Description
Capital Account Convertibility
Capital Account Convertibility: Is India Ready?
Who needs Capital Account Convertibility?
• In 1996, 5 Asian economies (South Korea, Malaysia, Indonesia, Thailand, Philippines) received net capital inflows amounting to $93.0 bn • 1 year later, they experienced an outflow of $12.1 bn (Source: IMF, 1998), a turnaround in a single year of $105 bn, amounting to more than 10% of the combined GDP of these countries • Consequently, 3 of these economies (Indonesia, Thailand & South Korea) have been mired in severe economic crisis
Who needs Capital Account Convertibility? Who needs Capital Account Convertibility?
• Thailand and Indonesia would have been far better off restricting borrowing from abroad instead of encouraging it • Korea might just have avoided a run on its reserves if controls on short-term borrowing had kept its short-term exposure to foreign banks, say, at 30 percent, rather than 70 percent of its liabilities • Indonesia, Thailand, and Korea—were the three in the region with the least short-term controls
Flow of the Presentation
• Why/ Why not CAC? • Objectives of CAC • Concomitants • How open is India’s Capital Account?
Introduction
Tarapore Committee I & II
• India’s Performance • Adequacy of Reserves • Why Tarapore II is infeasible?
Conclusions
• How India fares ? • Capital Account and Current Account • Possible Hiccups
Why Capital Account Convertibility ?
• CAC is widely regarded as a prestige characteristic of an economy; confidence to investors • Efficient global allocation of capital • Allows risk-spreading through global diversification of portfolios • Encourages responsible macroeconomic policies at home, enhances discipline • Access to foreign capital, increasing domestic investment • Opens the gate for international savings to be invested • Catalytic effects of foreign finance such as improvements in corporate governance, other aspects of institutional quality • Reduce the size of the black economy, improves law and order, tax compliance
Why not Capital Account Convertibility ?
• Will “emerging markets” be less at risk of being flooded with foreign capital ? • Will the flows not conflict with domestic goals of inflation control and exchange rate management ? • Will sudden reversals become less likely than before ? • Will contagion across countries become less severe ? • Will more of the inflows take the form of long-term physical investments rather than short-term flows ?
Overview of Full CAC in Indian Context
• Implies freedom of currency conversion in terms of inflows and outflows • Refers to the abolition of all restrictions with respect to movement of capital from India • Ensures that all non-residents i.e. corporate and individuals would be treated equally • Freedom to convert local financial assets into foreign assets and vice-versa at market determined rates of exchange • Embodies the creation and liquidation of claims on, or by, the rest of the world • Removal of the tax benefits accorded to NRIs via special bank deposit schemes
Evolution of CAC in India
• In 1994 August, the Indian economy adopted Current Account Convertibility, on account of compulsions by the IMF
• Tarapore Committee appointed by the Reserve Bank of India in 1997, for moving towards full CAC
Present Status of CAC in India
• For Foreign Corporate and Institutions, there is reasonable amount of convertibility • For non-resident Indians, there is approximately an equal convertibility, but one accompanied by procedural and regulatory impediments • For individuals, foreigners other than PIOs, there is near zero convertibility
Objectives of CAC in the Indian Context
• To facilitate growth in the economy by minimising the cost of equity and debt capital
• To improve the efficiency of the Indian financial sector • To provide opportunities for diversification of investments
Concomitants for a move to Full CAC
• • • • • • •
Fiscal-monetary policies Exchange rate management Prudential, regulatory and supervisory safeguards Measures for development of financial markets Foreign Currency Reserves Reasonable Fiscal Deficit Controlled Inflation
How Open is India’s Capital Account ?
• India’s de facto integration with international capital markets, measures sum of external liabilities and external assets as a % of GDP • From 2000 to 2006, the integration measure shot up by nearly 26 percentage points • Nevertheless, relative position among developing economies is towards the bottom • Integration remains least among BRIC countries • Gross inflows increased from 2.1 % of GDP in 1995-1996 to 8.6% of GDP in 2007-08 ($98.1 bn) • Gross outflows increased from 0.9% of GDP in 1995-96 to 2.3% of GDP in 2007-08 ($26.0 bn)
Source: India Policy Forum, Eswar S. Prasad (2008-09)
How Open is India’s Capital Account ?
