CAC: Of unholy trinity and more… - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

CAC: Of unholy trinity and more…

Mar 22, 2006

Following the government’s recent notification regarding full convertibility of the capital account in the special economic zones (SEZs), hordes of banks (both domestic and foreign) have made a beeline to get their spaces reserved in these SEZs. In consultation with the government, the RBI has appointed a committee, headed by SS Tarapore (who was also the head of the earlier committee on capital account convertibility), to review the experience of various measures of capital account liberalisation in India and also set out a framework for full convertibility. Let us delve deeper into the issue and understand what this means for the Indian financial markets. However, before moving ahead, let us understand the difference between capital account convertibility and current account convertibility.

Current account convertibility enables residents to make and receive trade-related payments - receive dollars, or any other foreign currency, for export of goods and services and pay dollars (or any other foreign currency) for import of goods and services. It also allows residents to make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts. Simply put, current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans.

Capital account convertibility (CAC), as defined by the Tarapore Committee, is the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. Simply, it allows residents to convert (buy or sell) currencies to make investments into foreign shares, properties and other assets.

CAC: Path for India

The road to convertibility in India has been a calculated and gradual transition path that began in the early 1990s when the Rangarajan committee on Balance of Payments recommended the introduction of a market-determined exchange rate regime. To begin with, India achieved the current account convertibility in August 1994 by accepting Article VIII of the Articles of Agreement of the International Monetary Fund.

Then, the Tarapore Committee on Capital Account Convertibility (CAC), which was set up in May 1997, chalked out a three-stage process to achieve CAC. This process was, however, to be completed by 1999-2000. The committee had indicated certain signposts to be achieved for the introduction of capital account convertibility. The three most important of them were: fiscal consolidation, a mandated inflation target and strengthening of the financial system. Some of the key recommendations of the committee were:

  • Reduction in gross fiscal deficit from 4.5% in 1997-98 to 3.5% of GDP in 1999-2000

  • Maintain inflation for the period 1997-98 to 1999-2000 at 3% to 5%

  • Gross NPAs of the public sector banks to be brought down from 13.7% in 1997-98 to 5% by 2000

  • Average effective cash reserve ratio (CRR) to be brought down from 9.3% to 3% by 2000

Now, importantly, the point to note is that although none of the core conditions of the Tarapore committee have been met even till 2005-06, the government has gone ahead and has allowed full convertibility, even though in a partial manner. Just to put things in perspective vis-à-vis the targets indicated by the Tarapore committee:

  • Gross fiscal deficit stands at around 4.1% of GDP

  • Inflation is hovering within the range of 5% to 6%

  • Gross NPAs of the public sector banks are still around 5%

  • Average effective cash reserve ratio (CRR) stands at 5%

What CAC brings with it?

In the run-up to full capital account convertibility, the Tarapore committee had charted out a phased liberalisation of capital inflows and outflows. Some of the recommendations (Source: India Investment Centre) of the committee in this regard were:

  • Allowing Indian joint ventures/ wholly-owned subsidiaries to invest up to US$ 50 m abroad;

  • Removal of existing requirement of repatriation of the amount of investment by way of dividend within in five years;

  • Allowing exporters/exchange earners to keep 100% of their forex earnings in the exchange earners foreign currency accounts;

  • Permitting individual residents to invest in financial assets abroad up to US$ 25,000 and gradually raising the limit to US$ 50,000 and US$ 100,000;

  • Allowing mutual funds to invest in securities abroad within an overall limit of US$ 500 m in phase I, US$1 bn in phase II and US$2 bn in phase III;

  • Giving banks greater freedom to borrow and deploy funds outside India in stages;

  • Allowing foreign institutional investors' portfolio funds to be invested and repatriated without prior RBI scrutiny;

  • Allowing FIIs, non-resident Indians and foreign banks full access to forward cover for their Indian assets;

  • Permitting banks and financial institutions to participate in gold markets aboard; and

  • Withdrawing the Reserve Bank from playing the role of the government's merchant banker.

What about the ‘unholy trinity’?

