News Release Details
Capital Account Convertibility
New Delhi 17-Aug-2007
The formal regime of capital account convertibility, when in place, will allow all residents-companies or individuals or other entities to invest, disinvest or transact in any asset/liability of any country, convert one currency to another or move funds anywhere in the world, according to their choice, subject to legal restrictions of those countries. This would mean the foreign exchange (forex) reserves of India can be utilized by any resident/non-resident without any restriction i.e. the foreign currency can be brought into India and be freely converted into rupees. Also the Indian rupee can be converted into any foreign currency and taken out of India by any resident/non-resident without taking any prior approval/permission. <b>Current scenario </b> Buoyed by very comfortable forex build up and strong GDP growth, the capital account transactions have been liberalized to a great extent over the years. This has facilitated, amongst other things, global acquisitions by Indian companies viz., Tata (Corus), Hindalco (Novalis), Kingfisher (Whyte & Mackey), etc. For most businesses and personal transactions, the rupee is practically fully convertible, i.e. no permission from RBI is required to convert rupee to forex or vice versa. Capital account transactions on which only part convertibility is allowed i.e certain ceilings have been imposed, or prior approval of RBI has to be taken, include, financial capital transfers abroad, external commercial borrowings, opening up of subsidiaries abroad, etc. However, considering the excess capital inflows, in cases where specific permission is required for certain transactions or for transactions above a certain ceiling, it is generally easily available. <b>Why capital account transactions cannot be completely liberalized ?</b> It is very difficult for Government of India to give unrestricted freedom to local residents to convert their domestic bank deposits and savings into any foreign exchange and invest outside India, as there is a risk of outflow of domestic savings if return on investment is attractive in that foreign market. This capital flight will leave less funds available in domestic financial market for Government borrowings (as on 1.4.2007, Government borrowings were Rs 16 lakh crore, which is about 61.5% of GDP at constant prices!) and may cause financial vulnerability to the country. Moreover, external Short-term Commercial Borrowings (SCBs), if completely liberalized, will pose exchange rate volatility problem and will increase speculative activity in the foreign exchange market. The exchange rate will be affected every time the SCBs are availed or repaid and since the tenure is below one year, the exchange rates will fluctuate between very short periods of time. Banks may use 1-month SCBs to manipulate the forex market. <b>The other side - why capital account convertibility should be liberalized ?</b> India’s need of FDI: The inflow of foreign equity capital can be in the form of portfolio flows (shares) or foreign direct investments (FDI). Whereas FIIs (Foreign Institutional Investors) mainly deal in financial markets (e.g. stock markets), FDI tends to be associated with transfer of technology, infusion of management, supply chain practices, etc. In that sense, FDI has greater impact on growth. In India, policies for capital inflow for portfolio investments are much more liberal, but the same cannot be said for FDI. To achieve 10 percent growth, country needs huge funds, which cannot be met from domestic sources. Foreign investment will be essential to support this growth. However, foreign inflows will come, only if there is adequate convertibility freedom on outflow of the domestic currency as well, i.e. full capital account convertibility from rupee to dollar would be a prerequisite to attract the much needed huge FDI inflows. Allowing domestic companies to invest abroad: India has a comfortable foreign exchange reserve of US $ 222 billion as on 20.7.2007. The level of reserves well exceeds India’s overall external debt of US $ 142.66 billion as of December 2006. However, maintaining high forex reserves has a cost. To absorb dollar inflows, RBI has to supply Indian rupees. RBI borrows these funds from the domestic financial market. The surplus dollar reserves are invested in US treasury bonds to earn interest, which is generally less than the interest paid for domestic borrowing. The difference is the cost, which RBI bears for holding the reserve, which is known as “quasi fiscal cost”. In case capital account convertibility is liberalized, domestic companies/individuals can utilize these surplus reserves to invest outside India, capitalise on global investment opportunities and maximize return on investment, which in turn will provide opportunity to bring in greater returns for the country. <b>Efficiently managing exchange rate, liquidity and export competitiveness</b> Recently, we have seen huge inflows on capital account from FIIs and in the form of FDI. RBI has been absorbing the excessive dollar inflows to stabilize the exchange rate. Without such actions by RBI, exports would be hit due to the appreciating rupee. On the other hand, absorbing dollar inflows by RBI releases rupees in the financial system, leading to inflationary pressure. During the recent past, when inflation was shooting up, RBI, in order to contain