Capital Account Convertibility

By Swapnil B. Walunj (PGP2007)

1) What is Capital Account Convertibility?

According to the Tarapore committee set up by the Reserve Bank of India (RBI) in 1997, Capital account convertibility (CAC) refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. It is associated with 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 of today, there exists restricted capital account convertibility in our country. By this any Indian entity (individual, company or otherwise) can invest or acquire assets outside India or a foreign entity remit funds for investment or acquisition of assets with a specified `cap' on such investments and for specific purpose.

2) How is CAC different from current account convertibility?

Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. In other words, it allows residents to make and receive trade-related payments — receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts etc. In India, current account convertibility was established with the acceptance of the obligations under Article VIII of the IMF’s Articles of Agreement in August 1994

3) What if we have full Capital Account Convertibility?

A full convertibility means movement of funds in and out of India without any restrictions and `no questions asked' basis. This would mean that anybody could approach a bank and instruct it to transfer money anywhere (exception will be the restricted countries and/or the regions specified from time to time) and allow banks to receive funds from any entity from abroad for credit as per instructions of the remitter. It would also mean that a domestic individual can pay in foreign currency for purchases in India - rupee or US dollar or euro or yen will mean the same. Thus it increases one’s ability to hold his cash in foreign currency.

4) Will it make the money laundering easier? Are there any restrictions?

Making the currency fully convertible does not mean encouraging movement of money obtained from dubious means. All inflows or outflows of money are subject to know your customer (KYC) and anti-money laundering (AML) guidelines.

The remitting Bank should ensure that the remitter is KYC-compliant and the funds comply with AML guidelines. Similarly the beneficiary Bank should also ensure compliance to KYC of the recipient of the remittance.

The freedom of movement of money is now restricted to the sector and quantum. For example, the FII investment in GOI bonds is capped at $2 billion; foreign holding in any domestic entity is restricted to 74 per cent, no FDI into retail space etc. The freedom will mean that one can use legitimate rupee resources for investment in foreign country and a legitimate foreign company can acquire business in India without any restrictions on specific sector or quantum of investment.

5) How will it help Indian Rupee and Indian economy?

Since rupee is not fully convertible, it is of no value - whereas US dollar, pound sterling, euro, Singapore dollar, Malaysian ringitt, Yen etc are accepted. Rupee as a convertible currency will be accepted in a convertible as well as non-convertible country. Fuller convertibility is expected to facilitate double-digit growth through higher investment and improve efficiency in financial sector through greater competition.

6) Any potential dangers?

Following the East Asian crisis, even the most ardent votaries of CAC in the World Bank and the IMF realised that the dangers of going in for CAC without adequate preparation could be catastrophic. Since then the received wisdom has been to move slowly but cautiously towards CAC with priority being accorded to fiscal consolidation and financial sector reform above all else.

The combined deficit of the governments was 7.7% of GDP in 2005-06, one of the highest in the world. Indian law stipulates fiscal deficit must fall by 0.3 percentage points a year until 2009 and while it has shrunk recently this is due more to high growth than budget discipline. Public finances are a case in point. The country runs a revenue deficit and a high fiscal deficit, making it vulnerable to shocks when foreign capital is allowed to enter and leave freely.

7) The roadmap ahead:-

The road map, released recently, was drawn up by an expert panel appointed by the central bank and outlines a three-phase plan extending to 2010-11 to allow greater movement of capital in and out of the local currency. The panel recommended that before achieving fuller capital account convertibility the central bank needed a more transparent exchange rate policy, the government should lower its stakes in state-run banks and measures should be taken to discourage overly high investment by foreign funds.

But analysts say the panel's suggestion that government's share in state-run banks should fall to 33% from 51% will fall foul of the ruling coalition's communist allies. The communists, whose main backers are trade unions, fear loss of state control will lead to job cuts. Probably the government would make the state-run banks stronger, may be through mergers, to face competition when fuller convertibility comes in. The report also said industrial houses should be allowed to set up private sector banks.

