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Great Indian Story of Convertibility

Determination of fuller capital account convertibility is not based on the contemporary thinking of economists. It is essentially led by policy-makers' preferences and judgments.

Great Indian Story of Convertibility

Determination of fuller capital account convertibility is not based on the contemporary thinking of economists. It is essentially led by policy-makers’ preferences and judgments.


apital account convertibility (CAC) occupied centre stage for about six years after India announced in 1994 her readiness to accept the obligations that entail external current account convertibility. For some curious reason, the issue almost disappeared from the reforms radar till late March 2006 when prime minister Manmohan Singh asked the ministry of finance and the Reserve Bank of India (RBI) to revisit the theme of CAC. The RBI has since constituted a committee to set out a road map to fuller CAC. The composition of the committee, however, is in line with the RBI’s penchant to appoint more or less the same persons in most of the committees.1

The terms of reference of the committee are: (i) to review the experience of various measures of capital account liberalisation in India; (ii) to examine implications of fuller CAC on monetary and exchange rate management, financial markets and the financial system; (iii) to study the implications of dollarisation in India of domestic assets and liabilities and internationalisation of the Indian rupee;

(iv) to provide a comprehensive medium term operational framework, with sequencing and timing, for fuller CAC taking into account the above implications and progress in revenue and fiscal deficits of both the centre and states; (v) to survey regulatory framework in countries which have advanced towards fuller CAC; (vi) to suggest appropriate policy measures and prudential safeguards to ensure monetary and financial stability; and (vii) to make such other recommendations as the committee may deem relevant to the subject. The committee is to commence its work from May 1, 2006 and is expected to submit its report by July 31, 2006.

In this article, we shall first provide a snapshot picture of the various measures undertaken in the area of exchange management and exchange control since the publication of report of the Committee on Capital Account Convertibility in 1997 (to be henceforth referred to Tarapore I). This we believe is necessary if one were to make a determination as to whether there should be fuller capital account convertibility. We shall set out to undertake this task and then discuss the policy choices available at the present time.


It would be legitimate to expect that in the Tarapore II report, there will be discussion on the actions that have so far been taken on the recommendations of Tarapore I, but that may not by itself be interesting for two reasons. First, it is necessary to ask some searching questions as to whether the Tarapore I recommendations were in fact based on a good data base, sound empirical methodology and testing, besides analytics. Next, the economic circumstances in which the Indian economy is presently placed and the international perceptions about the need for a full CAC are very different from

Economic and Political Weekly May 13, 2006 those in the mid-1990s. It must be noted that Tarapore I was submitted at the end of May 1997, before the onset of the east Asian currency and banking crises. The east Asian crises and subsequent crises in Latin America have shown that fuller CAC is neither necessary nor sufficient for achieving higher growth and economic stability.

The terms of reference now given would require Tarapore II to collect information about relevant international experiences as well as conduct a number of econometric tests – such as sensitivity and stress tests

– besides the probability of occurrence of the expected outcomes of the measures that are theoretically recommended for implementation as part of fuller CAC and to empirically establish the realism behind the road map it is expected to recommend.

Structural reforms formed the central component of the new policy regime established in India from 1991 onwards. They focused on progressive liberalisation of the trade and payments regime particularly after the introduction of a unified exchange rate system in March 1993. Initially (i e, till early 1997), the capital account liberalisation (CAL) process began with relaxation of rules relating to foreign direct investment, portfolio investment by foreign institutional investors, access for the Indian corporate entities to overseas financial markets in the form of global depository receipts (GDRs) and foreign currency convertible bonds (FCCBs), deposits for non-resident Indians (NRIs), and access to external commercial borrowings (ECBs). In August 1994, the country accepted the obligations under Article VIII of the Articles of Agreement of the International Monetary Fund (IMF) and thus ensured that current account convertibility for both inflows and outflows was secured.2