excessive liquidity in the system, did not absorb excess dollar inflows, which led to strengthening of the rupee (from Rs 44/US$ in March 2007 to Rs 40.24 /US$ in July 2007). Rupee appreciation is good for importers but it is bad for exporters as they realize lesser amount in terms of rupee for the same dollars, rendering them incompetitive. In such a scenario, it is advisable that capital convertibility norms be further liberalized as there is apparently no threat on forex reserves and at the same time it will improve export competitiveness. <b>Prerequisites for Full Capital Account Convertibility (FCAC)</b> Removing restrictions on Capital Account Convertibility and allowing free inflow of dollars and outflow of rupees will increase trade and foreign investments in the country and integrate domestic financial market with global markets. However, at the same time, it is fraught with risk. Exchange rates should be ideally based on the true economic fundamentals and should protect both, exports and imports. FCAC will remove restrictions from all dollar inflows and outflows. Capital flows from FIIs and through FDIs can happen both ways and can potentially destabilize exports, imports as well as the economy. Following are the necessary prerequisites, which should be considered before going in for FCAC. Reduction of Government dependence on domestic funds: The domestic liabilities of the Centre as a percentage of GDP, which were 45.4% in 1996-97, increased to 60.3% in 2005-06. The combined domestic liabilities of the Centre and States rose from about 56% of GDP in 1996-97 to an estimated 79% of GDP in 2005-06. Moreover, the current repayments are financed by fresh borrowings. At present, the Government has access to funds as it controls the domestic financial system through the public sector banks. FCAC will give freedom to the domestic banks (both PSUs and multinational banks) to invest in global markets. They will invest in the financial markets where they get maximum returns. In such a scenario, the availability of funds will become restricted for the Government. Hence, before going for FCAC, Government should reduce its dependence on domestic borrowings. The Tarapore Committee report on FCAC suggests that the revenue deficit should be nil by 2009 and a surplus fund should be created in order to pay back the borrowings. Manageable interest rate regime, another aspect of Rupee borrowings by Government: High domestic borrowings by Government create demand pressure on the rupee, resulting in higher interest rates. At present, due to high foreign capital inflows, the liquidity in the market is high, as RBI absorbs dollars and supplies rupees in return. This surplus liquidity in the system keeps interest rates under check. There is a possibility that net foreign inflows may reduce due to FCAC regime, as there will be no restriction on forex outflows. In such a case, high borrowing by the Government may shoot up interest rates. Therefore, before going for FCAC, high borrowing by the Government should be controlled in order to avoid risk of high interest rates. Moderate levels of inflation: Inflation should be managed at moderate levels (according to Tarapore Committee report 2006, it should be in 4-5% range), before introducing full convertibility of rupee. High inflation in domestic market will lead to higher prices rendering exports uncompetitive. This will have an aggravating impact on current account deficit. Going for full convertibility without comfortable current account balance (i.e. a surplus of exports of goods and services over imports) will put the country’s forex reserves at risk as inflows/outflows on capital account may be very volatile depending upon global financial sentiments. Development of domestic financial systems and integration with world markets: In the case of FCAC, RBI will have minimal role in regulating forex inflows and outflows. In such a case, both inflows and outflows could be highly volatile, as various investment opportunities will emerge in domestic as well as foreign markets. The financial system in India should be technologically advanced and should have adequate infrastructure so that it can be integrated with global financial markets and will be able to handle huge inflows and outflows. The domestic market should be mature & competent enough to take benefit of all these developments. <b>Epilogue</b> The mainstream view holds that capital account liberalization can be beneficial, when countries move in tandem with a strong macroeconomic policy framework, sound financial system and markets, supported by prudent regulatory and supervisory policies. The risks of FCAC arise mainly from inadequate preparedness before liberalization in terms of domestic and external sector policy consolidation, strengthening of regulation and development of financial markets, including infrastructure. Most currency crises arise out of prolonged overvalued exchange rates due to surplus capital flows, which later get reversed, leading to unsustainable current account deficits as these capital inflows bring down the exchange rates, affecting exports. It would be desirable to consider a gradual liberalization of capital account convertibility for resident corporate/business entities, banks, non-banking financial institutions and individuals. Please send your comments, suggestions and feedback to <a href=mailto:agarwalv@iocl.co.in class=normallink>agarwalv@iocl.co.in</a>
