rates of exchange. This means that capital account convertibility allows anyone to freely move from local currency into foreign currency and back. It refers to the removal of restraints on international flows on a country’s capital account, enabling full currency convertibility and open¬ing of the financial system.
Arguments for Capital Account Convertibility (CAC)—Capital
account convertibility is considered to be one of the major features of a developed economy. It helps attract foreign investment. It offers foreign investors a lot of comforts as they can reconvert local currency into foreign currency anytime they want to and take their money away. At the same time, capital account convertibility makes it easier for domestic com¬panies to tap foreign markets.
Before the development of modern banking, convertibility of currency meant the willingness of a government to convert its currency into gold or silver at a fixed rate. Nowadays, convertibility is best defined negatively as the absence of official restrictions on the conversion of balances held in a home currency into foreign currencies. Thirteen major types of control on transactions in foreign exchange levied by the number of member countries of the International Monetary Fund (IMF) (out of a total 188) that imposed such restrictions in 2004. Only thirty-five had independently floating curren¬cies, the rest intervened in foreign exchange markets. Most of the latter controlled foreign exchange transactions to prevent financial flows that would overwhelm official influence or profit from predictable, officially engineered exchange rate movements. Aside from this over-riding motive of curbing private competition in the foreign exchange markets, many countries controlled foreign exchange to prevent foreigners from buying or controlling too much of industrial, landed, or financial property.
Convertibility and India’s Position—Current account convertibility allows free inflows and out¬flows for all purposes other than capital purposes such as making investment and loans. It allows the resident to make and receive trade- related payments receive dollars (or any other foreign currency) for export of goods and services and pay dollars for imports of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment, etc. In India, current account convertibility was established with the acceptance of obligations under Article VIII of IMF’s Articles of agreement in 1994. Foreign exchange releases for current account transactions are still subject to quantitative limits, but they have been raised to comfortable levels. Exchange control has applied only to capital account transactions. On the removal of restrictions on capital account transactions, the government has dithered.
Concept of Capital Account Convertibility—Capital account
convertibility implies the freedom to convert domestic financial assets into overseas financial assets and vice versa. Broadly, it would mean free¬dom for firms and residents to freely buy overseas assets such as equity, bonds, property and acquire owner¬ship of overseas firms besides free repatriation of proceeds by foreign investors. To put it simply, Capital Account Convertibility (CAC) means the freedom to convert local financial assets into foreign financial assets and vice-versa at market determined
|
Foreign Exchange Facilities for Residents
|
||
|
(Updated upto January 20,2012)
|
||
|
Foreign Exchange Purchase Limits on Current Account under FEMA-1999
|
||
|
Authorised Dealers of
|
Category I : Commercial Banks and Authorised
|
|
|
Foreign Exchange:
|
Dealers appointed by RBI.
Category II: Full Fledged Money changers
|
|
|
Foreign Exchange Limits
|
||
|
(A) Travelling on private
|
||
|
visit
|
||
|
(i) Nepal & Bhutan:
|
No release of foreign currency, however, any amount in Indian Rupee.
|
|
|
(ii) Other Countries :
|
US
|
$ 10,000 in a financial year subject to the
|
|
following riders
|
||
|
(a)
|
upto US $ 3000 in cash.
|
|
|
(b)
|
balance in travellers cheque/banker’s draft.
|
|
|
(c)
|
Travellers proceeding to Libya and Iraq : upto US $ 5000 in cash and remaining in the form of Traveller’s cheques and Bank DD.
|
|
|
(d)
|
Travellers proceeding to Iran, Russian Federation and other CIS nations : Entire in cash.
|
|
|
(B) For Medical Treatment:
|
(a)
|
upto US $100,000 for self.
|
|
(b)
|
upto US $ 25,000 for maintenance expenses or for attendent in addition to (a).
|
|
|
(C) For Student:
|
(a)
|
US $ 100,000 per academic year
|
|
(b)
|
Student may avail US $ 10,000 for incidental expenses.
|
|
|
(c)
|
Out of (b) US $ 3000 may be carried in cash.
|
|
|
(D) On Emigration:
|
US $ 100,000 for incidental expenses.
|
|
The moment in India investments and borrowings are restricted.
