Capital Account Convertibility?

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Capital Account Convertibility?

What is capital a/c convertibility?
IN the second week of March, after PM Manmohan Singh called for a relook at capital account convertibility, RBI set up a committee, headed by the former deputy governor of RBI, SS Tarapore, which will this time around present a report by July 31. This is the second report on capital account convertibility Mr Tarapore will author after the first one in ’97. A fact that often escapes attention is — China had also announced a movement towards freeing capital controls in ’97, but did not pursue it enthusiastically. Following the Asian crisis in ’97, which hit many economies in the region, the wisdom of going in pursuit of this goal was questioned. It is now widely accepted that some sort of controls ought to be in place and certain milestones are met
before opening up.

What is capital a/c convertibility?
In a country’s balance of payments, the capital account features transactions that lead to changes in the overseas financial assets and liabilities. These include investments abroad and inward capital flows. Capital account convertibility implies the freedom to convert domestic financial assets into overseas financial assets at market determined rates. It can also imply conversion of overseas financial assets into domestic financial assets. Broadly, it would mean freedom for firms and residents to freely buy into overseas assets such as equity, bonds, property and acquire ownership of overseas firms besides, free repatriation of proceeds by foreign investors.

How does easing of capital controls benefit economies?
Once a country eases capital controls, typically, there is a surge of capital flows. For countries that face constraints on savings and capital can utilise such flows to finance their investment, which in turn stokes economic growth. The inflow of capital can help augment domestic resources and boost growth. Local residents would be in a position to diversify their
portfolio of assets, which helps them insulate themselves better from the consequences of any shocks in the domestic economy. For global investors, capital account convertibility helps them to seek higher returns by sharing risks. It also offers countries better access to global markets, besides resulting in the emergence of deeper and more liquid markets. Capital account
convertibility is also stated to bring with it greater discipline on the part of governments in terms of reducing excess borrowings and rendering fiscal discipline.

What are the pitfalls of easing of capital controls?
One of the main problems an economy that has opted for a free-float has to contend with is, the prospects of outflow of what is termed as speculative short-term flows. Denomination of a substantial part of local assets in foreign currencies poses the threat of outward flows and higher interest rates, which could de-stabilise economies. The volatility in exchange and
interest rates in the wake of capital inflows can lead to unsound funding and large unhedged foreign liabilities. This is especially so for economies that go in for a free-float without following prudent macro-economic policies, and ensuring financial reforms.

How far has India moved towards capital account convertibility?
Capital account convertibility is in vogue in terms of freedom to take out proceeds relating to FDI, portfolio investment for overseas investors and NRIs besides leeway for firms to invest abroad in JVs or acquisition of assets, and for residents and mutual funds to invest abroad in stocks and bonds with some restrictions. India seems to be taking the approach that easing of
capital controls would be marked by removal of capital outflow restrictions on NRIs first, corporates next, followed by banks and freedom for residents in the last stage.

What has been the experience of some of the countries that have opted for capital account convertibility?
The initial experience has been that of an improvement in their balance of payments position. In Malaysia, Indonesia, Mexico and Argentina, the surge in capital flows meant a widening of their current accounts. Inflation was also subdued for some time and the reserves were also bolstered. But after the current account deficit could be not sustained, some of these countries
introduced some controls. Mexico and Argentina reintroduced controls in the 80s, while Chile also placed fetters after it faced a crisis between ’82 and ’89. However, all of them subsequently opened up.