account

“The growing global macroeconomic imbalance – as evidenced by the large and
sustained current account deficit of the US – suggests that markets may at times allocate
global saving differently from what is perceived by the policy makers as appropriate and
sustainable in the long-run. Like the effect on resource allocation, the beneficial effects of
capital account liberalisation on growth are ambiguous.” – (Report on Currency and
Finance 2002-03, RBI.)

But at the same time, the RBI had started talking about Capital Account relaxations,
under pressure from the business classes in India. However, given the obvious pitfalls of
CAC policies, the RBI talked about a cautious approach to CAC.

“In India, it is recognised that the pace of liberalisation of the capital account would
depend on both domestic factors (especially progress in the financial sector reform), and
the evolving international financial architecture. The regulatory framework is being used
in several combinations to address problems of excessive inflows and pressures towards
outflows. In this regard, an integrated view of the state of development of activities in
financial markets needs to be taken.” - (Report on Currency and Finance 2002-03, RBI.)

It is interesting to note here that there already exists a great amount of freedom in
transacting foreign currencies today:

               Indian residents and companies (listed in the share markets) can invest in
       foreign companies, provided a) the foreign company has 10 per cent share holding
       in some Indian company and b) the domestic country does not invest an amount
       more than 25 per cent of the company’s total valuation. However, if an Indian
       company has a “proven track record” it can invest an amount up to 100 per cent of
       its total valuation in a foreign entity engaged in a “bonafide” business activity.

              There is no monetary limit on such aforesaid investments by individuals.

             Indian banks can invest their “unutilised” FCNR(B) funds (Foreign
       Currency (Non-Resident) Accounts (Banks)- accounts in which NRI’s and PIO’s
       can deposit in any Indian bank) abroad in only long term fixed income securities
       which have some minimum ratings (read credibility) internationally.

             An Indian exporter can give “loans” out of its foreign earnings to foreign
       importers without any limit; i.e. the foreign exchange earned need not necessarily
       be deposited in the country.

             Indians can have Residents Foreign Currency (domestic) Accounts in
       which they can hold their savings in foreign currency without any limit. They can
       also remit these foreign currencies to acquire foreign securities (from foreign
       stock markets) under Employees Stock Option Plan (ESOP) without any limits.

              NRI, PIO and non residents can take up to US$1 million per year out of
       the country from balances held in Non Resident Ordinary (NRO) accounts/ sales
       of Indian assets. Such assets may include those acquired through

Any further relaxations would render the Indian economy susceptible to the kind of crisis
faced by the other developing countries.

 Why then is the government interested in introducing Capital Account
The UPA government, since its inception, had has been pursuing the policies of
liberalistion and privatisation, which underscore its commitment to neo-liberalism.
Notwithstanding certain policy announcements in the NCMP, the government is
unwilling to change course and is in essence pursuing the same policies as the NDA. A
policy like Capital Account Convertibility is a reflection of this. Such policies solely
benefit the rich business houses, investors in the stock markets and those who control the
international finance markets. The prime minister and the finance minister are more than
eager to serve the vested interests of these classes.

Dani Rodrik, an eminent Harvard economist, has argued that
“The greatest concern I have about canonizing capital-account convertibility is that it will
leave economic policy in the typical “emerging market” hostage to the whims and fancies

of two dozen or so thirty-something country analysts in London, Frankfurt, and New
York. A finance minister whose top priority is to keep foreign investors happy will be
one who pays less attention to developmental goals. We would have to have blind faith in
the efficiency and rationality of international capital markets to believe that these two sets
of priorities will regularly coincide.”--- (“Who Needs Capital Account Convertibility?”
February 1998.)


The moral of the story is that with Capital Account Convertibility financial crises will
always be with us; and there is no magic wand to stop them. These conclusions are
important because they should make us appropriately wary about statements of the form,
“we can make free capital flows safe for the world if we do x at the same time,” where x
is the currently fashionable antidote to crisis. In India today the x is “strengthening the
domestic financial system and improving the prudential standards.” Tomorrow’s x is
anybody’s guess. If we are forced to look for a new series of policy errors each time a
crisis hits, we should be extremely cautious about our ability to prescribe a policy regime
that will sustain a stable system of capital flows. Hence any conclusions by the special
RBI committee would be just another such wishful thinking that others before us have
undertaken, whereas such policies may not be enough from preventing a crisis in India.
The only way to avoid such a crisis is to have regulated capital inflow into the economy,
the purpose of which is defeated by CAC.

                              Reserve Bank of India

On March 21st, the RBI set the ball rolling on full capital account convertibility (CAC) of
the rupee by setting up a committee to chalk out a road map. The committee will begin
work from May 1, 2006 and is expected to submit its report by July 31, 2006.

While the obvious uptake of this would mean more foreign money coming in, this will
also allow local companies to tap foreign markets more easily. However, what does CAC
mean for the common man? How will our life change if and when CAC becomes a

For that, let us understand what CAC exactly means.

Basically CAC implies freedom to convert local currency into foreign currency and vice
versa, for any purpose whatsoever, without needing any permission from the government.
The term “any purpose whatsoever” is important, for as of now India is convertible on the
current account. This means one can import and export goods or receive or make
payments for services rendered. However, investments and borrowings are restricted.

Therefore, let us try and understand the implications of CAC from the viewpoint of both
an NRI as well as a Resident.

CAC for NRIs

Our NRI diaspora will benefit tremendously if and when CAC becomes a reality. The
reason is on account of current restrictions imposed on movement of their funds.