Arguments against Capital Account Convertibility (CAC)—
Economists argue that jumping into capital account convertibility game without considering the downside of the step could harm the economy. The East Asian economic crisis is cited as an example by those opposed to capital account convertibility. Even the World Bank has . said that embracing capital account convertibility without adequate preparation could be catastrophic.
Tarapore Committee—A commi¬ttee on capital account convertibility was set up by the Reserve Bank of India (RBI) under the chairmanship of former RBI Deputy Governor S. S. Tarapore to ‘lay the road map’ to capital account convertibility. In 1997, the Tarapore Committee had indi¬cated the preconditions for Capital Account Convertibility. The three crucial preconditions were : (i) fiscal consolidation, (ii) a mandated inflation target, and (iii) strengthening of the financial system. The committee has recommended a three-year time frame for complete convertibility by 1999-2000. The highlights of the report including the preconditions to be achieved for the full float of money were as follows :
(i) Gross fiscal deficit to GDP ratio has to come down from a budgeted 4-5 percent in 1997-98 to 3-5% in 1999-2000;
(ii) A consolidated sinking fund has to be set up to meet government’s debt repayment needs; to be financed by increase in RBI’s profit transfer to the government and disinvestment proceeds;
(iii) Inflation rate should remain between an average 3-5 percent for the 3 year period 1997-2000;
(iv) Gross Non-Performing Assets (NPAs) of the public sector banking system needs to be brought down from the present 13-7% to 5% by 2000; and
(v) At the same time, average effective Cash Reserve Ratio (CRR) needs to be brought down from the current 9-3% to 3%.
RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a neutral Real Effective Exchange Rate. RBI should be transparent about the changes in REER. External sector policies should be designed to increase current receipts to GDP ratio and bring down the debt servicing ratio from 25% to 20%. Four indicators should be used for evaluat¬ing adequacy of foreign exchange reserves to safeguard against any contingency. Plus, a minimum net foreign asset to currency ratio of 40 per cent should be prescribed by law in the RBI Act.
In 2006, another committee (Tarapore Committee II) was set up by the Reserve Bank of India to revisit the subject of fuller capital account convertibility in the context of the progress in economic reforms, the stability of the external and financial sectors, accelerated growth and global integration. In this report, the committee suggested 3 phases of adopting the full convertibility of rupee in capital account : (i) First phase in 2006-07; (ii) Second phase in 2007-09, and (iii) Third phase by 2011.
Management of Capital Flows—
While managing capital flows, clear distinction is made between debt and non-debt creating flows, private and official flows, and short-term and long-term capital flows. There is A revealed preference for non-debt creating flows and long-term debt flows while de-emphasising short-term flows. The overall policy on capital flows is calibrated through :
(i) The cap on external commercial borrowings with restrictions on end- use;
(ii) a near unrestricted entry of capital in the form of foreign direct investment;
(iii) periodic upward revision of ceilings on portfolio investment by the FIIs;
(iv) low exposure of banks to real estates and stock markets;
(v) limited access to short-term borrowings for meeting working capital and other domestic requirements;
(vi) close monitoring of off- balance sheet items of the banking sector;
(vii) regulatory and prudential control over non-bank entities; and
(viii) restrictions on domestic residents to convert their domestic bank deposits and idle assets (such as real estate) in response to market developments or exchange rate expec¬tations.
The burden of adjustment to external payments imbalances generally falls both on the reserves and exchange rate. Recourse to reserves, which act as ‘shock absorbers’, is suitable only for short-term disequilibrium in external payments or to counter speculative attacks on a currency. A crucial question in this context is the quantum of foreign exchange reserves (FER), and, in particular, the level of Foreign Currency Assets (FCA). In India, some of the factors which have been found to influence the choice of the prudent level of reserves are : (i) the nature of the exchange rate regime,
(ii) the volume of international trans¬actions (scale factor), and (iii) the volatility of such transactions. How¬ever, these determinants of reserves adequacy may be misleading in an era where capital flows dominate the current account transactions. Another issue is the deployment of reserves; in line with the standard objective of holding reserves, the Reserve bank’s approach is one of loss minimisation. India’s FER comprise FCA, gold, and Special Drawing Rights (SDRs), and Reserve Tranche with IMF. Amongst these, the most important component is FCA which also happens to be the most liquid component and thus provide the necessary liquidity in crisis times. The import cover provided by FCA has considerably guided Indian import policy over time. In the recent period, it has been recognised that reserve adequacy indicators need to take into account capital flows as well.
