Capital Convertibility of Indian Currency: Boon or a Bane

By M.Narasingh Rao   |   Sunday, 18 June 2006, 07:00 Hrs
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In a significant move the center has decided to come up with a greater Capital Account Convertibility (CAC) of the Indian currency in a few days. The central bank has also appointed a six-person committee to produce a "road map" towards that goal by July 31.

What is Capital Account Convertibility?

The Capital Account Convertibility (CAC) of the Indian Currency means removal of restrictions on cross border movement of capital, no matter whether from India to rest of the world or the vise-versa. The formal regime of capital account convertibility, when in place, will allow all residents, including companies, individuals and other entities, to invest, divest or transact in any property or asserts/liability of any country. One could convert one currency to another or move funds anywhere in the world, according to one's personal choice, which will be unrestricted by law of the land.

Pre Conditions for Capital Account Convertibility.

The RBI had appointed the Tarapore committee to make recommendations on making the Indian rupee fully convertible. The panel had submitted its report in 1997. The panel had recommended a three year time frame for complete convertibility by 1999-2000 subject to satisfying certain conditions These pre conditions includes:

1. Bringing down gross fiscal deficit to GDP ratio to 3.5 percent in 1999-2000.
2. The inflation rate should remain at average 3-5 percent for the debt-servicing period.
3. Designing external sector policies to increase current receipt to GDP ratio and bringing down the debt-servicing ratio from 25 percent to 20 percent.
4. The gross Non Performing Assets of the public sector banking system needs to be brought down to 5 percent by 2000 and the CRR reduced to 3 percent.

The Present scenario:

The economic condition now stands at: gross fiscal deficit is 4.1 percent and estimated to come down to 3.8 percent of GDP in the next fiscal. The WPI-based inflation rates hanging over 4 percent so far in this fiscal. The current account deficit is below 3 percent and foreign debt is lower by $1,61,030 million (foreign debt was $124,326 million in Sept 2005) than the country's $1,40,429 million (as on Feb. 10 2006) forex reserves that could cover all most 13 months' imports. The gross NPA in the banking system is hinges on 5.2 percent where as the CRR is 5 percent currently.

Whether A Boon or A Bane:

At present, the Indian rupee is fully convertible on the current account for free trade in goods and services and transfer of remittances. Indian companies' borrowing abroad, investments abroad, individuals' ability to invest in stocks and property abroad are restricted by lack of convertibility. The gross domestic product has registered a robust 7-8 percent growth in the last few years, along with inflation moderating to 4 percent.The economic fundamentals are strong , the air of optimisim is thick, as the foreign investors investing their money on the Bombay Stock Exchange. The capital convertibility will give companies much needed flexibility and negotiating power to raise capital in any currencies at finer rates to acquire foreign assets with foreign capital, full convertibility seems the way to go now. The removal of these restrictions will help Indian economic agents to exploit the opportunities around the world.

Risk of Foreign portfolio Capital:

However the full convertibility poses major challenges as well. The flow of capital into India is generally of three types-portfolio equity, direct investment and loan capital (both long and short term). These different type of foreign capital flow have varying impact on balance of payment, capital market and the financial sector of our country .The port folio capital which is coming in to our country by the way of investments in equities and bonds floats in the stock market. Portfolio capital flows could increase to more significant levels in the future, as India's financial market would integrate globally in convertibility regime.

Foreign portfolio investors generally enjoy freedom enter and exit. It has been observed that portfolio capital is fickle and is subject to sudden outflow. If the market conditions turn adverse or the economy is on a downslide, then it will be possible for the investors- both Indian and foreign to exit the rupee and the currency could tumble. Such capital outflows put unnecessary pressure on the exchange rate and money supply management policy. A small crisis could trigger a big collapse.

Among the three major types of inflow, the advantage of FDI is clear as such flows can be directed in the desired areas as per the defined policy of the country. These flows are not volatile and therefore don't lead to unstable exchange rates. But unfortunately the flow of FDI into India is not adequate in comparison to other Asian countries.

There is need for careful monitoring of the inflows and their end-use and the government should keep options open to impose some restriction if the currency conditions turn adverse, otherwise, India could invite trouble like the South East Asian and Latin American countries.

Is Indian banking sector prepared for "CAC?”

Free and full float of rupees is expected to put a lot of pressure on Indian banks to improve their efficiency levels. In the full convertibility regime Indian banks will accept deposits in any currency from anywhere in the world. The crucial determinant will be the usual "swap cost" that is the cost of converting a currency into another depending on the current exchange rate at the material time. The other important thing would be the comparative interest rate in India as well in other deposit exporting countries.

Full capital account convertibility may encourage arbitrage. The exploitation of prevailed differential interest or exchange rate would become quite common. Even the individual depositors can make most use of those opportunities that would place Indian currency in high volatile category. In short we will head for a scenario where violent swings in interest and exchange rate are possible. How will Indian banks be prepared to deal with this kind of scenario? Rouge speculators cannot be eliminated from the system. If that happens, as happened in the South-East Asian countries and Latin America some years back, it would wipe out years of development and could unsettle the overall economy.

The Capital account convertibility is thus like a "double-edged sword,” so the government should place enough regulatory mechanism and safeguard measures before going for full convertibility announcement.

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