• Ratio of Gross external liabilities to GDP more reliable measure of effectiveness for developing countries • India does well on that front, middle of the pack • The RBI has eased up considerably over years • Each individual allowed to take up to $ 200,000 of capital out of India each year • FDI inflows in sectors such as retail and banking are restricted • Restrictions on participations of foreign investors in the Govt. debt market • Equity market investments permitted by registered FIIs, and through PNs (for those who do not wish to register), which remains tightly regulated
Tarapore Committee Recommendations (I)
• Gross Fiscal Deficit/GDP ratio to come down to 3.5% • The annual average rate of inflation for the previous 3 years to lie between 3-5% • Gross Non-Performing Assets of public sector banks to come down to 5% in 2000 from 13.7% in 1997 • Average Cash Reserve Ratio should come down to 3% • The Debt-Servicing Ratio to come down to 20%
Source: Tarapore Committee Report on Capital Account Convertibility in India, 1997
India’s Performance on the above criteria post-2000
I. Gross Fiscal Deficit/GDP
• Fiscal deficit to GDP ratio came below the 4% mark only in 2006-07
• Fiscal stimulus measures adopted by the Government of India in 2008-09 • Fiscal deficit to GDP ratio increased to 6.8%, highest
since 1998-99 • India has performed poorly on the fiscal front • Target of 3.5% deficit set out accomplished only once
Source: dbie.rbi.org.in, Indiastat.com/economy
India’s Performance on the above criteria post-2000
II. Gross NPAs – Public Sector Banks
• Gross NPAs of public sector banks have been on a decline • The NPAs came below the 5% mark only in 2004-05 • However, the gross NPAs of these banks have come down remarkably since 2000-01 • This criteria is steady to consider India’s readiness towards full CAC
Source: dbie.rbi.org.in, Indiastat.com/economy
India’s Performance on the above criteria post-2000
III.
Average Effective CRR
• Lowest level of average CRR in the year 2003-04, at 4.5% • The average CRR well above the Tarapore committee’s prescribed limit of 3% • Only in the year 2009-10 CRR came down drastically due to fears of the slowdown • Still remains higher than the floor • This criterion not met while evaluating India’s readiness
Source: dbie.rbi.org.in, Indiastat.com/economy
India’s Performance on the above criteria post-2000
IV.
Debt-Servicing Ratio
• Debt servicing ratio has never touched the required 20% limit set by the Tarapore committee • More or less hovered in a similar range
V.
Average Inflation
• From 1997-2000, the average inflation rate decreased continuously from 5.6% to 4.5% • However, since 1999-2000, the average inflation rate has hovered above the 5% limit
Source: dbie.rbi.org.in, Indiastat.com/economy
Adequacy of Reserves
• Helps in gauging an economy’s ability to withstand external shocks • India now has a foreign reserve base of $283.6 billion • Present import cover is of more than 14 months, which is way above the prescribed ‘safe’ level of 6 months • Reserves/Debt-Service ratio has also shot up from 0.5 to 7.2 over the period, • India’s total foreign reserves well exceed India’s overall external debt. Source: rbi.org.in
Tarapore Committee II: Recommendations
• The sequential full Capital Account Convertibility to be adopted in three phases: 2006-07 (Phase-I), 2007-09 (Phase-II) and 2009-10 and 2010-11 (Phase-III) • FIIs to be banned from investing fresh capital through the issue of fresh Participatory Notes • PNs to be gradually phased out • Industrial houses to be allowed and encouraged to set up banks • Discriminatory tax treaties (such as Double Tax Avoidance Treaty or DTAA) to be abolished, since they are incompatible with the concept of Capital Account Convertibility
Source: Tarapore Committee Report on Capital Account Convertibility in India, 2006
Tarapore Committee II: Recommendations
• For resident corporates, the ceiling for financial capital transfer abroad to be relaxed from 25% of their net worth • External Commercial Borrowing limit per annum to be increased • Ceiling for loans and borrowings by resident banks from overseas banks to be relaxed from 25% of their unimpaired tier-I capital
Source: Tarapore Committee Report on Capital Account Convertibility in India, 2006
Why Tarapore Committee II Recommendations remain Infeasible ?
