17

Capital Account Convertibility in India

B. A. Prakash

17.1 Introduction

In 1991, the Indian economy faced an unprecedented balance of payment crisis. The current account deficit soared to a level of 3.2 per cent of the GDP, which in 1990–91 was unsustainable. The foreign currency assets dipped from $3.4 billion at the end of March 1990, to a low of $975 million on 12, July, 1991, equivalent to barely a week’s imports. To face the crisis, the government of India implemented the Structural Adjustment Reforms, aiming to achieve stabilization, restructuring and globalization of the economy. The exchange rate was adjusted downwards in two stages in July 1991, which amounted to a cumulative downward adjustment of about 18 per cent. The quantitative restrictions on trade were abolished. The rationalization and reduction of the tariff were undertaken. The foreign investment policy underwent a radical change. The central plank of the new regime was a system of automatic approval of the proposals for foreign equity participation, up to 51 per cent in the high priority industries. Significant changes were made in the Foreign Exchange Regulation Act (FERA). The dual exchange rate system was introduced in March 1992. In March 1993, the dual exchange rate system gave way to a unified market-based exchange rate regime. The convertibility for the foreign direct investors was extended to the portfolio investments by the foreign institutional investors in the Indian stock exchanges. The Indian corporates were allowed to access the overseas financial markets in the form of the Global Depository Receipts (GDRs) and the Foreign Currency Convertible Bonds (FCCBs). Due to the above measures, there was a steady and sustained improvement in the balance of payment position. The country’s dependence on the external assistance and the external commercial borrowings came down. There was an unprecedented increase in the foreign exchange reserves, from $5,834 million in 1990–91 to $167,392 million in October 2006. There was an appreciation in the rupee since 2003–04 in dollar terms. This is the context in which the issue of the Capital Account Convertibility (CAC) has been discussed in the official circles in India. But the global economic crisis of 2007 and 2008, and its adverse impacts on the external sectors of many developing countries have created a rethinking on the Fuller CAC (FCAC). In this chapter, we examine the issues of the FCAC, the recommendations of the Tarapore I Committee on the CAC, the liberalization of the CAC since 1997, the recommendations of the Tarapore II Committee report, the desirability of the CAC in India and the global crisis and full CAC in India.

17.2 Issues in Fuller Capital Account Convertibility (FCAC)

17.2.1 Definition of Capital Account Convertibility (CAC)

The currency convertibility refers to the freedom of converting the domestic currency into the other internationally accepted currencies and vice versa. Convertibility in that sense is the obverse of the controls or restrictions on the currency transactions. While the current account convertibility refers to the freedom in respect of the ‘payments and transfers for the current international transactions’, the CAC would mean a freedom of the currency conversion in relation to the capital transactions, in terms of the inflows and outflows.

The CAC also refers to the freedom of converting the local financial assets into the foreign financial assets and vice versa. It is associated with changes of the ownership in the foreign and domestic financial assets, and liabilities, and embodies the creation and liquidation of claims on, or by, the rest of the world. The CAC can be, and is, coexistent with the restrictions other than on the external payments.

The experience with the capital account liberalization suggests, that the countries, including those that have an open capital account, do retain some regulations influencing the inward and outward capital flows.

17.2.2 Significance of Fuller Capital Account Convertibility (FCAC)

India has cautiously opened up its capital account since the early 1990s, and the capital controls in India today can be considered as the most liberalized since the late 1950s. Nevertheless, several capital controls continue to persist. In this context, the FCAC would signify the additional measures, which could be taken in furtherance of the CAC, and in that sense the FCAC would not necessarily mean zero capital regulation.

The FCAC is not an end in itself, but should be treated only as a means to realize the potential of the economy, to the maximum possible extent, and at the least cost. Given the huge investment needs of the country, and that the domestic savings alone will not be adequate to meet this aim, the inflows of the foreign capital become imperative.

The inflow of the foreign equity capital can be in the form of the portfolio flows or the Foreign Direct Investment (FDI). The FDI also tends to be associated with the non-financial aspects, such as the transfer of technology, the infusion of management and the supply chain practices. In that sense, it has a greater impact of growth. In India, the policies for portfolio or the Foreign Institutional Investor (FII) flows are far more liberal, but the same cannot be said for the FDI. Attracting the foreign capital inflows also depends on the transparency and freedom of exit for the non-resident inflows, and easing of capital controls on outflows by residents. The objectives of the FCAC in this context are—(i) to facilitate growth through a higher investment by minimizing the cost of equity and debt capital; (ii) to improve the efficiency of the financial sector through a greater competition, thereby minimizing the intermediation costs, and (iii) to provide opportunities for the diversification of investments by the residents.

17.2.3 Lessons from the Currency Crises in Other Countries

The risks of the FCAC arise mainly from inadequate preparedness before liberalization in terms of the domestic and external sector policy consolidation, strengthening of prudential regulation, and the development of the financial markets, including the infrastructure, for an orderly functioning of these markets.

In the above context, the East Asian experience, and that of some other emerging market economies, is of relevance:

1. The East Asian currency crisis began in Thailand in late June 1997, and afflicted other countries such as Malaysia, Indonesia, South Korea and the Philippines. It lasted up to the last quarter of 1998. The major macro-economic causes for the crisis were identified as—the current account imbalances with the concomitant savings-investment imbalance, the overvalued exchange rates, and the high dependence upon potentially short-term capital flows. These macro-economic factors were exacerbated by the micro-economic imprudence such as maturity mismatches, currency mismatches, moral hazard behaviour of the lenders and the borrowers, and excessive leveraging.
2. Brazil was suffering from both the fiscal and the balance of payments weaknesses, and was affected in the aftermath of the East Asian crisis in the early 1998, when the inflows of the private foreign capital suddenly dried up. After the Russian crisis in 1998, the capital flows to Brazil came to a halt.
3. In 1998, Russia faced a serious foreign exchange crisis, due to the concerns about its fiscal situation, and had to introduce a series of emergency measures, including the re-intensification of the capital controls and the announcement of a debt moratorium.

