Capital Account Convertibility

Until 1997, Asia attracted almost half of total capital inflow to developing countries. The economies of Southeast Asia in particular maintained high interest rates attractive to foreign investors looking for a high rate of return. As a result the region's economies received a large inflow of hot money and experienced a dramatic run-up in asset prices. At the same time, the regional economies of Thailand, Malaysia, Indonesia, the Philippines, Singapore, and South Korea experienced high growth rates, 8-12% GDP, in the late 1980s and early 1990s.

At the time Thailand, Indonesia and South Korea had large private current account deficits and the maintenance of pegged exchange rates encouraged external borrowing and led to excessive exposure to foreign exchange risk in both the financial and corporate sectors. In the mid-1990s, two factors began to change their economic environment. As the U.S. economy recovered from a recession in the early 1990s, the U.S. Federal Reserve Bank under Alan Greenspan began to raise U.S. interest rates to head off inflation. This made the U.S. a more attractive investment destination relative to Southeast Asia, which had attracted hot money flows through high short-term interest rates, and raised the value of the U.S. dollar, to which many Southeast Asian nations' currencies were pegged, thus making their exports less competitive. At the same time, Southeast Asia's export growth slowed dramatically in the spring of 1996, deteriorating their current account position. The situation that followed is better known as South Asian crisis of 1997.

In this background we will try to discuss Capital Account Convertibility and its way ahead for India.

What is capital account convertibility?

In India, the foreign exchange transactions (transactions in dollars, pounds, or any other currency) are broadly classified into two accounts: current account transactions and capital account transactions. If an Indian citizen needs foreign exchange of smaller amounts, say $3,000, for traveling abroad or for educational purposes, she/he can obtain the same from a bank or a money-changer. This is a “current account transaction”. But, if someone wants to import plant and machinery or invest abroad, and needs a large amount of foreign exchange, say $1 million, the importer will have to first obtain the permission of the Reserve Bank of India (RBI). If approved, this becomes a “capital account transaction”. This means that any domestic or foreign investor has to seek the permission from a regulatory authority, like the RBI, before carrying out any financial transactions or change of ownership of assets that comes under the capital account.

In simple language what this means is that CAC allows anyone to freely move from local currency into foreign currency and back.

Why is CAC such an emotive issue?

CAC is widely regarded as one of the hallmarks of a developed economy. It is also seen as a major comfort factor for overseas investors since they know that anytime they change their mind they will be able to re-convert local currency back into foreign currency and take out their money.

Why it's better for India to go slow. Pros and cons.

Gains from full mobility:

Those in favor of full capital account convertibility advance these arguments in its favor:

• An arbitrary (i.e. without CAC) distribution of capital among different nations is not necessarily efficient, and all countries, irrespective of whether they borrow or lend, stand to gain from the reallocation caused by freer capital mobility on account of full Capital Account Convertibility. National income goes up in the country experiencing capital outflows due to higher interest incomes, while that in the debtor country increases as the interest paid is less than the increase in output.

• Capitalists in the labour-abundant economies tend to lose with a fall in the marginal productivity of capital, and the opposite happens in labour-scarce countries, so that developing nations, which are usually capital-scarce, gain in two ways under free movement of capital вЂ" the inflow of capital raises the national income and produces a healthy, unrestricted impact on income distribution as well.

• Finally, it is argued that when full capital account convertibility is in place, government wasteful and misrepresentative policies are likely to be followed by currency crisis that threaten to make the government highly unpopular. Therefore, under capital account convertibility, the healthy effects of capital mobility are magnified through a change in domestic policy in the right direction.

The evidence and the counter-arguments

This positive scenario painted by pro- CAC enthusiasts is sullied when we look at what has actually happened to developing nations that have gone for full-capital account convertibility way in the 1980s and 1990s.

Here are the counter-arguments why full convertibility is correlated with the crises and why, even otherwise, it is not such a good thing:

• During the good years of the economy, it might experience huge inflows of foreign capital, but during the bad times there will be an enormous outflow of capital under “herd behaviour”. For example, the South East Asian countries received US$ 94 billion in 1996 and another US$ 70 billion in the first half of 1997. However, under the threat of the crisis, US$ 102 billion flowed out from the region in the second half of 1997, thereby accentuating the crisis.

• There arises the possibility of misallocation of capital inflows. Such capital inflows may fund low-quality domestic investments, like investments in the stock markets or real estates, and desist from investing in building up industries and factories, which leads to more capacity creation and utilisation, and increased level of employment. This also reduces the potential of the country to increase exports and thus creates external imbalances.

• An open capital account can lead to “the export of domestic savings” (the rich can convert their savings into dollars or pounds in foreign banks or even assets in foreign countries), which for capital scarce developing countries would curb domestic investment. Moreover, under the threat of a crisis, the domestic savings too might leave the country