Group presentation on CAC and India's Journey towards CAC

2.  The freedom to convert the 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
- As per Report of the Committee on Capital
Account Convertibility, RBI, 1997
 Different from current account
transaction
 Indian citizen needs foreign exchange of smaller
amounts, say $3,000, for travelling abroad or for
educational purposes, she/he can obtain the same
from a bank or a money-changer

4.  Implies progressive integration of the domestic financial system with
international financial flows.
 Regarded as one of the hallmarks of a developed economy. Signals
openness of the economy
 Comfort factor for overseas investors. Encourages global capital flows
into the country
 Indian businesses - access to cheaper external credit (Global rates +
Country risk) - without having to ask permission of the RBI.
 High Risk – High Gain – Good Times – Chance of huge inflows of
foreign capital; Bad times – Chance of an enormous outflow of
capital
 Chance of “export of domestic savings” - for capital scarce developing
countries this could curb domestic investment
 Exposes an economy to extreme volatility on account of “hot money”
flows

5. Pros:
• Increases competition and reduces inefficiency; aids price discovery
• Allows access to funds at global rates (plus country risk)
• Disciplines domestic policy and exchange rate monitoring.
• Integrates economy to global trade and capital flows.
• Capital controls ineffective with open trade, human movement.
• Natural direction of evolution for Developing economies (globalization)
Cons:
• No evidence linking improved growth to CAC (Bhagwati, Rodrik, Stiglitz)
• Increases vulnerability to herd behavior, contagion, sentiment.
• Downside exceeds upside – High Risk, High/Moderate Gain.
• Reduces monetary, exchange rate autonomy for a nation.

6.  The East Asian currency crisis Q2 1997- Q4 1998) - Began in Thailand. Malaysia, Indonesia,
South Korea and the Philippines.
 Macroeconomic causes:
◦ current account imbalances with concomitant savings-investment imbalance
◦ overvalued exchange rates,
◦ high dependence upon potentially short-term capital flows.
Microeconomic imprudence
- maturity mismatches, currency mismatches,
◦ moral hazard behaviour of lenders and borrowers and excessive leveraging.
 The Russian FX Crisis - Re-intensified capital controls and debt moratorium. CAC in 2006.
 The Mexican crisis -1994–95 - Overvalued Exchange Rate. Caused by short-term capital inflows.
 Similar Crisis – Brazil (post Asian Crisis), Argentina (removed peg in 2001), Turkey (1994)

7.  Tarapore Committee setup in 1996-97 - Capital Account Convertibility (CAC)
 Committee favored CAC as a goal to be achieved in 3 years (by 2000) – considered too
aggressive target by economists (30 years avg by other liberalized nations)
 Established road map and benchmarks. Main issue areas: fiscal consolidation, inflation
target, financial system, exchange rate management, Balance of Payments.
 Levels of Convertibility –
◦ Foreign Corporate – Reasonably High Degree
◦ NRI Individual– Full Convertibility (Tax Benefits) but with Procedural/Regulatory delays (
◦ Non NRI Individual – Near Zero Convertibility
◦ Resident Individual – High Restrictions (relaxed by some extent)
◦ Resident Corporate – Medium Restrictions
 Targeted Parameters for CAC in 2000:
◦ Bring down Central government fiscal deficit from 4.5% in 1997-98 to below 3.5 % of GDP by 1999-
2000
◦ Inflation to be reduced to World Average (3-5 % ) - RBI Key Objective should be to monitor and
actively manage Inflation
◦ Financial system: CRR at 3%; Gross NPAs at 5%; Interest rate deregulation by 1998.
◦ BoP: “Sustainable” current account deficit; build up “adequate” reserves.

8.  1997 Asian crisis – major cause related to exchange rate fluctuations due not-
regulated capital account . Rapid surge of capital outflow (short term loans etc).
 Aftermath - Shift in international sentiment against CAC, Decreased IMF Focus
and less pressure from USA/Developed Nations - Reduced momentum.
 India - Steady liberalization continued, but not at the pace or with the
commitment indicated by the Tarapore Committee.
• Led to formation of 2nd Tarapore Committee in 2006 – For FCAC (Fuller CAC).
 Objectives of Fuller CAC –
◦ to facilitate economic growth through higher investment by minimising the cost of both
equity and debt capital;
◦ to improve the efficiency of the financial sector through greater competition, thereby
minimising intermediation costs and
◦ to provide opportunities for diversification of investments by residents.
 Idea was to streamline regulations –
◦ All non-residents should be treated equally
◦ Simplify rules for Residents.

9.  Current State:
◦ Strong BoP, High reserves. But is it enough security?
◦ Well “managed” floating exchange rate . Less volatility despite regulated capital flow.
◦ Increasingly efficient Financial markets. Much improved and improving, banking system.
◦ Mature Long-term government debt market, more efficient price discovery
 Risks -
◦ High Inflation (Compared to Global Standards) and External Debt (though under
moderation and monitoring)
◦ Large fiscal deficit, High public debt - Govt focused on targeted reduction in phases.
◦ Pressure from Industry vs Uncertain Future ahead – prioritization.

10.  Don’t Rush In - Despite high reserves we need to worry about inflation. Also
emerging economies need to take care of Exports competitiveness.
 Fiscal Management - Improving the quality of public expenditure, both current and
capital. Aggregate fiscal adjustment must/should occur, but this will take time.
 Exchange Rate Mgmt - Suggestion from Tarapore Committee –Device different
framework for exchange rate and monetary management. Nominal exchange rate
needs to become a shock absorber, and the FX market needs to deepen.
 A Strong RBI - Supervision has improved; legal sanctions are stronger.RBI needs to
move from a nanny to headmaster.
 Focus on Short Term Bank loans- RBI needs to closely monitor short term bank
loan flows (an additional risk mitigation device as done in Chile in 1990’s).
 Finally – It’s a Judgment Call - Gains, both signaling and substantive, could be
substantial, but are the risks manageable.
 Conditions seem ripe to put more full-blooded CAC back on the front-burner. We
are in the right direction to reach the destination. But it pays to be cautious.