From the various currency crises experienced in the past 15 years, certain lessons emerge, which are summarized below:

1. Most of the currency crises arise out of the prolonged overvalued exchange rates, leading to unsustainable current account deficits. As the pressure on the exchange rate mounts, there is a rising volatility of flows as well as of the exchange rate itself. An excessive appreciation of the exchange rate, causes the exporting industries to become unviable, and the imports to become far more competitive, causing the current account deficit to worsen.
2. Even the countries that had apparently comfortable fiscal positions have experienced currency crises, and a rapid deterioration of the exchange rate. In many other economies, large unsustainable levels of external and domestic debt, directly led to currency crises. Hence, a transparent fiscal consolidation is necessary and desirable, to reduce the risk of the currency crisis.
3. The short-term debt flows react quickly and adversely during the currency crises. The receivables are typically postponed, and the payables accelerated, aggravating the balance of payments position.
4. The domestic financial institutions, in particular banks, need to be strong and resilient. The quality and proactive nature of the market regulation is also critical to the success of an efficient functioning of the financial markets during the times of the currency crisis.
5. The imposition of safeguards in the form of moderate controls on the capital flows may be necessary in some cases.
6. The quality of balance sheets, in terms of risk exposure, needs to be monitored.
7. While the impossibility of the trinity (fixed exchange rate, open capital account and independent monetary policy) may be a theoretical construct, in practice, it is possible to approach situations, which are close enough, through a combination of the prudential policies.
8. The opening up of the foreign investment in the domestic debt market needs to be pursued with caution, as also the issuance of the foreign currency linked domestic bonds.

17.3 Recommendations of the Committee on Capital Account Convertibility, 1997 (Tarapore I)

A committee on the capital account convertibility was set up by the Reserve Bank of India (RBI), under the chairmanship of the former RBI deputy governor S.S. Tarapore to ‘lay the road map’, to the capital account convertibility.

The five-member committee has recommended a three-year time frame for the 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:

17.3.1 Preconditions

1. The gross fiscal deficit to the GDP ratio has to come down from a budgeted 4.5 per cent in 1997–98 to 3.5 per cent in 1999–2000.
2. A consolidated sinking fund has to be set up to meet the government’s debt repayment needs. The fund is to be financed by an increase in the RBI’s profit transfer to the government, and the disinvestment proceeds.
3. The inflation rate should remain between an average 3–5 per cent for the three-year period 1997–2000.
4. The gross NPAs of the public sector banking system, needs to be brought down from the present 13.7 per cent to five per cent by 2000. At the same time, the average effective CRR needs to be brought down from the current 9.3 per cent to three per cent.
5. The RBI should have a monitoring exchange rate band of plus-minus five per cent, around a neutral Real Effective Exchange Rate (REER). RBI should be transparent about the changes in REER.
6. The external sector policies should be designed to increase the current receipts to the GDP ratio, and bring down the debt-servicing ratio from 25 per cent to 20 per cent.
7. Four indicators should be used for evaluating the adequacy of the foreign exchange reserves to safeguard against any contingency. Plus, law in the RBI Act should prescribe a minimum net foreign asset to the currency ratio of 40 per cent.

17.3.2 Phased Liberalization of Capital Controls

These are the committee’s recommendations for a phased liberalization of the controls on the capital outflows over the three-year period.

1. The Indian joint venture and the wholly owned subsidiaries (JVs/WOSs), should be allowed to invest up to $50 million in ventures abroad at the level of the Authorized Dealers (Ads) in phase I with transparent and comprehensive guidelines set out by the RBI. The existing requirement of the repatriation of the amount of investment, by way of the dividend, within a period of five years may be removed. Furthermore, JVs/WOSs could be allowed to be set up by any party, and not be restricted to only the exporters and the exchange earners.
2. The exporters/exchange earners may be allowed 100 per cent retention of the earnings in the Exchange Earners Foreign Currency (EEFC), which accounts with complete flexibility in the operation of these accounts, including the cheque writing facility in Phase I.
3. The individual residents may be allowed to invest in the assets in the financial markets abroad, up to $25,000 in Phase I, with a progressive increase to $50,000 in Phase II and $100,000 in Phase III. Similar limits may be allowed for the non-residents, out of their non-repatriable assets in India.
4. The SEBI-registered Indian investors may be allowed to set funds for the investments abroad, subject to the overall limits of $500 million, in Phase I, $ one billion in Phase II and $ two billion in Phase III.
5. The banks may be allowed much more liberal limits with regard to the borrowings from abroad, and the deployment of funds outside India. Borrowing (short and long term) may be subjected to an overall limit of 50 per cent of the unimpaired Tier 1 capital in Phase 1, 75 per cent in Phase II and 100 per cent in Phase III, with a sublimit for short term borrowing. In case of the deployment of funds abroad, the requirement of section 25 of the Banking Regulation Act, and the prudential norms for open position and gap limits would apply.
6. The foreign direct and portfolio investment, and the disinvestments should be governed by comprehensive and transparent guidelines, and prior the RBI approval at various stages may be dispensed with, subject to reporting by the ADs. All the non-residents may be treated on par for the purposes of such investments.
7. In order to develop and enable the integration of the forex, money and securities market, the participants on the spot market should be permitted to operate in the forward markets; the FIIs, the non-residents and the non-resident banks may be allowed forward cover to the extent of their assets in India. The all-India Financial Institutions (FIs), fulfilling the requisite criteria should be allowed to become full-fledged Ads. The currency futures may be introduced with the screen-based trading and an efficient settlement system. The participation in the money markets may be widened, market segmentation removed and the interest rates deregulated. The RBI should withdraw from the primary market in the government securities. The role of the primary and the satellite dealers should be increased. The fiscal incentives should be provided for the individuals investing in the government securities. The government should set up its own office of public debt.
8. There is a strong case for liberalizing the overall policy regime on the gold. Banks and the FIs, fulfilling the well-defined criteria may be allowed to participate in the gold markets in India and abroad, and deal in the gold products.

