Perspective On Capital In India Essay Online For Free - Free Essay Example

Sample details Pages: 12 Words: 3733 Downloads: 5 Date added: 2017/06/26 Category Finance Essay Type Argumentative essay Did you like this example? Just like in any other country, Indias foreign exchange transactions (transactions in dollars, pounds, or any other currency) are also broadly classified into two accounts, namely, the current account transactions and capital account transactions. A current account transaction could be exemplified where an Indian citizen needing foreign exchange of smaller amounts, say $3,000, for travelling abroad or for educational purposes, can obtain the same from a bank or a money-changer. On the other hand, a capital account transaction involves someone who wants to import plant and machinery or invest abroad, and needs a large amount of foreign exchange, say $1 million. Don’t waste time! Our writers will create an original "Perspective On Capital In India Essay Online For Free" essay for you Create order But, the importer will have to first obtain the permission of the Reserve Bank of India (RBI) only then that the transaction becomes a capital account transaction. This means that any domestic or foreign investor has to seek the permission from a regulatory authority, like the RBI, before carrying out any financial transactions or change of ownership of assets that comes under the capital account. Nowadays, there are a whole range of financial transactions on the capital account that may be freed form such restrictions. But this is still not the same as full capital account convertibility. Tarapore Committee on Capital Account Convertibility appointed in February, 1997 defines Capital Account Convertibility as the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. It is associated with the changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by the rest of the world. ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦. In other terms we can say Capital Account Convertibility (CAC)  means that the home currency can be freely converted into foreign currencies for acquisition of capital assets abroad and vice versa. In a more term, it means that irrespective of whether one is a resident or non-resident of India ones assets and liabilities can be freely (i.e. without permission of any regulatory authority) denominated (or cashed) in any currency and easily interchanged between that currency and the Rupee. Background of CAC in India By August 1994, India was forced to adopt full current account convertibility under the obligations of IMFs article of agreement (Article No. VII). The committee on Capital Account Convertibility, under Dr S. S. Tarapores chairmanship, submitted its report in May 1997 and observed that international experience showed that a more open capital account could impose tremendous pressures on the financial system. Hence, the committee recommended certain signposts or preconditions for Capital Account Convertibility in India. However, the agenda of Capital Account Convertibility was put on hold following the South-East Asian crisis. Even the finance minister acknowledged this point that the idea of Capital Account Convertibility was floated in 1997 by the Tarapore Committee, but could not be implemented as the Asian Crisis cropped up. (The Hindu, March 25, 2006). In the early nineties, Indias foreign exchange reserves were so low that even a few weeks of imports were hard to pay.  To overcome this crisis situation,  Indian Government had to pledge a part of its gold reserves to the Bank of England to obtain foreign exchange.  However, after reforms were initiated and there was some improvements on FOREX front in 1994,  transactions on the current account were made fully convertible and foreign exchange was made freely available for such transactions. But, still yet the capital account transactions were not fully convertible. The rationale behind this was that  India wanted to conserve precious foreign exchange and protect the rupee from volatile fluctuations. Nevertheless, by late nineties situation further improved when a committee on capital account convertibility was setup in February, 1997 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.  The committee recommended that full capital account convertibility be brought in only after certain preconditions were satisfied. These included low inflation, financial sector reforms, a flexible exchange rate policy and a stringent fiscal policy.   However, the report was not accepted due to Asian Crisis. A three-year time frame for complete convertibility by 1999-2000 was recommended by the committee. A report highlighted the preconditions to be achieved for the full float of money and these are as follows:- Pre-Conditions Set By Tarapore Committee: Gross fiscal deficit to GDP ratio to come down from a budgeted 4.5 % in 1997-98 to 3.5% in 1999-2000. A consolidated sinking fund to be set up to meet governments debt repayment needs; to be financed by increased in RBIs profit transfer to the government and disinvestment proceeds. Inflation rate to remain between an average 3-5 % for the 3-year period 1997- 2000. Gross NPAs of the public sector banking system to be brought down from the present 13.7% to 5% by 2000. At the same time, average effective CRR needs to be brought down from the current 9.3% to 3%. RBI to have a Monitoring Exchange Rate Band of  ± 5% around a neutral Real Effective Exchange Rate and the RBI to be transparent about the changes in REER. External sector policies to be designed to increase current receipts to GDP ratio and bring down the debt servicing ratio from 25% to 20%. Four indicators to be used for evaluating adequacy of foreign exchange reserves to safeguard against any c ontingency. Plus, a minimum net foreign asset to currency ratio of 40 % to be prescribed by law in the RBI Act. Phased liberalisation of capital controls. The last precondition for a phased liberalisation of