References: 1) http://www.economictimes.com/

2) http://www.hinduonline.com/

Inflation

by, Saurabh Shukla (PGDSM-MIT)

The Inflation :
In Jan 2007 , WPI rose to 6.6% , After all the effort made by RBI did provide results in terms of bringing down inflation to 16 month low . Since last year December RBI has maintained a grip on the CRR to tackle creeping inflation which could have otherwise resulted in hyper inflation.


Some of the Key reasons :
1) The main contributor to inflation in India was prices of crude oil , Every commodity’s price get affected by crude oil price directly .
2) High liquidity in market was another key factor which encouraged consumers to spend more and result too much money chasing few goods .
3) From last couple of years lower harvest is also contributing to rising prices of food items which hit poor hard.


What can still contribute to inflation:
1) Stock Market boom : Sensex is doing fairly good and domestic and international investors will pump more money into the stock market
2) The growing confidence on India is leading to huge FDI’s , Corporate houses are very focussed on expanding their business in India and Asia
3) Crude prices are still very unstable and it is very much possible that they again start fluctuating
4) Increasing employment because of booming IT , Retail , Aviation sectors which is supplying more disposable income day by day.

So it is evident that forces will push inflation to go up again and central bank and government has to come up with concrete and long term solution to curb inflation and provide shield to common man.

Future impacts and remedies :

It will be very important for RBI to maintain the status quo in terms of its policies , Lowering the interest rates or decreasing CRR at this point of time can again give a boost to inflation.

• Inflation plays an instrumental role in Indian politics and government making , In 1998 a coalition led by the Bharatiya Janata Party (BJP) was defeated in a Delhi state election after a six-fold rise in onion prices. Given current scenario if UPA government can maintain low inflation then it will convet into a big votebank for them in coming elections.
• In februry 2007 once wheat prices rose by 12% , Indian government banned wheat export to meet the domestic demand , if inflation is under control then again the wheat export can be started.
  Manufacturing goods contribute 64% of WPI so government will also try to make sure that prices of manfactured goods remain at a stable level.
• Low inflation might send economy again into cycle of high spending and hence high borrowing.
  Downward inflation will be helpful for exporters , now they can purchase cheap goods in domestic market and sell it in international market , whereas importers might face problems because they will not be getting as much profit as they used to get earlier.
• Contrary to higher inflation where organizations tend to save cost by cutting on employees wages and firing workforce , in Low inflation scenario employment growth will be fast as it will not be very expensive for firms to recruit new resources.
  
  Overall reduced inflation has given some relief to the midle class and lower class population of India , specially in terms of food items and goods for daily use. This will be very helpful for retired people with fixed incomes because their money buys a little less each month
  
  
  
  References:
  
  1) www.economictimes.com
  2) www.rediff.com
  

Solving the Impossible Trinity

shared by Ashish Jalan (PGP 2007-09)

RAGHUVIR MUKHERJI

The government should not try to curb the flow of dollars (as debt) into India. The RBI should be relieved of its burden of controlling the exchange rate. We should introduce full capital account convertibility to ensure that the rupee can be traded anywhere, and exporters will not need to sell their dollars in India, reducing the inflationary pressure this activity currently generates, says RAGHUVIR MUKHERJI

Reams are being written about how the rising rupee is hurting exporters, and opinion is divided on whether the Government and the RBI should intervene to check the growth of the rupee vis-À-vis the dollar and other major 'hard' currencies. Since January 2007, the rupee has risen 8 per cent against the US dollar, touching a nine-year high of 40.22 last week. The rupee has also gained close to 5 per cent against the Euro, and a little more than 5 per cent against the pound sterling.

As many readers would know by now, the RBI is caught in Robert Mundell's Impossible Trinity syndrome: capital mobility coupled with fixed exchange rates and interest rate autonomy — no central bank can achieve all three simultaneously.

The RBI bravely managed to hold the INR-$ rate in the region of 44 till the middle of March but to do that it had to keep buying dollars in exchange for INR. This injected liquidity into the market, which caused inflation and reduced the impact of interest rate hikes that the RBI had introduced in the hope of containing inflation.