As has been mentioned in these columns before, no one is born an NRI. An NRI becomes
an NRI when he leaves India for a job or doing business abroad. Now what happens is
that in the process, he may leave his Indian assets behind --- investments and monies that
he owned when he was an Indian Resident. Though such funds and assets can be moved
abroad, there are some rules and restrictions.

Though an NRI may remit an amount up to $ 1 million per calendar year, out of his NRO
account for all bonafide purposes, to the satisfaction of the banker, for any such
remittance, an undertaking from the remitter and a certificate from a chartered accountant
is required. For property, there is a lock-in of ten years. In other words, sale proceeds of a
house that has been purchased using rupee funds, cannot be repatriated unless such house
is owned for ten years.

Then there are various documentary evidences that need to be submitted to the banker for
proving that the purpose is bonafide. For example, if the money is required for medical
purposes, a bill or an estimate form the overseas hospital or the doctor is required. If its
for education purposes, the I-20 or letter from the university along with the estimated fees
would need to be submitted. Even for assets brought out of foreign exchange which
ordinarily should have full repatriability some restrictions creep in. For example, take real
estate purchased out of foreign exchange. An NRI can repatriate funds representing the
sale proceeds of only two such properties in his entire lifetime!!

CAC will eliminate these difficulties.

Implications of CAC for a Indian Resident

As most readers would know, as of now, we Residents cannot freely move money
abroad. There are certain allowable limits beyond which permission from RBI is needed.
The table lists the specific limits for purposes generally applicable.

Purpose                Limit per annum
Private visit abroad $10,000
Business Travel        $25,000
Gifts / Donations       $5,000 each
For persons going
abroad              for $1,00,000
For            persons
emigrating abroad

For maintenance of
close relatives
                     $1,00,000 or as per fee
For studies abroad
For general purpose
including           $25,000
As far as I am concerned, these limits are already quite liberal. Even if I wanted to I
would not be able to use any additional funds allowed. Simply because I cant afford it.
However, for those who harbour ambitions of buying a villa in the south of France or a
studio apartment in Manhattan, I appreciate that $25,000 would be pocket change. Also,
according to some Richie Riches, the limit for private travel is dismal and should increase
at least ten fold.

In any case, the point here is that for the average person, CAC may not have a direct
benefit. However, there could be indirect advantages. CAC would attract more FDI, more
investments and a greater choice of products and services than are available currently.
Therefore, in terms of quality of life and variety of products, both investment and
consumer, CAC is something we all can look forward to.

Last point. The term “any purpose whatsoever” implies “any legal purpose whatsoever.”
The laws of the land still stand irrespective of CAC. Therefore, things such as
participation in online lotteries, or buying drugs or even subscription say to Mr. Hugh
Hefner’s publication are still out of bounds!

September 04, 2006

India has been relentlessly moving on the path towards liberalization, opening up its
markets and loosening its controls over many economic matters so as to integrate with the
global economy.

Despite the opposition to globalization from some quarters, India has been quite watchful
in its approach to embracing global economy. The issue of capital account convertibility
is one such where the nation has tread very cautiously.

A high-level committee to look into this matter, appointed by the Reserve Bank of India,
on Friday recommended that India move to fuller capital account convertibility over the
next five years and has laid down the roadmap for the move.

So what is capital account convertibility?

To put is simply, capital account convertibility (CAC) -- or a floating exchange rate --
means the freedom to convert local financial assets into foreign financial assets and vice
versa at market determined rates of exchange. This means that capital account

convertibility allows anyone to freely move from local currency into foreign currency and

It refers to the removal of restraints on international flows on a country's capital account,
enabling full currency convertibility and opening of the financial system.

A capital account refers to capital transfers and acquisition or disposal of non-produced,
non-financial assets, and is one of the two standard components of a nation's balance of
payments. The other being the current account, which refers to goods and services,
income, and current transfers.

How are capital a/c convertibility and current a/c convertibility different?

Current account convertibility allows free inflows and outflows for all purposes other
than for capital purposes such as investments and loans. In other words, it allows
residents to make and receive trade-related payments -- receive dollars (or any other
foreign currency) for export of goods and services and pay dollars for import of goods
and services, make sundry remittances, access foreign currency for travel, studies abroad,
medical treatment and gifts, etc.

Why capital account convertibility?

Capital account convertibility is considered to be one of the major features of a developed
economy. It helps attract foreign investment. It offers foreign investors a lot of comfort as
they can re-convert local currency into foreign currency anytime they want to and take
their money away.

At the same time, capital account convertibility makes it easier for domestic companies to
tap foreign markets. At the moment, India has current account convertibility. This means
one can import and export goods or receive or make payments for services rendered.
However, investments and borrowings are restricted.

But economists say that jumping into capital account convertibility game without
considering the downside of the step could harm the economy. The East Asian economic
crisis is cited as an example by those opposed to capital account convertibility.

Even the World Bank has said that embracing capital account convertibility without
adequate preparation could be catastrophic. But India is now on firm ground given its
strong financial sector reform and fiscal consolidation, and can now slowly but steadily
move towards fuller capital account convertibility.

What is the Tarapore Committee?

The Reserve Bank of India has appointed a committee to set out the framework for fuller
Capital Account Convertibility.

The Committee, chaired by former RBI governor S S Tarapore, was set up by the
Reserve Bank of India in consultation with the Government of India 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

Economists Surjit S Bhalla, M G Bhide, R H Patil, A V Rajwade and Ajit Ranade were
the members of the Committee.

The Reserve Bank of India has also constituted an internal task force to re-examine the
extant regulations and make recommendations to remove the operational impediments in
the path of liberalisation already in place. The task force will make its recommendations
on an ongoing basis and the processes are expected to be completed by December 4,
2006. The Task Force has been set up following a recommendation of the Committee.

