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CAPITAL ACCOUNT CONVERTIBILITY

at is currency convertibility?
Currency convertibility means 'the Ireedom to convert one currency into other internationally
accepted currencies. There are two popular categories oI currency convertibility, namely :
O Convertibility Ior current international transactions; and
O Convertibility Ior international capital movements.
Currency convertibility implies the absence oI exchange controls or restrictions on Ioreign
exchange transactions.

at is meant by Current Account Convertibility:

Current account convertibility is popularly deIined as the Ireedom to buy or sell Ioreign
exchange Ior :-
a. The international transactions consisting oI payments due in connection with
Ioreign trade, other current businesses including services and normal short-
term banking and credit Iacilities
b. Payments due as interest on loans and as net income Irom other investments
c. Payment oI moderate amounts oI amortisation oI loans Ior depreciation oI
direct investments
d. Moderate remittances Ior Iamily living expenses
e. Authorised Dealers may also provide exchange Iacilities to their customers
without prior approval oI the RBI beyond speciIied indicative limits, provided,
they are satisIied about the bonaIides oI the application such as, business
travel, participation in overseas conIerences/seminars, studies/ study tours
abroad, medical treatment/check-up and specialised apprenticeship training.
at is meant by Capital Account Convertibility?
Tarapore Committee on Capital Account Convertibility appointed in February, 1997 deIines
Capital Account Convertibility as the 'Ireedom to convert local Iinancial assets into Ioreign
Iinancial assets and vice versa at market determined rates oI exchange. In other terms we
can say Capital Account Convertibility (CAC) means that the home currency can be Ireely
converted into Ioreign currencies Ior acquisition oI capital assets abroad and vice versa.

Background of Capital Account Convertibility :
Foreign exchange transactions are broadly classiIied into two types: current account
transactions and capital account transactions. In the early nineties, India`s Ioreign exchange
reserves were so low that these were hardly enough to pay Ior a Iew weeks oI imports. To
overcome this crisis situation, Indian Government had to pledge a part oI its gold reserves to
the Bank oI England to obtain Ioreign exchange. However, aIter reIorms were initiated and
there was some improvement on FOREX Iront in 1994, transactions on the current account
were made Iully convertible and Ioreign exchange was made Ireely available Ior such
transactions. But capital account transactions were not Iully convertible. The rationale behind
this was clear.that India wanted to conserve precious Ioreign exchange and protect the rupee
Irom volatile Iluctuations.
By late nineties situation Iurther improved, a committee on capital account convertibility was
setup in February, 1997 by the Reserve Bank oI India (RBI) under the chairmanship oI
Iormer RBI deputy governor S.S. Tarapore to "lay the road map" to capital account
convertibility. The committee recommended that Iull capital account convertibility be
brought in only aIter certain preconditions were satisIied. These included low inIlation,
Iinancial sector reIorms, a Ilexible exchange rate policy and a stringent Iiscal policy.
However, the report was not accepted due to Asian Crisis.
The Iive-member committee has recommended a three-year time Irame Ior complete
convertibility by 1999-2000. The highlights oI the report including the preconditions to be
achieved Ior the Iull Iloat oI money are as Iollows:-
Pre-Conditions Set By Tarapore Committee :
O Gross Iiscal deIicit to GDP ratio has to come down Irom a budgeted 4.5 per cent in
1997-98 to 3.5 in 1999-2000.
O A consolidated sinking Iund has to be set up to meet government's debt repayment
needs; to be Iinanced by increased in RBI's proIit transIer to the govt. and
disinvestment proceeds.
O InIlation rate should remain between an average 3-5 per cent Ior the 3-year period
1997-2000
O Gross NPAs oI the public sector banking system needs to be brought down Irom the
present 13.7 to 5 by 2000. At the same time, average eIIective CRR needs to be
brought down Irom the current 9.3 to 3.
O RBI should have a Monitoring Exchange Rate Band oI plus minus 5 around a
neutral Real EIIective Exchange Rate RBI should be transparent about the changes in
REER.
O External sector policies should be designed to increase current receipts to GDP ratio
and bring down the debt servicing ratio Irom 25 to 20.
O Four indicators should be used Ior evaluating adequacy oI Ioreign exchange reserves
to saIeguard against any contingency. Plus, a minimum net Ioreign asset to currency
ratio oI 40 per cent should be prescribed by law in the RBI Act.
O Phased liberalisation oI capital controls

The Committee's recommendations Ior a phased liberalization oI controls on capital
outIlows over the three year period which have been set out in detail in a tabular Iorm
in Chapter 4 oI 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 oI the Authorised
Dealers (ADs) in phase 1 with transparent and comprehensive guidelines set out by
the RBI. The existing requirement oI repatriation oI the amount oI investment by way
oI dividend etc., within a period oI 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 oI earnings in
Exchange Earners Foreign Currency (EEFC) accounts with complete Ilexibility in
operation oI these accounts including cheque writing Iacility in Phase I.