By the end of March, when inflation threatened to become a political issue, it let the dollar fall to 42. However, as the dollar continued to surge into India's booming economy, the RBI could not support it and it progressively plummeted to the region of 40.

This is obviously hurting India's sunrise, export-driven services sector (primarily Information Technology and Information Technology Enabled Services) which have been the poster-boys of India's post-liberalisation growth. More worryingly, it is hurting manufacturing exports, where a much larger proportion of India's citizens find employment and where India is already at a disadvantage vis-À-vis such countries as China, Taiwan and Thailand.

The Central Government and the RBI have rightly decided not to intervene heavily in the foreign exchange market. The cost of maintaining the dollar is high: a large proportion of dollars bought by the RBI are re-invested into US Treasury Bonds, where the rate of return is abysmally low: 3-5 per cent. The excess liquidity sloshing around in the economy has to be mopped up through government bonds, where again, interest has to be paid.

So, effectively, to prop up the exchange rate, the tax-payer's money is used to pay for the difference between the domestic interest rate and the rate earned by the RBI, and there is less left for much-needed public goods like schools and roads. Moreover, if the dollar continues to fall, the RBI will be hit by a much larger capital loss on its assets side.

Expensive medicine

The government has, instead, announced a slew of duty drawback measures and other incentives to help exporters. These are better targeted at small and medium enterprises who are struggling. In the latest Monetary and Credit Policy, the RBI has demonstrated that it is still worried about inflation, by again raising the Capital Reserve Ratio (CRR) by 0.5 per cent to 7 per cent. It has also wisely decided to remove the Rs 3,000-crore cap on the daily LAF (Liquidity Adjustment Facility) to mop up excess liquidity. However, as explained earlier, this is expensive medicine that diverts scarce government resources away from more vital areas.

One of the constraints of the 'impossible trinity' is capital mobility in the form of foreign direct investment (FDI). According to the RBI, in 2006-07 India had a trade deficit of $64 billion. This was offset by a surplus of $55 billion in the 'invisibles' account (including record inward remittances of $28.8 billion by Indian workers overseas), leaving a current account deficit of $9 billion.

This was offset by a surplus of $45 billion in the capital account, of which the largest component of $16 billion came as External Commercial Borrowings (ECBs) by Indian firms. The net change in reserves for the year was $36.6 billion.

As these figures prove, India's balance of payments would be negative if capital flows, powered by ECBs, were not what they were. However, a disturbing trend is that we seem to be taking this inflow of foreign capital for granted.

To check growth in ECBs, the maximum permissible rate of interest that domestic borrowers could pay on ECBs was lowered by the RBI in an earlier cycle to LIBOR+150 basis points for loans of up to five years, and LIBOR+250 basis points for loans more than five years.

Recently, the RBI imposed fresh restrictions on end-use of ECBs, mandating that all ECBs above $20 million must be used for funding expenditure in foreign exchange, and all ECBs below that will require RBI approval to be used in India. This could starve Indian firms of cheap capital available overseas, and raise the cost of capital in India.

Restrictions

Licensing and restrictions create monopolies and opportunities for exploitation. Whereas 'ring-fencing' a few critical areas such as Defence and nuclear energy is justified, the Government's proposed new security law (the National Security Exception Act) will give it overriding powers to refuse FDI in a large number of sectors (such as airports, telecom, aviation, oil exploration and pharmaceuticals) in the 'national interest'.

Apart from the repercussions on India's FDI and BoP situation that this might have, discretionary powers like these create opportunities for corruption. Placed 70 out of 163 countries (where 1 is the best) in the Transparency International Corruption Perception rankings, India's record in this area is not exactly stellar. Instead of the RBI trying to curb the flow of dollars (as debt) into India, or trying to artificially keep the exchange rate down, India's exporting community can prosper by tapping new opportunities (like contract research and manufacturing, knowledge process outsourcing, carbon trading, renewable energy and green fuels) and introducing innovations that foreign capital will bring with it.