• P-notes formed approximately 55% component of FIIs in 2007 • Even as the government attempted phasing out PNs, a mere rumour resulted in a stock market crash • DTAA needed to promote International trade; serious repercussions expected in exports if CAC not implemented simultaneously • ECB limit increased to $500 million more in response to the liquidity crunch; present government thinking of rolling back this increased ceiling
Source: “Why capital Account Convertibility in India is Premature” Williamson (2006) Economic Times: 10 December 2009
Possible Hiccups
Possible Hiccups
• Effect of a financial crisis on the Indian economy with full capital account convertibility difficult to predict • Global problems directly impacted domestic economies with full CAC • Argument of diversification of risk – benefits minority • Examples of Ireland and Iceland not very encouraging • No clarity regarding regulatory measures required to prevent abuse • Speculators known to move markets recklessly and increase the risk for common investors • Possibility of misallocation of capital inflows • Open capital account may lead to the export of domestic savings • Entry of foreign banks can create an unequal playing field • Full CAC exposes an economy to extreme volatility on account of “hot money” flows
Source: Capital Account Convertibility and Risk management in India”, Amadou N.R.Sy, IMF Working Paper WP/07/251
Isn’t Capital Account liberalization a natural follow up to Current Account Convertibility?
• Markets for goods and services operate with a certain degree of efficiency and predictability
• Financial markets are fundamentally different • Asymmetric information combined with implicit insurance; excessive lending • Mismatch between short-term liabilities and longterm assets; vulnerability to bank runs and panic • Herd behaviour results in excess volatility and contagion effects • Asset values determined by expectations about future returns, dynamics of asset prices can be rich, exhibiting bubbles
Conclusion
How has India fared ?
• Seems to have taken a convoluted approach • Capital account has become open, but also government controls (sometimes as modest as registration requirements) • Part of a cautious and calibrated strategy – reducing vulnerability to crisis • Favourable outcome in benefit – risk tradeoff • Caution appreciated in relation to global financial turmoil and limited impact • Allowed India to maintain a stable exchange rate • Constrained independence of monetary policy, harder to manage inflationary pressure
Conclusion
• Advancing to fuller convertibility of currency may benefit the capital markets by bringing in cheaper capital • India’s financial integration still in its nascent stage, possibility of a financial/currency crisis cannot be ruled out • The recent global meltdown calls for cautious moves • Rigorous regulatory and monitoring body required to prevent disruption in the capital markets India is not yet ready for full Capital Account Convertibility, but it should prepare a robust roadmap for adopting CAC in future.
Conclusion
• Exhaustive studies prove that full CAC by itself does not make a country a more attractive investment destination • More important parameters are a strong financial sector and fiscal rectitude • These are exactly the signposts that the Tarapore committee has advocated • Full CAC is not an ‘end’, it is only a means for achieving a broader set of macroeconomic reforms • With difficult signposts, it is unlikely that India will move towards fuller convertibility by adhering to timelines
The value of the Tarapore committee report might well lie in its emphasis on crucial procedural and macroeconomic issues, rather than full CAC per se
References
• • • • • dbie.rbi.org.in Indiastat.com/banksandfinancialinstitutions/3/stats.aspx rbi.org.in Indiastat.com/economy Tarapore Committee Report on Capital Account Convertibility in India, 2006 Why capital Account Convertibility in India is Premature, Williamson (2006) Capital Account Convertibility and Risk management in India, Amadou N.R.Sy, IMF Working Paper WP/07/251 www.financialexpress.com/news/pns-lose-sheen-fall-to-15.55-offiis-assets-under-mgmt/490789/ Economic Times: 10 December 2009
•
• • •
doc_483023536.pptx
Capital Account Convertibility
Capital Account Convertibility: Is India Ready?