It is important to note that once a member accepts the obligations under Article VIII, it cannot reverse its action. But India’s entry into the list of countries under Article VIII was characterised by a few unresolved issues. One of the unresolved issues related to the transfer of amortisation payments on loans by non-resident relatives. Yet another one related to the repatriation of property income of NRIs and deposits with Indian companies of NRIs and overseas corporate bodies (OCBs) that were on a non-repatriation basis. The understanding in August 1994 was that repatriation on this account would be permitted in a phased manner over a threeyear period. Current payments on advertisements in foreign television media were not permitted, a restriction that was removed only in February 2004. Again, foreign investors could repatriate dividends net of taxes on the condition that over a five-year period, an amount equivalent to the repatriated dividends is made good through export earnings, a restriction that had come to be known as “dividend balancing” and that was dispensed with after considerable pressure from foreign investors with effect from November 5, 1999.

Current account convertibility together with other reforms gave much confidence to foreign investors about the prospects of the Indian economy. Total foreign investments which were about $ 559 million in 1992-93 went up to $ 6,133 million by the close of 1996-97 – the year that was the base for the recommendations of Tarapore

I. Current account deficit as proportion of India’s GDP which was 1.7 per cent in 1992-93 was 1.2 per cent by 1996-97. Foreign exchange reserves that stood at $ 9,832 million at the end of 1992-93 moved up to $ 26,423 million.

The CAL measures taken since the submission of Tarapore I report have been substantial as could be seen from their listing in the annexure of the annual reports of the Reserve Bank of India.3 They are characterised by gradualism in that the quantitative ceilings in respect of certain items (say in respect of foreign direct investment as per cent of paid up capital of Indian corporate entities) have been increased. Gradualism could be also seen in a number of other measures where quantitative ceilings cannot be applied (as for example in regard to investments by Indian corporate bodies and resident individuals). The measures cover a wide range.

Listing out the measures in a chronological order is not attempted in this paper. Such an approach would be required if one were to know as to (i) how the process of gradualism took place and (ii) what has prompted the authorities to introduce liberalisation measures in modest doses at different points in time. Our purpose here is to have an idea of CAL that has already taken place and the main considerations that underlie them. We shall accordingly provide only a few measures for illustrative purposes.

Liberalisation of Exchange Control

The main areas of focus of CAL are:

(a) external commercial borrowings (ECBs);

  • (b) foreign investment; (c) non-resident deposits; (d) Indian corporate investments abroad; (e) relaxations given to authorised dealers and banks in India;
  • (f) transactions relating to resident Indians; and (g) others. ECBs in the Indian context should be understood to refer to loans taken from foreign markets/ entities abroad, FCCBs, leasing, floating rate notes (FRNs), trade credits and self-liquidating loans. Foreign investments cover both foreign direct investment and portfolio investments made by foreign institutional investors (FIIs). NRIs and OCBs could also take part in foreign investment besides foreign investors and firms abroad. NRIs at times get clubbed together with persons of Indian origin (PIO). Investments by Indian corporate entities would include manufacturing entities, service providers, banks and other financial institutions. Resident Indians are Indian nationals residing in India for at least six months at a stretch in a year. The residual category, namely, others include transactions relating to gold, financial markets and mutual funds.
  • The gradual approach implies steady increases in the ceilings or caps on the amounts that can be borrowed or repatriated. This is guided by the consideration that external debt should be within sustainable limits. The gradual approach also implies that countries would place restrictions on the terms and conditions of capital transactions. Ever since the east Asian crisis in 1997, countries have been cautious in incurring short-term external liabilities for the fear that increase in such liabilities would send signals to foreign investors of stress and in some cases of vulnerability to speculative attacks. Thus, for example, the ceiling for ECB in India is at present placed at $ 500 million or equivalent with a minimum average maturity of five years under the automatic route. If the average maturity is lower, say three to five years, the ceiling placed is mere $ 20 million. In respect of trade credits, the maturity period is one year, and the amounts under this category can only be up to $ 20 million.