controls on capital outflows over the three year period was a priori: To allow Indian Joint Ventures/Wholly Owned Subsidiaries to invest in ventures abroad and to remove the requirement of repatriation of the amount of investment by way of dividends and so on. Furthermore, the JVs/WOs were allowed to be set up by any party and not be restricted to only exporters/exchange earners. To allow individual residents to invest in assets in financial market abroad up to $ 25,000 in Phase I with progressive increase to US $ 50,000 in Phase II and US$ 100,000 in Phase III. Similar limits were allowed for non-residents out of their non-repatriable assets in India. To allow banks much more liberal limits in regard to borrowings from abroad and deployment of funds outside India . To govern foreign direct and portfolio investment and disinvestment through comprehensive and transparent guidelines. To permit all participants on the spot market to operate in the forward markets in order to develop and enable the integration of FOREX, money and securities market. To allow banks and financial institutions to participate in gold markets in India and abroad and deal in gold products to strengthen the case for liberalising the overall policy regime on gold. The assumption of the committee was that these pre-conditions would take care of possible problems created by unseen flight of capital. Given a sound fiscal and financial set-up, the flight of capital was unlikely to be large, particularly in the short run, as capital would be invested and not all of it would be in a liquid form. The process of opening up the Indian economy has proceeded in balanced steps. The exchange rate regime was allowed to be determined by market forces as against the fix ed exchange rate linked to a basket of currencies. This was followed by the convertibility of the Indian rupee for current account transactions with India accepting the obligations under Article VIII of the IMF in August 1994. Capital account convertibility has proceeded at a steady pace.  RBI views capital account convertibility as a process rather than as an event. The distinct improvement in the external sector has enabled a progressive liberalisation of the exchange and payments regime in India. Reflecting the changed approach to foreign exchange restrictions, the restrictive Foreign Exchange Regulation Act (FERA), 1973 has been replaced by the Foreign Exchange Management Act, 1999. Critical Factors in Adopting Capital Account Convertibility (CAC) There are number of issues which are of concern for adopting CAC in India. Some of which are as follows:   Ãƒâ€š Short-Term External Borrowings The impact of allowing unlimited access to short-term external commercial borrowing for meeting working capital and other domestic requirements. In respect of short-term external commercial borrowings, there is already a strong international consensus that emerging markets should keep such borrowings relatively small in relation to their total external debt or reserves. Many of the financial crises in the 1990s occurred because the short-term debt was excessive. When times were good, such debt was easily accessible. The position, however, changed dramatically in times of external pressure. All creditors who could redeem the debt did so within a very short period, causing extreme domestic financial vulnerability. The occurrence of such a possibility has to be avoided, and the Indian Reserve would do well to continue with its policy of keeping access to short-term debt limited as a conscious policy at all times whether good or bad. Free Convert ibility of Domestic Assets The Indian Monetary System provided unrestricted freedom to domestic residents to convert their domestic bank deposits and idle assets (such as, real estate), in response to market developments or exchange rate expectations. The daily movement in exchange rates is determined by flows of funds, that is, by demand and supply of spot or forward transactions in the market. If supposedly, the exchange rate is depreciating disproportionately and is expected to continue to do so in the near future, the domestic residents would be likely to convert a part or whole of their stock of domestic assets from domestic currency to foreign currency. This was thought to be financially desirable as the domestic value of their converted assets was expected to increase because of anticipated depreciation. It is furthermore thought that if a large number of residents so decide simultaneously within a short period of time, as they may, this expectation would become self-fulfi lling. A severe external crisis is then unavoidable. External Events External events such as the Kargil war or Pokhran Test Although at present our reserves are high and exchange rate movements are, by and large, orderly. However, there can be events like Kargil war or Pokhran Test, which creates external uncertainty. Domestic stock of bank deposits in rupees in India is presently close to US $ 290 billion, nearly three and a half times our total reserves. At the time of Kargil or Pokhran or the oil crises, the multiple of domestic deposits over reserves was in fact several times higher than now. One can imagine what would have had happened to our external situation, if within a very short period, domestic residents decided to rush to their neighbourhood banks and convert a significant part of these deposits into sterling, euro or dollar. No emerging market exchange rate system can cope with this kind of contingency. This may be an unlikely possibility today, but it must be factored in while deciding on a long term policy of free convertibility of stock of domestic assets. Incidentally, this kind of eventuality is less likely to occur in respect of industrial countries with international currencies such as Euro or Dollar, which are held by banks, corporates, and other entities as part of their long-term global asset portfolio (as distinguished from emerging market currencies in which banks and other intermediaries normally take a daily long or short position for purposes of currency trade). Impact of Capital Account Convertibility The first impact of CAC adopted by India is the acceptance of Indian Rupee currency all over the world. In case of  two convertible currencies, Forward Exchange Rates reflect interest rate differentials between these two  currencies. Thus, we can say that the Forward Exchange Rate for the higher interest rate currency would depreciate so as to neutralize the interest rate difference.   