The Task Force will be convened by Salim Gangadharan, chief general manager, in-
charge, foreign exchange department, Reserve Bank of India, and will have the following
terms of reference:

      Undertake a review of the extant regulations that straddle current and capital
       accounts, especially items in one account that have implication for the other
       account, and iron out inconsistencies in such regulations.
      Examine existing repatriation/surrender requirements in the context of current
       account convertibility and management of capital account.
      Identify areas where streamlining and simplification of procedure is possible and
       remove the operational impediments, especially in respect of the ease with which
       transactions at the level of authorized entities are conducted, so as to make
       liberalisation more meaningful.
      Ensure that guidelines and regulations are consistent with regulatory intent.
      Review the delegation of powers on foreign exchange regulations between
       Central Office and Regional offices of the RBI and examine, selectively, the
       efficacy in the functioning of the delegation of powers by RBI to Authorised
       Dealers (banks).
      Consider any other matter of relevance to the above.

The Task Force is empowered to devise its work procedure, constitute working groups in
various areas, co-opt permanent/special invitees and meet various trade associations,
representative bodies or individuals to facilitate its work. It will make recommendations
on an ongoing basis to rectify the anomalies and remove operational impediments. The
processes are expected to be completed by December 4, 2006.

How does capital a/c convertibility affect you?

As most of us know, resident Indians cannot move their money abroad freely. That is,
one has to operate within the limits specified by the Reserve Bank of India and obtain
permission from RBI for anything concerning foreign currency.

For example, the annual limit for the amount you are allowed to carry on a private visit
abroad is $10,000: of which only $5,000 can be in cash. For business travel, the yearly
limit is $25,000. Similarly, you can gift or donate up to $5,000 in a year.

The RBI limit raises the limit if you are going abroad for employment, or are emigrating
to another country, or are going for studies abroad: the limit in both these cases is

You are also allowed to invest into foreign stock markets up to the extent of $25,000 in a

For the average Indian, these 'limits' seem generous and might not affect him at all. But
for heavy spenders and those with visions of buying a house abroad or a Van Gogh
painting, it will mean a lot. . .

But with the markets opening up further with the advent of capital account convertibility,
one would be able to look forward to more and better goods and services.

And how will it affect Non-Resident Indians?

Capital account convertibility may NRIs as it will help remove all shackles on movement
of their funds.

Currently, NRIs have to produce a whole lot of documents and certificates if they want to
buy a house in India (for which the lock-in period is 10 years, meaning they can't take
their money back overseas if they sell the house after having owned it for less than 10
years), or send money to India from their overseas accounts.

NRIs: Tax benefits may be removed

However, the Tarapore Committee on fuller capital account convertibility has
recommended bringing foreign individuals on par with Non-Resident Indians in terms of
convertibility and tax treatment.

The committee has proposed that the government must review tax benefits offered to
NRIs for investments in foreign currency non-resident (banks) and non-resident
(external) rupee account deposit schemes, while suggesting that foreign individuals be
allowed to invest in these deposit schemes but without any tax concessions.

The committee said a movement towards capital account convertibility implied that all
non-residents (corporates and individuals) should get equal treatment. This means that the
tax benefits extended to NRIs under these schemes should be removed.

The committee recommends that these deposit schemes should be extended to non-
residents (other than NRIs), in two phases.

In Phase I, non-residents could first be provided the FCNR (B) deposit facility, without
tax benefits, subject to know-your-customer (customer identification) and financial action
task force's (FATF) anti-money laundering norms.

Similarly, in Phase II, the NR(E)RA deposit scheme, with cheque writing facility, could
also be extended to non-residents.

With respect to the capital market, at present only NRIs are allowed to invest in
companies listed on the Indian stock exchanges, subject to certain stipulations.

The committee said all individual non-residents and non-resident corporates should be
allowed to invest in the Indian stock market through Sebi-registered entities, including
mutual funds and portfolio management schemes.

These entities will be responsible for meeting KYC and FATF norms and the money
should come through bank accounts in India.

The committee has also recommended that the resident foreign currency (RFC) and RFC
(deposit) accounts should be merged. The account holders should be allowed to move
foreign currency balances to overseas banks.

For those wishing to continue with the RFC accounts, foreign currency
current/savings chequable accounts should be provided, in addition to the foreign
currency term deposits.

     Precaution is the word on capital account convertibility
August 31, 2006

MUMBAI, AUG 30: Nearly a month after the submission of capital account
convertibility road map, the Reserve bank of India (RBI) has indicated that a judgmental
view needs to be taken whether and when a country has reached the threshold. In the
annual report, RBI stated that so far India has chosen to proceed cautiously and in a
gradual manner, calibrating the pace of capital account liberalisation with underlying
macroeconomic developments, the state of readiness of the domestic financial system and
the dynamics of international financial markets.

In the case of financial integration, a “threshold” in terms of preparedness and resilience
of the economy is important for a country to get full benefits. “A judgmental view needs
to be taken whether and when a country has reached the threshold and the financial
integration should be approached cautiously, preferably within the framework of a
plausible roadmap that is drawn up by embodying the country-specific context and

institutional features,” said RBI. Further it also said that the experience so far has shown
that the Indian approach to financial integration has stood the test of time.

Commenting ahead, RBI said, “At this stage, the optimism generated by impressive
macroeconomic performance accompanied with stability has given rise to pressures for
significantly accelerating the pace of external financial liberalisation. It is essential to
take into account the risks associated with it while resetting an accelerated pace of a
gradualist approach.”

