Capital Account Convertibility

Capital Account Convertibility. Should India adopt full convertibility? Capital Account Convertibility-or a floating exchange rate-is a feature of a nation's financial regime that centers around the ability to conduct transactions of local financial assets into foreign financial assets freely and at market determined exchange rates. It is sometimes referred to as Capital Asset Liberation or CAC. CAC is mostly a guideline to changes of ownership in foreign or domestic financial assets and liabilities.

Tangentially, it covers and extends the framework of the creation and liquidation of laims on, or by the rest of the world, on local asset and currency markets.

Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. In other words, it allows residents to make and receive trade-related payments receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts, etc.

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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 comfort as they can re-convert 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 companies to tap foreign markets. At the moment, India has current account convertibility. This means one can import and export goods or receive or make payments for services rendered.

However, investments and borrowings are restricted.

But economists say 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. But India is now on firm ground given its strong financial sector reform and fiscal consolidation, and can now slowly but steadily move towards fuller capital account convertibility.

CAC has 5 basic statements designed as points of All types of liquid capital assets must be able to be exchanged freely, between any two nations, with standardized exchange rates. The amounts must be a significant mount (in excess of $500,000). Capital inflows should be invested in semi-liquid assets, to prevent churning and excessive outflow. Institutional investors should not use CAC to manipulate fiscal policy or exchange rates. Excessive inflows and outflows should be buffered by national banks to provide collateral.

Prior to its implementation, foreign investment was hindered by uneven exchange rates due to transactions, and national banks were disassociated from fiscal exchange policy and incurred high costs in supplying hard-currency loans for those few local companies that wished to do business abroad. Due to the low exchange rates and lower costs associated with Third World nations, this was expected to spur domestic capital, which would lead to welfare gains, and in turn lead to higher GDP growth.

The tradeoff for such growth was seen as a lack of sustainable internal GNP growth and a decrease in domestic capital investments. When CAC is used with the proper restraints, this is exactly what happens. The entire outsourcing movement with Jobs and factories going oversees is a direct result of the foreign investment aspect of CAC. The Tarapore Committee's recommendation of tying liquid assets to static assets (i. e. investing in long term government bonds, etc) was seen by many economists as directly responsible for stabilizing the idea of capital account liberalization.

The Reserve Bank of India has appointed a committee to set out the framework for fuller Capital Account Convertibility. The Committee, chaired by former RBI governor S S Tarapore, was set up by the Reserve Bank of India in consultation with the Government 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.

Economists Surjit S Bhalla, M G Bhide, R H Patil, A V RaJwade and Alit Ranade were the members of the Committee. The Reserve Bank of India has also constituted an internal task force to re-examine the extant regulations and make recommendations to remove the operational impediments in the path of liberalisation already in place. The task force will make its recommendations on an ongoing basis and the processes are expected to be completed by December 4, 2006.

The Task Force has been set up following a recommendation of the Committee. The Task Force will be convened by Salim Gangadharan, chief general manager, in- harge, foreign exchange department, Reserve Bank of India, and will have the following terms of reference: Undertake a review of the extant regulations that straddle current and capital accounts, especially items in one account that have implication for the other account, and iron out inconsistencies in such regulations.

Examine existing repatriation/ surrender requirements in the context of current account convertibility and management of capital account. Identify areas where streamlining and simplification of procedure is possible and remove the operational impediments, especially in espect of the ease with which transactions at the level of authorized entities are regulations are consistent with regulatory intent.

Review the delegation of powers on foreign exchange regulations between Central Office and Regional offices of the RBI and examine, selectively, the efficacy in the functioning of the delegation of powers by RBI to Authorised Dealers (banks). Consider any other matter of relevance to the above. The Task Force is empowered to devise its work procedure, constitute working groups in various areas, co-opt permanent/special invitees and meet various trade ssociations, representative bodies or individuals to facilitate its work.