17.4 Liberalization of Capital Account in India Since 1997

The position in relation to the capital account in India in 1997 was that of an economy, which had taken the early steps in the capital account liberalization. From 1991, the regulatory framework for inflows was significantly liberalized, particularly for the FDI and the portfolio flows (largely FIIs). The capital account convertibility had all along been available for the non-residents. There were, however, severe procedural hurdles, and a maze of approvals required for both the inflows and the outflows by the non-residents. Within the non-residents there has, for three decades, been a separate category namely, the nonresident Indians (NRIs), that are provided special schemes for the investments that are not available to other non-residents.

In the case of the residents, the capital account was tightly controlled. For the resident corporates, the inflows were permitted which were contextually (in 1997) somewhat liberal, but subject to a complex set of approvals and procedures. For the outflows from the corporate sector, limited facilities were provided, but again, those were subject to several approval requirements and procedural hurdles. The banks had limited facilities for borrowing abroad, although they were allowed to raise the resources abroad, outside the restricted limits for the purposes of financing the exports and raising of the deposits under the NR(E)RA and FCNR(B) Schemes. For the resident individuals, however, there was a total ban on the capital outflows.

In its report (May 1997), the Committee on the Capital Account Convertibility (CAC), had set out detailed preconditions and signposts for moving towards the capital account convertibility, and also set out the timing and sequencing of the measures. In any meaningful assessment of the liberalization of the capital account since 1997, it is necessary to undertake the assessment against the backdrop of vital parameters.

Against this backdrop, an attempt is made here to briefly assess the progress on meeting the preconditions, and a broad-brush evaluation is attempted on the implementation of measures since 1997. (Table 17.1)

We can see that while significant efforts have been made at fiscal consolidation and greater fiscal transparency, introduced as required, under the Fiscal Responsibility and Budget Management Act (FRBM), 2003 and the FRBM Rules (2004), it is clear that fiscal consolidation has fallen short of the expectations of the 1997 Committee, in terms of the centre’s gross fiscal deficit as a percentage of the GDP. The domestic liabilities of the centre as a percentage of the GDP, which was 45.4 per cent in 1996–97 increased to 60.3 per cent in 2005–06. The gross interest payments as a percentage of the revenue receipts which was 47.1 per cent in 1996–97, has come down to 37.3 per cent in 2005–06, partly due to the perceptible reduction in the interest rates, as also changes in the system of centre-states transfers, which impinge on the gross interest payments of the centre. The shortfall in the extent of the fiscal consolidation envisaged by the 1997 Committee for 1999–2000 has not been attained even by 2005–06. Again, the 1997 Committee’s recommendation of a consolidated sinking fund, to ensure a smooth repayment of the borrowings, has not been implemented and an alternative mechanism has not been devised. As such, the repayments continue to be financed by fresh borrowing.

 

TABLE 17.1 Preconditions (per cent)

Item	Recommendation of 1997 Committee for 1999–2000	Position in 2005–06
Gross Fiscal Defi cit of the Centre as a percentage of GDP	3.5	4.1
Inflation Rate	3.0–5.0* (average for 3 years)	4.6 (average for 3 years)
Financial Sector
(i) Gross NPAs as a percentage of total advances@	5.0	5.2 (2004 05)
(ii) Average effective CRR for the banking system	3.0	5.0

 

As against the 1997 Committee’s recommendation of a formal inflation mandate, such a system has not been put in place. Nonetheless, the three-year average rate of inflation (wholesale price index) for the period ended in March 2006 was 4.6 per cent, which is within the 1997 Committee’s recommended range. The relatively low inflation rate in India in the recent period has also to be viewed in the context of the relatively low international inflation rates, and improved Indian macro-economic performance in the recent years. The globalization-induced productivity and competition have had a major influence in reducing the inflation rates.

While the 1997 Committee’s objective on the gross NPAs of the banking sector by 1999–2000, has been attained by 2004–05, the authorities have not reduced the CRR to 3 per cent. The concerns of the 1997 Committee on the need to strengthen the financial system, in the context of liberalization, continues to be a matter to be addressed.

The 1997 Committee had recommended that there should be a more transparent exchange rate policy, with a monitoring band of +_ 5 per cent around the neutral Real Effective Exchange Rate (REER), and that the RBI should ordinarily not intervene within the band. The RBI has not accepted this recommendation.

The 1997 Committee indicated that with the then Current Receipts (CR) to the GDP ratio of 15 per cent, the economy could sustain a Current Account Deficit to the GDP ratio at two per cent. The 1997 Committee envisaged that the authorities should endeavour, through external sector policies, to increase the CR-GDP ratio, such that the Debt Service Ratio (DSR) comes down from 25 per cent to 20 per cent. The CR-GDP ratio in 2005–06 was 24.5 per cent. The debt service ratio for 2005–06 is placed at 10.2 per cent (including repayments under the India Millennium Deposit Scheme); the debt service ratio for 2004–05 was only 6.2 per cent. Clearly, there have been significant improvements in the external sector, far beyond that envisioned by the 1997 Committee report.

The RBI has taken a number of additional measures, outside the 1997 Committee’s recommendations.

The capital inflows were fairly liberalized by the time of the 1997 Committee report, and the essential recommendations of the committee were to remove or reduce the procedural impediments. While some of these procedural problems have been largely attended to, certain difficulties still remain. Following the 1997 Committee report, the RBI has delegated the powers to the Authorized Dealers (ADs). In some cases this has merely shifted the controls and worsened the procedural impediments.

In the case of the resident corporates, the financial capital transfers abroad have been permitted within a limit of 25 per cent of their net worth.

The investment overseas, by the Indian companies and the registered partnership firms, up to 200 per cent of their net worth is permitted. The outflows in 2005–06 are reported at $3.1 billion.

The loans and borrowings by the resident banks from the overseas banks and correspondents are limited to 25 per cent of the unimpaired Tier I Capital; these limits amount to $2.7 billion as of March 31, 2006. The extent of such borrowing is not readily available. The 1997 Committee recommended significantly higher limits.

