Gained in Translation on capital account convertibility

Indian Express, March 23, 2006

- Ila Patnaik

What is the current account?

The current account is where we buy and sell ordinary goods (or
services) from the rest of the world. On the current account, we
import refrigerators or export steel. On the current account, we
import insurance services, export software, receive remitances from a
sibling in England, or send money abroad to a child attending college
in New Zealand. All these are current account transactions. Today,
India has "current account convertibility" in the sense that you are
free to buy foreign exchange for the purpose of importing goods or
services. In other words the rupee is convertible on the current

What is the capital account?

A country's capital account is a statement of the money that enters or
goes out of the country on account of investment or borrowing. If an
Indian company takes a loan from an American bank, the loan shows up
as an entry in the capital account. If a UK company invests in a
factory in India, this is classified as Foreign Direct Investment
(FDI) and shows up in the capital account. When foreigners buy shares
in Indian companies their investment shows up as portfolio investment
on the capital account. These are examples of inflows of
capital. Similarly, there are examples of outward capital flows. For
example, when the Tatas purchased Tetley and Daewoo, capital from
India went abroad. A key facet of capital account convertibility is
where Indian households, and not just firms, buy assets outside the

The capital account is about our portfolios. It is where we invest in
global assets, and global portfolios invest in Indian assets. It is
about foreigners buying Indian shares, bonds, real estate, or giving
loans to Indians. Conversely, it is about global diversification for
households in India.

Today the rupee is not fully convertible on the capital account as
there exist restrictions on money that comes in to buy assets in India
or that goes out of India to acquire assets abroad. Even though we do
not have full capital account convertibility, India's capital account
has been opening up slowly and steadily since 1993.

How open is India's capital account today?

Currently there are restrictions on the capital account. There are
limits to Indian companies borrowing abroad. There are restrictions on
foreigners investing in India. For example, in some sectors such as
telecom and media there are limits on the share the foreign partner
can hold. There are also restrictions on foreigners buying shares of
Indian companies. Only foreign institutional investors (FIIs) can hold
shares in Indian companies, individuals cannot. In addition, there are
restrictions on the amount that an FII can hold.

There are many more restrictions on Indians sending money abroad
that does not have to do with importing goods or services. Purchasing
a company is allowed but limits exist on the amount that can be
sent. Global diversification of household portfolios is practically

What will full capital account convertibility do?

With full capital account convertibility, there will be no
restrictions for foreigners seeking to buy Indian assets. Conversely,
there will be no restrictions for Indian households or companies
taking rupees out or bringing foreign exchange for doing global

Who has full capital account convertibility in the world?

All mature market economies of the world have full
convertibility. Among the big economies India and China are roughly
the only places where important controls are still left.

Why is capital account convertibility desirable?

There are four sets of reasons.

First, it is good for India if foreigners come into India and invest
in Indian assets - this makes more capital available for India's
development. In economist jargon, it reduces the cost of capital. When
steel imports are made easier, steel becomes cheaper in
India. Similarly, when inflows of capital into India are made easier,
capital becomes cheaper in India. More projects become viable at a
lower cost of capital.

Second, it is good for India if Indian households are globally
diversified in their portfolios - this reduces risk and stabilises the
economy. A globally diversified equity portfolio has roughly half the
risk of an Indian equity portfolio. So the benefits are quite
large. What this means is that even when conditions are bad in India,
globally diversified households will be buoyed by offshore assets,
will be able to spend more, and thus prop up the Indian economy.

Third, if India tries to have controls on the capital account, these
are rather easy to evade through various unscrupulous means. A big
license-permit raj has been setup, but it merely achieves corruption
and inefficiency - in practice, huge amounts of capital are moving
across the border anyway. It is better for India if these transactions
happen in white money. Pushing for convertibility is about reducing
the size of the black economy. This will improve law and order, tax
compliance and corporate governance.

Fourth, and most important, convertibility induces competition against
Indian finance. Currently, Indian finance is a monopoly in
intermediating the savings of Indian households for the investment
plans of Indian firms. No matter how inefficient Indian finance is,
the households and firms do not have an alternative, thanks to capital
controls. With convertibility, Indian savings will have the choice of
moving to offshore venues, and firms will have the choice of financing
projects offshore. This will bring competition to bear on Indian
finance. Exactly as we saw with trade liberalisation, which
consequently led to lower prices and superior quality of goods
produced in India, capital account liberalisation will improve the
quality and drop the price of financial intermediation in India. This
will have repercussions for Indian GDP growth, since finance is the
`brain' of the economy.