The apex bank stated that the overall approach to the management of India’s foreign
exchange reserves in recent years reflects the changing composition of the balance of
payments and the ‘liquidity risks’ associated with different types of flows and other

              Towards Greater CAC: Recent Relaxations
Last Updated 15 Mar, 2003

The road to convertibility, in India, is a calculated gradual transition path starting in the
early '90s when the High Level Committee on Balance of Payments, chaired by C
Rangarajan, recommended the introduction of a market-determined exchange rate
regime. The Liberalized Exchange Rate Management system was instituted in March
1992 as a transitional phase before the convergence of the dual rates on March 1, 1993.
The current account convertibility was achieved in August 1994 by accepting Article VIII
of the Articles of Agreement of the International Monetary Fund.

At the next stage, a 14-member Sodhani panel, an expert group on foreign exchange, was
set up in November 1994. The Sodhani Committee Report tabled in 1995 helped develop,
deepen and widen the forex market through introduction of various products. The
Tarapore Committee on Capital Account Convertibility in 1997 defined the framework
for      the     third     and    final      stage      of     forex      liberalisation.

The S S Tarapore Committee on Capital Account Convertibility (CAC) in May 1997 had
chalked out three stage, to be completed by 1999-2000. The committee had indicated
certain signposts to be achieved for the introduction of capital account convertibility. The
three most important of them are: fiscal consolidation, a mandated inflation target and
strengthening of the financial system. The two major recommendation of the committee

      a reduction in gross fiscal deficit from 4.5 per cent to 3.5 per cent in 1999-2000,
      a mandated rate of inflation for the period 1997-98 to 1999-2000 at 3 to 5 per

The point to note is that although none of the core conditions of the Tarapore panel have
been met, the RBI has gone ahead charting its own course. Even in 2002-03, banks' CRR
is much higher than what Tarapore had recommended and so are gross NPAs not to speak
of the fiscal deficit. In essence, RBI's approach is not clinical but sequential.

In the run-up to full convertibility, the committee had charted out a phased liberalisation
of capital inflows and outflows:

      Allowing Indian joint ventures/ wholly-owned subsidiaries to invest up to $ 50
       million abroad;
      Removal of existing requirement of repatriation of the amount of investment by
       way of dividend within in five years;
      Allowing exporters/exchange earners to keep 100 per cent of their forex earnings
       in the exchange earners foreign currency accounts;
      Permitting individual residents to invest in financial assets abroad up to $ 25,000
       and gradually raising the limit to $ 50,000 and $ 1,00,000;
      Allowing mutual funds to invest in securities abroad within an overall limit of $
       500 million in phase I, $1 billion in phase II and $2 billion in phase III;
      Giving banks greater freedom to borrow and deploy funds outside India in stages;
      Allowing foreign institutional investors' portfolio funds to be invested and
       repatriated without prior RBI scrutiny;
      Allowing FIIs, non-resident Indians and foreign banks full access to forward
       cover for their Indian assets;
      Permitting banks and financial institutions to participate in gold markets aboard;
      Withdrawing the Reserve Bank from playing the role of the government's
       merchant banker.

Here are the measures that the Reserve Bank has taken over the last few months to
emphasize its commitment of capital account convertibility to individuals, corporations,
banks and other market players:

      Overseas funds are allowed to hedge their entire foreign currency exposures
       arising from investments in Indian equities instead of just 15 per cent earlier.
      Indian banks were initially allowed to invest up to 50 per cent of their equity
       capital or $ 25 million -whichever is higher - in overseas money market or debt
       instruments. Now this limit too has been removed and it is up to the board of the
       individual banks to decide on how much they want to invest abroad.
      Indian residents are allowed to open domestic accounts to deposit foreign
       currency obtained through payments received for services provided overseas,
       honorariums or gifts and residual travel money. There is no ceiling on the amount
       that may be kept in such accounts.
      Indian firms can borrow up to $ 50 million from global sources without
       government approval and prepay foreign loans ahead of schedule.

      Individuals can now get up to $ 500 without filling any form or submission of any
      Remittance of foreign exchange for medical treatment up to $ 50,000 is allowed
       without submission of any documents.
      Remittance of foreign exchange for travel and education or gifting of funds up to
       $ 5,000 has also been freed.
      Individual professionals can now retain up to 100 per cent of their foreign
       exchange earning in EEFC accounts.
      Repatriable status accorded to all non-resident bank deposits except balances in
       NRO accounts.
      Capital transfers for NRIs up to $ 1,00,000 out of sale of immovable property as
       also inheritances and legacies has been permitted.
      Limits for Indian direct investments under the automatic route has been doubled
       to $ 100 million.
      Software exporters are encouraged by permitting them to receive 25 per cent of
       the value of their exports in the form of equity of start-up companies.
      Two-way fungibility of ADRs/GDRs was operationalized to bring about
       alignment in the prices of Indian stocks in the domestic and international markets.
      Corporates have been accorded greater freedom to raise (up to $ 50 million) and
       pre-pay foreign currency borrowings (up to $ 100 million).
      Corporates have also been accorded greater freedom to raise short-term
       suppliers/buyers credit for imports (up to $ 20 million).
      FIIs have been allowed to trade in exchange traded derivatives in India.
      Corporations are free to rebook cancelled foreign exchange forward contracts.
      Swap and open position limits available to banks have been raised to enable them
       to offer finer rates to the customers.
      Finally, RBI is also actively considering introducing rupee-based currency

There is still a long way to go. For instance, banks have been allowed to deploy money
overseas without any restrictions but only in debt and money market instruments and not
in equities. Similarly, the cap on $ 500 million for mutual funds to take overseas
exposure may sound too little. Nobody is allowed to punt on the rupee and RBI is still
policing the forex market, albeit in a subtle way. But the Reserve Bank seems to be more
concerned about "effective convertibility". For all practical purposes, rupee is now
virtually convertible on capital account for individuals. As far as business is concerned,
all "flow" transactions are convertible; it is only the "stock" - the assets - that is left out.