    Keeping in view the need to reduce external debt liabilities, Indian companies have been allowed to convert ECBs into equity subject to certain conditions. Moreover, Indian companies can prepay the ECBs under the automatic route and the existing FCCBs.

    In the case of FDI, the gradual approach

    Economic and Political Weekly May 13, 2006

    in India implies not only sectoral limits but also gradual extension of items/areas where FDI is permitted. For instance, under the RBI automatic route, FDI is allowed in all activities excepting in a few items. This is the case also in respect of NRI/OCB investments. In respect of FIIs, the limits are on their aggregate investments as well as on an individual FII investment in a company. For instance, the aggregate holding of all FIIs/subaccounts of FIIs should not exceed 24 per cent of the paid up capital of a company, but this limit could be increased up to 49 per cent by the Indian company if the general body passes a resolution to that effect. The ceiling for investment by a single FII in a company is 10 per cent of the total paid up capital.

    FIIs have been given some flexibility as well as prudential support in that their total investment has been placed in terms of two components – equity and debt instruments

    – in the ratio of 70:30.

    NRI deposits have all been now rendered repatriable. Non-resident ordinary accounts, however, can be held by NRIs with residents.

    The CAL in India is also characterised by measures that broaden and strength linkages with the international markets through permissions granted to Indian companies and authorised dealers (ADs) and banks to invest abroad. In the case of ADs and banks, CAL measures have also been informed of prudential considerations as well as liquidity positions. Thus for example, Indian companies can invest in rated bonds/fixed income securities up to certain limits. They can also invest in the overseas financial sector. They can invest up to 100 per cent of their net worth by way of market purchase for investment in a foreign entity without any limit to the amount of such investment. Indian companies with overseas offices can also acquire immovable properties abroad for their business or for staff residential purposes. ADs can borrow foreign currencies from their head offices or branches or correspondents outside India up to 25 per cent of their unimpaired tier I capital or $ 10 million, whichever is higher. ADs can invest in overseas money market/debt instruments provided they are of sovereign issue with high rating and with residual maturity of less than one year. Indian banks can invest undeployed FCNR (B) funds in overseas markets in long-term fixed income securities with high ratings. The CAL measures also provided for hedging against currency risks and price risks.

    The general perception in India is that CAL measures have not taken into account the foreign exchange needs of resident Indians. This perception has arisen partly because resident Indians have been given the lowest priority in the sequencing of CAL. At present, resident Indians are given permission to remit foreign exchange for employment abroad, emigration, maintenance of close relatives abroad, education, and medical treatment. The limit in this regard is placed uniformly at $ 1,00,000 based on simple selfdeclaration. Resident employees of software companies can purchase foreign securities under the ADR/GDR linked stock option scheme up to $ 50,000 in a block of five calendar years. Residents can open, hold and maintain current accounts in foreign currency in India out of the foreign exchange acquired by them. They can also retain foreign exchange in cash or travellers cheques up to $ 2,000. They can also invest in rated bonds/fixed income securities abroad up to certain limits and under certain conditions. They can borrow interest free loans up to $ 2,50,000 from their close relatives resident outside India on repatriation basis with a maturity of over one year. Residents can hold international credit cards for use in India or abroad subject to certain regulations.

    The Future Policy Choices

    The CAL measures undertaken so far have taken care of almost all the exchange requirements of foreign investors and NRIs. One has not come across any serious complaints from foreign investors or NRIs about exchange restrictions relevant for them. The foreign exchange requirements of ADs and commercial banks and resident Indians too have been served well by the CAL measures as seen from the above listing. In general, the space between the actual amount of CAL and fuller CAC is small. India, one could argue, has almost arrived at the doorsteps of full CAC.

    This does not mean that all the areas for CAL have been exhausted. For example, one can examine the possibility of having foreign currency bonds issued by corporate entities to resident Indians – an area that has not been so far opened. Again, one can explore as to whether non-residents can participate directly in the public sector’s divestment process without any limit. Moreover, the definition of ADs itself could be widened to accommodate all India financial institutions and other financial institutions that are being closely monitored by regulators from the point of view of prudential compliance.