Who needs Capital Account Convertibility?
• In 1996, 5 Asian economies (South Korea, Malaysia, Indonesia, Thailand, Philippines) received net capital inflows amounting to $93.0 bn • 1 year later, they experienced an outflow of $12.1 bn (Source: IMF, 1998), a turnaround in a single year of $105 bn, amounting to more than 10% of the combined GDP of these countries • Consequently, 3 of these economies (Indonesia, Thailand & South Korea) have been mired in severe economic crisis
Who needs Capital Account Convertibility? Who needs Capital Account Convertibility?
• Thailand and Indonesia would have been far better off restricting borrowing from abroad instead of encouraging it • Korea might just have avoided a run on its reserves if controls on short-term borrowing had kept its short-term exposure to foreign banks, say, at 30 percent, rather than 70 percent of its liabilities • Indonesia, Thailand, and Korea—were the three in the region with the least short-term controls
Flow of the Presentation
• Why/ Why not CAC? • Objectives of CAC • Concomitants • How open is India’s Capital Account?
Introduction
Tarapore Committee I & II
• India’s Performance • Adequacy of Reserves • Why Tarapore II is infeasible?
Conclusions
• How India fares ? • Capital Account and Current Account • Possible Hiccups
Why Capital Account Convertibility ?
• CAC is widely regarded as a prestige characteristic of an economy; confidence to investors • Efficient global allocation of capital • Allows risk-spreading through global diversification of portfolios • Encourages responsible macroeconomic policies at home, enhances discipline • Access to foreign capital, increasing domestic investment • Opens the gate for international savings to be invested • Catalytic effects of foreign finance such as improvements in corporate governance, other aspects of institutional quality • Reduce the size of the black economy, improves law and order, tax compliance
Why not Capital Account Convertibility ?
• Will “emerging markets” be less at risk of being flooded with foreign capital ? • Will the flows not conflict with domestic goals of inflation control and exchange rate management ? • Will sudden reversals become less likely than before ? • Will contagion across countries become less severe ? • Will more of the inflows take the form of long-term physical investments rather than short-term flows ?
Overview of Full CAC in Indian Context
• Implies freedom of currency conversion in terms of inflows and outflows • Refers to the abolition of all restrictions with respect to movement of capital from India • Ensures that all non-residents i.e. corporate and individuals would be treated equally • Freedom to convert local financial assets into foreign assets and vice-versa at market determined rates of exchange • Embodies the creation and liquidation of claims on, or by, the rest of the world • Removal of the tax benefits accorded to NRIs via special bank deposit schemes
Evolution of CAC in India
• In 1994 August, the Indian economy adopted Current Account Convertibility, on account of compulsions by the IMF
• Tarapore Committee appointed by the Reserve Bank of India in 1997, for moving towards full CAC
Present Status of CAC in India
• For Foreign Corporate and Institutions, there is reasonable amount of convertibility • For non-resident Indians, there is approximately an equal convertibility, but one accompanied by procedural and regulatory impediments • For individuals, foreigners other than PIOs, there is near zero convertibility
Objectives of CAC in the Indian Context
• To facilitate growth in the economy by minimising the cost of equity and debt capital
• To improve the efficiency of the Indian financial sector • To provide opportunities for diversification of investments
Concomitants for a move to Full CAC
• • • • • • •
Fiscal-monetary policies Exchange rate management Prudential, regulatory and supervisory safeguards Measures for development of financial markets Foreign Currency Reserves Reasonable Fiscal Deficit Controlled Inflation
How Open is India’s Capital Account ?
• India’s de facto integration with international capital markets, measures sum of external liabilities and external assets as a % of GDP • From 2000 to 2006, the integration measure shot up by nearly 26 percentage points • Nevertheless, relative position among developing economies is towards the bottom • Integration remains least among BRIC countries • Gross inflows increased from 2.1 % of GDP in 1995-1996 to 8.6% of GDP in 2007-08 ($98.1 bn) • Gross outflows increased from 0.9% of GDP in 1995-96 to 2.3% of GDP in 2007-08 ($26.0 bn)
Source: India Policy Forum, Eswar S. Prasad (2008-09)
How Open is India’s Capital Account ?