Individuals also allowed to invest in listed firms abroad.

      Permission also be granted to listed Indian companies to invest abroad in
       companies listed in recognized overseas stock exchanges, having at least 10 per
       cent shareholding in a company listed on a recognized stock exchange in India.

       Such investments should not exceed 25 per cent of the Indian company's net
       worth as on the date of the last audited balance sheet.
      Mutual funds are being permitted to invest abroad in companies which are listed
       on overseas stock exchanges, and which have at least 10 per cent shareholding in
       a company listed on a recognized stock exchange in India. The overall cap for
       investment abroad by mutual funds is, hereby, raised to $ 1 billion.
      Apart from companies, individuals are also being permitted to invest abroad in
       companies which are listed on overseas stock exchanges and which have at least
       10 per cent shareholding in a company listed on a recognized stock exchange in
      The limit on annual basis of investment has been raised up to $50 million by
       Indian companies planning to make acquisitions of foreign units or direct
       investment abroad in joint ventures/wholly owned subsidiaries on an annual basis
       through automatic route without being subject to the three year profitability

                    Full convertibility: Must we have it?

Arvind Panagariya

Economic Times, October 26, 1998

Should India embrace full capital account convertibility in the near future? And was
Prime Minister Mahathir of Malaysia wise to reintroduce controls in the wake of a crisis?
The answers to these questions are asymmetric: while India is well advised to wait before
entering the world of convertibility, Mahathir was ill advised to exit it.

Why should those of us who support free trade be hesitant to support free currency
convertibility? The answer is provided by Professor Jagdish Bhagwati of Columbia
University in an article provo-catively titled ``The capital myth: the difference between
trade in widgets and dollars''. Writing in the May/June, 1998 issue of Foreign Affairs,
Bhagwati argues that while free trade has been shown to generate net positive benefits,
evidence of similar gains from free capital mobility has simply not been provided.

There is a tendency on the part of many to present capital mobility as an all or nothing
choice. Yet, many forms of capital flows can and do take place without free currency
convertibility. The Resurgent India Bonds, foreign direct investment (FDI) and
investments by Foreign Institutional Investors are but a few examples.

The case against moving from this partial mobility to full convertibility is based on two
premises. First, most of the benefits of capital mobility can be reaped via partial mobility,
principally equity and direct foreign investment.

And second, full convertibility invariably brings with it enhanced risk of the ``twin
crises'', one in the currency market and the other in the banking sector. China's experience
since mid-1980s provides support for the first of these premises.

To date, China does not enjoy even current account convertibility, let alone capital
account convertibility. Yet, attracted by its macroeconomic stability and high rates of
return on investment, foreign investors have flocked to the country.

According to the Asian Development Bank, today, China ranks first among developing
countries and second among all countries in terms of FDI. During 1993-96, 38 to 40 per
cent of the FDI into developing countries went to China. In 1996, the absolute level of
this investment was $46 billion.

In the same ear, the total private capital inflow into the country was twice that received
by its nearest developing-country rival, South Korea. Admittedly, under currency
convertibility, these capital inflows would have been even larger.

But how much larger and at what cost? Given China's already high share in the inflows to
developing countries and the presence of competing destinations, the additional flows
would have been of second order importance. And given the ongoing financial crises, the
cost of convertibility would have been very large.

Regarding the second premise, an opposing view is that currency crises can be largely
avoided by adopting flexible exchange. Surjit Bhalla (Economic Times September 14) in
effect argues that the crises in east and south-east Asian economies could have been
avoided had these economies been on flexible exchange rates.

Under this scenario, the local currency would have appreciated with capital inflows, the
return on future inflows would have declined and the volume of capital inflows would
have been automatically arrested before reaching crisis proportions. Admittedly, the logic
underlying this argument has an important policy implication: if a country must embrace
capital-account convertibility, on balance, it is better off opting for flexible exchange

Fixed rates seem to be inherently incompatible with freely flowing capital. It is not
altogether implausible to suggest that the Bretton Woods system, conceived at a time
when capital flows were negligible and designed primarily to facilitate trade in goods,
broke down under pressures generated by increased capital mobility subsequently.

That said, it will be a mistake to conclude that flexible exchange rates eliminate the risk
of currency and banking crises. Just because a price is determined in the market does not
mean that it cannot be subject to precipitous movements.

No price is more flexible than the stock price and yet no market is more susceptible to a
crash than the stock market. Crisis-proportion movements in the flexible exchange rate
are also not unusual. As recently as this month, between October 1 and 8, the dollar

depreciated against the yen by 20 per cent! Within last one year, the floating Mexican
peso has slid down more than 30 per cent.

A negative side effect of flexible exchange rates is that the appreciation of the currency,
resulting from capital inflows, has an adverse effect on the competitiveness of the
country's exports. This was perhaps a key reason why the countries in east and southeast
Asia opted for fixed exchange rates. To the extent that exports affect growth, under
flexible rates, the countries would have had to sacrifice real income.

Flexible exchange rates also do not rule out banking crises which result from capital
mobility. This is especially true when banking sector is itself vulnerable as in India.
There is a general agreement among specialists that capital mobility played a crucial role
in triggering the banking crisis in Japan. According to a highly simplified account
provided by Professor David Weinstein of the University of Michigan, in the late
seventies and early eighties, via complex regulations, Japanese banks were effectively
allowed to function as a cartel.