    One would be tempted to know as to whether this is the opportune time to declare fuller CAC. For the policy authorities, this is only one dimension of the policymaking process even though there is a general market perception that given the buoyancy of stock markets, the large foreign exchange assets, and the generally good economic prospects, full-scale CAC should be undertaken. It is, however, possible that policy authorities would deliberately choose to maintain the status quo. That is, the current gradualist approach on CAC would be continued. This policy choice could be treated as an independently determined one. Or, it could be in association with the stipulation about meeting some predetermined preconditions for implementing fuller CAC. This would imply that one could, as a matter of policy, consider having fuller CAC once the preconditions are met. Yet another policy option would be to bid goodbye to gradualism and quickly move to fuller CAC say within a few months. Finally, policy authorities could consider having a definitive road map to fuller CAC, the option that would be the subject of inquiry by Tarapore II. Laying down a road map would not, however, preclude a gradualist approach or setting up preconditions. The preconditions could be in the nature of reiteration of what had been spelt out in Tarapore I report or in the nature of additions or variations of the preconditions that were enumerated in Tarapore I report.

    None of the policy alternatives question the desirability of fuller CAC or in the least a well-stacked CAL. The theoretical stand is essentially in favour of capital account convertibility for augmenting efficiency and growth.4 Informational problems could however come in the way of efficiency but transparency practices, knowledge revolution and market regulations including risk management strategies could restrict adverse selection, moral hazard and disorderly volatility and help attain the second best.

    The empirical evidence on fuller CAC is not decisive. Countries that have liberalised capital movements along with implementation of prudential policies and sound institutional framework have

    Economic and Political Weekly May 13, 2006 posted better economic outcomes than those that did not provide supplemental policy and institutional support to capital account liberalisation. Again, countries that had CAC had to impose capital controls on indications of financial stress in order to thwart potential systemic problems.

    A Short Guide to Policy Determination

    The desirability of having fuller CAC should be viewed not merely from the point of view of the current or even estimated inflation rates, foreign exchange reserves, current account and fiscal deficits, and non-performing assets of the banking system as the preconditions approach envisages, but also from the viewpoint of the institutional framework that is being continuously improved and the potential growth of the economy based on the productivity gains arising out of adoption of new technologies. Presently, the inflation rates as reflected in the movements of the wholesale price index for all commodities are placed at around 4 per cent per annum. Foreign exchange reserves have gone beyond $ 150 billion, more than six months of average imports. The current account deficit is presently estimated to be less than 2 per cent of GDP and is consistent with the sustained growth of net capital receipts.5 Fiscal deficit of the centre is in the ball park of 4 per cent of GDP, while non-performing assets of the banking sector are steadily on the decline.

    One could argue that the outcomes on preconditions are not exactly in line with what has been recommended by Tarapore

    I.6 But recommendations about safe or desirable end-period statistics of variables considered to be critical for adoption of CAC should not be considered sacrosanct. In any case, the set of preconditions and the suggested end-period statistics for the pre-conditions are not a part of any internally consistent model in Tarapore I, a point that needs to be kept in view. Now that (a) the actual outcomes are close to the statistical magnitudes given in Tarapore I report, (b) the risk management strategies exist, and (c) the general economic situation is considered good, the determination of the timing of fuller CAC is essentially a matter of policymakers’ judgment.

    There has been considerable discussion of India’s high potential growth with almost all the estimates of growth ranging from 8 per cent to 10 per cent a year. The projections are based partly on the expected application of new technologies and on the favourable demographic dividend. Insofar as the institutional framework is concerned, one needs to view it in two parts. The first is in terms of the implementation of a number of international standards and codes in the areas of accounting, auditing, transparency practices in fiscal and monetary policies, securities regulation, insurance regulation, banking supervision and regulation, anti-money laundering, payments system and corporate governance. Transmission of assessments of compliance with the standards to the public at large would provide enormous comfort for policy-makers, and keen observers of the Indian economic scene while deciding on fuller CAC. The second part would have to do with the legal support to the institutional and policy framework and processes. There has been strengthening of the institutional framework in India in recent years, with discussions being focused on not only passing of new or amended laws but also on economic governance of all the segments of the financial sector.

