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Capital Account Convertibility
|by Arnab Sain|
Overview of Fuller Capital Account Convertibility and the committee’s approach
Meaning of Capital Account Convertibility
The cross-country experience with capital account liberalization suggests that countries, including those which have an open capital account, do retain some regulations influencing inward and outward capital flows. The 2005 IMF Annual Report on Exchange Arrangement and Exchange Restrictions shows that while there is a general tendency among countries to lift controls on capital movement, most countries retain a variety of capital controls with specific provisions relating to banks and credit institutions and institutional investors. Even in the European Community (EC), which otherwise allows unrestricted movement of capital, the EC Treaty provides for certain restrictions.
The path to fuller capital account convertibility (FCAC) is becoming unidirectional towards greater capital account convertibility. For the purpose of this Committee, the working definition of CAC would be as follows: CAC refers to the freedom to convert local financial assets into foreign financial assets and vice versa. It is associated with 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. CAC can be, and is, coexistent with restrictions other than on external payments.
There is some literature which supports a free capital account in the context of global integration, both in trade and finance, for enhancing growth and welfare. The perspective on CAC has, however, undergone some change following the experiences of emerging market economies (EMEs) in Asia and Latin America which went through currency and banking crises in the 1990s. A few countries backtracked and re-imposed some capital controls as part of crisis resolution. While there are economic, social and human costs of crisis, it has also been argued that extensive presence of capital controls, when an economy opens up the current account, creates distortions, making them either ineffective or unsustainable. The costs and benefits or risks and gains from capital account liberalization or controls are still being debated among both academics and policy makers. The IMF, which had mooted the idea of changing its Charter to include capital account liberalization in its mandate, shelved this proposal.
These developments have led to considerable caution being exercised by EMEs in opening up the capital account. The link between capital account liberalization and growth is yet to be firmly established by empirical research. Nevertheless, 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 prudential regulatory and supervisory policies. Objectives and Significance of Fuller Capital Account Convertibility (FCAC) in the Indian Context
Following a gradualist approach, the 1997 Committee recommended a set of measures and their phasing and sequencing. India has cautiously opened up its capital account since the early 1990s and the state of capital controls in India today can be considered as the most liberalized it has ever been in its history since the late 1950s. Nevertheless, several capital controls continue to persist. In this context, FCAC would signify the additional measures which could be taken in furtherance of CAC and in that sense, ‘Fuller Capital Account Convertibility’ would not necessarily mean zero capital regulation. In this context, the analogy to de jure current account convertibility is pertinent. De jure current account convertibility recognizes that there would be reasonable limits for certain transactions, with ‘reasonableness’ being perceived by the user.
FCAC is not an end in itself, but should be treated only as a means to realize the potential of the economy to the maximum possible extent at the least cost. Given the huge investment needs of the country and that domestic savings alone will not be adequate to meet this aim, inflows of foreign capital become imperative.
The inflow of foreign equity capital can be in the form of portfolio flows or foreign direct investment (FDI). FDI tends to be also associated with nonfinancial aspects, such as transfer of technology, infusion of management and supply chain practices, etc. In that sense, it has greater impact on growth. To what extent FDI is attracted is also determined by complementary policies and environment. For example, China has had remarkable success in attracting large FDI because of enabling policies like no sectoral limits, decentralized decision making at the levels of provisional and local governments and flexible labor laws in special economic zones. By contrast, in India, policies for portfolio or Foreign Institutional Investor (FII) flows are much more liberal, but the same cannot be said for FDI. Attracting foreign capital inflows also depend on the transparency and freedom for exit of non-resident inflows and easing of capital controls on outflows by residents. The objectives of FCAC in this context are:
Some Lessons from the Currency Crises in Emerging Market Economics
The risks of FCAC arise mainly from inadequate preparedness before liberalization in terms of domestic and external sector policy consolidation, strengthening of prudential regulation and development of financial markets, including infrastructure, for orderly functioning of these markets.
In the above context, the East Asian experience and that of some other EMEs is of relevance:
Committee’s Approach to FCAC and Related Issues
In practice, the distinction between current and capital account transactions is not always clear-cut. There are transactions which straddle the current and capital account. Illustratively, payments for imports are a current account item but to the extent these are on credit terms, a capital liability emerges and with increase in trade payments, trade finance would balloon and the resultant vulnerability should carefully be kept in view in moving forward to FCAC. Contrarily, extending credit to exports is tantamount to capital outflows.
As regards residents, the capital restrictions are clearly more stringent than for non-residents. Furthermore, resident corporates face a relatively more liberal regime than resident individuals. Till recently, resident individuals faced a virtual ban on capital outflow but a small relaxation has been undertaken in the recent period. There is justification for some liberalization in the rules governing resident individuals investing abroad for the purpose of asset diversification. The experience thus far shows that there has not been much difficulty with the present order of limits for such outflows. It would be desirable to consider a gradual liberalization for resident corporates/business entities, banks, non-banks and individuals. The issue of liberalization of capital outflows for individuals is a strong confidence building measure, but such opening up has to be well calibrated as there are fears of waves of outflows. The general experience is that as the capital account is liberalized for resident outflows, the net inflows do not decrease, provided the macroeconomic framework is stable.
As India progressively moves on the path of FCAC, the issue of investments being channeled through a particular country so as to obtain tax benefits would come to the fore as investments through other channels get discriminated against. Such discriminatory tax treaties are not consistent with an increasing liberalization of the capital account as distortions inevitably emerge, possibly raising the cost of capital to the host country. With global integration of capital markets, tax policies should be harmonized. It would, therefore, be desirable that the government undertakes a review of tax policies and tax treaties.
In terms of the concomitants to FCAC, some sustainable macroeconomic indicators need to be considered. While a precise prioritization of these indicators would be difficult, the policy for macroeconomic stability widens in scope in an open economy with domestic and external market liberalization. The conventional focus on price stability and counter-cyclical monetary and fiscal policies needs to be modulated to address the issue of financial stability consistent with the objectives of FCAC.
A hierarchy of preferences may need to be set out on capital inflows. In terms of type of flows, allowing greater flexibility for rupee denominated debt which would be preferable to foreign currency debt, medium and long term debt in preference to short-term debt, and direct investment to portfolio flows. There are reports of large flows of private equity capital, all of which may not be captured in the data (this issue needs to be reviewed by the RBI). There is a need to monitor the amount of short term borrowings and banking capital, both of which have been shown to be problematic during the crisis in East Asia and in other EMEs.
Greater focus may be needed on regulatory and supervisory issues in banking to strengthen the entire risk management framework. Preference should be given to control volatility in cross-border capital flows in prudential policy measures. Given the importance that the commercial banks occupy in the Indian financial system, the banking system should be the focal point for appropriate prudential policy measures. In the absence of strong risk management policies and treasury management skills, banks may be prone to excessive risk taking. Strong prudential policies will help banks in minimizing financial risks and possible losses. These prudential measures should be applicable to both balance sheet items as also off-balance sheet items.
Management of normal flows may have to be distinguished from emergence of vulnerable situations of large inflows as also sudden cessation of inflows. Potential for large outflows also cannot be precluded under conditions of uncertainty. Major shifts in sentiments, leverage, and liquidity problems could cause major financial panics rendering shocks to the entire financial system. Broad Framework for Timing, Phasing and Sequencing of Measures.
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