CAPITAL ACCOUNT

CONVERTIBILTY & SOME ISSUES

What is Convertibility?
 CONVERTIBILITY

 Current Account convertibility: refers to currency

convertibility required in the case of transactions relating to
exchange of goods and services, money transfers and all those
transactions that are classified in the current account.

 Capital Account convertibility: refers to convertibility required

in the transactions of capital flows that are classified under the
capital account of the balance of payments.
Difference between capital and
current account

Capital Account

A capital account refers to
capital transfers and
acquisition or disposal of
non-produced, non-financial
assets. E.g. purchase/sell of
property, ownership in a
firm etc.

Capital account
convertibility allows free
movement from local
currency into foreign
currency and back.

Current Account

A current account refers to
goods and services,
income, and current
transfers. E.g. export/import
of goods and services.

Current account
convertibility allows free
inflows and outflows for all
purposes other than for
capital purposes such as
investments and loans.
 CAPITAL ACCOUNT
CONVERTIBILITY
 Freedom to residents to convert local financial assets
into foreign assets, and/or to take on foreign liabilities
and invest proceeds in India or abroad.
 Freedom to non residents to create rupee assets or
liabilities and alter them .
 In other words, I would be free to keep money in a
Swiss Bank!
 And, say, Microsoft could issue a rupee bond in the
Indian market.
 Why capital account
convertibility?

Capital account convertibility is considered to be one
of the major features of a developed economy. It
helps attract foreign investment. It offers foreign
investors a lot of comfort as they can re-convert local
currency into foreign currency any time they want to
and take their money away.

At the same time, capital account convertibility
makes it easier for domestic companies to tap
foreign markets.

Greater access for resident companies to foreign
capital and debt markets – reduce cost of capital.
 Capital Account
Transactions

FDI and FII

FDI – Foreign Direct Investment
 Asserts controlling stake with inclination to
control….a firm.

FII
 Stock Market / Securities market based investment
with no inclination to control
 Problems with CAC

During the good years of the economy, there are
huge inflows of foreign capital, but during the bad
times there is an enormous outflow of capital under
“herd behaviour”.

Misallocation of capital inflows.

Export of domestic savings.

Entry of foreign banks can create an unequal playing
field.

Full capital account convertibility exposes an
economy to extreme volatility on account of “hot
money” flows.
Recommendations by Tarapore
Committee

Raise the annual limit for the amount you are
allowed to carry on a private visit abroad from
$25000 presently to $100000.

Permission to invest into foreign stock markets up to
the extent of $25,000 in a year.

Banning the Participatory Notes to avoid/reduce
money laundering.
 Asian Crisis

Started in July 1997 in Thailand

Indonesia, South Korea and Thailand most affected

Hong Kong, Malaysia, Laos and Philippines had
second level effect

All these known as Asian Tigers
 Asian Crisis (2)


Until 1997, Asia attracted almost half of total capital
inflow to developing countries.

These economies maintained high interest rates
attractive to foreign investors.

Received a large inflow of hot money and experienced
a dramatic run-up in asset prices.

Thailand, Malaysia, Indonesia, the Philippines,
Singapore, and South Korea experienced high, 8-12%
GDP growth rates in the late 1980s and early 1990s.

This achievement was broadly acclaimed by economic
institutions including the IMF and World Bank, and was
known as part of the Asian economic miracle.
 Asian Crisis (3)

Productivity did not increase !

In 1994, Western investors lost confidence in
securities in East Asia and began to pull money out,
creating a domino effect.

Large Current Account Deficits

Large External Borrowings

Russia, Brazil and US pulled-out investments from
Asia
 Asian Crisis (4)

Role of IMF was controversial

Currencies weakened by 50% or more

Stock markets crashed by 75%

Interest Rates roofed up to 40% or even 500%

Depression

Unemployment
 IMF Views

One of the objectives of IMF is to promote CAC !

Basic objective of IMF is to bailout economies in
crisis related to BoP

IMF urged India 3 times in 2005 to be liberal on
Capital Account

Contrary Views on objectives of IMF
 Indian Approach

Partial CAC

Slow approach

Policy watch after every move

Current Account Improvements

Productivity Improvements

Democratic pressures positive