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Committee on Capital Account Convertibility



The Committee on Capital Account Convertibility headed by SS Tarapore, the former Deputy Governor RBI submitted wide ranging recommendations. It has prescribed a time bound programme phased between 1997-2000 at the end of which the rupee will be fully convertible. The capital account convertibility and pre-conditions has to be an on going process. As per the committee, the capital account convertibility means the freedom to convert local financial assets into foreign financial assets and vice versa at market determined exchange rates. It implies freedom to citizens to buy and sell foreign exchange and utilise it for defined purposes.

Committee has suggested certain pre-conditions in terms of:

  • (a) fiscal consolidation i.e. reduction in Central Govt.’s gross fiscal deficit to GDP ratio from budgeted 4.5% in 1997-98 to 4% in 1998-99 and 3.5% in 1999-2000 accompanied by reduction in States’ deficit as also a reduction in the quasi-fiscal deficit),
  • (b) a mandated inflationary target i.e. the mandated rate of inflation for the three year period should be an average of 3-5 % and there should be empowering of the RBI on the inflation mandate approved by Parliament and
  • (c) strengthening of financial system i.e. complete deregulation of interest rates in 1997-98 without any formal control on interest rates, average effective CRR to be reduced from 9.3% as on 31.03.97 to 8%, 6% and 3% during the aforesaid three years period. Similarly NPAs of the banks should be reduced to 5% by 1999-2000.
  • In addition, the conduct of exchange rate policy, balance of payments, adequacy of foreign exchange reserves are the macro level economic indicators that should be continuously monitored.
  • The committee envisages many advantages of more open capital account which include the availability of a larger capital stock to supplement domestic resources and thereby higher growth, reduction in the cost of capital and improved access to international financial markets. CAC allows the resident to hold an internationally diversified portfolio which reduces the vulnerability of income streams and wealth to domestic real and financial stocks, lowers funding costs for borrowers and creates prospects of higher yield for savers. Associated gains would be dynamic gains from financial integration. Allocative efficiency improves as a result and this can stimulate innovation and improve productivity. CAC provides the impetus for domestic tax regimes to rationalise and converge into international tax structures. This removes inducement for domestic agents towards evasion and capital flight.

    Apprehension and concerns

  • (a) Pre-conditions too tough to achieve
  • (b) Difficult fiscal deficit target which will result in cut-down in infrastructure investment
  • (c) Autonomy for RBI requires political consensus.
  • (d) Three year time frame too short
  • (e) Drastic reduction in NPAs will result in write-off and will cause losses for banks.
  • (f) Concept of narrow banks is impractical and will lead to closure of weak banks.
  • (g) Checks and balances needed to prevent freedom from being misused.
  • (h) Interest rates too high and will attract hot money and lead to instability.

    Pre-conditions:

  • (a) Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5% in 1997-98 to 3.5% in 1999-2000.
  • (b) A consolidated sinking fund has to be set up to meet govt.’s debt repayment needs, to be financed by increases in RBI’s profit transfer to the Govt. and disinvestment proceeds.
  • (c) Transparent and globally comparable procedures for fiscal accounting.
  • (d) Inflation rate should remain between an average 3-5 for the 3 year period 1997-2000.
  • (e) Gross NPAs of the PSBs needs to be brought down from the present 13.7% to 5% by 2000. At the same time, average effective CRR needs to be brought down from current 9.3% to 3%.
  • (f) RBI should have a monitoring exchange rate of plus minus 5% around a neutral real effective exchange rate, RBI should be transparent about the changes in real effective exchange rate (REER).
  • (g) External sector policies should be designed to increase current receipt to GDP ratio and bring down the debt servicing ratio from 25% to 20%.
  • (h) Four indicators should be used for evaluating adequacy of foreign exchange reserves to safeguard against any contingency. Plus, a minimum net foreign assets to currency ratio of 40% should be prescribed by law.
  • Narrow banks mean the banks that do not perform the full range of banking functions but focus instead on a limited range of activities. The objective of such limitation is to limit their activities so that the scope for losses is reduced.
  • Implications of CAC for the Indian Banking system: The Indian Banking system consists of an array of banks with divergent resource base, functional coverage and clientele. The public sector bans have been the mainstay of the banking system in India with a market share of about 85% of total business. Foreign banks are basically concentrated in metro/urban areas and their exposure to non-fund based / off-balance sheet items are relatively of higher magnitude than the PSBs. In terms of operational efficiency and viability, the performance of PSBs has been far from impressive. An important factor responsible for the low profitability of banks in India is the relatively high intermediation cost which varies from around 2.88% of total assets in PSBs compared with 2.5% of private sector banks.

    Given the structure of liabilities and assets of banks in India, CAC throws a number of challenges which banks have to cope with, as under:

  • (a) Convertibility exposes banks’ liabilities and assets to more price and exchange risks and banks may have to build necessary expertise to manage these risks.
  • (b) With the removal of capital controls, banks can supplement their domestic deposit base with borrowings from off-shore markets. The volatility in foreign money and capital markets could be easily transmitted to Indian banks’ balance sheets, especially so in the case of weak and fragile banks, and could prove contagious. To avoid the risks associated with the transmission of volatility of interest rates or exchange rates, adequate asset-liability management systems by banks should be put in place. Besides, technology upgradation in banks should be undertaken to help build strong risk management systems and management information systems and to pave the way for an efficient payment and settlement mechanism.
  • (c) Fluctuations in interest rates are likely to affect the cost of borrowings for emerging markets and alter the relative attractiveness of investing in these markets. Real exchange rate volatility may cause currency and maturity mismatches, creating large losses for bank borrowers.To curb the incipient insolvency leading ultimately to banking crises, a system of vigilant and alert internal control system as well as a comprehensive supervisory system should be evolved.
  • (d) A direct fall-out of CAC will be increasing pressure on the margins of banks arising partly out of greater competition and partly due to the disintermediation process with strong domestic corporate borrowers accessing world markets directly. The resultant pressure on the return on assets of the PSBs is likely to make the banking system vulnerable.

    CONVERTIBILITY
  • A currency is considered to be fully convertible if its holder can convert at any time, into gold or any other generally acceptable foreign currency at a predetermined fixed rate, without any restriction from the monetary authority. In such a situation, the currency is convertible both for affecting payment against the current transactions and capital transactions and the monetary authority fixes buying and selling prices for gold and other generally acceptable foreign currencies.
  • Full convertibility on current accounts was introduced by RBI on 19.08.94, it had taken steps like making LERMS effective from 1.3.92 and accepting during Aug 1994, the IMF Article VIII which makes it mandatory on a member to have no inward or outward restrictions on current account and trade related transactions.
  • As regards the capital account, it is a complex issue, the details of which are given as under:


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