Countries all over the world are involved in transactions that can be classified broadly on the basis of geography into two. They are as follows:
1) Transactions between residents
2) Transactions between residents and non residents
The first classification involves only one currency while the second transaction involves more than one currency.
The second category of transactions is recorded by the country in order to keep a track of the inflow and out flow of currencies. This is called as Balance of payments. The details about balance of payments give a picture of how much inflow of currency has occurred due to transactions like exports, unilateral transfers, and foreign direct investments which is treated as a good signal as it leads to increase in money supply. Whereas outflow of currency takes place due to import of goods, investments made by the country in other countries which results in reduction in money supply. These Balance Of Payments are broadly classified into current account and capital account components.The various items included under these two heads are listed below.
I. Current Account
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General merchandise, goods for processing, repairs on goods produced in ports by carries and non-monetary gold.
Transportation, travel, communications, construction, financial and computer services, royalties and license fees, other professional and business services.
Direct investment income, portfolio investment income, and compensation of employees
(D) Current Transfers
Government current transfers, workers' remittances and other current transfers.
II. Capital and Financial Account
1. Capital Account
(A) Capital transfers
Government and private transfers of fixed assets and forgiveness of liabilities.
(B) Non-produced and Non-financial assets
Land and subsoil assets, patents, copyrights, trademarks, franchises.
2. Financial Account
(C) Direct Investment
External investments with lasting interest in enterprises.
(D) Portfolio Investment
External investments in securities and financial derivatives.
(E Other investment
External investments other than reserves, direct and portfolio investments. For example, short- and long-terms loans, trade credits, currency holdings and deposits, other accounts receivable and payable.
(F) Reserve Assets
Monetary gold, foreign exchange assets and other claims.
As we observe while all trade related transactions are classified under current account, major investments made outside the country in form of securities, derivatives, FDIs, purchase of fixed assets are classified under capital account. Full Capital account convertibility refers to the reduction or removal of regulations with regard to capital account. Capital transactions are strictly regulated by RBI and prior permission is to be obtained in order to proceed with transactions that are a part of the capital account. Removal of these regulations on capital account is termed as capital account convertibility. The overview of Capital account convertibility, the requirements for implementing FCAC and its implications in the Indian context have been discussed below:
Capital account convertibility:
The Tarapore Report (2006) defines CAC as "capital account convertibility refers to the freedom to convert local financial assets into foreign financial assets and vice versa. It is associated with 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."
FEMA (Foreign exchange management act) is an act that consolidates the law with respect to foreign exchange in order to facilitate foreign exchange and at the same time have a control in order to maintain the foreign exchange market in India.
Industrialised nations such as the U.S have resorted to full capital account convertibility implying that there are no regulations for making short and long term investment in other countries without prior permission from the regulatory authorities while countries like India follow partial capital account convertibility. Currencies like North Korea's won and Cuba's national peso are not convertible.
Economic conditions for implementation of FCAC:
There are certain basic criteria for allowing full account convertibility in a country.
Some of them are as follows:
Low budget deficits
Low Balance of payment deficits
Low level of government borrowings
Always on Time
Marked to Standard
Low level of NPAs in banks
These criteria imply that the economy must be healthy enough for foreign investors to invest in the country. Short term investments are the ones that would bring about a major change in the country if FCAC is permitted. This is basically because long term investments take place irrespective of whether CAC is prevailing or not. But short term investments would open up on a large scale if FCAC comes into existence.
India and FCAC:
As mentioned above the main conditions required for FCAC are not prevalent in India. India has huge amount of deficits, high inflation, high level of NPAs and high amount of government borrowings.
This implies that even if FCAC is implemented, India will not be an attractive venue for the foreign traders to invest as the economic conditions are not satisfactory and safe to get a high return on investments. The major drawbacks that India would face if FCAC is implemented are listed below:
The Domestic producers of raw material and machinery would face tough competition from foreign firms, for example, countries like China has a low rate of exchange and hence the price of raw materials and machinery would be by and large cheaper.
There will be large scale diversion of funds towards foreign countries which would lead to export of jobs thereby creating unemployment in India. Japan is the standing example of this situation where the investments have got diverted to China due to low wage rate and hence huge unemployment is prevailing in JAPAN.
One of the major disadvantages or threats due to FCAC is that Rupee will be controlled by currency speculators. FCAC would lead to participation of Rupee in FOREX market. Purchase and sale of Rupee in huge volumes to make profits in FOREX market will in turn result in huge fluctuation of rupee's exchange rate.
All major markets which are in the maturity stage are fully convertible. India and China are among the few countries which still has a control over its capital accounts. This proved to be a major shield during global recession. Countries with Full capital account convertibility got badly hit during recession and are still in the revival stage. Hence we may infer that FCAC proves to be detrimental during the economic slowdown.