Apart from the long-term benefits that CAC shall provide to investors in India, it should be noted that, if there is a financial contagion, an open capital account has the ability to throw the financial system into a state of mess. This is on the back of a financial system’s ‘unholy trinity’, according to which a country may not simultaneously have an open capital account, a fixed exchange rate and an independent domestic monetary policy. Instead, domestic macroeconomic management becomes hostage to the need to manage foreign capital flows. This might require the central bank to raise interest rates (and consequently dampen domestic credit offtake) when private capital is expected to exit the country, even for reasons that are entirely external to the domestic economy, such as a rise in interest rates elsewhere in the world.

International experience shows that the more open the country’s capital account and the more volatile the capital flows in the global economy, the more binding is the constraint on national policymakers (see what happened with policymakers in Southeast Asian countries in the 1997 financial crisis as currencies collapsed on the back of massive capital outflows – see adjacent chart). The impossibility of this trinity stems from the fact that if CAC is accepted, according to theory, you either have the choice of giving up monetary independence or giving up the stable currency objective and letting the exchange rate float freely so that monetary policy can then be directed to inflation control.

India has a managed float with no fixed rate targets for rupee movements. Daily movements are, however, watched very closely by the RBI. Our markets are relatively thin and the declared policy of the RBI is to meet temporary demand supply imbalances that arrive from time to time. The RBI’s objective is also to keep market movements orderly and ensure that there is no liquidity problem or rumour or panic induced volatility. In such a case, whether to go for full convertibility makes sense for an emerging market like India is a case that requires deeper discussion.

However, we still believe that the partial move towards full convertibility on the capital account is a step in the right direction towards aligning with the globalisation mantra that we have practiced so closely. But, once full convertibility is achieved, investors in all asset classes (debt, equity, real estate) might have to bear additional bouts of volatility as the Indian currency will then be more aligned to the world financial markets and thus be more prone to ‘jerks’ in the global system.

Equitymaster requests your view! Post a comment on "CAC: Of unholy trinity and more…". Click here!

  

More Views on News

My Latest Stock Recommendation (Fast Profits Daily)

Oct 9, 2020

How I picked an exciting stock using trends from both the commodity and equity markets.

Data is the New Oil but It's Also the New Sugar. Here's How to Fight it (Profit Hunter)

Jun 1, 2020

Is too much data hurting your quest for market beating returns?

Quantum Mutual Fund: Hum woh nahi hain (The Honest Truth)

Apr 29, 2020

Ajit Dayal on how the mutual fund industry robs you of your wealth.

This One Trigger Could Turnaround Yes Bank's Stock Price (The 5 Minute Wrapup)

Oct 16, 2019

If Yes Bank manages to do this, it could be the start of a much-needed turnaround for the bank.

Gold could Hit 40,000 Sooner Than Expected (Profit Hunter)

Aug 16, 2019

Domestic gold prices are firing on both engines now. Gold prices could touch 40,000 faster than you could imagine.

More Views on News

Most Popular

This One Smallcap Stock is a Must Have in Your Portfolio (Profit Hunter)

Nov 11, 2020

Investing in this smallcap could open doors of huge, long-lasting wealth.

This Diwali Consider Richa's #1 Stock Pick for 2021 (Profit Hunter)

Nov 13, 2020

Why I admire the approach that Richa uses to zero in on stocks with huge upside potential.

Should You Buy Gold Now? (Fast Profits Daily)

Nov 11, 2020

Pfizer has announced a vaccine for covid-19. In response, gold prices have fallen. Should you buy? Find out in this video..

Don't Let Brokerages Fool You into Buying HUL & Nestle. The Real Money is in These Stocks Right Now... Views On News (Views On News)

Nov 12, 2020

Rahul Shah discusses why he preferred a little known stock over Nestle Ltd and how he was proven right.

US Elections: Won a Battle, Now the War (The Honest Truth)

Nov 13, 2020

Ajit Dayal on the urgent need to fix the disparity between the rich and the poor in the US.

More

Covid-19 Proof
Multibagger Stocks

Covid19 Proof Multibaggers
Get this special report, authored by Equitymaster's top analysts now!
We will never sell or rent your email id.
Please read our Terms

MARKET STATS