As the Current Account Deficit (CAD) implies a net increase in liabilities to foreigners, it is necessary to monitor the sustainability of exter¬nal liabilities in terms of the ability to service them without erosion in import purchasing power. Even while taking into account the costs of holding reserves, the nature and periodicity of exogenous shocks, the availability of exceptional finance and the growing degree of openness, the level of reserves need to be build up
The moment in India investments and borrowings are restricted.
Arguments against Capital Account Convertibility (CAC)—
Economists argue that jumping into capital account convertibility game without considering the downside of the step could harm the economy. The East Asian economic crisis is cited as an example by those opposed to capital account convertibility. Even the World Bank has . said that embracing capital account converti¬bility without adequate preparation could be catastrophic.
Tarapore Committee—A commi¬ttee on capital account convertibility was set up by the Reserve Bank of India (RBI) under the chairmanship of former RBI Deputy Governor S. S. Tarapore to ‘lay the road map’ to capital account convertibility. In 1997, the Tarapore Committee had indi¬cated the preconditions for Capital Account Convertibility. The three crucial preconditions were : (i) fiscal consolidation, (ii) a mandated inflation target, and (iii) strengthening of the financial system. The committee has recommended a three-year time frame for complete convertibility by 1999-2000. The highlights of the report including the preconditions to be achieved for the full float of money were as follows :
(i) Gross fiscal deficit to GDP ratio has to come down from a budgeted 4-5 percent in 1997-98 to 3-5% in 1999-2000;
(ii) A consolidated sinking fund has to be set up to meet government’s debt repayment needs; to be financed by increase in RBI’s profit transfer to the government and disinvestment proceeds;
(iii) Inflation rate should remain between an average 3-5 per cent for the 3 year period 1997-2000;
(iv) Gross Non-Performing Assets (NPAs) of the public sector banking system needs to be brought down from the present 13-7% to 5% by 2000; and
(v) At the same time, average effective Cash Reserve Ratio (CRR) needs to be brought down from the current 9-3% to 3%.
RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a neutral Real Effective Exchange Rate. RBI should be transparent about the changes in REER. External sector policies should be designed to increase current receipts to GDP ratio and bring down the debt servicing ratio from 25% to 20%. Four indicators should be used for evaluat¬ing adequacy of foreign exchange reserves to safeguard against any contingency. Plus, a minimum net foreign asset to currency ratio of 40 per cent should be prescribed by law in the RBI Act.
In 2006, another committee (Tarapore Committee II) was set up by the Reserve Bank of India to revisit the subject of fuller capital account convertibility in the context of the progress in economic reforms, the stability of the external and financial sectors, accelerated growth and global integration. In this report, the committee suggested 3 phases of adopting the full convertibility of rupee in capital account : (i) First phase in 2006-07; (ii) Second phase in 2007-09, and (iii) Third phase by 2011.
Management of Capital Flows—
While managing capital flows, clear distinction is made between debt and non-debt creating flows, private and official flows, and short-term and long-term capital flows. There is A revealed preference for non-debt creating flows and long-term debt flows while de-emphasising short-term flows. The overall policy on capital flows is calibrated through :
(i) The cap on external commercial borrowings with restrictions on end- use;
(ii) a near unrestricted entry of capital in the form of foreign direct investment;
(iii) periodic upward revision of ceilings on portfolio investment by the FIIs;
(iv) low exposure of banks to real estates and stock markets;
(v) limited access to short-term borrowings for meeting working capital and other domestic requirements;
(vi) close monitoring of off- balance sheet items of the banking sector;
(vii) regulatory and prudential control over non-bank entities; and
(viii) restrictions on domestic residents to convert their domestic bank deposits and idle assets (such as real estate) in response to market developments or exchange rate expec¬tations.
