Financial Sector Reforms And

Capital Account Convertibility

Presented by:
Prashant Rastogi (10)
Vishal Singh (28)
Shrey Saurabh (47)
Priyanka Singh (50)
Nitish Singh (54)
 TWO PHASES OF REFORMS

• FIRST GENERATION( EARLY 1990’S):-1ST PHASE

Creating an efficient , productive and profitable financial sector to
function with operational flexibility and functional autonomy.

• SECOND GENERATION(MID… 1990’S):-2ND PHASE

strengthening the financial system and introducing the structural
improvement .
 1ST PHASE(EARLY 1990’S)
The main objectives, therefore, of the financial sector reform process in India
initiated in the early 1990s have been to:

● Innovations spurred by deregulation and liberalization have been marked feature

of this transformation.

● rapid strides in technology in the areas of telecommunication and electronic data

processing

● the distinction between banks and non-banking financial institution has become
thin.

●provide funds to certain sectors a concessional interest rates

● Open the external sector in a structured fashion.

 2ND PHASE(MID.. 1990’S)

Financial sector reforms are at the centre stage of the economic

liberalization that was initiated in India in mid 1990. This is partly because
the economic reform process itself took place amidst two serious crises
involving the financial sector:

• the balance of payments crisis that threatened the international

credibility of the country and pushed it to the brink of default; and

• the grave threat of insolvency confronting the banking system which had
for years concealed its problems with the help of defective accounting
policies.
 Financial Sector and Monetary Policy
OBJECTIVES AND REFORMS:
• Removal of the erstwhile existing financial repression.
• Creation of an efficient ,productive and profitable financial sector.
• Enabling the process of price discovery by the market determination of
interest rates that improves allocative efficiency of resources.
• Providing operational and financial system for increasing international
competition.
• Opening the external sector for increasing international competition.
• Opening the external sector in a calibrated manner.
• Promoting financial stability in the wake of domestic and external shocks.
 BALANCE OF PAYMENT

BALANCE OF PAYMENT (BoP) is a systematic record of all

economic transaction between the resident of a country and
the rest of the world

There are two types of accounts in BoP

1. current account

2. capital account
Briefing about current and capital account
 Capital Markets

End- March 1980 1991 2000 2002 2003

No of stock 9 22 23 23 23
exchanges

No of listed 2,265 6229 9,871 9,644 9,413

companies

Market 6,800 1,10,279 11,92,630 7,49,248 6,31,921

capitalization
(RS .Crore)

Select Stocks Market indictor in India year

 Accounts for
• Even though capital market has gown in size and depth in post
reform period ,the magnitude of activities is still negligible
compared to those prevalent internationally.
• India accounted for .40% in market capitalization. 0.59 % in
terms of global turnover in equity market in 2001.
• The liberalization and consequent reform measures lead to
foreign investors and led to rise in the FIIs investment in India.
• Currently there are 500 registered FIIs in India which include
asset management companies ,pension funds ,investment
trusts and incorporated institutional portfolio managers .
• FIIs are eligible to invest in listed as well as unlisted securities.
Turning point in indian financial systems
• 14 large commercial banks were nationalized with an
objective of:
 Re-orientation of credit flows so as to benefit the hitherto
neglected sector such as agriculture ,small –scale industries and small
borrowings .
 widening of branch network of banks ,particularly in the rural and
semi-urban areas.
 Greater mobilization of savings through bank deposits.
This resulted in increase of GDP from 10 % to 25%,thus
providing support to expanding agricultural
,industrial and commercial activities.
 Capital Account Convertibility
• Capital Account Convertibility is a feature of a nation's
financial regime that centers on the ability to conduct
transactions of local financial assets into foreign financial
assets freely and at market determined exchange rates.

• It is sometimes referred to as Capital Asset Liberation or CAC.

• It is basically a policy that allows the easy exchange of local

currency (cash) for foreign currency at low rates.
 What full CAC do
With full CAC, there will be no restrictions for foreign seeking to Indian assets.
Conversely there will be no restrictions for Indian households or companies
taking rupees out or bringing foreign exchange for doing global
diversifications
The Advantage of FCAC in this context are:

• to facilitate economic growth through higher investment by minimizing the

cost of both equity and debt capital .
• The free movement of capital leads to additional benefits in the form of the
flow of technology and intellectual property .
• The free movement of capital is expected to bring about convergence of
interest rates and tax rates and structures.
• Diversifying portfolios internationally
• Induces competition against Indian finance
• Reduces size of black economy
 Risks of Capital Account Convertibility
 
An increase in domestic financial sector vulnerability, and a consequent higher probability
of financial disruptions are commonly seen as a risk of financial liberalization in general, and
of capital account opening, in particular. 