How can capital controls be evaded?

The current account has seen sharp growth since 1991 and spectacular
growth since 2000 after which it has increased by nearly 2.5 times as
both imports and exports have risen sharply. In 2004-05, inflows and
outflows on the current account added up to $313 billion, or 48% of

As a country's trade integration with the world increases, there are
innumerable nodes through which money flows in and out. To account for
the purpose of each flow becomes difficult. For example, gems and
jewellery and software are among India's biggest exports. Who is to
say whether the true value of a polished gem is USD 100 or USD 1
million? Who is to say what is the true value of a software programme?

Indian companies have opened offices all over the world. These can be
used to show trade transactions that can be easily overinvoiced or
underinvoices. Thus, companies and individuals can now circumvent
capital controls and move money in and out of the country. As the
trade account becomes larger, there is increasing de facto capital
account convertibility, especially for those who are in the business
of importing and exporting, the lucky ones with relatives and friends
abroad and dishonest citizens who are able to engage in illegal
activites. The only ones who are hurt by capital controls are honest

What will CAC mean for Indian households and companies?

Indian households and companies will be able to freely buy and sell
rupees legally in India and abroad, to invest in foreign equity to
give loans, take loans, accept foreign investment. There will be no
questions asked when rupees are converted into dollars or yen, no
forms to fill, no limits to be adhered to. The rupee will be a hard

What are the dangers of CAC to the Indian economy?

As more money flows in and out of the country it becomes difficult to
control the price of the rupee due to the large amounts involved. This
could raise difficulties for the RBI which could have to buy or sell
larger and larger amounts of dollars if it wished to manipulate the
rupee dollar rate. It would end up building up even larger reserves
than it has currently. These create difficulties in setting interest
rates according to the needs of the Indian economy. Capital account
convertibility means that eventually the rupee has to be allowed to
become more flexible.

Then why is India opting for full capital account convertibility at
this stage?

With effective convertibility already in place for all except honest
citizens, a policy that penalises honest Indian citizens becomes
indefensible. Shifting to convertibility is, to a significant extent,
about converting the de facto to the de jure. Moreover, the case for
manipulation of the exchange rate of the rupee by the RBI is
weak. India is a strong and growing economy. When imports rise faster
than exports and not being finaced by capital flows, we are likely to
witness a weaker rupee. If the rupee were to be artificially propped
up, it would be bad policy as it would be making expensive imports
cheap and encourage their consumption. As the economy grows and
becomes larger, these mistakes would become even more expensive. These
are good times when inflation is low, when our exports and imports are
doing well, when fiscal deficits are on a path to correction and when
India has mountains of foreign exchange reserves. This is a good time
to set forth on a path to CAC.

Why is it said that the East Asian Crisis led to concerns about

Many East Asian countries experienced a massive exit of capital across
the border, based on a flight both by local citizens and by
foreigners. This is commonly interpreted as being a problem with
convertibility. However, what really happened in East Asia was
mistakes about exchange rate management. Central banks were active
manipulators of currency markets, and had run out of instruments to
sustain artificial exchange rates. When it became clear that massive
devaluations were in store, everyone ran for the exits.

The lesson of the East Asian Crisis is that central banks should not
engage in market manipulation. Attributing the crisis to convertibility
is mistaking a symptom for a cause.

What are the risks in having CAC? Where might trouble arise?

In the international experience with convertibility, the weakest link
tends to be banking. Banks have very high debt - they have a
debt-equity ratio of 20. This extreme leverage goes with extreme
risk. Slight mistakes by the CEO can lead to bankruptcy. As an
example, banks themselves generally refuse to lend to a private
company which has a debt equity ratio of more than 2.

Though the level of loans gone bad - called Non Performing Assets or
NPAs - with banks in India is not very high, it is well understood
that the incentive structure of a bank owned by the government could
be warped. A bank owned by the government knows that it will not be
allowed to go bankrupt. This is a serious problem in India, where 80%
of bank deposits are with PSU banks.

A bank could easily take on a lot of currency risk. So, for example, a
bank could borrow cheaply abroad in yen and lend at much higher
interest rates in India. Its calculations about the profits it expects
to make could go horribly wrong if the yen rupee exchange rate changes
drastically. Since the government owns these banks the foreign loans
taken by the banks are effectively loans taken by the government and
the government will stand by and honor them.

Hence, the safe thing for India to do is to move forward on all
aspects of convertibility now, but retain tight controls on the
globalisation of banking for a few years.


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