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Capital Account Convertibility

Introduction:

The Prime Minister, Dr. Manmohan Singh in his speech at the Reserve Bank of India, Mumbai, on March 18, 2006 referred to the need to review the subject of Capital Account Convertibility in the Indian context. To quote:

“Considering the changes that have taken place over the last two decades, it appears that there is merit in moving towards fuller Capital Account Convertibility within a transparent framework. I therefore request the Finance Minister and the Reserve Bank of India to revisit this subject and come out with a suitable roadmap.”

The committee submitted its report on July 31, 2006.

Subsequently, the Reserve Bank of India, in consultation with the Government of India, appointed a committee chaired by Mr. S.S. Tarapore, to set out a roadmap towards Full Capital Account Convertibility.

Overview of Full Capital Account Convertibility:

Full Capital Account Convertibility implies freedom of currency conversion in relation to capital transactions in terms of both inflows and outflows. Thus, CAC for Indian economy refers to the abolition of all restrictions with respect to movement of capital from India to different countries across the globe and vice versa.
The status of Capital Account Convertibility in India for various non residents is as follows:

For Foreign Corporates and Institutions, there is reasonable amount of convertibility
For non-resident Indians, there is approximately an equal convertibility, but one accompanied by procedural and regulatory impediments

For individuals, foreigners other than PIOs, there is near zero convertibility

Movement towards FCAC implies that all non-residents i.e. corporates and individuals would be treated equally. This would mean removal of the tax benefits accorded to NRIs via special bank deposit schemes.

Objectives of CAC in the Indian Context:

i) To facilitate growth in the economy by minimising the cost of equity and debt capital
ii) To improve the efficiency of the Indian financial sector through greater competition, thereby minimising the intermediation costs
iii) To provide opportunities for diversification of investments by residents

Concomitants for a move to Full Capital Account Convertibility:

The fiscal-monetary policies, exchange rate management, prudential, regulatory and supervisory safeguards and measures for development of financial markets, all assume importance. The implementation of these measures and the pace of liberalisation are a simultaneous process.

Pre-Conditions of Full CAC in India: Tarapore Committee Recommendations

(I)The 1997 committee had laid down the following preconditions to be satisfied before India adopted CAC gradually (over a period of 3 years from 1997-2000)

i) Gross Fiscal Deficit/GDP ratio to come down to 3.5%
ii) The annual average rate of inflation for the previous 3 years to lie between 3-5%
iii) Gross Non-Performing Assets of public sector banks to come down to 5% in 2000 from 13.7% in 1997
iv) Average Cash Reserve Ratio should come down to 3%
v) The Debt-Servicing Ratio to come down to 20%

India's Performance on the above criteria post-2000:

i) Gross Fiscal Deficit/GDP %

The fiscal deficit to GDP ratio came below the 4% mark only in 2006-07 followed by 3.3% in 2007-08. However, due to the fiscal stimulus measures adopted by the Government of India in 2008-09, the fiscal deficit to GDP ratio increased to 6.8%, the highest since 1998-99. This indicates that India has performed poorly on the fiscal front. Considering that the target of 3.5% deficit set out by the Tarapore committee has only been accomplished once, this criterion would not be a stable one in judging India's readiness to adopting Full Capital Account Convertibility.

ii) Three Years' Average Inflation Rate

During 1997-2000, the average inflation rate decreased continuously from 5.6% to 4.5%. However, since 1999-2000, the average inflation rate has hovered above the 5% limit, which is above the recommended band set by the Tarapore Committee.

iii) Gross NPAs - Public Sector Banks

The gross NPAs of public sector banks have been on a decline. The NPAs came below the 5% mark only in 2004-05 as opposed to the target of 2000-2001. However, the gross NPAs of these banks have come down remarkably since 2000-01.

iv) Average Effective Cash Reserve Ratio

The lowest level of average CRR has been in the year 2003-04, at 4.5%. The average CRR is well above the Tarapore committee's prescribed limit of 3%. It is only in the year 2009-10, that the CRR has come down drastically due to fears of the slowdown, but it still remains higher than the floor. Hence, this criterion is not met while evaluating India's readiness to adopting full Capital Account Convertibility.

v) Debt-Servicing Ratio-

It is the amount of export earnings needed to meet the annual interest and principal payments on a country's external debts

The panels indicate that the debt servicing ratio has never touched the required 20% limit set by the Tarapore committee.