• Inadequate capital base

• Large amounts of bad loans
• Insufficient market discipline: absence of competition, restrictions to entry, faulty information
• Faulty clearing and settlement systems
• Governmental and political interference in bank activities

All of these constitute basic building blocs to assess the soundness of financial sectors and
will require attention in the context of liberalization.
 
 Pre-requisites
For the successful functioning of CAC system, certain essential condition
will have to be satisfied

• Comfortable current account position

• Maintenance of domestic economic stability
• Adequate foreign exchange reserves
• Restriction on inessential imports as long as the foreign exchange position
is not very comfortable
• An appropriate industrial policy and conductive investment climate
• An outward development strategy and sufficient incentives for export
growth
 INDIAN SENARIO
TARAPORE COMMITTEE APPOINTMENT
The Reserve bank of India appointed a committee to set out the framework for
fuller capital account convertibility.

• The committee chaired by former RBI governor S S Tarapore on February 28,

1997.
• Tarapore committee defines CAC as “the freedom to convert local financial
assets into foreign financial assets and vice versa at market determined rates of
exchange”.

According to committee For successful CAC, emerging market countries should-

• Pursue sound macroeconomic policies
• Strengthen the domestic financial system
• Phase capital account liberalization appropriately
• Provide information to the market
 The tarapore committee suggested following
preconditions

• A reduction in GROSS FINANCIAL 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 as an average 3-5% for the 3 year period

1997-98 to 1999-2000

• A fully DEREGULATED INTERESTED RATE structure by 1997-98

• A REDUCTION OF NON –PERFORMING ASSETS as percentage of total

advances to 12% by 1997-98 , 9% by 1998-99, 5 % by 1999
 Banking System in the context of FCAC

 
As the economy gets increasingly integrated with the global system, the Indian
banking system too would progressively integrate with the rest of the world.

commercial banks should be able to manage multi-dimensional operations in

situations of both large inflows and outflows of Capital, which account for over
75 per cent of the market share in the financial sector.

A robust banking regulation, efficient clearing and settlement arrangement

appropriate accounting & auditing standards and conducive legal framework to
deal with the large capital flows.
 
Adequate institutional frameworks need to be developed for a higher level of
co- ordination among regulators, domestic as well as international, than at
present.
 CONTINUED

Heavy transactions add to the risks of the banking system that are not so
evident in a less open domestic banking system.
 
Currency Risk - Fluctuations in the exchange rates may adversely affect
economic agents with long and short positions in foreign currency, and
cause mismatches between foreign currency denominated assets and
liabilities
 
Transfer & Legal Risk Enhanced cross-border transactions may give rise to
legal rights and obligations which are different from those arising from
domestic transactions
 
Risk of Regulatory Arbitrage – The differences in regulatory and
supervisory regimes across countries may create incentives for capital
to flow across borders to countries with inadequately regulated and
supervised financial markets.
 REFORMS IN GOVT SECURITIES MARKET
Institutional Measures
❖ Administered interest rates on government securities were replaced by an auction system for price
discovery.
❖ Primary Dealers (PD) were introduced as market makers in the government securities market.
❖ For ensuring transparency in the trading of government securities. Delivery versus Pay (DvP)
settlement system was introduced.
❖ Repurchase agreements (repo) was introduced as a tool of short term liquidity adjustment.
❖ Market Stabilization Scheme (MSS) has been introduced, which has expanded the instruments
available to the Reserve Bank for managing the surplus liquidity in the system.
Increase in Instruments in Government Securities Market
❖ 91-day Treasury bill, Zero Coupon Bonds, Floating Rate Bonds, Capital Indexed Bonds were issued
and exchange traded interest rate futures were introduced.
Enabling Measures
❖ Foreign Institutional Investors (FIIs) were allowed to invest in government securities subject to
certain limits.
❖ Introduction of automated screen-based trading in government securities through Negotiated
Dealing System (NDS). Setting up of risk-free payments and settlement system in government
securities through Clearing Corporation of India Limited (CCIL). Phased introduction of Real Time
Gross Settlement System (RTGS).
❖ Introduction of trading of government securities on stock exchanges for promoting retailing in such
securities, permitting non-banks to participate in repo market.
 REFORMS IN FOREX MARKET
Institutional Framework
• Replacement of the earlier Foreign Exchange Regulation Act, 1973 by the market friendly
Foreign Exchange Management Act, 1999.
• Delegation of considerable powers by RBI to Authorised Dealers to release foreign
exchange for a variety of purposes.
Increase in Instruments in forex market
• Development of rupee-foreign currency swap market. Introduction of additional hedging
instruments, such as, foreign currency-rupee options.
• Authorised dealers permitted to use innovative products like cross-currency options,
interest rate and currency swaps, forward rate agreements in the international forex
market.
Liberalisation Measures
• Authorised dealers permitted to initiate trading positions, borrow and invest in overseas
market subject to certain specifications and ratification by respective Banks’ Boards.
• Banks are also permitted to fix interest rates on non-resident deposits, subject to certain
specification.
• Permission to various participants in the foreign exchange market, including exporters,
Indian investing abroad general limit of US$25,000 per year.
Monetary and Exchange Rate Management and Capital
Account Liberalization

The main pillars of exchange rate management in India can be characterized as

follows….
• The RBI does not have a fixed “target” for the exchange rate, which it tries to defend or
pursue over time.