RISKS involved in FCAC:
There are various risk factors that impact the economy if FCAC is implemented. The major risk factors are discussed below:
MARKET RISK - When corporate and financial institutes get access to other securities and market, interest rate and foreign exchange rate like market risks become more complex, as foreign participation changes the dynamics of domestic market.
CREDIT RISK - credit risk will become higher with cross- border transaction. Transfer rate will be higher when required currency will not be available to borrowers. Settlement risk will be higher in foreign exchange, as several hour gaps can change the currency rate.
LIQUIDITY RISK - There will be a larger flow of different foreign currency fund, which will create problem in proper valuation of assets and liability, in turn resulting in difficulty in reasonable pricing.
RISK IN DERIVATIVE TRANSACTION - Risk in derivative transaction include both market and credit risk, for example OTC derivative may not be able to meet their obligation as the available collateral will not be sufficient.
OPERATIONAL RISK - Operational risk, like legal risk may increase due to the difference in domestic and foreign law .For instance different codes in bankruptcy can complicate the recovery process.
REGULATORY ISSUE - The risk in regulation of arbitrage will increase, as there are different norms and regimes in different countries. The regulation difficulty will increase with big multi-national institutions working in different countries, which will require coordination between domestic market and foreign counterpart.
These factors are also to be considered and analysed completely before the implementation of FCAC regime in any developing economy as all these factors have a bearing on the economy's development.
TARAPORE COMMITTEE and FCAC:
Capital account convertibility was considered by RBI in the year 1997 when TARAPORE committee was formed in order to facilitate developing economies to transition into globalised market economies.
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SS Tarapore committee includes 5 members(S S Bhalla, M G Bhind, Kirti Prakash,A V Rajwade. The CAC was planned to be phased over a three year period with first phase in 1997-98, second one at 1998-99 and final phase in the year ending 2000.
They recommended full CAC could be brought in if some preconditions are satisfied, they are
Stringent fiscal policy
Financial sector reforms
Flexible exchange rate policy
The mandated rate of inflation rate should be from 3% to 5% for the three year time period and the RBI has taken mandate of inflation that should approved by the parliamentary.
During these years, the Indian economy's situation was as follows:
In public sector banks there was decrease in the non performing assets for the three years i.e.. 12%, 9%, 5%.
For the banks the CRR had gradually decreased. For the year 1997 it was 9.3%, and it was reduced to 8% to 97-98 ,6% in 98-99 and 3% in 99-2000
From the year 1997-98 there was a complete deregulation in the structure of interest rate.
There was a reduction in gross fiscal deficit to 3.5% by 1999-2000, with respect to GDP.
To avoid instability in exchange rates the committee has brought up a system, with corrections regarding to the real effective exchange rates(REER), and this was monitored by Central Bank at a band of plus or minus 5%.
Capital inflows should be invested in semi liquid assets, to avoid churning and excessive outflow
It also says phased liberalisation of capital out flows and inflows to allow for the following
Indian companies can invest in foreign countries up to $50 million
It also says financial institutions and banks to participate in the gold market in the foreign countries, and especially for the banks to borrow and deploy funds outside India
It also permits Indian individual to invest in assets abroad in 3 different phases ($25000, $50000, $100000)
Allowing exchange earners and exporters to put their entire money in the EEFC account and the usage of funds is flexible to them.
TARAPORE Recommendations: 2:
These include 3-phase road map towards free, float and full CAC by 2011, starting from 2006-07,and second spread (2007-09) with the year ending in 2011 .These recommendations are very useful to the banking domain regarding regulation, deposits from overseas, supervision, external commercial borrowings and overseas banking operations made very liberal.
It was mainly concerning the prohibiting participatory notes, discriminatory taxes, the report made by the Reserve Bank of India about PN's the money raised by it should not be done for FII's. So, existing PN holders are given one year time to exit. Corporate Investments from abroad should made very easier .ECB's are mainly related to the volume of the trade credit.
And it also says that the non residents of India shall be allowed to invest in the stock market especially in the sector of the banking domain, also rising of ceiling rates in the sector of external commercial borrowings, which mainly concerned regarding trade credit, and also Imported linked short term loans will have a continuous monitor of banks in a comprehensive manner.
In this a special case has been developed for the non resident corporate for the sake to invest in Indian bourses from SEBI registered bodies which includes portfolio management and mutual funds schemes.
Rise in prices and appreciation of currency are affecting India's exports and balance of trade in turn. The fiscal deficits are being under estimated as individual states deficits are ignored and oil bonds are being issued to public sector companies at highly subsidised rates incurring losses. Hence India needs to work on sustaining the economic fundamentals and ensure a strong banking system before implementation of FCAC. Implementation of FCAC is not recommendable at this point of time and stability in the fundamentals has to be attained before implementing FCAC in India .