November 25, 2012

MA0042 [Treasury Management] Set1 Q4

Q.4 What is capital account convertibility? What are the implications on implementing CAC?

Ans:


Capital Account Convertibility (CAC)

Capital Account Convertibility (CAC) refers to relaxing controls on capital account transactions. It means freedom of currency conversion in terms of inflow and outflows with respect to capital account transaction. Most of the countries have liberalised their capital account by having an open account, but they do retain some regulations for influencing inward and outward capital flow. Due to global integration, both in trade and finance, CAC enhances growth and welfare of country.

The perception of CAC has undergone some changes following the events of emerging market economies (EMEs) in Asia and Latin America, which went through currency and banking crises in 1990s. A few counties backtracked and re-imposed capital controls as part of crisis resolution. Crisis such as economic, social, human cost and even extensive presence of capital controls creates distortions, making CAC either ineffective or unsustainable. The cost and benefits from capital account liberalisation is still being debated among academics and policy makers. These developments have led to considerable caution being exercised by EMEs in opening up capital account. The Committee on Capital Account Convertibility (Chairman: Shri. S.S. Tarapore) which submitted its report in 1997 highlighted the benefits of a more open capital account but at the same time cautioned that CAC could pose tremendous pressures on the financial system. India has cautiously opened its capital account and the state of capital control in India is considered as the most liberalised it had been since late 1950s.

The different ways of implementing CAC are as follows:
Open the capital account for residents and non-residents.
Initially open the inflow account and later liberalise the outflow account.
Approach to simultaneously liberalise control of inflow and outflow account.

Liberalisation of current account transactions
Current account transaction refers to converting domestic currencies freely into foreign currency and vice versa. The domestic currency is said to be convertible on the current account. This is known as current account convertibility. The benefits of current account transaction are as follows:

Current account convertibility enhances the increase of capital inflow in to the country.

The confidence of a country will be enhanced when the country will manage its affairs without exchange restrictions which enhance the international confidence in the countries policies.

Relaxing the exchange restrictions has improved the Balance of Payment (BOP) in the country.

The exclusion of exchange restrictions tends to increase the capital inflows and thus promote efficient allocation of inflows to the growth of the countrys economy.

RBI has introduced more relaxations in current account transactions. The authorised dealers (ADs) have been permitted to provide exchange facilities to their customers up to specified limit without prior approval of the RBI. The liberalisation rules regarding current account transaction of RBI under FEMA 1999 are as follows:

Authorised Dealers of Category - I banks permits withdrawal of foreign exchange payments below USD 2million by the individuals and approval of Ministry of Commerce and Industry, GOI is not mandatory.

As per the Rule 4 of FEMA (current account transactions), it is mandatory to get approval of Ministry of Commerce and Industries for drawing foreign exchange remittances ,when the payment exceeds 5% on local sales and 8% increase on exports.

Liberalised remittance scheme is a facility extended to the residents of India. Under this scheme; the residents can remit in any current or capital account up to USD 2 million per financial year. This facility is only for resident individuals. The resident individuals can purchase and hold immovable property or shares or debt instrument outside India, without the prior approval of RBI. Residents can open, maintain and hold foreign currency accounts with banks outside India. The liberalised remittance scheme is not applicable for the following:

- Any purpose under Schedule I and any item under Schedule II are prohibited for remittance under Foreign Exchange Management Rules 2000.
- The resident individual cannot remit directly to Nepal, Bhutan and Pakistan.
- There can be no remittances made directly or indirectly towards countries identified as non-co-operative countries and territories by the Financial Action Task Force (FATF).
- The individuals and organisations identified and advised by the RBI as significant risk of committing terrorism are not eligible for any remittances directly or indirectly.

Liberalisation of Exchange Earners Foreign Currency (EEFC) account - EEFC account is a foreign currency account maintained by a resident individual with an authorised dealer in India. These accounts are non-interest bearing and they are used for hedging against foreign currency fluctuations by the business organisations which have exports and imports in foreign currency payments. Some of the liberalised measures in EEFC account are:

- RBI has permitted to earn interests on EEFC account if the outstanding balance is USD 1 million.
- Due to liberalisation, all categories of foreign exchange earners can avail credit in this account based on their foreign exchange earnings. RBI decides on credit and debit limits.
- If the reimbursement for an international credit card is provided in foreign exchange, it may be considered as a remittance through normal banking and the earnings can be credited to EEFC account.

Other measures
The other measure taken towards CAC is fuller capital account convertibility which is explained as follows:

Fuller Capital Account Convertibility (FCAC)
Indias cautious approach towards capital account and assessing it as a liberalisation process based on certain pre conditions has held India in good state. But with the changes that have taken place over the last two decades, India felt the need to revisit the CAC and suggested a new map towards FCAC based on current situations. RBI, in consultation with the Government of India (GOI) appointed a committee on FCAC. S.S Tarapore was the chairman of committee. The committee suggested several recommendations for the development of financial market in addition to addressing issues related to interaction of monetary policy and exchange rate management, regulation and supervision of banks, and the timing and sequencing of capital account liberalisation measures. The objectives of FCAC are as follows:

Economic growth - It facilitates economic growth through higher capital investment .This will lead to growth in employment opportunities, infrastructure development and other areas.

Improvement in financial sector - Huge capital flow into the system will lead to the improvement of financial sector which will enhance performance of the companies. This will enhance the liquidity in the system.

Diversify the investment: The diversification of investment will help ordinary people, to invest in foreign countries without restriction. This will help them to diversify their portfolio.

Risks involved in FCAC
FCAC risk arises from inadequate preparedness before liberalisation in domestic and external sector of policy consolidation, strengthening of regulation and development of financials markets. A transparent financial consolidation is necessary to reduce risk of the currency crisis. The risks are as follows:

Market risks - Markets risks like interest rate and foreign exchange risks become more complicated when financial institutions have access to new markets or securities. Participation of foreign investors in domestic market changes the working of the domestic market. For example, banks have to quote rates and take open positions in new and more volatile currencies. Likewise, the change in foreign interest rate, affects the banks interest rate and liabilities.

Credit risk: It includes a new dimension with cross border transaction. Cross border transactions introduces country risks to domestic market participants, the risk associated with economic, social, and political environment of the borrowers country. 

Risk in derivatives transaction It is very important with FCAC as derivatives transaction are main tools used in hedging risks .It includes both market and credit risk.

Liquidity risk: It includes risk in foreign currencies denominated assets and liabilities. Large flow of funds in different currencies will expose the banks to greater variations in their liquidity position and complicate their asset-liability management.

Operational risk: The difference between domestic and foreign legal rights and obligations and their enforcements is important with FCAC. Operational risk may increase with FCAC.

Limitations of FCAC
The effort of making the Indian rupee fully convertible has a number of difficulties involved in it. The limitations are as follows:
Indian industries lack competitive strength.
Lack of emphasis on the quality of labour and management practices.
Inadequate technology for industrial economy.
Absence of prudent fiscal management.
Lack of resilient exchange rate mechanism at work.
Inadequate attention on tariff reduction and the rationalisation of tax structure in the adjustment scheme.
Inflationary pressure on the economy.

Consequences of FCAC
India might face the following consequences if it implements full convertibility without adequate reform measures:
It will have to face the danger of becoming vulnerable to free movement of foreign capital, which may further worsen the macro-economic imbalances.
Though the banks and financial institutions are fully capitalized, they are not fully prepared to handle the intricacies of the fuller convertibility. Hence it is desirable to further strengthen their financial base.
The prevailing high interest rates in the economy will attract capital inflow. This will result in rupee appreciation which will affect Indian exporters.

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