However, sometimes  there can be opportunities when forward rates do not fully neutralize interest rate differentials.   In such situations, arbitrageurs get into the act and forward exchange rates quickly adjust to eliminate the possibility of risk-less profits. Capital account convertibility is likely to bring depth  and large volumes in  long-term Indian Rupee (INR) currency swap markets.   Thus, for a better market determination of INR exchange rates, the INR should be convertible. If capital account is made fully convertible it will imply the following: Market forces will regulate all current and capital account transactions and there will be no restriction on the inflow or the outflow of capital either by non-resident Indians or by foreigners. There will be no restriction on foreign exchange transactions and the RBI and the government will not intervene even where the cost or the quantity of the transaction is concerned. Purely market forces will determine the exchange rate of rupee in relation to any foreign currency. RBI can intervene in relation to foreign currency only by buying and selling of the rupee in the market. Indian companies will be free to go aboard and raise money. They will also be free to invest in GDRs and maintain offshore funds. Similarly foreign companies will be free to invest in India without any intervention of the RBI or the government Indians will be free to maintain foreign bank accounts and deposit withdraw and maintain foreign currency in any bank without any restriction. There will be no restriction on the repatriation of capital by foreigners. Dangers from Capital Account Convertibility in India At present very few countries permit absolute free market in foreign exchange. Among developing countries only a handful at present has, what may be called, full convertibility in both current and capital accounts. Even many industrial countries still do not allow free flows of capital account transactions. Some of the Latin American countries notably Uruguay, Argentina and Chile which had prematurely liberalised capital account in the early eighties have subsequently imposed a very tight control on capital mobility in the subsequent periods. It has been estimated that eventual capital flights out of these countries have been much more that initial capital inflows after capital account liberalisation. Some countries have however, notably, The U.K. and New Zealand, implemented capital account convertibility successfully. An examination of case study of successful and unsuccessful capital account liberalisation suggest that capital account liberalisation be best introduced as o ne of the last steps of economic reforms. Whenever it was introduced prematurely it had been disastrous. In general it has been observed that capital account liberalisation and full convertibility of exchange rate succeeds when it follows (and definitely not precedes) Fiscal reform, price stability, domestic financial reform, balance of payments stability and acceleration in growth of domestic output, particularly industrial output. In India very few of these objectives are fulfilled by now. Fiscal deficit of the Centre after falling from 8.3% of GDP in 1990-91 to 6.0% of GDP in 1991-92, has remained around that level since then. What is worst is that while real public investment has fallen sharply, unwarranted subsidies and bureaucratic expenditure have remained virtually at their pre-reform levels. In fact in some states, subsides, instead of falling have actually increased after the reform. Inflation continued at 10% per annum for many years after the reform in spite of man y favourable conditions, including good monsoon and low oil price. It has now come down to around 6% after a very tight squeeze on money and credit since 1995-96. But the credit squeeze increased both nominal and real interest rates, and currently the interest rates in India are well above the international levels. The credit squeeze also hampered the growth of industry and overall growth. Balance of payments situation is far from satisfactory. The improvement in foreign exchange reserve is more due to special factors like NRI remittances and deposits and portfolio capital inflow. There is no notable improvement in either trade balance or balance of payments. There is a dangerous illusion about capital account liberalisation. It is generally assumed that it can encourage only inflow of capital, ignoring the possibility that once deregulation is introduced it may also lead to outflow of capital. Experiences suggest that initially inflow is more than outflow because foreigners t ake advantage of initial low prices of shares and properties. Besides domestic residents may also bring back illegal capital held abroad. But if the real sector of the economy does not improve, especially lags behind more dynamic economy elsewhere in the world, then capital later goes out. The outflow can be more than inflow because not only foreigners can take back capital but even domestic residents can take advantage of the deregulated environment and invest abroad. It would therefore be prudent to wait for the real improvement of the economy, particular in current account balance, industrial growth rate, fiscal deficit and financial reform, before entering into an adventurous path of capital account liberalisation and full convertibility of rupee. Thus India will have to gradually move