The resident individuals are permitted remittance abroad, of up to $25,000 per year. The committee was provided a figure of remittance under this facility for 2004 and 2005 amounting to $28.3 million, and an additional $1.9 million for immovable property. The resident individuals are also permitted to invest without limit in the overseas companies listed on a recognized stock exchange, and which have a shareholding of at least 10 per cent in an Indian company listed on a recognized stock exchange in India, as well in the rated bonds or fixed income securities.

In the case of the External Commercial Borrowing (ECB), there is an annual limit on the ECB authorizations, which is currently $18 billion. The issues of queuing, to ensure that small borrowers are not crowded out, do not appear to have been addressed. Furthermore, the ECB up to $500 million per year can be availed of, under the automatic route.

On the issue of the forward contracts in the foreign exchange market, the 1997 Committee had recommended that participation should be allowed without any underlying exposure. The hedging of the economic exposure was also recommended but not permitted. The RBI has not accepted the basic principle underlying the 1997 Committee’s recommendation.

The core of the capital account liberalization measures, proposed by the 1997 Committee, was essentially in relation to the residents. While the resident corporates have been provided fairly liberal limits, the liberalization for the resident individuals has been hesitant, and in some cases inoperative, because of the procedural impediments.

To the extent the RBI regulates the outflows by the resident individuals and corporates under myriad of schemes it must make special efforts to collect the information. As such flows could be expected to rise in a regime of a relatively more liberalized capital account.

Thus, we can see, that while there has been a fair amount of liberalization, the basic framework of the control system has remained unchanged. The RBI has liberalized the framework on an ad hoc basis, and the liberalized framework continues to be a prisoner of the erstwhile strict control system. Progressively, as the capital account liberalization gathers pace, it is imperative that there should be a rationalization and simplification of the regulatory system and procedures in a manner, wherein there can be a viable and meaningful monitoring of the capital flows.

The government appointed a second committee on FCAC in 2006, to remove inconsistencies in the policy framework that have emerged since 1997.

17.5 Committee on Fuller Capital Account Convertibility 2006 (Tarapore II)

The status of capital account convertibility in India, for the various non-residents is as follows. For the foreign corporates, and the foreign institutions, there is a reasonable amount of convertibility. For the Non-Resident Indians (NRIs), there is approximately an equal amount of convertibility, but one accompanied by severe procedural and regulatory impediments. For the non-resident individuals, other than the NRIs, there is near-zero convertibility. Movement towards an FCAC implies that all the non-residents (corporates and individuals) should be treated equally. This would mean the removal of the tax benefits, presently accorded to the NRIs, via special bank deposit schemes for NRIs, namely, the Non-Resident External Rupee Account [NR (E)RA] and the Foreign Currency Non-Resident (Banks) Scheme[FCNR(B)].

It would be desirable to consider a gradual liberalization for the resident corporate, business entities, banks, non-banks and individuals. The issue of liberalization of the capital outflows for the individuals is a strong confidence building measure, but such opening up has to be well-calibrated, as there are fears of waves of outflows. The general experience is that as the capital account is liberalized for the resident outflows, the net inflows do not decrease, provided the macro-economic framework is stable.

As India progressively moves on the path of an FCAC, the discriminatory tax treaties and tax policies should be harmonized. It would, therefore, be desirable, that the government undertakes a review of the tax policies and tax treaties.

An hierarchy of preferences may need to be set out on the capital inflows. In terms of the type of flows, allowing greater flexibility for the rupee-denominated debt, which would be preferable to the foreign currency debt; the medium and long term debt in preference to the short-term debt; and direct investment to the portfolio flows.

A greater focus may be needed on the regulatory and supervisory issues in banking, to strengthen the entire risk management framework. A preference should be given to control the volatility in the cross-border capital flows in the prudential policy measures through the banking system.

17.5.1 Broad Framework for Timing, Phasing and Sequencing of Measures

On a review of the existing controls, a broad timeframe of a five-year period in the three phases, 2006–07 (Phase I), 2007–08 and 2008–09 (Phase II) and 2009–10 and 2010–11 (Phase III) has been considered appropriate by the committee. This enables the authorities to undertake stocktaking after each phase before moving on to the next phase. The roadmap should be considered as a broad time path for the measures and the pace of the actual implementation would no doubt be determined by the authorities’ assessment of the overall macro-economic developments, as also the specific problems as they unfold. There is a need to break out of the ‘control’ mindset, and the substantive items subject to capital controls should be separated from the procedural issues. This will enable a better monitoring of the capital controls, and enable a more meaningful calibration of the liberalization process.

17.5.2 Concomitants for a Move to FCAC

The Tarapore Committee II feels that while a certain extent of capital account liberalization has taken place, since 1997, it would be necessary to set out a broad framework, for chalking out the sequencing and timing of further capital account liberalization.

17.5.3 Fiscal Consolidation

The Fiscal Responsibility and Budget Management (FRBM) Legislation was enacted in 2003, and the rules were notified in 2004. Steps are required to reduce the fiscal and revenue deficits. The revenue deficit was to be eliminated by 31 March, 2008, and adequate surpluses were to be built up thereafter. The deadline for reducing the Centre’s fiscal deficit to three per cent of the GDP, and elimination of the revenue deficit has been extended by the Central Government to 31 March, 2009. The Twelfth Finance Commission (TFC) recommended, that the revenue deficits of the states should be eliminated by 2008–09, and that the fiscal deficits of the states should be reduced to three per cent of the GDP.

The committee recommended that as a part of better fiscal management, the Central Government and the states should graduate from the present system of computing the fiscal deficit, to a measure of the Public Sector Borrowing Requirement (PSBR). The PSBR is a more accurate assessment of the fiscal’s resource dependence on the economy. Rough indications point to the probability of the PSBR being about three per cent of the GDP, above the fiscal deficit. The RBI should attempt a preliminary assessment of the PSBR, and put it in the public domain, which would then facilitate the adoption of the PSBR as a clearer indicator of the public sector deficit.

For an effective functional separation, enabling more efficient debt management as also the monetary management, the committee recommended that the Office of Public Debt, should be set up to function independently outside the RBI.