The burden of adjustment to external payments imbalances generally falls both on the reserves and exchange rate. Recourse to reserves, which act as ‘shock absorbers’, is suitable only for short-term disequilibrium in external payments or to counter speculative attacks on a currency. A crucial question in this context is the quantum of foreign exchange reserves (FER), and, in particular, the level of Foreign Currency Assets (FCA). In India, some of the factors which have been found to influence the choice of the prudent level of reserves are : (i) the nature of the exchange rate regime,
(ii) the volume of international trans¬actions (scale factor), and (iii) the volatility of such transactions. How¬ever, these determinants of reserves adequacy may be misleading in an era where capital flows dominate the current account transactions. Another issue is the deployment of reserves; in line with the standard objective of holding reserves, the Reserve bank’s approach is one of loss minimisation. India’s FER comprise FCA, gold, and Special Drawing Rights (SDRs), and Reserve Tranche with IMF. Amongst these, the most important component is FCA which also happens to be the most liquid component and thus provide the necessary liquidity in crisis times. The import cover provided by FCA has considerably guided Indian import policy over time. In the recent period, it has been recognised that reserve adequacy indicators need to take into account capital flows as well.
As the Current Account Deficit (CAD) implies a net increase in liabilities to foreigners, it is necessary to monitor the sustainability of exter¬nal liabilities in terms of the ability to service them without erosion in import purchasing power. Even while taking into account the costs of holding reserves, the nature and periodicity of exogenous shocks, the availability of exceptional finance and the growing degree of openness, the level of reserves need to be build up
much higher than the current level to take into account the volatile and short-term portion of capital flows in additional to the conventional import and debt service cover.
The overall approach to foreign exchange reserve management is built upon a host of identifiable factors and other contingencies, which, inter alia, include : (i) the size of the current account deficit; (ii) the magnitude of short-term liabilities (including current repayment obliga¬tions on long-term loans); (iii) the possible variability in portfolio invest¬ments and other types of capital flows; (iv) the unanticipated pres¬sures on the balance of payments arising out of external shocks; and (v) movements in the repatriable foreign currency deposits of non-resident Indians. Leaving aside short-term variations in reserve levels, the quantum of reserves is calibrated in a way to ensure that in the long-run it is in line with the growth in the economy and the size of risk-adjusted capital flows.
India’s Policy Stance—India’s present policy stance is to approach , liberalisation on capital account cautiously, gradually, in a well-sequenced manner, treating it as a process and responding to domestic monetary and financial sector developments as also the evolving international financial architecture. India has followed a multi-pronged approach in dealing with the gyra¬tions of capital flows. It appears that there is considerable merit in careful calibration of:
(i) The pace and sequencing of external sector reforms—It should be recognized that reversal of any step in liberalisation is very difficult since markets tend to react very negatively to reversals.
(ii) Operationally, management of capital account involves a distinction not only between residents and non-residents or between inflows and outflows but also between individuals, corporates, and financial intermediaries.
(iii) The financial intermediaries
are usually a greater source of vola¬tility amongst these. Therefore, a necessary condition for capital account liberalisation is the presence
of a well-regulated and mature financial sector with the strong super¬visory framework. Only after the financial sector has attained some degree of credibility and resilience, could it improve and strengthen further through other symbiotic gains from capital flows emanating from better accounting procedures, trans¬parency norms, corporate governance etc.
(iv) A fair degree of trade and current account liberalisation should accompany/precede the process of capital account liberalisation. This only enables the economy to absorb higher capital inflows but also pre¬vents current account outflows in the guise of capital flows and vice-versa.
(v) There should be clear hierar¬chy in the nature of capital flows with equity flows getting more preference to short-term debt flows. Within equity investments, direct investment should be given precedence over portfolio investment.