• Rather, the RBI pursues a managed float and, as such, is prepared to intervene in the
market to dampen excessive volatility as and when necessary.

• The RBI’s purchases or sales of foreign currency are undertaken through a number of
banks and are generally discreet and smooth

• An attempt is made to ensure that foreign exchange operations and exchange rate
movement are transaction oriented rather than being purely speculative in nature.
Through this RBI balance monetary effect of capital flows & export competitiveness of
he economy
 Reforms in other segments of Financial
Sector
• Another important development under the reform process has been the opening
up of mutual funds to the private sector in 1992, which ended the monopoly of
Unit Trust of India (UTI), a public sector entity. These steps have been buttressed
by measures to promote market integrity. The Indian capital market was opened
up for foreign institutional investors (FIIs) in 1992.

• The Indian corporate sector has been allowed to tap international capital markets
through American Depository Receipts (ADRS), Global Depository Receipts (GDRS),
Foreign Currency Convertible Bonds (FCCBs) and External Commercial Borrowing
(ECBs). Similarly, Overseas Corporate Bodies (OCBs) and nonresident

• Indian (NRIs) have been allowed to invest in Indian companies. FIIs have been
permitted in all types of securities including Government securities and they enjoy
full capital convertibility. Mutual funds have been allowed to open offshore funds
to invest in equities abroad.
 COMPARISION

Subsequent to the report, substantial liberalization of the capital account has

been made, particularly with respect to inward foreign investment. India has
managed to achieve the following preconditions:

• A mandatory annual average inflation rate of 4.7% percent (as against the
realized rate of 3.4 percent in 2002–03)
• A deregulated interest rate environment (except rates on bank savings
deposits and small savings schemes);
• A reduction of the cash reserve requirement (CRR) to the statutory minimum
of 6 % (as against the current requirement of 4.5 percent)
• An external debt service ratio of 18.9% of total exports (as against 27% in
1995-96)
• Foreign exchange reserves providing an import cover of more than six months
(as against 17 months at end-October 2003)
• The adoption of best practices for risk management, accounting standards and
disclosure norm
 How open is Indian capital account today?

• There are limits to indian companies borrowing abroad. Restriction on

indian’s sending money abroad that does not have to do with importing
goods and services.

• Restrictions on foreigners investing in india

• In addition there is restriction on amount that an FII can holds

• Purchasing a company is allowed but limit exists on the amount that can
be sent

• Global diversification of household portfolio, is practically non existent

 Effect of Appreciation of Rupee

Our currency become

•Appreciation
f of Rs.
costlier this leads to
decrease in the Export < Import
demand of our
product

Negative BoP

GDP
(Decrease)

To help this RBI will purchase all the foreign currency And once again the previous Exchange
Rate will come
 Effect of Appreciation of Rupee

Our currency become

•Appreciation
f of Rs.
costlier this leads to
decrease in the Export < Import
demand of our
product

Negative BoP

GDP
(Decrease)

To help this RBI will purchase all the foreign currency And once again the previous Exchange
Rate will come
 Cont.

Huge Capital
Export > Import BoP (+ve)
Inflow

Increase in foreign
Investment Exchange reserve

S>D (foreign
Interest
reserve)

Demand of product
Inflation Price and services
 What will CAC mean for indian households and
companies?

• Indian households and companies will be able to freely buy

and sell rupees legally in India and abroad to invest in foreign
equity to give loans, take loans, accept foreign investment.

• There will be no question asked when rupees are converted

into dollars or yen, no forms to fill, no limits to be adhered.

• The rupees will be hard currency.

 Conclusion
• Despite strong inflows there have been no major real appreciation of the
exchange rate.

• Monetary independence has not been lost and a wedge between

domestic and foreign interest rates has been successfully created and
maintained.

• The emphasis on preconditions and a policy of gradual liberalization have

enabled India to reap the benefits of opening while avoiding the sources
of vulnerability

• India should opt for FCAC at this stage as these are good times when our
exports and imports are doing well, when our fiscal deficits are on the
path of correction and when india has mountains of foreign exchange
reserves.
 Thank you !

FOR hearing us…….