Thus, India has not met most of the prerequisites set by the Tarapore committee for moving towards full Capital Account Convertibility. Barring the NPAs of the Public Sector Banks which have come down drastically, India has performed poorly on other fronts, including on the fiscal front. The Fiscal Responsibility and Budget Management Act (FRBM) was enacted to eliminate the revenue deficit and to reduce the central fiscal deficit to 3% by March 31, 2009. However, due to the economic stimulus package unveiled by the government in response to the acute economic slowdown, there has been a sharp increase in the central fiscal deficit and as a result, the FRBM Act has been temporarily suspended.

Adequacy of Reserves:

The adequacy of reserves is considered an important parameter for capital account liberalization as it helps in gauging an economy's ability to withstand external shocks. The RBI has been pursuing a policy of maintaining an adequate level of foreign exchange reserves to meet India's import requirements, unforeseen contingencies and liquidity risks. Compared to US $5.8 billion in the financial year 1990-91, India now has a foreign reserve base of $283.6 billion (as on December 18, 2009). Thus, from an import cover of just 2 months in 1990-91, India now has an import cover of more than 14 months, which is way above the prescribed ‘safe' level of 6 months. The Reserves/Debt-Service ratio has also shot up from 0.5 to 7.2 over the period, which indicates a comfortable level of debt servicing using the foreign reserves during periods of exigency. India's total foreign reserves well exceed India's overall external debt.

Tarapore Committee-II: Recommendations

The second round of Tarapore committee set up to suggest a roadmap for full Capital Account Convertibility came out with the following set of recommendations:

i) The sequential full Capital Account Convertibility to be adopted in three phases: 2006-07 (Phase-I), 2007-09 (Phase-II) and 2009-10 and 2010-11 (Phase-III)
ii) FIIs to be banned from investing fresh capital through the issue of fresh Participatory Notes; PNs to be gradually phased out
iii) Industrial houses to be allowed and encouraged to set up banks
iv) Discriminatory tax treaties (such as Double Tax Avoidance Treaty or DTAA) to be abolished, since they are incompatible with the concept of capital Account Convertibility
v) For resident corporates, the ceiling for financial capital transfer abroad to be relaxed from 25% of their net worth
vi) External Commercial Borrowing limit per annum to be increased
vii) Ceiling for loans and borrowings by resident banks from overseas banks to be relaxed from 25% of their unimpaired tier-I capital

Conclusion

Accordingly, it can be concluded that the issue of India adopting full Capital Account Convertibility still remains questionable. Adoption of the second Tarapore committee recommendations still remains infeasible as the preconditions set by the committee in the prior period itself have not been met. Even as advancing to fuller convertibility of currency may benefit the capital markets by bringing in cheaper capital, the possibility of a financial/currency crisis cannot be completely ruled out since India's financial integration is still in its nascent stage. As of now, India needs a rigorous regulatory and monitoring body which would have an effective system for intervening at the right time to ensure domestic stability and prevention of disruption in the Indian capital markets. It can be concluded that India is not yet ready for full Capital Account Convertibility, but it should prepare a robust roadmap for adopting CAC in future.

Exhaustive studies conducted by international rating agencies prove the point that full capital account convertibility by itself does not make a country a more attractive investment destination. More important parameters in this respect are a strong financial sector and fiscal rectitude. These are exactly the signposts that the Tarapore committee has advocated. With many signposts that are difficult to reach, it is unlikely that India will move towards fuller convertibility by adhering to the path and the timelines set out. In that respect, the value of the Tarapore committee report might well lie in its emphasis on crucial procedural and macroeconomic issues rather than Full Capital Account Convertibility per se.

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