(vi) External liabilities should be kept under constant watch and any eventuality of reverse movement should be factored in. For this purpose (a) external debt should be calculated not only in terms of its original maturity but also residual maturity, (b) there should a clear understanding of the quality and magnitude of contingent liabilities and derivatives, (c) maturity profile of external borrowings should be carefully modulated so as to prevent payments in a lump, (d) short-term debt /trade credits need to be constantly monitored, and (e) there should be flexibility of retirement/prepay¬ment of costly debt at times of benign international interest rate regime.
Management of the capital account involves management of control, regulation, and liberalisation. As liberalisation advances, the administrative measures would get reduced and price-based regulations would naturally increase, but the freedom and flexibility to change the mix and re-impose controls should always be demonstrably available. Such freedom to exercise the policy of controls adds comfort to the markets at times of grave uncertainty. Foreign exchange reserves should at least be sufficient to cover likely variations in capital flows or the ‘liquidity-at-risk’.
Furthermore, adequate reserves, keeping in view the national balance sheet considerations, which include public and private sectors, also provide comfort and confidence to market participants. The basic issue in any policy context is whether capital controls lead to distortions in exchange rate or the liberalized capital flows that lead to distortions in the exchange rate. In respect of emerging economies, the conduct of market participants shows that automatic self-correcting mechanisms do not operate in the forex markets. Hence, the need to manage capital account – which may or may not include special prudential regulations and capital controls. There are many subtleties and nuances in such a management of capital account which encompassed several macro issues and micro structures.
Recent Policy Stance to Attract Foreign Capital (FDIs and FIIs)—
Even though it makes good economic sense to ease unnecessary capital controls at times when the country needs inflows, we need to determine what the objectives of controls are, the kind of controls that the country would like to keep and which ones are detrimental and should be removed.
Capital controls, or controls on the cross-border flow of money for sale and purchase of assets, are imposed for three broad reasons :
(i) In largely open economies, concerns about terrorism or money laundering require that information is being provided before money can be transferred across borders. When a country becomes a member of the Financial Action Task Force (FATF), it is required to pass laws that require it to prevent money flows from being used for such activities. These require financial firms to fulfil various Know Your Customer (KYC) obligations. When India became a member of the FATF, it introduced these laws. The regulations in India that flow from these laws are, far more stringent than in other FATF member countries, involving proof of residence and paper documents beyond proof of identity. While the excesses would need to be sorted, controls arising from FATF obligations will have to
moment in India investments and borrowings are restricted.
Arguments against Capital Account Convertibility (CAC)—
Economists argue that jumping into capital account convertibility game without considering the downside of the step could harm the economy. The East Asian economic crisis is cited as an example by those opposed to capital account convertibility. Even the World Bank has . said that embracing capital account converti¬bility without adequate preparation could be catastrophic.
Tarapore Committee—A commi¬ttee on capital account convertibility was set up by the Reserve Bank of India (RBI) under the chairmanship of former RBI Deputy Governor S. S. Tarapore to ‘lay the road map’ to capital account convertibility. In 1997, the Tarapore Committee had indi¬cated the preconditions for Capital Account Convertibility. The three crucial preconditions were : (i) fiscal consolidation, (ii) a mandated inflation target, and (iii) strengthening of the financial system. The committee has recommended a three-year time frame for complete convertibility by 1999-2000. The highlights of the report including the preconditions to be achieved for the full float of money were as follows :
(i) Gross fiscal deficit to GDP ratio has to come down from a budgeted 4-5 percent in 1997-98 to 3-5% in 1999-2000;
(ii) A consolidated sinking fund has to be set up to meet government’s debt repayment needs; to be financed by increase in RBI’s profit transfer to the government and disinvestment proceeds;
(iii) Inflation rate should remain between an average 3-5 percent for the 3 year period 1997-2000;
(iv) Gross Non-Performing Assets (NPAs) of the public sector banking system needs to be brought down from the present 13-7% to 5% by 2000; and
(v) At the same time, average effective Cash Reserve Ratio (CRR) needs to be brought down from the current 9-3% to 3%.
RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a neutral Real Effective Exchange Rate. RBI should be transparent about the changes in REER. External sector policies should be designed to increase current receipts to GDP ratio and bring down the debt servicing ratio from 25% to 20%. Four indicators should be used for evaluat¬ing adequacy of foreign exchange reserves to safeguard against any contingency. Plus, a minimum net foreign asset to currency ratio of 40 per cent should be prescribed by law in the RBI Act.
In 2006, another committee (Tarapore Committee II) was set up by the Reserve Bank of India to revisit the subject of fuller capital account convertibility in the context of the progress in economic reforms, the stability of the external and financial sectors, accelerated growth and global integration. In this report, the committee suggested 3 phases of adopting the full convertibility of rupee in capital account : (i) First phase in 2006-07; (ii) Second phase in 2007-09, and (iii) Third phase by 2011.
Management of Capital Flows—
While managing capital flows, clear distinction is made between debt and non-debt creating flows, private and official flows, and short-term and long-term capital flows. There is A revealed preference for non-debt creating flows and long-term debt flows while de-emphasising short-term flows. The overall policy on capital flows is calibrated through :
(i) The cap on external commercial borrowings with restrictions on end- use;
(ii) a near unrestricted entry of capital in the form of foreign direct investment;
(iii) periodic upward revision of ceilings on portfolio investment by the FIIs;
(iv) low exposure of banks to real estates and stock markets;
(v) limited access to short-term borrowings for meeting working capital and other domestic requirements;
(vi) close monitoring of off- balance sheet items of the banking sector;
(vii) regulatory and prudential control over non-bank entities; and
(viii) restrictions on domestic residents to convert their domestic bank deposits and idle assets (such as real estate) in response to market developments or exchange rate expec¬tations.
The burden of adjustment to external payments imbalances generally falls both on the reserves and exchange rate. Recourse to reserves, which act as ‘shock absorbers’, is suitable only for short-term disequilibria in external payments or to counter speculative attacks on a currency. A crucial question in this context is the quantum of foreign exchange reserves (FER), and, in particular, the level of Foreign Currency Assets (FCA). In India, some of the factors which have been found to influence the choice of the prudent level of reserves are : (i) the nature of the exchange rate regime,
(ii) the volume of international trans¬actions (scale factor), and (iii) the volatility of such transactions. How¬ever, these determinants of reserves adequacy may be misleading in an era where capital flows dominate the current account transactions. Another issue is the deployment of reserves; in line with the standard objective of holding reserves, the Reserve bank’s approach is one of loss minimisation. India’s FER comprise FCA, gold, and Special Drawing Rights (SDRs), and Reserve Tranche with IMF. Amongst these, the most important component is FCA which also happens to be the most liquid component and thus provide the necessary liquidity in crisis times. The import cover provided by FCA has considerably guided Indian import policy over time. In the recent period, it has been recognised that reserve adequacy indicators need to take into account capital flows as well.
As the Current Account Deficit (CAD) implies a net increase in liabilities to foreigners, it is necessary to monitor the sustainability of exter¬nal liabilities in terms of the ability to service them without erosion in import purchasing power. Even while taking into account the costs of holding reserves, the nature and periodicity of exogenous shocks, the availability of exceptional finance and the growing degree of openness, the level of reserves need to be build up
much higher than the current level to take into account the volatile and short-term portion of capital flows in additional to the conventional import and debt service cover.
The overall approach to foreign exchange reserve management is built upon a host of identifiable factors and other contingencies, which, inter alia, include : (i) the size of the current account deficit; (ii) the magnitude of short-term liabilities (including current repayment obliga¬tions on long-term loans); (iii) the possible variability in portfolio invest¬ments and other types of capital flows; (iv) the unanticipated pres¬sures on the balance of payments arising out of external shocks; and (v) movements in the repatriable foreign currency deposits of non-resident Indians. Leaving aside short-term variations in reserve levels, the quantum of reserves is calibrated in a way to ensure that in the long-run it is in line with the growth in the economy and the size of risk-adjusted capital flows.