17.5.4 Monetary Policy Objectives

In the rapidly changing international environment, and the drawing up of a roadmap towards fuller capital account convertibility, the issue of greater autonomy for monetary policy needs to be revisited. The committee recommended that, consistent with the overall economic policy, the RBI and the government should jointly set out the objectives of monetary policy for a specific period, and this should be put in the public domain. Once the monetary policy objectives are set out, the RBI should have unfettered instrument independence, to attain the objectives. Given the lagged impact of the monetary policy action, the objectives should have a medium-term perspective. The committee recommended that the proposed system of setting objectives should be initiated from the year 2007–08. Strengthening the institutional framework for setting the monetary policy objectives is important in the context of an FCAC. The RBI has instituted a Technical Advisory Committee on Monetary Policy. While this is a useful first step, the committee recommended that a formal Monetary Policy Committee should be the next step in strengthening the institutional framework. At an appropriate stage, a summary of the minutes of the Monetary Policy Committee, should be put in the public domain with a suitable lag.

17.5.5 Strengthening of the Banking System

On the strengthening of the banking system, the committee has the following recommendations:

1. The commercial banks should be subject to a single Banking Legislation, and separate legislative framework for groups of public sector banks should be abrogated.
2. The minimum share of the government and the RBI in the capital of public sector banks, should be reduced from 51 per cent (55 per cent for SBI) to 33 per cent, as recommended by the Narasimham Committee on Banking Sector Reforms (1998).
3. With regard to the proposed transfer of ownership of the SBI from the RBI to the government, the committee recommended, that given the imperative need for strengthening the capital of banks in the context of Basel II and FCAC, this transfer should be put on hold. This way the increased capital requirement for a sizeable segment of the banking sector, would be met for the ensuing period.
4. In the first round of setting up new private sector banks, those private sector banks with institutional backing have turned out to be the successful. The authorities should actively encourage similar initiatives by the institutions to set up new private sector banks.
5. Until amendments are made to the relevant statutes to promote consolidation in the banking system, and address the capital requirements of the public sector banks, the RBI should evolve policies to allow, on a case-by-case basis, industrial houses to have a stake in the Indian banks or promote new banks. The policy may also encourage non-banking finance companies to convert into banks. After exploring these avenues until 2009, the foreign banks may be allowed to enhance their presence in the banking system.
6. The issues of corporate governance in the banks, powers of the boards of the public sector banks, remuneration issues, hiring of personnel with requisite skills in specialized functions, and succession planning need early attention.
7. The voting rights of the investors should be in accordance with the provisions of the Companies Act.
8. Following the model of the comprehensive exercise undertaken on transparency, a number of groups or committees could be set up for examining each set of issues, under the overall guidance and co-ordination of a high level government—the RBI Committee to ensure concerted and early action, to expeditiously prepare the financial system to meet the challenges in the coming years in the context of Basel II and the move to a FCAC.

17.5.6 External Sector Indicators

Given the present CR-GDP ratio of 24.5 per cent, the CR-CP ratio of 95 per cent, and a debt service ratio in the range of 10–15 per cent, a CAD-GDP ratio of three per cent could be comfortably financed. Should the CAD-GDP ratio rise substantially over 3 per cent, there would be a need for policy action.

In terms of the external liabilities, which include the portfolio liabilities, India’s reserves cover over half the liabilities. In the context of large non-debt flows in recent years, greater attention is required to the concept of reserve adequacy in relation to the external liabilities.

While the reserves are comfortable in relation to the various parameters, the committee has some concerns about the coverage of data on the short-term debt, including suppliers’ credit. Again there are concerns, whether the flow of private equity capital are fully captured in the data (on FDI). The Committee suggested that the RBI should undertake an in-depth examination of the coverage and accuracy of these data.

17.5.7 Monetary Policy Instruments and Operations

The sterilization and the open market operations (OMO), and interventions in the forex markets, have to be so calibrated along with the domestic monetary instruments, so as to be consistent with the monetary policy objectives. A major objective of the monetary policy is containing inflationary expectations and to attain this objective, action needs to be undertaken well before the economy reaches the upper turning point of the cycle.

Given the nascent state of development of the market-based monetary policy instruments, and the size of capital flows, it would be necessary to continue to actively use the instrument of the reserve requirements.

The LAF should be essentially an instrument of equilibrating short-term liquidity. The Committee recommended that, over a period of time, the RBI should build up its stocks of government securities, so as to undertake effective outright OMO.

The interest cost of sterilization to the government and the RBI, in 2005–06 is reported to be in the broad range of Rs 4,000 crore (though reduced somewhat by the corresponding earnings on the forex reserves). While the costs of sterilization are often highlighted, the costs of non-intervention and non-sterilization are not easily quantifiable, as the costs are in terms of lower growth, lower employment, loss of competitiveness of India, lower corporate profitability and lower government revenues. These costs could be far more, than the visible costs of sterilization.

While appreciating the RBI’s dilemma of a shortage of instruments, the committee recommended the following:

1. The RBI should activate the variable rate repo, and reverse the repo auctions or the repo and reverse repo operations on a real time basis.
2. The RBI should consider longer-term LAF facilities.
3. To the extent the RBI assesses the excess liquidity to be more than transient; it should also use the Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR). Where there is a large increase in the liquidity and the credit expansion above the trend line, bank profitability is higher, and the banks can be legitimately expected to bear a part of the burden of containing the deleterious expansion of liquidity. The committee recognized that the CRR couldn’t be as effective as in the earlier years, as banks are anyway maintaining large balances for the settlement operations.
4. To the extent the capital inflows are exceptionally high, and the economy is inundated with excess liquidity, arising out of FII inflows, the authorities may consider, in very exceptional circumstances, the imposition of an unremunerated reserve requirement on the fresh FII inflows.

17.5.8 Exchange Rate Management

The articulation of the exchange rate policy gives the Committee concern. The authorities have centered the articulation of the exchange rate policy on managing volatility. The Committee is of the view that apart from the volatility, what is more important is the level of the exchange rate. The Committee recommended that the RBI needs to undertake work to refine the REER index by the incorporation of services to the extent possible.

