The freedom to convert the local financial assets into foreign financial assets and vice-versa at market determined

rates of exchange. It is associated with the changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by the rest of the world
As per Report of the Committee on Capital Account Convertibility, RBI, 1997

Different from current account transaction

Indian citizen needs foreign exchange of smaller amounts, say $3,000, for travelling abroad or for educational purposes, she/he can obtain the same from a bank or a money-changer

Implies progressive integration of the domestic financial system with international financial flows. Regarded as one of the hallmarks of a developed economy. Signals openness of the economy Comfort factor for overseas investors. Encourages global capital flows into the country Indian businesses - access to cheaper external credit (Global rates + Country risk) - without having to ask permission of the RBI. High Risk High Gain Good Times Chance of huge inflows of foreign capital; Bad times Chance of an enormous outflow of capital Chance of export of domestic savings - for capital scarce developing countries this could curb domestic investment Exposes an economy to extreme volatility on account of hot money flows

Pros: Cons:

Increases competition and reduces inefficiency; aids price discovery Allows access to funds at global rates (plus country risk) Disciplines domestic policy and exchange rate monitoring. Integrates economy to global trade and capital flows. Capital controls ineffective with open trade, human movement. Natural direction of evolution for Developing economies (globalization)

No evidence linking improved growth to CAC (Bhagwati, Rodrik, Stiglitz) Increases vulnerability to herd behavior, contagion, sentiment. Downside exceeds upside High Risk, High/Moderate Gain. Reduces monetary, exchange rate autonomy for a nation.

The East Asian currency crisis Q2 1997- Q4 1998) - Began in Thailand. Malaysia, Indonesia, South Korea and the Philippines. Macroeconomic causes: current account imbalances with concomitant savings-investment imbalance overvalued exchange rates, high dependence upon potentially short-term capital flows. Microeconomic imprudence maturity mismatches, currency mismatches,

moral hazard behaviour of lenders and borrowers and excessive leveraging.

The Russian FX Crisis - Re-intensified capital controls and debt moratorium. CAC in 2006. The Mexican crisis -199495 - Overvalued Exchange Rate. Caused by short-term capital inflows.

Similar Crisis Brazil (post Asian Crisis), Argentina (removed peg in 2001), Turkey (1994)

Tarapore Committee setup in 1996-97 - Capital Account Convertibility (CAC) Committee favored CAC as a goal to be achieved in 3 years (by 2000) considered too aggressive target by economists (30 years avg by other liberalized nations) Established road map and benchmarks. Main issue areas: fiscal consolidation, inflation target, financial system, exchange rate management, Balance of Payments. Levels of Convertibility
Foreign Corporate Reasonably High Degree NRI Individual Full Convertibility (Tax Benefits) but with Procedural/Regulatory delays ( Non NRI Individual Near Zero Convertibility Resident Individual High Restrictions (relaxed by some extent) Resident Corporate Medium Restrictions

Targeted Parameters for CAC in 2000:

Bring down Central government fiscal deficit from 4.5% in 1997-98 to below 3.5 % of GDP by 19992000 Inflation to be reduced to World Average (3-5 % ) - RBI Key Objective should be to monitor and actively manage Inflation Financial system: CRR at 3%; Gross NPAs at 5%; Interest rate deregulation by 1998. BoP: Sustainable current account deficit; build up adequate reserves.

1997 Asian crisis major cause related to exchange rate fluctuations due notregulated capital account . Rapid surge of capital outflow (short term loans etc). Aftermath - Shift in international sentiment against CAC, Decreased IMF Focus and less pressure from USA/Developed Nations - Reduced momentum. India - Steady liberalization continued, but not at the pace or with the commitment indicated by the Tarapore Committee. Led to formation of 2nd Tarapore Committee in 2006 For FCAC (Fuller CAC). Objectives of Fuller CAC
to facilitate economic growth through higher investment by minimising the cost of both equity and debt capital; to improve the efficiency of the financial sector through greater competition, thereby minimising intermediation costs and to provide opportunities for diversification of investments by residents.

Idea was to streamline regulations

All non-residents should be treated equally Simplify rules for Residents.

Current State:
Strong BoP, High reserves. But is it enough security? Well managed floating exchange rate . Less volatility despite regulated capital flow. Increasingly efficient Financial markets. Much improved and improving, banking system. Mature Long-term government debt market, more efficient price discovery

Risks High Inflation (Compared to Global Standards) and External Debt (though under moderation and monitoring) Large fiscal deficit, High public debt - Govt focused on targeted reduction in phases. Pressure from Industry vs Uncertain Future ahead prioritization.

Dont Rush In - Despite high reserves we need to worry about inflation. Also emerging economies need to take care of Exports competitiveness. Fiscal Management - Improving the quality of public expenditure, both current and capital. Aggregate fiscal adjustment must/should occur, but this will take time. Exchange Rate Mgmt - Suggestion from Tarapore Committee Device different framework for exchange rate and monetary management. Nominal exchange rate needs to become a shock absorber, and the FX market needs to deepen. A Strong RBI - Supervision has improved; legal sanctions are stronger.RBI needs to move from a nanny to headmaster. Focus on Short Term Bank loans- RBI needs to closely monitor short term bank loan flows (an additional risk mitigation device as done in Chile in 1990s). Finally Its a Judgment Call - Gains, both signaling and substantive, could be substantial, but are the risks manageable. Conditions seem ripe to put more full-blooded CAC back on the front-burner. We are in the right direction to reach the destination. But it pays to be cautious.