India’s Policy Stance—India’s present policy stance is to approach , liberalisation on capital account cautiously, gradually, in a well-sequenced manner, treating it as a process and responding to domestic monetary and financial sector developments as also the evolving international financial architecture. India has followed a multi-pronged approach in dealing with the gyra¬tions of capital flows. It appears that there is considerable merit in careful calibration of:
(i) The pace and sequencing of external sector reforms—It should be recognized that reversal of any step in liberalisation is very difficult since markets tend to react very negatively to reversals.
(ii) Operationally, management of capital account involves a distinction not only between residents and non-residents or between inflows and outflows but also between individuals, corporates, and financial intermediaries.
(iii) The financial intermediaries
are usually a greater source of vola¬tility amongst these. Therefore, a necessary condition for capital account liberalisation is the presence
of a well-regulated and mature financial sector with the strong supervisory framework. Only after the financial sector has attained some degree of credibility and resilience, could it improve and strengthen further through other symbiotic gains from capital flows emanating from better accounting procedures, trans¬parency norms, corporate governance etc.
(iv) A fair degree of trade and current account liberalisation should accompany/precede the process of capital account liberalisation. This only enables the economy to absorb higher capital inflows but also pre¬vents current account outflows in the guise of capital flows and vice-versa.
(v) There should be clear hierar¬chy in the nature of capital flows with equity flows getting more preference to short-term debt flows. Within equity investments, direct investment should be given precedence over portfolio investment.
(vi) External liabilities should be kept under constant watch and any eventuality of reverse movement should be factored in. For this purpose (a) external debt should be calculated not only in terms of its original maturity but also residual maturity, (b) there should a clear understanding of the quality and magnitude of contingent liabilities and derivatives, (c) maturity profile of external borrowings should be carefully modulated so as to prevent payments in a lump, (d) short-term debt /trade credits need to be cons¬tantly monitored, and (e) there should be flexibility of retirement/prepay¬ment of costly debt at times of benign international interest rate regime.
Management of the capital account involves management of control, regulation, and liberalisation. As liberalisation advances, the administrative measures would get reduced and price-based regulations would naturally increase, but the freedom and flexibility to change the mix and re-impose controls should always be demonstrably available. Such freedom to exercise the policy of controls adds comfort to the markets at times of grave uncertainty. Foreign exchange reserves should at least be sufficient to cover likely variations in capital flows or the ‘liquidity-at-risk’.
Furthermore, adequate reserves, keeping in view the national balance sheet considerations, which include public and private sectors, also provide comfort and confidence to market participants. The basic issue in any policy context is whether capital controls lead to distortions in exchange rate or the liberalized capital flows that lead to distortions in the exchange rate. In respect of emerging economies, the conduct of market participants shows that automatic self-correcting mechanisms do not operate in the forex markets. Hence, the need to manage capital account – which may or may not include special prudential regulations and capital controls. There are many subtleties and nuances in such a management of capital account which encompassed several macro issues and micro structures.
Recent Policy Stance to Attract Foreign Capital (FDIs and FIIs)—
Even though it makes good economic sense to ease unnecessary capital controls at times when the country needs inflows, we need to determine what the objectives of controls are, the kind of controls that the country would like to keep and which ones are detrimental and should be removed.
Capital controls, or controls on the cross-border flow of money for sale and purchase of assets, are imposed for three broad reasons :
(i) In largely open economies, concerns about terrorism or money laundering require that information is being provided before money can be transferred across borders. When a country becomes a member of the Financial Action Task Force (FATF), it is required to pass laws that require it to prevent money flows from being used for such activities. These require financial firms to fulfil various Know Your Customer (KYC) obligations. When India became a member of the FATF, it introduced these laws. The regulations in India that flow from these laws are, far more stringent than in other FATF member countries, involving proof of residence and paper documents beyond proof of identity. While the excesses would need to be sorted, controls arising from FATF obligations will have to
security. Almost all countries in the world, including the most advanced ones, have laws that prevent foreign ownership of, say, ports, airports or other infrastructure facilities where the government feels that the security of the country may be compromised. For example, the government may choose to prevent FDI in a port by a foreign government or an entity owned by it, especially by a govern¬ment it does not trust. Such capital controls are in place in India as well as in advanced open economies and it is unlikely that such restrictions will go away as long as national security remains an issue.