iii) Individual residents may be allowed to invest in assets in Iinancial 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 Ior non-residents out oI their
non-repatriable assets in India.

iv) SEBI registered Indian investors may be allowed to set Iunds Ior investments
abroad subject to overall limits oI $ 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 Irom
abroad and deployment oI Iunds outside India. Borrowings (short and long term) may
be subject to an overall limit oI 50 per cent oI unimpaired Tier 1 capital in Phase 1, 75
per cent in Phase II and 100 per cent in Phase III with a sub-limit Ior short term
borrowing. in case oI deployment oI Iunds abroad, the requirement oI section 25 oI
Banking Regulation Act and the prudential norms Ior open position and gap limits
would apply.

vi) Foreign direct and portIolio 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 oI such investments.

vii) In order to develop and enable the integration oI Iorex, money and securities
market, all participants on the spot market should be permitted to operate in the
Iorward markets; FIIs, non-residents and non-resident banks may be allowed Iorward
cover to the extent oI their assets in India; all India Financial Institutions (FIs)
IulIilling requisite criteria should be allowed to become Iull-Iledged ADs; currency
Iutures may be introduced with screen based trading and eIIicient settlement system;
participation in money markets may be widened, market segmentation removed and
interest rates deregulated; the RBI should withdraw Irom the primary market in
Government securities; the role oI primary and satellite dealers should be increased;
Iiscal incentives should be provided Ior individuals investing in Government
securities; the Government should set up its own oIIice oI public debt.

viii) There is a strong case Ior liberalising the overall policy regime on gold; Banks
and FIs IulIilling well deIined criteria may be allowed to participate in gold markets
in India and abroad and deal in gold products.
The assumption oI the committee was that these pre-conditions would take care oI possible
problems created by unseen Ilight oI capital. Given a sound Iiscal and Iinancial set-up, the
Ilight oI capital was unlikely to be large, particularly in the short run, as capital would be
invested and not all oI it would be in a liquid Iorm.


Present Status :

Major Pre-Conditions by Tarapore
Committee
Status as on Marc 2006
1 Reduction in gross Iiscal deIicit to
3.5 by 1999-2000
The present Iiscal deIicit is still at 4.1 (above
the level oI 3.5). However, estimates Ior the
next Iiscal year are pegged at 3.8
2. The inIlation rate Ior 3 years should be
an average 3 to 5
InIlation at present is around 4.00.
3. Forex reserves should at least be
enough to cover 6 months import cover
The present Iorex reserves are enough to cover
more than one year`s imports.
4. Gross NPAs to be brought down to 5
by 1999-2000
Gross NPA Ior the banking sector is still
marginally higher than 5
5. CRR to be reduced to 3 by 1999-
2000
CRR is still at 5.00
6. Interest Rate to be Iully deregulated All interest rates, except Saving Fund interest
rates, have already been deregulated.

The process oI opening up the Indian economy has proceeded in steady steps.
O First, the exchange rate regime was allowed to be determined by market Iorces as
against the Iixed exchange rate linked to a basket oI currencies.
O Second, this was Iollowed by the convertibility oI the Indian rupee Ior current account
transactions with India accepting the obligations under Article VIII oI the IMF in
August 1994.
O Third, capital account convertibility has proceeded at a steady pace. RBI views
capital account convertibility as a process rather than as an event.
O Fourth, the distinct improvement in the external sector has enabled a progressive
liberalisation oI the exchange and payments regime in India. ReIlecting the changed
approach to Ioreign exchange restrictions, the restrictive Foreign Exchange
Regulation Act (FERA), 1973 has been replaced by the Foreign Exchange
Management Act, 1999.

Thus, at present in India we have a restricted capital account convertibility. Indian entities
(i.e. individuals, companies or otherwise) are allowed to invest or acquire assets outside India
or a Ioreign entity remit Iunds Ior investment or acquisition oI assets with speciIied cap on
such investments and Ior speciIic purpose. A Iull convertibility will allow Iree movement oI
Iunds in and out oI India without any restrictions on purpose and amount. Thus, aIter Iull
convertibility is allowed, residents in India will be able to transIer money abroad and receive
Irom other entities across the world. However, government will certainly make rules and
regulations to ensure these do not lead to money laundering or Iunding Ior illegal activities.

Prime Minister Manmohan Singh on 18
th
March 2006 said that the country's economic
position internally and externally had become 'Iar more comIortable' and it was worth looking
into greater capital account convertibility. In a speech at the Reserve Bank oI India (RBI) in
the country's Iinancial hub Mumbai, Prime Minister Manmohan Singh said he would ask the
Finance Minister and RBI to come out with a roadmap to greater convertibility 'based on
current realities'. PM also said "Given the changes that have taken place over the last two
decades, there is merit in moving towards Iuller capital account convertibility within a
transparent Iramework," Singh said.
RBI in its circular issued in March, 2006 has laid down that economic reIorms in India have
accelerated growth, enhanced stability and strengthened both external and Iinancial sectors.
Our trade as well as Iinancial sector is already considerably integrated with the global
economy. India's cautious approach towards opening oI 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 Iuller capital account convertibility within a transparent Iramework. There
is, thus, a need to revisit the subject and come out with a roadmap towards Iuller Capital
Account Convertibility based on current realities. In consultation with the Government oI
India, the Reserve Bank oI India has appointed a committee to set out the Iramework Ior
Iuller Capital Account Convertibility.