A well-developed corporate bond market will help to reduce reliance on ECBs. SEBI is already working on this. The RBI can also become a lender to credit-worthy Indian companies in order to put its bulging corpus of foreign exchange reserves to good use and enable it to get a better return on at least a part of its reserves.

The Government's proposal to set up a special purpose vehicle with $5 billion seed capital, to give dollar-denominated loans for infrastructure-related projects in India is a step in the right direction, but more can be done in this area. Moreover, the RBI should be relieved of its burden of controlling the exchange rate, which is looking more and more like an attempt to boil the ocean. Along with this, we should introduce full capital account convertibility to ensure that the rupee can be traded anywhere, and exporters will not need to sell their dollars in India, reducing the inflationary pressure that this activity currently generates in the Indian economy.

Even if this leads to a temporary surge in the rupee, the market will correct itself, as imports increase, at no extra cost to the government. Of course, this will mean a larger market for rupees in terms of geographic reach, and one on which the RBI will have less control. But given that synthetic, non-delivery rupee futures are already trading in Dubai and Singapore, the government might as well give up what is turning out to be a losing and expensive battle.

(The author is a Senior Consultant with the Domain Competency Group of Infosys Technologies Ltd. His views are personal.)

Subprime Simplified

shared by Ateet Bansal (PGP-2007-2009)

Q1. What is a subprime loan?

A subprime loan is made to customers who typically have low credit scores and histories of payment defaults or bankruptcies. Subprime offers the opportunity for borrowers with less than ideal credit standing to gain access to funds. Borrowers use this credit to purchase homes, or finance other forms of spending such as purchasing a car, paying for living expenses, housing loan, or even paying down a high interest credit card.

However, due to the risk profile of the subprime borrower, this access to credit comes at the price of higher rates.


Q2. What is the risk to this kind of lending and borrowing arrangement?

Capital markets operate on the basic premise of risk versus reward. Investors who bet on stocks are taking a higher risk in the hope of higher returns, compared to investors who invest in risk-free government bonds, but are content with low returns.

The same goes for loans. Less creditworthy sub-prime borrowers represent a riskier investment, so lenders will charge them a higher interest rate than they would charge a regular borrower for the same loan.


Q3. What the events that can lead to a crisis in this loan segment?

Banks which lend to sub-prime customers, securitize the interest receivables from these loans, and sell the bonds to financial investors. These investors could be hedge funds, pension funds, insurance companies or any other institutional investor.

When interest rates shoot up, customers are unable to keep up with mortgage and loan repayments, and start defaulting. This means that the interest payments due on the bonds cannot be serviced.

A steep rise in the rate of sub-prime mortgage foreclosures has caused more than two dozen sub-prime mortgage lenders, including some of the biggest US sub-prime lender to fail or file for bankruptcy, threatening broader impacts on the US housing market and economy.

Ratings agency downgrades of subprime-related securities have gained momentum in recent weeks. The mounting problems could force ratings agencies to downgrade billions of dollars of mortgage securities below investment grade, a move that would in turn force many investors to sell their holdings and exacerbate the spiral of losses.


Q4. Why have are other markets been hit by the ongoing subprime loan crisis?

Anticipated defaults on subprime mortgages and tighter lending standards could combine to drive down home values, making homeowners feel less wealthy and thus contributing to a gradual decline in spending that may weaken the US economy.

Many emerging market economies are heavily dependant on the US for export revenues. A slowdown in the US economy could in turn trigger a slowdown in countries relying on it.

But even the stock markets of countries that do not export goods to US in a big way have been hit. This is because a hedge fund or any other institutional investor that has put money in mortgage- backed securities in the US is usually invested in other markets as well. So, when these funds suffer huge losses because of the subprime loan crisis, they try to offset it by booking profits in other markets.

The leveraged positions taken by these investors would suck out liquidity from the system. How much would emerging markets like India be impacted would depend on the crisis' severity