The 1997 Committee recommended that:

• The RBI should have a Monitoring Exchange Rate Band of +/—5 per cent around the neutral REER. The RBI should ordinarily intervene, as and when the REER is outside the band. The RBI should ordinarily not intervene when the REER is within the band.
• The RBI could, however, use its judgment to intervene even within the band to obviate the speculative forces and unwarranted volatility. The Committee further recommends that the RBI should undertake a periodic review of the neutral REER, which could be changed as warranted by the fundamentals.

The present Committee endorses the recommendations of the 1997 Committee. The Committee recommended that, as an operative rule, if the CAD persists beyond three per cent of the GDP (referred as an outer sustainable limit, at the present time) the exchange rate policy should be reviewed.

17.5.9 Development of Financial Markets

Any country, intending to introduce FCAC needs to ensure that different market segments are not only well-developed, but also that they are well integrated. Broadly, there are three main dimensions of a well-developed financial system. These are: (i) vibrancy and strength of the physical infrastructure of the markets as reflected by the IT systems, communication networks, business continuity and disaster management capabilities, (ii) the skill and competency levels of people, who man the offices of financial intermediaries like commercial and investment banks, the institutions that manage trading platforms and clearing and settlement arrangements, and the market intermediaries like brokerage houses, and (iii) the quality of regulatory and supervisory arrangements.

17.5.10 Regulatory and Supervisory Issues in Banking

Under the FCAC regime, the banking system will be exposed to a greater market volatility. Hence, it is necessary to address the relevant issues in the banking system, including the regulatory and supervisory aspects to enable the system to become more resilient to the shocks, and sustain the operations with a greater stability.

In a new environment, the commercial banks should be able to manage multidimensional operations, in situations of both large inflows and outflows of the capital. In particular, their own exposures to the exchange rate risk, coupled with their exposure to the corporates, which are exposed to similar risk panning across the national jurisdictions, add to the multiplicity of risks which need to be closely monitored and prudently managed. The RBI, therefore, needs to review the prudential standards, applicable to the commercial banks and should consider making the regulations activity-specific, instead of keeping them institution-specific.

As regards the substantive regulations on the capital account, the Committee recommended a five-year roadmap, with three phases on the timing and sequencing of the measures.

Some of the significant measures are set out below:

1. The Committee recommended that the overall ECB ceiling, as also the ceiling for automatic approval should be gradually raised. The rupee denominated ECB (payable in foreign currency) should be outside the ECB ceiling. The ECBs of over 10-year maturity in Phase I, and over seven-year maturity in Phase II, should be outside the ceiling. The end-use restriction should be removed in Phase I.
2. The Committee has concerns about the volume of trade credit, as there could be sudden changes in the availability of such credit. Furthermore, there are concerns as to whether the trade credit numbers are fully captured in the data, even while noting, that the suppliers’ credit of less than 180 days are excluded from these data.
3. Recognizing that the Indian industry is successfully building up its presence abroad, there is a strong case for liberalizing the present limits for the corporate investment abroad. The Committee recommended that the limits for such outflows should be raised in phases, from 200 per cent of net worth to 400 per cent of net worth.
4. Although the EEFC accounts are permitted in the present framework, these facilities do not effectively serve the intended purpose. The Committee recommended that the EEFC account holders should be provided foreign currency current and savings accounts, with cheque writing facility and interest-bearing term deposits. In practice, some banks are erroneously providing cheque writing facilities only in rupees.
5. The project exports should be provided greater flexibility, and these facilities should also be provided for the service exports.
6. In the case of the Participatory Notes (PNs), the nature of the beneficial ownership or the identity, is not known, unlike in the case of the FIIs. These PNs are freely transferable, and trading of these instruments makes it all the more difficult to know the identity of the owner.
7. The Committee recommended that the non-resident corporates should be allowed to invest in the Indian stock markets through the SEBI-registered entities, including the mutual funds and the Portfolio Management Schemes, that will be individually responsible for fulfilling KYC and FATF norms. The money should come through bank accounts in India.
8. At present, only multilateral institutions are allowed to raise the rupee bonds in India. To encourage, selectively, the raising of the rupee denominated bonds, the Committee recommended that other institutions and corporates should be allowed to raise the rupee bonds (with an option to convert into foreign exchange), subject to an overall ceiling, which should be gradually raised.
9. Borrowing the facilities of banks, are at present restrictive, though there are various special facilities, which are outside the ceiling. The Committee recommended that the limits for borrowing overseas, should be linked to the paid-up capital and the free reserves, and not to the unimpaired Tier I capital, as at present, and raised substantially to 50 per cent in Phase I, 75 per cent in Phase II and 100 per cent in Phase III.
10. At present, only mutual funds are permitted to invest overseas, subject to the stipulations for each fund. The Committee recommended that the various stipulations on the individual fund limits, and the proportion in relation to NAV should be abolished.
11. The present facility for individuals to freely remit $25,000 per calendar year enables the individuals to open foreign currency accounts overseas. The Committee recommended that this annual limit be successively raised to $50,000 in Phase I, $100,000 in Phase II and $200,000 in Phase III.
12. The residents can at present invest, without any limit, directly in such overseas companies, as have a shareholding of at least 10 per cent in an Indian company. This facility is cumbersome to operate, and in the context of the large increase in limits for the individuals, proposed under (i) above, the committee recommended that this facility should be abolished.
13. The Committee recommended that the RFC and RFC(D) accounts should be merged. The account holders should be given a general permission to move the foreign currency balances to the overseas banks. Those wishing to continue the RFC accounts should be provided the foreign currency current/and savings chequable accounts, in addition to the foreign currency term deposits.
14. At present, only the NRIs are allowed to maintain FCNR(B) and NR(E)RA deposits. The committee recommended that the non-residents (other than NRIs) should also be allowed access to these deposit schemes. Since the NRIs enjoy the tax concessions as FCNR(B) and NR(E)RA deposits, it would be necessary to provide FCNR(R)/ NR(E)RA deposit facilities, as separate and distinct schemes for the non-residents (other than the NRIs) without tax benefits.
15. At present, only the NRIs are allowed to invest in the companies on the Indian stock exchange, subject to certain stipulations. The Committee recommended that individual non-residents should be allowed to invest in the Indian stock market though the SEBI-registered entities, including the mutual funds and the Portfolio Management Schemes that will be responsible for meeting the KYC and the FATF norms, and that the money should come through the bank accounts in India.