• Ratio of Gross external liabilities to GDP more reliable measure of effectiveness for developing countries • India does well on that front, middle of the pack • The RBI has eased up considerably over years • Each individual allowed to take up to $ 200,000 of capital out of India each year • FDI inflows in sectors such as retail and banking are restricted • Restrictions on participations of foreign investors in the Govt. debt market • Equity market investments permitted by registered FIIs, and through PNs (for those who do not wish to register), which remains tightly regulated
Tarapore Committee Recommendations (I)
• Gross Fiscal Deficit/GDP ratio to come down to 3.5% • The annual average rate of inflation for the previous 3 years to lie between 3-5% • Gross Non-Performing Assets of public sector banks to come down to 5% in 2000 from 13.7% in 1997 • Average Cash Reserve Ratio should come down to 3% • The Debt-Servicing Ratio to come down to 20%
Source: Tarapore Committee Report on Capital Account Convertibility in India, 1997
India’s Performance on the above criteria post-2000
I. Gross Fiscal Deficit/GDP
• Fiscal deficit to GDP ratio came below the 4% mark only in 2006-07
• Fiscal stimulus measures adopted by the Government of India in 2008-09 • Fiscal deficit to GDP ratio increased to 6.8%, highest
since 1998-99 • India has performed poorly on the fiscal front • Target of 3.5% deficit set out accomplished only once
Source: dbie.rbi.org.in, Indiastat.com/economy
India’s Performance on the above criteria post-2000
II. Gross NPAs – Public Sector Banks
• Gross NPAs of public sector banks have been on a decline • The NPAs came below the 5% mark only in 2004-05 • However, the gross NPAs of these banks have come down remarkably since 2000-01 • This criteria is steady to consider India’s readiness towards full CAC
Source: dbie.rbi.org.in, Indiastat.com/economy
India’s Performance on the above criteria post-2000
III.
Average Effective CRR
• Lowest level of average CRR in the year 2003-04, at 4.5% • The average CRR well above the Tarapore committee’s prescribed limit of 3% • Only in the year 2009-10 CRR came down drastically due to fears of the slowdown • Still remains higher than the floor • This criterion not met while evaluating India’s readiness
Source: dbie.rbi.org.in, Indiastat.com/economy
India’s Performance on the above criteria post-2000
IV.
Debt-Servicing Ratio
• Debt servicing ratio has never touched the required 20% limit set by the Tarapore committee • More or less hovered in a similar range
V.
Average Inflation
• From 1997-2000, the average inflation rate decreased continuously from 5.6% to 4.5% • However, since 1999-2000, the average inflation rate has hovered above the 5% limit
Source: dbie.rbi.org.in, Indiastat.com/economy
Adequacy of Reserves
• Helps in gauging an economy’s ability to withstand external shocks • India now has a foreign reserve base of $283.6 billion • Present import cover is of more than 14 months, which is way above the prescribed ‘safe’ level of 6 months • Reserves/Debt-Service ratio has also shot up from 0.5 to 7.2 over the period, • India’s total foreign reserves well exceed India’s overall external debt. Source: rbi.org.in
Tarapore Committee II: Recommendations
• The sequential full Capital Account Convertibility to be adopted in three phases: 2006-07 (Phase-I), 2007-09 (Phase-II) and 2009-10 and 2010-11 (Phase-III) • FIIs to be banned from investing fresh capital through the issue of fresh Participatory Notes • PNs to be gradually phased out • Industrial houses to be allowed and encouraged to set up banks • Discriminatory tax treaties (such as Double Tax Avoidance Treaty or DTAA) to be abolished, since they are incompatible with the concept of Capital Account Convertibility
Source: Tarapore Committee Report on Capital Account Convertibility in India, 2006
Tarapore Committee II: Recommendations
• For resident corporates, the ceiling for financial capital transfer abroad to be relaxed from 25% of their net worth • External Commercial Borrowing limit per annum to be increased • Ceiling for loans and borrowings by resident banks from overseas banks to be relaxed from 25% of their unimpaired tier-I capital
Source: Tarapore Committee Report on Capital Account Convertibility in India, 2006
Why Tarapore Committee II Recommendations remain Infeasible ?