towards capital account convertibility, step by step, one reform after the other and then finally introduce full convertibility of rupee as the last step of economic reforms when all of the above listed objectives are fulfilled and as Dr. Y.V.Reddy, Deputy Governor RBI, put it as, In India, it is recognised that the pace of liberalisation of the capital account would depend on both domestic factors, especially progress in the financial sector reform and the evolving international financial architecture. Pros (for) of Capital Account Convertibility for India It allows domestic residents to invest abroad and have a globally diversified investment portfolio; this reduces risk and stabilizes the economy. A globally diversified equity portfolio has roughly half the risk of an Indian equity portfolio. So, even when conditions are bad in India, globally diversified households will be buoyed by offshore assets; will be able to spend more, thus propping up the Indian economy. Our NRI Diaspora will benefit tremendously if and when Capital Account Convertibility becomes a reality. The reason is on account of current restrictions imposed on movement of their funds. As the remittances made by NRIs are subject to numerous restrictions which will be eased considerably once Capital Account Convertibility is incorporated. It also opens the gate for international savings to be invested in India. It is good for India if foreigners invest in Indian assets this makes more capital available for Indias development. That is, it reduces the cost of cap ital. When steel imports are made easier, steel becomes cheaper in India. Similarly, when inflows of capital into India are made easier, capital becomes cheaper in India. Controls on the capital account are rather easy to evade through unscrupulous means. Huge amounts of capital are moving across the border anyway. It is better for India if these transactions happen in white money. Convertibility would reduce the size of the black economy, and improve law and order, tax compliance and corporate governance. Most importantly convertibility induces competition against Indian finance. Currently, finance is a monopoly in mobilizing the savings of Indian households for the investment plans of Indian firms. No matter how inefficient Indian finance is, households and firms do not have an alternative, thanks to capital controls. Exactly as we saw with trade liberalization, which consequently led to lower prices and superior quality of goods produced in India, capital account liberaliza tion will improve the quality and drop the price of financial intermediation in India. This will have repercussions for GDP growth, since finance is the brain of the economy. Cons (against) of Capital Account Convertibility for India During the good years of the economy, it might experience huge inflows of foreign capital, but during the bad times there will be an enormous outflow of capital under herd behavior (refers to a phenomenon where investors acts as herds, i.e. if one moves out, others follow immediately). For example, the South East Asian countries received US$ 94 billion in 1996 and another US$ 70 billion in the first half of 1997. However, under the threat of the crisis, US$ 102 billion flowed out from the region in the second half of 1997, thereby accentuating the crisis. This has serious impact on the economy as a whole, and can even lead to an economic crisis as in South-East Asia. There arises the possibility of misallocation of capital inflows. Such capital inflows may fund low-quality domestic investments, like investments in the stock markets or real estates, and desist from investing in building up industries and factories, which leads to more capacity creation and utilisation, and increa sed level of employment. This also reduces the potential of the country to increase exports and thus creates external imbalances. 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 curb domestic investment. Moreover, under the threat of a crisis, the domestic savings too might leave the country along with the foreign investments, thereby rendering the government helpless to counter the threat. Entry of foreign banks can create an unequal playing field, whereby foreign banks cherry-pick the most creditworthy borrowers and depositors. This aggravates the problem of the farmers and the small-scale industrialists, who are not considered to be credit-worthy by these banks. In order to remain competitive, the domestic banks too refuse to lend to these sectors, or demand to raise interest rates to more co mpetitive levels from the subsidised rates usually followed. International finance capital today is highly volatile, i.e. it shifts from country to country in search of higher speculative returns. In this process, it has led to economic crisis in numerous developing countries. Such finance capital is referred to as hot money in todays context. Full capital account convertibility exposes an economy to extreme volatility on account of hot money flows. It does seem that the Indian economy has the competence of bearing the strains of free capital mobility given its fantastic growth rate and investor confidence. Most of the pre-conditions stated by the Tarapore Committee have been well complied to through robust year on year performance in the last five years especially. The forex reserves provide enough buffer to bear the immediate flight of capital which although seems unlikely given the macroeconomic variables of the economy alongside the confidence that international investors have leveraged on India. However it must not be forgotten that Capital Account Convertibility is a big step and integrates the economy with the global economy completely thereby subjecting it to international fluctuations and business cycles. Thus due caution must be incorporated while taking this decision in order to avoid any situation that was faced by Argentina in the early 80s or by the Asian economies in 1997-98.