Capital account convertibility has now become a popular topic of discussion, especially after Reserve Bank of India published the second Tarapore Committee Report. Capital account convertibility refers to the freedom to convert the domestic currency to any internationally accepted currency. I also mean conversion of foreign currency into the domestic currency. The issue became a topic of debate after the first Committee on Capital Account Convertibility headed by Shri. S.S. Tarapore submitted their report in 1997. The second committee on Capital Account Convertibility, headed by Shri. S.S. Tarapore again submitted their report in July 2006. A lay man raise a question “ why the capital account convertibility attracts so much discussions?
Capital account is a part of the Balance of Payment (BoP) of a country, which represents the capital inflow to the domestic economy from other parts of the world. The current account, the other part of the BoP consists of trade account also. The trade account represents the trading balance, which is the net of exports, and imports A deficit trade account indicate imports exceeding the exports. The current account is the sum total of the other receipts and payments like debt service charges, travel and tourism and other payments and the trade account. Capital account on the other hand purely shows the capital inflow and outflow to the country and abroad.
While making their recommendations, the committee studied the international experience as well. The Latin American and East Asian currency crisis gave great lessons to learn before any country opt for full convertibility. Making a currency fully convertible attracts foreign investors extensively. When the domestic capital formation is very weak, countries will depend on overseas market for funding their business operation. Essentially, these countries will be forced to keep the interest above the international rate in order to attract capital. However, such countries will be forced to bring down the interest rate in order to protect their economy, which would eventually result into a sudden capital flight and depreciation in the value of domestic currency. The Committee on CAC was aware of this imminent danger and suggested a road map in their first report.
The major suggestions of the Committee were the spreading of implementation over a period of three years, financial consolidation by reducing the fiscal deficit , separate money and debt management, fiscal transparency, inflation targeting at 3-5 per cent, consolidation in financial sector, reduction of the level of Non-performing Assets in the Banking sector to below 5 percent, reduction of CRR to below 3 percent, refining the exchange rate policy by adopting a rate band of +/-5.0 percent etc. The Committee also suggested a schedule of implementation in a phased manner covering a period from 1997-98 to 1999-2000. The second committee suggested relaxation in invest norms, prohibition of Participatory Notes ((PN), increase in the limit for remittance abroad by individuals, permission to mutual funds to invest abroad etc. and suggested a five period ending 2010-11 for implementation. Many people have expressed their reservations against going for a full convertibility in light of the East Asian currency crisis.
Though capital account convertibility enables the residence to enjoy the benefits available at overseas markets through cross border investments and borrowings, the contagious effect of a currency crisis due to the integration of markets around the world always poses a danger to the economy. The worst affected would be the capital market since the capital market around the world are highly integrated. Empirical evidences show that a movement in the international capital market will have a reflection in the domestic capital markets also. Secondly, the opening up of economy would promote heavy inflow of FII activities in the capital market and resulting into excessive bullish tendency. This tendency will attract the domestic retail investors substantially and a reverse trend on account of a sudden withdrawal of FII activities will bring substantial loss to the domestic retail investors and damage the domestic economy to a great extent. The FIIs are looking for profit and when ever they smell a sign of reversal of returns, they will take back their investments and shift to another centre from where they can earn more. Therefore, in the interest of the economy, it is advisable to permit capital account convertibility under a controlled regime than opening up the economy fully.
Capital account is a part of the Balance of Payment (BoP) of a country, which represents the capital inflow to the domestic economy from other parts of the world. The current account, the other part of the BoP consists of trade account also. The trade account represents the trading balance, which is the net of exports, and imports A deficit trade account indicate imports exceeding the exports. The current account is the sum total of the other receipts and payments like debt service charges, travel and tourism and other payments and the trade account. Capital account on the other hand purely shows the capital inflow and outflow to the country and abroad.
While making their recommendations, the committee studied the international experience as well. The Latin American and East Asian currency crisis gave great lessons to learn before any country opt for full convertibility. Making a currency fully convertible attracts foreign investors extensively. When the domestic capital formation is very weak, countries will depend on overseas market for funding their business operation. Essentially, these countries will be forced to keep the interest above the international rate in order to attract capital. However, such countries will be forced to bring down the interest rate in order to protect their economy, which would eventually result into a sudden capital flight and depreciation in the value of domestic currency. The Committee on CAC was aware of this imminent danger and suggested a road map in their first report.
The major suggestions of the Committee were the spreading of implementation over a period of three years, financial consolidation by reducing the fiscal deficit , separate money and debt management, fiscal transparency, inflation targeting at 3-5 per cent, consolidation in financial sector, reduction of the level of Non-performing Assets in the Banking sector to below 5 percent, reduction of CRR to below 3 percent, refining the exchange rate policy by adopting a rate band of +/-5.0 percent etc. The Committee also suggested a schedule of implementation in a phased manner covering a period from 1997-98 to 1999-2000. The second committee suggested relaxation in invest norms, prohibition of Participatory Notes ((PN), increase in the limit for remittance abroad by individuals, permission to mutual funds to invest abroad etc. and suggested a five period ending 2010-11 for implementation. Many people have expressed their reservations against going for a full convertibility in light of the East Asian currency crisis.
Though capital account convertibility enables the residence to enjoy the benefits available at overseas markets through cross border investments and borrowings, the contagious effect of a currency crisis due to the integration of markets around the world always poses a danger to the economy. The worst affected would be the capital market since the capital market around the world are highly integrated. Empirical evidences show that a movement in the international capital market will have a reflection in the domestic capital markets also. Secondly, the opening up of economy would promote heavy inflow of FII activities in the capital market and resulting into excessive bullish tendency. This tendency will attract the domestic retail investors substantially and a reverse trend on account of a sudden withdrawal of FII activities will bring substantial loss to the domestic retail investors and damage the domestic economy to a great extent. The FIIs are looking for profit and when ever they smell a sign of reversal of returns, they will take back their investments and shift to another centre from where they can earn more. Therefore, in the interest of the economy, it is advisable to permit capital account convertibility under a controlled regime than opening up the economy fully.
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