(iii) In addition capital controls have been seen, as tools for macro economics policy. When emerging economies witness pressure on their currencies, they loosen or tighten capital controls. These controls are of many kinds. They include price- based measures or quantitative restrictions. Controls may be on various kinds of asset classes such as debt, equity, derivatives, bank capital, mutual funds or direct investment. Controls may differ according to whether residents or non-residents are investing. They may differ depending on whether they concern inflows or outflows.
Whether such controls are able to reduce the pressure on the currency is still not settled. However, one thing appears to be clear—almost all emerging economies have slowly removed controls that permanently impede cross-border capital flows. The two exceptions are India and China. Countries such as Brazil have opened up their capital account but have kept in place transparent price- based controls that can be imposed by the government.
In India, we have tied ourselves up in knots. Even at a time when the country needs capital inflows, it is not easy for the government to move at the required speed. The U.K. Sinha Committee on capital controls documented the complex maze of capital controls that has taken the power of switching controls on and off, depending on the need of the hour, away from the government and into the hands of a number of financial regulators. Various financial sector laws and regulations treat foreign investors differently from Indian investors, with a bias against foreign investors. This has created a situation in which, even when macro-economic stability requires that at a time when the flow of capital is weak, when the current account deficit is strong when the government wishes to reduce capital controls, it is unable to do so.
Today, when India wants to attract foreign capital, the experience of foreigners with the Indian regu¬latory system, the legal complexity and the tax uncertainty are such that capital does not flow in easily. We cannot take foreign capital flows for granted. Considering how vulnerable a large trade account makes the country, it is not surprising that other emerging economies have got rid of the complex capital controls and moved to simple, transparent frame¬works. Hopefully, it is important that the system of controls now be re¬examined and rationalised keeping in mind the objectives they serve.
Conclusion
CAC offers various challenges to the Reserve Bank of India, the banks, the corporates and the market. While the various signposts that Tarapore has suggested are necessary parts of the process of opening up, they are not sufficient in themselves. There is a danger that they may be treated as sermons on the Mount to be heard and not followed, what is important therefore is (first) to get our players ready for the global market place.’ Convertibility need not be our over¬riding priority. There is no need or use to hustling towards CACs; move¬ment should be at a pace we are comfortable with, taking into account all relevant factors and the environ¬ment, in which our country has to function. At regular intervals, in the process, we should monitor relevant information, monitor policies adop¬ted and their actual implementation. The programme can be accelerated of decelerated depending upon the performance vis-a-vis the agreed preconditions or signposts, and modifications should be introduced from time to time in the light of the experience gained.
Viewed from all these perspec¬tives, the current level of reserves
continues to be comfortable. While there.is no set formula to meet all situations, the RBI applies portfolio management principles and risk management. If India was not seriously affected by the Asian currency crisis, it was primarily because of the Government going slow on CAC. The lessons of the upheaval are, nevertheless, quite relevant and should not be lost sight of by advocates of immediate CAC. Though the desirability of CAC cannot be denied, there is a need for vigilance and foresight to guard against the activities of currency speculators and unscrupulous hedge funds. The conditions laid down by the Tarapore Committee are relevant and, in our enthusiasm for financial sector reforms, the lessons of the Asian crisis should not be forgotten. In these circumstances, CAC can perhaps wait till the Tarapore Com¬mittee preconditions are reasonably satisfied and a good measure of financial stability is achieved. This may be the overriding reason for India to advance slowly towards capital account convertibility. One may not fully agree with Prof. Jagdish Bhagwati when he says that “.he will avoid full convertibility like the plague”. This may appear a harsh judgement, but not wrong. It finds support from Paul Krugman when he remarks that “it is an extremely dangerous world out there. The risks of getting caught in the pinball game are too high.” In this context, mana¬gement of asset portfolio acquires immense significance. Innovative institutional measures for deploy¬ment of foreign exchange reserves, beyond liberalisation of capital out¬flows of selective capital control, become necessary.
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