The banks, in turn, helped many inefficient firms stay afloat through a ``cash-flow
insurance'' whose burden fell on the larger, more profitable firms. Liberalisation by Japan
in early 1980s led the larger, profitable firms to defect in a big way to the Euro-dollar

That left the domestic banks with less profitable firms as their only borrowers. Seeking
more profitable investments, the banks turned to the real estate market and East Asia. The
rest, as we all know, is history.

The lesson to be derived from the Japanese and similar other experiences is that, unlike
the goods markets, the liberalisation of financial markets is a complex affair. Before we
embark upon full currency convertibility, it is advisable to at least get our banking sector
on its feet. Otherwise, we risk currency and banking crises and with them the risk of
administering a serious setback to the more urgent reforms. It may be sobering to recall
that some of the European countries such as Portugal, Spain and Ireland did not opt for
capital account convertibility until late 1980s or early 1990s.

In spite of these arguments against introducing capital-account convertibility in India,
why was Malaysia's decision to introduce capital controls ill conceived? The answer is
that having already been on convertibility for some years, Malaysia faces a situation quite
different from that of India.

Its problems were twofold: persuading the departed capital to return and encouraging the
capital still within its borders not to depart.

The controls have given exactly the wrong message to the departed capital: if you return,
there may be no exit doors for you.

As for the capital that remains within Malaysia, any success in controlling it will be
short-lived. Professor Carmen Reinhart of the University of Maryland has carefully
studied the episodes in which countries having been on convertibility for some time tried
to combat capital outflows by re-introducing capital controls (Spain in 1992, Chile in
1991, an Brazil and Malaysia in 1994).

Her conclusion is that the success of such controls in stemming outflows is temporary.

Having once been there, the residents and banks seem to be quickly able to devise
channels that circumvent the controls. The bottom line is that convertibility is a one-way
street. Or as Bhagwati quips, having once entered the Mafia underworld, if you want out,
you leave in a coffin.

          Capital Account Convertibility - An Introduction
In the last two decades a generalized shift towards floating exchange rate regimes was
observed and capital account convertibility took place in many industrialized countries.
Following the action taken by the developed countries, one third of 131 developing
countries also adopted floating exchange rates and some of them took appropriate
measures to liberalize capital account transactions.

Convertibility of Indian rupee had been mooted for a decade before the partial
liberalization came into effect. What is convertibility? Convertibility of a currency
implies that a currency can be converted into another currency without any limitations or
any control. A currency is said to be fully convertible, if any currency can be converted
into some other currency at the market price of that currency. The need for currency
conversions arises mainly from foreign exchange transactions. But these foreign
exchange transactions are subject to some regulatory restrictions. If currency has to be
convertible, it will not be subject to these restrictions.

There are two main types of convertibility: 1) current account convertibility and 2)
capital account convertibility. Current account convertibility refers to convertibility
required in the case of transactions relating to exchange of goods and services, money
transfers and all those transactions that are classified under the current account. On the
other hand, capital account convertibility refers to convertibility required in the
transactions of capital flows that are classified under the capital account of the balance of

Capital Account Convertibility begins with liberalization of capital account by the
governments of the nations. There is only a subtle difference between liberalization and
convertibility. How can one define capital account convertibility? It is defined as the
"freedom to convert local financial assets into foreign financial assets and vice versa at
market determined rates of exchange" (Benu Schneider, 2000). It is often associated with

changes of ownership in foreign and domestic financial assets and liabilities and involves
creation and liquidation of claims on or by the rest of the world.

In the wake of severe currency crises in the late 1990s in many parts of the world, and the
globalization of financial markets, many developing Latin American and Asian countries
have been considering the openness of capital account. Though a fixed rate regime seems
to be an exception from the general rule since the early 1990s, it is necessary to explore
the ultimate motives behind a fixed peg. If one wants lower inflation than the potential
anchor country, a long-standing appreciation has to be chosen as in the case of
Switzerland and Singapore. If the country is more inflationary and unable to fight against
the ultimate cause of this, it has to accept a long-standing depreciation. But the degree of
openness plays an important role for the choice of an exchange rate regime. The question
of exchange rate regime assumes significance when the more inflationary country is able
to balance the ultimate cause of inflation, the budget deficit. This calls for anti-
inflationary measures to be taken including the commitment to a fixed exchange rate.
There is always an ongoing controversy about the pace and the sequence of
implementation of capital account convertibility.

There are several pros and cons associated with capital account convertibility. It has
several economic implications. There is skepticism that rapid and unplanned
liberalization of the capital account can become more harmful than beneficial to the
economy, given lack of some macroeconomic fundamentals like huge fiscal deficit, rising
inflation etc. This skeptical view needs to be given serious consideration given the mixed
experience in some of the East Asian and Latin American countries. The liberalization of
the capital transactions can lead to capital inflow in the country but this opening also
gives a way for flight of capital from the country. It is necessary for the experts and the
officials to bring into effect full convertibility with some restrictions to avoid any form of
crisis in the later stage.

The crises in East Asia and Brazil had demanded prudential norms to be adopted by the
countries who vote for liberalization. Many economists suggest the need for the return of
capital controls. Krugman (1999) says that "sooner or later we will have to turn the clock
at least part of the way back: to limit capital flows for countries that are unsuitable for
either currency unions or free floating". Joseph Stiglitz (1999) raised a voice of concern
and concluded that volatile markets were inescapable reality; Developing countries need
to manage them; They will have to consider policies that put some limit on capital flows.