• P-notes formed approximately 55% component of FIIs in 2007 • Even as the government attempted phasing out PNs, a mere rumour resulted in a stock market crash • DTAA needed to promote International trade; serious repercussions expected in exports if CAC not implemented simultaneously • ECB limit increased to $500 million more in response to the liquidity crunch; present government thinking of rolling back this increased ceiling
Source: “Why capital Account Convertibility in India is Premature” Williamson (2006) Economic Times: 10 December 2009
Possible Hiccups
Possible Hiccups
• Effect of a financial crisis on the Indian economy with full capital account convertibility difficult to predict • Global problems directly impacted domestic economies with full CAC • Argument of diversification of risk – benefits minority • Examples of Ireland and Iceland not very encouraging • No clarity regarding regulatory measures required to prevent abuse • Speculators known to move markets recklessly and increase the risk for common investors • Possibility of misallocation of capital inflows • Open capital account may lead to the export of domestic savings • Entry of foreign banks can create an unequal playing field • Full CAC exposes an economy to extreme volatility on account of “hot money” flows
Source: Capital Account Convertibility and Risk management in India”, Amadou N.R.Sy, IMF Working Paper WP/07/251
Isn’t Capital Account liberalization a natural follow up to Current Account Convertibility?
• Markets for goods and services operate with a certain degree of efficiency and predictability
• Financial markets are fundamentally different • Asymmetric information combined with implicit insurance; excessive lending • Mismatch between short-term liabilities and longterm assets; vulnerability to bank runs and panic • Herd behaviour results in excess volatility and contagion effects • Asset values determined by expectations about future returns, dynamics of asset prices can be rich, exhibiting bubbles
Conclusion
How has India fared ?
• Seems to have taken a convoluted approach • Capital account has become open, but also government controls (sometimes as modest as registration requirements) • Part of a cautious and calibrated strategy – reducing vulnerability to crisis • Favourable outcome in benefit – risk tradeoff • Caution appreciated in relation to global financial turmoil and limited impact • Allowed India to maintain a stable exchange rate • Constrained independence of monetary policy, harder to manage inflationary pressure
Conclusion
• Advancing to fuller convertibility of currency may benefit the capital markets by bringing in cheaper capital • India’s financial integration still in its nascent stage, possibility of a financial/currency crisis cannot be ruled out • The recent global meltdown calls for cautious moves • Rigorous regulatory and monitoring body required to prevent disruption in the capital markets India is not yet ready for full Capital Account Convertibility, but it should prepare a robust roadmap for adopting CAC in future.
Conclusion
• Exhaustive studies prove that full CAC by itself does not make a country a more attractive investment destination • More important parameters are a strong financial sector and fiscal rectitude • These are exactly the signposts that the Tarapore committee has advocated • Full CAC is not an ‘end’, it is only a means for achieving a broader set of macroeconomic reforms • With difficult signposts, it is unlikely that India will move towards fuller convertibility by adhering to timelines
The value of the Tarapore committee report might well lie in its emphasis on crucial procedural and macroeconomic issues, rather than full CAC per se
References
• • • • • dbie.rbi.org.in Indiastat.com/banksandfinancialinstitutions/3/stats.aspx rbi.org.in Indiastat.com/economy Tarapore Committee Report on Capital Account Convertibility in India, 2006 Why capital Account Convertibility in India is Premature, Williamson (2006) Capital Account Convertibility and Risk management in India, Amadou N.R.Sy, IMF Working Paper WP/07/251 www.financialexpress.com/news/pns-lose-sheen-fall-to-15.55-offiis-assets-under-mgmt/490789/ Economic Times: 10 December 2009
•
• • •
doc_483023536.pptx