The Committee recommended that at the end of the five-year period, ending in 2010–11, there should be a comprehensive review to chalk out the future course of action.

17.6 Desirability of Capital Account Convertibility (CAC) in India

The CAC implies complete mobility of the capital across the countries. The logic behind CAC is that when there is FCAC, the capital would move from the developed country, where the rental rate is low, to the LDC where the rental rate is high. The Marginal Productivity of the capital is higher in the LDC’s, than in the DC’s. The presumed merits and demerits of the CAC in India are the following:

17.6.1 Merits of CAC

1. The rates of return on debt and equity in India are high by the world standards. With the CAC, the foreign money will come into India to arbitrage this differential away, and reduce these rates of return, that is, the cost of the capital faced by the companies of India in equity and debt finance will drop. At a lower cost of the capital, more investment projects would be viable, which would generate a faster pace of the investment and growth in the economy. Thus, liberalizing the flow of the FPIs and the FIIs can reduce the cost of capital to the enterprises.
2. With the convertibility, Indians would be able to diversity their portfolios internationally, which would help them to insulate themselves better from the consequences of any shocks in the domestic economy. Instead of being constrained to only hold the Indian real estate, equity and debt, we will reduce over the risk by diversifying internationally. This means that in a bad year in India, when the Indian financial assets generate a poor return, the foreign assets owned by the Indians would continue to generate a good return. This reduction in the variability returns would make the Indians happier, since they face less risk and help stabilize India’s macro economy.
3. This will help India turn into a major financial centre in Asia. Given its vast pool of skilled labour force, and the rapidly developing IT industry, India certainly has the potential to become such a centre. Full convertibility is a necessary condition, for becoming a hub of financial activity.
4. Full convertibility would boost foreign investment in India. This can bridge saving— Investment Gap of the LDC’s. The FDI spreads the fruits of technological innovation and intellectual property, around the world.
5. The CAC puts new pressures upon the macro-economic management of the economy in the sense, that the poor macro-economic policies will swiftly generate large outflows of funds and price volatility. The financial markets will constantly monitor the economic policy. This will constrain the behaviour of the policy makers, and diminish the likelihood of the irresponsible policy choices. The CAC also brings up the spectre of a significant macro-economic crisis, if irresponsible policies are adopted.
6. Similarly, the adoption of the convertibility will speed up the financial sector. For instance, giving the individuals and firms an access to the global markets may bring pressure on the domestic banks, to become more competitive. Like wise, the possibility of a crisis may force the government to act more urgently on the fiscal deficits and debt.
7. The CAC also has important ramification for taxation. The convertibility opens up new avenues for a narrowing of the tax base, and hence upgrades the priority of a harmonization of the taxation in India, with international standards. The tax levels would come down to international levels, thereby reducing the evasion and capital flight.
8. The CAC can bring greater discipline on the part of the governments in terms of reducing excess borrowings, and rendering fiscal discipline. Again, with lower rates of interest, the cost of government borrowing will come down, and thereby reduce the fiscal deficit.
9. 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 illegal dollar-rupee market will display spurious volatility under such pressures. Hence, the institutional development of India’s foreign exchange market should precede the convertibility. The two key approaches for this are (a) the transition of the spot market away from the inter-bank market, to modern screen-based trading that is widely accessible all over the country (b) the transition, away from the inter bank dollar-rupee forward market, to a modern dollar-rupee futures market without the entry barriers. These approaches would transform the quality of the foreign exchange market.
10. The convertibility would generate massive flows of funds, into and out of India, as the Indians and foreigners modify their portfolios to reflect new investment possibilities. Even if all policies in the terms of financial regulation are correctly orchestrated, the volatility in the dollar-rupee market will innately increase. But, given the tradition of the government controls in India, we are all used to expecting a low volatility of the dollar-rupee market. This raises the urgency of the developing futures, and the options on the dollar-rupee, which would give people a method for managing these risks.