The desirability of capital account convertibility is questioned by various economists at
different points of time. The benefits of capital account liberalization can be attained only
when the capital controls are lifted at a particular pace when certain preconditions are
met. What are these preconditions? These preconditions can be broadly classified under
the following heads: fiscal consolidation, inflation rate, financial sector reform, monetary
policy, exchange rate policy, current account balance, foreign exchange reserves, prudent
supervisory norms and lowering tariff barriers. Taking these factors into account,
management of capital flows and the degree of liberalization have to be undertaken by
small and developing economies.

In this book, we present the issues involved in capital account liberalization. The first
article in the book, "Issues in CAC in Developing Countries", describes the choice of
CAC for developing countries. It explains the step-wise implementation of CAC to reap
its benefits. The author V Subbulakshmi describes the preconditions required to be met
before CAC is attempted, necessary policy reforms that need to be addressed for
initiating the process of CAC, the speed at which the implementation is to be carried out,
and the prudential measures that need to be adopted while going for full convertibility.
While addressing these issues, the author studies the pattern of international private
capital flows in developing countries that attempted CAC. The author also highlights the
problems that are encountered in financial intermediation and risk of capital flight.

The second article, "Capital Management Techniques in Developing Countries: An
Assessment of Experiences from the 1990's and Lessons for the Future", discusses capital
management techniques by relating them to two complementary types of financial
policies: policies that govern international private capital flows and those that enforce
prudential management of domestic financial institutions. The authors Gerald Epstein,
Ilene Grabel and Jomo K S state that capital management techniques can be static or
dynamic. Three types of circumstances trigger implementation of management
techniques or lead authorities to strengthen or adjust existing regulations _ changes in the
economic environment, the identification of vulnerabilities, and the attempt to close
loopholes in existing measures. This article presents seven case studies of the diverse
capital management techniques employed in Chile, Colombia, Taiwan POC, India,
China, Singapore and Malaysia during the 1990s. The authors draw general policy
lessons from the experiences of these countries.

In the third article, "Opening the Capital Account of Transition Economies: How Much
and How Fast", the authors Daniel Daianu and Radu Vranceanu analyze to what extent
and at what pace should transition economies carry out the KA liberalization process. In
the late eighties, many developing countries followed the example of the most advanced
countries and opened their capital account (KA) in an attempt to reap new gains from
increased integration with the world economy. By 2000, after the wave of financial and
currency crises that hurt the global economy in the last decade, enthusiasm about KA
liberalization has much faded. Firstly, the relationship between development and capital
account liberalization did not come out to be as solid as initially expected; secondly,
greater capital mobility has brought about increased global financial instability. New
thinking in international economics calls for proper sequencing in opening the KA:
liberalization should proceed in step with progress in macroeconomic stability, structural
reform and creation of a sound internal financial system.

The fourth article, "Capital Account Openness and Inflation: A Panel Data Study for the
1990s", discusses the relation between opening of capital account and inflation. Two
trends were predominant in the 1990s: global disinflation and capital account
liberalization (CAL). The author Abhijit Sen Gupta while examining the existence of
correlation between these two factors provides the results of previous studies on the
existence of correlation. The article also provides a theoretical framework in support of
the existence of correlation between CAL and disinflation. The study confirms that there

is a negative correlation between CAL and inflation and CAL can act as a significant
predictor of disinflation.

The fifth article, "Capital Account Liberalisation and Poverty", focuses on the neglected
topic of the costs of CAL to poorer countries. This article assesses the relevance and
applicability of the previous studies with regard to poor countries. It traces the likely
impact of CAL on poverty in terms of policy implication, (level and stability of
government flows, management of capital flows, market discipline and taxation and
capital mobility), industrial investment, performance and availability, and maturity and
cost of credit. The author Alexander Cobham concludes by saying that the net growth
benefit of CAL cannot be established for poor countries. Nevertheless, a variety of costs
and dangers can be clearly identified. Therefore, the author opines that policy makers
must retain the option to use capital controls.

The sixth article, "Capital Account Liberalization, The Cost of Capital and Economic
Growth", explains the process by which the benefits of capital account liberalization are
transmitted to the real economy and thereby provides empirical evidence against the view
that CAL brings no real benefits. The author Peter Blair Henry addresses the following
two main issues: requirement of CAL and the role of CAL in improving the real
economy. The author in his study analyzes the changes in the cost of capital, investment
growth and the growth rate of output per worker for a sample of 18 countries. His
findings conclude that as a consequence of liberalization, on an average, there is a decline
in the cost of capital, an increase in the investment rate and an increase in the growth rate
of output per worker. The article thus lays out the process by which the effects of
liberalization are transmitted to the real economy.

The seventh article, "Who needs Capital-Account Convertibility?" is a renowned article
in this field and is a pioneer of many research articles in this area. In this article, the
author Dani Rodrik questions the desirability of CAC. The article explains the difference
between current account and capital account convertibility and unique characteristics of
financial markets which tend to make CAC less desirable. The author makes an
interesting comment that there is always an awakening among the policy makers that
makes them work towards new economic models after experiencing a crisis. The author
has found that the magnitude of the recent crises is not justified by changes in the
fundamentals of the affected economies. He suggests that it is not advisable to propagate
CAC as a necessary tool for growth. He finds that there is no evidence that CAC has
beneficial effects on economies with stronger institutions. The author further emphasizes
that controls need to be maintained on short-term borrowings. He draws an analogy
between capital flows and a medicine with horrific side effects. While these side effects
cannot be controlled, it is not a prudent measure to abandon the sale of such medicine

It is opined by some of the economists that opening of capital accounts is the logical
culmination of the process of developing a deep, mature and efficient domestic financial
system. Domestic and international financial liberalization go together since it is not easy
to liberalize domestic financial transactions while keeping the controls on the cross-

border transactions. It is suggested that developing countries should control capital flows
while they build deep and diversified financial systems, upgrade prudential supervision
and strengthen their monetary and fiscal institutions (Barry Eichengreen, 1998).