    Like the national authorities, the international financial community is concerned about crisis prevention in all emerging market economies so that financial stability is secured globally. Both national and international financial communities recognise that financial stability is not guaranteed by either CAC or by capital controls.

    Does it mean that a good degree of capital mobility can coexist with exchange rate stability through intervention even when the exchange rate regime is considered flexible? The short answer is yes. Central banks may also have to satisfy themselves with some self-imposed discipline on their autonomy and independence in the conduct of monetary policy. In any case, most emerging market economies manage exchange rates. They also do not have unfettered freedom in the conduct of monetary policy. Under such an environment, establishment of fuller CAC is possible. Determination of fuller CAC in the ultimate analysis is not based on the contemporary thinking of economists: it is

    essentially led by policy-makers’ preferences and judgments.



    1 The committee to be headed by S STarapore, former deputy-governor of the RBI has members in Surjit S Bhalla, M GBhide, A V Rajwade, R H Patil and AjitRanade. Barring the last two names, theother members of the committee were members of the 1997 Tarapore Committeeon Capital Account Convertibility. Fromthe point of view of good practices of publicadministration, one would expect the officialagencies to name on their official committees, persons who have not beencurrently or in the very recent past servingon different official committees and workinggroups. For the terms of reference of thecommittee that begins its work from May1, 2006, refer to Monetary and CreditInformation Review, Volume II, Issue 9, March 2006, p 3, Reserve Bank of India,Mumbai.

    2 Article VIII of the IMF’s Articles of Agreement has seven sections. Of these theimportant ones are Section 2 dealing withavoidance of restrictions on current payments and Section 3 on avoidance ofdiscriminatory currency practices. UnderSection 2, the wording of sub-section (a)provides the obligation thus: “…no membershall, without the approval of the Fund,impose restrictions on the making of payments and transfers for current international transactions.”

    3 Report on Currency and Finance, 2002-03, Reserve Bank of India, Mumbai, 2003 provides details.

    4 The literature on capital account liberalisation is vast. For the latest on the debate on CAC see Stephany Griffith-Jones,John Williamson and Ricardo Gottschalk, ‘Should Capital Controls Have a Place inthe Future International Monetary System’in Marc Uzan (ed), The Future of the International Monetary System, Edward Elgar, Cheltenham, UK and Northampton,MA, US, 2005, pp 135-67. Also, Eichengreen, Barry and Michael Mussa,‘Capital Account Liberalisation and theIMF’, Finance and Development, December1998.

    5 The Report of the High Level Committeeon Balance of Payments (1993) under thechairmanship of C Rangarajan felt that forthe medium term, a current account deficit of 1.6 per cent of GDP can be maintainedthrough a sustained level of net capitalreceipts. See for the main contents of thereport, the Annual Report, 1992-1993, Reserve Bank of India, Mumbai, 1993, p


    6 Tarapore I report mentions a number ofpre-conditions and provides certain statistical magnitudes that need to beobserved by the terminal year (i e, at theend of three years). Here is a sample: GFD/GDP ratio for the centre should be 3.5 percent accompanied by reduction in the states’deficit and in the quasi-fiscal deficit; averageinflation rate of 3-5 per cent during thethree years ending 1999-2000; gross NPAsof the banking sector as a percentage oftotal advances to be 5 per cent by theterminal year; average effective CRR forthe banking system to be 3 per cent by1999-2000; current account receipts as apercentage of GDP to rise beyond 15 percent and the debt service ratio to be 20 percent and current account deficit to GDP ratio to be consistent with the two parameters given for current accountreceipts and debt service ratio; andinternational reserves to be not less than six months of imports.

    Economic and Political Weekly May 13, 2006

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