17.6.2 Demerits of CAC

1. Asymmetric information, combined with the implicit results in excessive lending for the risky projects.
2. A mismatch between the short term liabilities and the long term assets, leaves the financial intermediaries vulnerable to bank runs and financial panic, a problem that is particularly severe in the cross-border transactions, where there is no international lender of the last resort.
3. When the markets cannot observe the intrinsic quality of money managers, these managers are likely to place a little weight on their private information, and exhibit herd behaviour, resulting, in turn, in excess volatility and the contagion effects.
4. Since the asset values are determined by the expectations about future returns, the dynamics of the asset prices can be quite rich, exhibiting bubbles.
5. The International finance capital today is ‘highly volatile’, that is, it shifts from country to country in search of higher speculative returns. In this process, it has led to economic crisis in the numerous developing countries, and such finance capital is referred to as ‘hot money’ in today’s context. Full CAC exposes an economy to extreme volatility on account of the ‘hot money flows’.
6. There arises the possibility of misallocation of the capital inflows. Such capital inflows may find low quality domestic investments, like investments in the stock markets or real estates, and desist from investing in building up the industries and factories, which leads to more capacity creation and utilization, and an increased level of employment. This also reduces the potential of the country to increase the exports, and thus creates external imbalances.
7. When there is capital inflow, banks tend to fund the high-risk projects and inadequate monitoring. If this is the situation, the banks should not have access to foreign borrowing. This can precipitate into a crisis. One reason for the East Asian Crisis was the poor monitoring by the Thai Central Bank.
8. During the good years, it might experience huge inflows of the foreign capital, but during the bad times there will be an enormous outflow of the capital under ‘herd behaviour’ (refers to a phenomenon, where the investors act as ‘herds’ that is, if one moves out, others follow immediately as had happened in south Asia).
9. 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 curt the domestic investment under the threat of a crisis The domestic savings too, might leave the country along with foreign investment, thereby rendering the government helpless to counter the threat.
10. The fiscal indiscipline can also lead to a crisis, when the market finally decided to cease financing the deficit. If there is a large budget deficit, the real interest rate will be high. This attracts capital outflows. This causes appreciation of the domestic currency, when the currency is flexible (freely floating). But, when a fixed exchange rate prevails, this inflow can cause an increase in the nominal money supply, which could feed inflationary pressures. Even though the government can conduct sterilization through the open market operation, this is not a permanent solution. This increases the government dealt held by the residents, and hence add to the interest cost. This could make the current account deficit unsustainable. This can lead to a reversal of the capital flows.
11. During the periods of excessive inflows of the capital, the domestic currency appreciates under a flexible exchange rate regime. This affects the competitiveness of the host country in the international goods market. This widens the trade deficit by increasing the imports. When the capital outflow occurs, the domestic currency depreciates. This can result in cost-push inflation. The exchange rate depreciation cannot win back lost markets abroad, because of the hysterisis effect.
12. If a country maintains a fixed exchange rate system, or a dirty float, the capital inflows result in the accumulation of the forex reserves. Large forex reserves stabilize the currency, and prevent outflows. But, this comes at the cost of holding low return foreign assets as reserves, which can lead to significant interest costs for the economy.
13. When an exchange rate crisis occurs, this causes a run on the forex reserves of the Central Bank, which may cause the fixed exchange rate regime to collapse. The Central Bank may try to protect the peg by raising the interest rate. But, this can worsen the problem, and worsen the balance sheets of the banks.
14. Sterilization is difficult in the LDCs due to the under-developed, financial markets and Bond markets. When a government sells public bonds, they are placing an interest-bearing liability, in place of cash in the hands of the public. Similarly, CRR cannot be too much out of line, with the levels abroad, if the economy is financially integrated with the rest of the world.

17.7 Global Crisis and Full Capital Account Convertibility (CAC) in India

The global crisis of 2007 and 2008 is considered as the worst economic and financial crisis, faced by the world since the world depression of 1930s.The crisis has inflicted a heavy damage in the external sector transactions of the USA and the other developed capitalist countries. However, the impact of the crisis was small in India, especially in the external sector. The mixed economic system, the regulatory framework in the domestic and external sectors, and the policy against full capital account convertibility, has helped India from the collapse of the external sector transactions. In this section, we examine the features of the global crisis and the positive outcomes from the policy, against the full CAC in India. The features of the global crisis are the following.

1. Due to the global crisis, a large number of financial institutions-investment banks, insurance companies, non-banking financial institutions, banks etc. collapsed in USA and the other developed capitalist countries.
2. The financial institutions which collapsed, functioned as a parallel banking system, engaged in providing the credit to financial and speculative activities. They were not regulated properly, as in the case of the commercial banks by the central bank. There was a wide spread collapse of these financial institutions which do not have proper regulation. The financial institutions used to resort to a reckless lending to unworthy creditors. This is known as the subprime crisis.
3. Due to the process of globalization, most of the developed as well as the underdeveloped countries were more integrated with the world economy. Due to the high degree of external links, the crisis of one country or region will immediately spread to the other countries or regions.
4. The global crisis has created a crash in the stock, derivatives and the commodity markets throughout the world. The wide variations in the price of crude oil in the international market within a year (2008), created acute balance of payment problems, and variations in the domestic price level of many countries.
5. The crisis has led to the fall in the exchange rate of the US dollar and other world currencies. The wide variations in the exchange rates create acute problems in the export, import, external flows of funds etc.
6. The global crisis has resulted in a steep fall in the exports, imports, and created acute problems in the domestic sector of many countries. The fall in the exports have destroyed many industries which are export oriented.
7. The global crisis has led to the contraction of the output, and created a large scale unemployment of the workers engaged in the exports, the export oriented industries and the service activities.
8. The crisis has proved that giving full freedom to the external transactions like trade, exchange rates, mobility of foreign funds etc., will create adverse economic consequences in the domestic economy.

One major external sector policy which helped India from the collapse of the external sector transactions, balance of payment crisis, falls in exchange rate and unhealthy outflows of the financial capital was the policy against full CAC. We give below a list of the positive effects of the policy.

1. The international finance capital usually shifts from country to country, in search of higher speculative profits. The Policy against the full CAC, prevented Indian economy from the adverse effects of a large scale shift of the finance capital, from India to the rest of the world during the global crisis.
2. The inflows of the finance capital and the other flows of foreign funds occur when an economy is in the boom period with a higher rate of growth, mild inflation and higher profitability. On the other hand, a reverse flow will occur when the economy is in recession or depression. The policy against full CAC has prevented the return flows of the finance capital, and other funds in the period of global crisis.
3. The policy against full CAC helped India to maintain somewhat stable exchange rate preventing a devaluation of the Indian Rupee. This also prompted the NRI, who deposited their savings in the foreign banks and the foreign financial institutions, to shift their savings to the Indian banks and other financial institutions.
4. The global economic crisis and the acute problems created in the external sector of many developing countries, give ample evidence against any move towards fuller CAC in India.

17.8 Conclusion

Globalization is a reality that makes opening up of the capital account a desirable step. But, a country like India has to move in this direction cautiously. The East Asian currency crisis, and the consequences of it, gave ample evidence against making a hasty move towards the FCAC. The global economic crisis of 2007 and 2008, the worst economic and financial crisis since the world depression of 1930s, also gives us the lesson against the fuller capital account convertibility. A major external sector policy which helped India from the collapse of the external sector transactions, balance of payment crisis, falls in exchange rate and unhealthy outflows of the finance capital was the policy against full CAC. The experiences of countries in the global crisis also suggest that it is not desirable to implement the Tarapore II committee recommendations of a phased programme, for removing the existing controls in the near future.

 

References

Reserve Bank of India, (1997). Report on the Commit-tee on Capital Account Convertibility. Mumbai: RBI.

Reserve Bank of India, (2006). Report on the Commit-tee on Fuller Capital Account Convertibility. Mumbai: RBI.