Market oriented economists are incessantly advocating liberalization of capital account
claiming that a plethora of benefits are associated with it. In their view, it maximizes the
efficiency in the use of capital; it enforces market discipline and makes capital markets
adapt to change in the policy shifts; makes financial supervision and regulation of capital
markets by the government more structured; affords freedom to dispose off their income
and wealth as they deem good in their interest. These economists argue that individuals'
self interests get translated into social interests in the long-run.

However operationalizing CAC is a crucial issue for the regulatory authority and it calls
for prudent measures to be adopted on their way to attain CAC. If benefits from
liberalizing the capital account exceed the related costs, in the long-run there should be a
visible positive relationship between the degree of capital account openness and growth
rates and vice versa. Empirical analysis of the experience in the emerging economies
does not bring a strong support to one view or the other (Rodrik 1998, Quinn, 1997, IMF
1999). Consequences of CAC may differ significantly between developed and developing
countries. In an empirical study, Edwards (2001) shows that the effect of capital account
opening on growth is stronger in a developed country than in a developing country.
Edison et. al. (2002) also show the existence of a positive relationship between growth
and capital account liberalization.

Setting apart the general principles behind opening of the capital account, a country
deciding to implement such a major reform should see to that its policy makers take into
account the impact of such a measure given the set of well-defined country
characteristics. It is imperative to study the past experiences of different nations and the
implications of such a measure on the country's economy and related macroeconomic
factors. There is however no "one size fits all" solution for the problems that are likely to
be countered in the process. The correct choice of a particular strategy depends on
macroeconomic stability, structural fragility, and weak financial systems. The countries
that experienced major financial crises in the last two decades shared a common feature,
weak financial system.

To sum up, unrestricted capital mobility may lead to increased global financial instability
in the presence of imperfect information in the financial market. Liberalizing capital
account may lead to increasing market concentration and market power of some firms. In
this book, we discuss the issues to be given due importance while making an attempt to
open the capital account by a developing country. We hope that this book gives an insight
into the concept and related issues. This book is the first of the series under this head. Our
subsequent books will discuss the experiences of Asian and Latin American countries in
their venture of opening the capital account.

          Is India ready for capital account convertibility?
Sankalp Saini, 2007

Nearly a decade after the Centre appointed a committee on the issue of full convertibility
of the Rupee, the UPA government seems to be serious about taking it to its logical end.

The Reserve Bank of India recently formed a six-member committee headed by former
Deputy Governor S S Tarapore that will prepare a roadmap towards capital account
convertibility (CAC) — the first step towards making the Rupee freely convertible.

The committee will review the experience of various measures of capital account
liberalisation in India, examine implications of fuller capital account convertibility on
monetary and exchange rate management and provide a comprehensive medium-term
operational framework. It will submit its report by July 31 of this year.

The move comes after Prime Minister Manmohan Singh recently asked the Finance
Ministry and RBI to work out a roadmap in this regard to attract greater foreign
investments. Finance Minister P Chidambaram has also backed the proposal.

Holy grail

For long, capital account convertibility has been seen as a holy grail by proponents of
globalization. Imagine buying property in Singapore or investing in stocks in the
Japanese market without any fears of being hounded by the tax authorities. Full
convertibility      of     Rupee        promises      all      this      and     more.

CAC is widely regarded as one of the hallmarks of a developed economy. From the point
of view of overseas investors it is significant since they know that at anytime they will be
able to re-convert local currency back into foreign currency and take out their money. To
attract foreign investment, many developing countries went in for CAC in the 1980s.
However, what they did not realize was that free mobility of capital leaves countries
susceptible     to     both     sudden       and     huge     inflows      and    outflows.

And unless there are financial institutions capable of dealing with such huge flows,
countries may not be able to cope as was demonstrated by the East Asian crisis of the late
90s. Following the crisis, even the most vocal supporters of CAC realised that the result
of going in for CAC without adequate preparation could be catastrophic.

Indian scenario

Currently in India, the Rupee is convertible on the current account, which covers external
trade in goods and services. Despite the economic reforms of the 90s, movement on
convertibility of Rupee for capital purposes has been slow as RBI adopted a cautious
approach,     especially    after    the    1997     East     Asian    currency     crisis.

The RBI had appointed the Tarapore Committee to make recommendations on making

the rupee fully convertible. The committee had recommended a three-year timeframe for
complete convertibility by 1999-2000 subject to satisfying certain conditions.

The government was also required to design external sector policies to increase current
receipts to GDP ratio and bring down the debt-servicing ratio from 25 per cent to 20 per


The policymakers seem confident that even after full and free float of the currency, the
economy is resilient enough to withstand the vagaries of international fiscal and monetary
turbulence. With FII inflows playing a significant role, adequate safeguards to be in place
so that the economy is not left vulnerable to flight of capital.

Adopting CAC would require domestic banks to be stronger and bigger to compete with
international banks. They have to build skills to handle multi-currency balance sheet
operations and the dollarisation of domestic assets. They will have to equip themselves
with heightened risk management practices to deal with high volumes of currency flows
at a global level.

International experiences with capital account liberalisation suggest a strong macro-
economic backdrop and establishment of prudential norms of supervision and regulation
as essential preconditions for currency convertibility.

With India's growth engine in full throttle, stable inflation, moderating fiscal deficit, low
risk of an external debt crisis, the situation seems just right for an acceleration in the pace
of       opening       up        the       boundaries       for       cross-border       flows.

CAC could be the logical culmination of India's journey towards globalisation.

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