New Delhi 17-Aug-2007
The formal regime of capital account convertibility, when in place, will allow all residents-companies or individuals or other entities to invest, disinvest or transact in any asset/liability of any country, convert one currency to another or move funds anywhere in the world, according to their choice, subject to legal restrictions of those countries. This would mean the foreign exchange (forex) reserves of India can be utilized by any resident/non-resident without any restriction i.e. the foreign currency can be brought into India and be freely converted into rupees. Also the Indian rupee can be converted into any foreign currency and taken out of India by any resident/non-resident without taking any prior approval/permission. <b>Current scenario </b> Buoyed by very comfortable forex build up and strong GDP growth, the capital account transactions have been liberalized to a great extent over the years. This has facilitated, amongst other things, global acquisitions by Indian companies viz., Tata (Corus), Hindalco (Novalis), Kingfisher (Whyte & Mackey), etc. For most businesses and personal transactions, the rupee is practically fully convertible, i.e. no permission from RBI is required to convert rupee to forex or vice versa. Capital account transactions on which only part convertibility is allowed i.e certain ceilings have been imposed, or prior approval of RBI has to be taken, include, financial capital transfers abroad, external commercial borrowings, opening up of subsidiaries abroad, etc. However, considering the excess capital inflows, in cases where specific permission is required for certain transactions or for transactions above a certain ceiling, it is generally easily available. <b>Why capital account transactions cannot be completely liberalized ?</b> It is very difficult for Government of India to give unrestricted freedom to local residents to convert their domestic bank deposits and savings into any foreign exchange and invest outside India, as there is a risk of outflow of domestic savings if return on investment is attractive in that foreign market. This capital flight will leave less funds available in domestic financial market for Government borrowings (as on 1.4.2007, Government borrowings were Rs 16 lakh crore, which is about 61.5% of GDP at constant prices!) and may cause financial vulnerability to the country. Moreover, external Short-term Commercial Borrowings (SCBs), if completely liberalized, will pose exchange rate volatility problem and will increase speculative activity in the foreign exchange market. The exchange rate will be affected every time the SCBs are availed or repaid and since the tenure is below one year, the exchange rates will fluctuate between very short periods of time. Banks may use 1-month SCBs to manipulate the forex market. <b>The other side - why capital account convertibility should be liberalized ?</b> India’s need of FDI: The inflow of foreign equity capital can be in the form of portfolio flows (shares) or foreign direct investments (FDI). Whereas FIIs (Foreign Institutional Investors) mainly deal in financial markets (e.g. stock markets), FDI tends to be associated with transfer of technology, infusion of management, supply chain practices, etc. In that sense, FDI has greater impact on growth. In India, policies for capital inflow for portfolio investments are much more liberal, but the same cannot be said for FDI. To achieve 10 percent growth, country needs huge funds, which cannot be met from domestic sources. Foreign investment will be essential to support this growth. However, foreign inflows will come, only if there is adequate convertibility freedom on outflow of the domestic currency as well, i.e. full capital account convertibility from rupee to dollar would be a prerequisite to attract the much needed huge FDI inflows. Allowing domestic companies to invest abroad: India has a comfortable foreign exchange reserve of US $ 222 billion as on 20.7.2007. The level of reserves well exceeds India’s overall external debt of US $ 142.66 billion as of December 2006. However, maintaining high forex reserves has a cost. To absorb dollar inflows, RBI has to supply Indian rupees. RBI borrows these funds from the domestic financial market. The surplus dollar reserves are invested in US treasury bonds to earn interest, which is generally less than the interest paid for domestic borrowing. The difference is the cost, which RBI bears for holding the reserve, which is known as “quasi fiscal cost”. In case capital account convertibility is liberalized, domestic companies/individuals can utilize these surplus reserves to invest outside India, capitalise on global investment opportunities and maximize return on investment, which in turn will provide opportunity to bring in greater returns for the country. <b>Efficiently managing exchange rate, liquidity and export competitiveness</b> Recently, we have seen huge inflows on capital account from FIIs and in the form of FDI. RBI has been absorbing the excessive dollar inflows to stabilize the exchange rate. Without such actions by RBI, exports would be hit due to the appreciating rupee. On the other hand, absorbing dollar inflows by RBI releases rupees in the financial system, leading to inflationary pressure. During the recent past, when inflation was shooting up, RBI, in order to contain excessive liquidity in the