New Exchange Rate Regime & Partial and Full Convertibility | Economics Optional Notes for UPSC PDF Download

Introduction

• Capital account convertibility refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange
• India has achieved full current account convertibility long back. Since then there are demand to go for capital account convertibility. For considering this government has formed Tarapore committee. It has given some condition to introduced capital account convertibility.
• According to Tarapore committee first condition was, fiscal deficit should be less than 3.5%. However after Covid crisis there is chance of breaching this mark.
• Second condition was inflation between range of 3 to 5%. In recent few years India has achieved this target.
• Third condition was Debt servicing ratio to be reduced to 20%. Currently it is 18%. Fourth condition was NPA less than 5%. However NPA in recent few years have touched double digit.
• Fifth condition was forex reserve of more than 22 billion $. India has achieved this. India is currently sitting on 400 billion forex reserve.
• Many conditions of Tarapore committee are yet to fulfill. India should only considered capital account convertibility after fulfillment of all conditions.

The Recommendations of Tarapore committee

Tarapore committee 1

• 1997
  • Pre conditions before
  • Fiscal deficit be reduced to <3.5% of GDP
  • Deterrmines Capital Flow
  • Inflation between 3-5%
  • Determines capital flow
  • Financial strengthrning – Since, there will be greater competition to the Financial Intermediaries
  • NPA below 5%
  • CRR  < 3%
  • Weak banks should be liquidated / merged
  • Interest rate to be decontrolled (has been done)
  • Forex reserve over 22 billion $
  • Independence to RBI
  • Monitoring exchange rate band of 5% around the Real Effective Exchange Rate (REER)
  • Debt servicing ratio (debt payment (principle + interest )/ export earning) to be reduced to 20%
  • Currently 18%
• Recommended implementation in 3 years, ie till 2000 in phases
• Obviously, not done

Should be done

• Reserves of 350 billion $ , more than the 22 billion $ as per Tarapore 1 and how many of the conditions are fulfileld
• RBI has come up with schemes like Market Stabilisation Schemes in 2004
  • Alloes RBI to sell/buy securities in order to modify liquidity and sterilise inflws/outflows
  • Fiscal Deficit, Inflation, NPA
  • See Economic Bodies, Regulators
• As the Economy gets more globalised it will become harder than ever to reamin aloof
  • It also incentises use of alternative mechanisms to get around such restrictions – like Transfer Pricing by corporates
• ALL the Points written above about the general benefits of CAC

Tarapore 2–  Also on CAC

• 2006
• 5 year plan  – 3 phased
• Recommendations
  • NRI be allowed to invest in the Capital Markets
  • NRI deposits – be given tax incentives
  • Raise ceiling on ECB limits
  • Foreign corporates be allowed to invest in Indain equity and debt
  • Review of tax treaties like DTAA with Mauritius
  • Suspension of Participatory Notes
  • Consolidation of banking system – Like the 4 Ds of Economic Survey
• Conditions
  • FRBM targets
  • CAD < 3%
  • Banking Sector reforms
  • PDMA
  • Reduce Public/ RBI equity share in PSBs

Other recommendations

• Expedite and augment the Masala Bonds Market
  • Ensures that raising debt by a company does not put pressure on the BoP , unlike a conventional ECB

“Partial Capital Account Convertibility cannot serve the purpose of integrating Indian Economy with World Economy”.

• Capital account convertibility is freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. India currently have partial capital account convertibility. There are continuous demand for full capital account convertibility.
• It is said that Indian rupee is overvalued. With full capital account convertibility, exchange rate might calibrate to its actual value. It might help India to increase its export.
• Full capital account convertibility can increase flow of FDI and FPI in the economy. It will also help Indian firms to borrow at low cost from global market.
• However full capital account convertibility has some risk. It increases vulnerability of economy to shocks. There could be large capital inflow or outflow due to economic shocks. ASEAN crisis suggest that it can lead to crisis in the economy.
• It is seen that China and Japan also don’t have full capital account convertibility. However these two countries are more integrated with world than India. Thus it can be said that partial capital account convertibility is not necessary for global integration of economy.

The benefits and harms of full capital account convertibility.

Benefits of CAC

• Capital
•  availability of a larger capital stock to supplement domestic resources and thereby higher growth
•  reduction in the cost of capital and improved access to international financial markets.
• dynamic gains from financial integration. Competition is intensified among financial intermediaries and as margins are reduced there is more efficient intermediation. The quality of financial assets improves
• CAC allows residents to hold an internationally diversified portfolio which reduces the risk of income streams and wealth to domestic shocks. This also enables lower funding costs for borrowers
• FDI, FII flows and the benefits
• Vehicle Currency
  • Seigniorage benefits
• Reduces Distortion in the global allocation of savings
• Reforms
  • Sets up an incentive mechanism to carry out Economic Reforms
  • Eg Tax Reforms

Monetary policy

• Conduct of monetary policy is strengthened by the pursuit of a realistic and appropriate exchange rate policy which reflects fundamentals and is flexible enough to equilibrate the balance of payments
• t does not permit monetary policy to take on an excessive burden of the adjustment

Fiscal policy

• reducing crowding out effects in the access to fund

Cons

• Impossible trinity – Mundell
• Vulnerability to international shocks
  • India was more protected from the GFC because we did not have the CAC
• Currency volatility
  • Rangarajan: Herd instinct in the financial market which tends to exaggerate the weakness
• Higher FII means higher fx reserves have to be maintained. These fx reserves can’t be invested in India
• May cause Greater Speculation
  • Timing
  • May escalate the crisis
• As JAGDISH BHAGWATI says – Not a pre requisite for growth
  • Almost all countries including China, Japan that prospered did not have CAC
  • Remember Bhagwati did not talk about the CAC and stopped at the 5th stage
• Conditions imposed by Tarapore committee not fulfilled
• Banks may fail due to the high competition
• IMF which used to be a champion of CAC, has recently said that it should be country specific
• Malaysia could check the impact of the Asian Crisis using Capital Controls . Similalry, Iceland in 2008