The Committee consists oI the Iollowing:
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 oI reIerence oI the Committee will be:

i. To review the experience oI various measures oI capital account liberalisation in
India,
ii. To examine implications oI Iuller capital account convertibility on monetary and
exchange rate management, Iinancial markets and Iinancial system,
iii. To study the implications oI dollarisation in India oI domestic assets and liabilities
and internationalisation oI the Indian rupee,
iv. To provide a comprehensive medium-term operational Iramework, with
sequencing and timing, Ior Iuller capital account convertibility taking into account the
above implications and progress in revenue and Iiscal deIicit oI both centre and states,
v. To survey regulatory Iramework in countries which have advanced towards Iuller
capital account convertibility,
vi. To suggest appropriate policy measures and prudential saIe- guards to ensure
monetary and Iinancial stability, and
vii. To make such other recommendations as the Committee may deem relevant to the
subject.
Technical work is being initiated in the Reserve Bank oI India. The Committee will
commence its work Irom May 1, 2006 and it is expected to submit its report by July 31,
2006. The Committee will adopt its own procedures and meet as oIten as necessary. The
Reserve Bank oI India will provide Secretariat to the Committee.

FACTORS IC ARE CRITICAL / OF CONCERN IN ADOPTING CAPITAL
ACCOUNT CONVERTIBILITY:
There are number oI issues which are oI concern Ior adopting capital account convertibility.
O The impact oI allowing unlimited access to short-term external commercial borrowing
Ior meeting working capital and other domestic requirements. In respect oI 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 oI the Iinancial 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 oI external
pressure. All creditors who could redeem the debt did so within a very short period,
causing extreme domestic Iinancial vulnerability. The occurrence oI such a possibility
has to be avoided, and we would do well to continue with our policy oI keeping
access to short-term debt limited as a conscious policy at all times good and bad.

O Providing unrestricted Ireedom 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. The day-to-day movement in exchange rates is
determined by "Ilows" oI Iunds, 0 by demand and supply oI spot or Iorward
transactions in the market. Now, suppose the exchange rate is depreciating unduly
sharply (Ior whatever reasons) and is expected to continue to do so Ior the near Iuture.
Now, Iurther suppose that domestic residents, thereIore, that they should convert a
part or whole oI their stock oI domestic assets Irom domestic currency to Ioreign
currency. This will be Iinancially desirable as the domestic value oI their converted
assets is expected to increase because oI anticipated depreciation. And, iI a large
number oI residents so decide simultaneously within a short period oI time, as they
may, this expectation would become selI-IulIilling. A severe external crisis is then
unavoidable.
O Although at present our reserves are high and exchange rate movements are, by and
large, orderly. However, there can be events like Kargil ware or Pokhran Test, which
creates external uncertainty, Domestic stock oI bank deposits in rupees in India is
presently close to US $ 290 billion, nearly three and a halI times our total reserves. At
the time oI Kargil or Pokhran or the oil crises, the multiple oI domestic deposits over
reserves was in Iact several times higher than now. One can imagine what would have
had happened to our external situation, iI within a very short period, domestic
residents decided to rush to their neighbourhood banks and convert a signiIicant part
oI these deposits into sterling, euro or dollar. No emerging market exchange rate
system can cope with this kind oI contingency. This may be an unlikely possibility
today, but it must be Iactored in while deciding on a long term policy oI Iree
convertibility oI "stock" oI domestic assets. Incidentally, this kind oI eventuality is
less likely to occur in respect oI industrial countries with international currencies such
as Euro or Dollar, which are held by banks, corporates, and other entities as part oI
their long-term global asset portIolio (as distinguished Irom emerging market
currencies in which banks and other intermediaries normally take a daily long or short
position Ior purposes oI currency trade).

Impact of Capital Account Convertibility
AIter Iull convertibility is adopted by India, it will lead to acceptance oI Indian Rupee
currency all over the world.
In case oI two convertible currencies, Forward Exchange Rates reIlect interest rate
diIIerentials between these two currencies. Thus, we can say that the Forward Exchange Rate
Ior the higher interest rate currency would depreciate so as to neutralize the interest rate
diIIerence. However, sometimes there can be opportunities when Iorward rates do not Iully
neutralize interest rate diIIerentials. In such situations, arbitrageurs get into the act and
Iorward exchange rates quickly adjust to eliminate the possibility oI risk-less proIits.
Capital account convertibility is likely to bring depth and large volumes in long-term INR
currency swap markets. Thus Ior a better market determination oI INR exchange rates, the
INR should be convertible.