system, did not absorb excess dollar inflows, which led to strengthening of the rupee (from Rs 44/US$ in March 2007 to Rs 40.24 /US$ in July 2007). Rupee appreciation is good for importers but it is bad for exporters as they realize lesser amount in terms of rupee for the same dollars, rendering them incompetitive. In such a scenario, it is advisable that capital convertibility norms be further liberalized as there is apparently no threat on forex reserves and at the same time it will improve export competitiveness. <b>Prerequisites for Full Capital Account Convertibility (FCAC)</b> Removing restrictions on Capital Account Convertibility and allowing free inflow of dollars and outflow of rupees will increase trade and foreign investments in the country and integrate domestic financial market with global markets. However, at the same time, it is fraught with risk. Exchange rates should be ideally based on the true economic fundamentals and should protect both, exports and imports. FCAC will remove restrictions from all dollar inflows and outflows. Capital flows from FIIs and through FDIs can happen both ways and can potentially destabilize exports, imports as well as the economy. Following are the necessary prerequisites, which should be considered before going in for FCAC. Reduction of Government dependence on domestic funds: The domestic liabilities of the Centre as a percentage of GDP, which were 45.4% in 1996-97, increased to 60.3% in 2005-06. The combined domestic liabilities of the Centre and States rose from about 56% of GDP in 1996-97 to an estimated 79% of GDP in 2005-06. Moreover, the current repayments are financed by fresh borrowings. At present, the Government has access to funds as it controls the domestic financial system through the public sector banks. FCAC will give freedom to the domestic banks (both PSUs and multinational banks) to invest in global markets. They will invest in the financial markets where they get maximum returns. In such a scenario, the availability of funds will become restricted for the Government. Hence, before going for FCAC, Government should reduce its dependence on domestic borrowings. The Tarapore Committee report on FCAC suggests that the revenue deficit should be nil by 2009 and a surplus fund should be created in order to pay back the borrowings. Manageable interest rate regime, another aspect of Rupee borrowings by Government: High domestic borrowings by Government create demand pressure on the rupee, resulting in higher interest rates. At present, due to high foreign capital inflows, the liquidity in the market is high, as RBI absorbs dollars and supplies rupees in return. This surplus liquidity in the system keeps interest rates under check. There is a possibility that net foreign inflows may reduce due to FCAC regime, as there will be no restriction on forex outflows. In such a case, high borrowing by the Government may shoot up interest rates. Therefore, before going for FCAC, high borrowing by the Government should be controlled in order to avoid risk of high interest rates. Moderate levels of inflation: Inflation should be managed at moderate levels (according to Tarapore Committee report 2006, it should be in 4-5% range), before introducing full convertibility of rupee. High inflation in domestic market will lead to higher prices rendering exports uncompetitive. This will have an aggravating impact on current account deficit. Going for full convertibility without comfortable current account balance (i.e. a surplus of exports of goods and services over imports) will put the country’s forex reserves at risk as inflows/outflows on capital account may be very volatile depending upon global financial sentiments. Development of domestic financial systems and integration with world markets: In the case of FCAC, RBI will have minimal role in regulating forex inflows and outflows. In such a case, both inflows and outflows could be highly volatile, as various investment opportunities will emerge in domestic as well as foreign markets. The financial system in India should be technologically advanced and should have adequate infrastructure so that it can be integrated with global financial markets and will be able to handle huge inflows and outflows. The domestic market should be mature & competent enough to take benefit of all these developments. <b>Epilogue</b> The mainstream view holds that capital account liberalization can be beneficial, when countries move in tandem with a strong macroeconomic policy framework, sound financial system and markets, supported by prudent regulatory and supervisory policies. The risks of FCAC arise mainly from inadequate preparedness before liberalization in terms of domestic and external sector policy consolidation, strengthening of regulation and development of financial markets, including infrastructure. Most currency crises arise out of prolonged overvalued exchange rates due to surplus capital flows, which later get reversed, leading to unsustainable current account deficits as these capital inflows bring down the exchange rates, affecting exports. It would be desirable to consider a gradual liberalization of capital account convertibility for resident corporate/business entities, banks, non-banking financial institutions and individuals. Please send your comments, suggestions and feedback to <a href=mailto:agarwalv@iocl.co.in class=normallink>agarwalv@iocl.co.in</a>