The Hindu Business Line : Capital account convertibility — Carefully-calibrated approach needed

INDIA's foreign exchange reserves have crossed the $100-billion mark. This is no surprise, if one looks at the continuous increase in the last 50 months or so, though the rate of growth has been phenomenal over the last one-and-half years. However, the very crossing of the $100-billion mark has triggered debate whether the time is ripe for the country to go in for capital account convertibility (CAC).

The crossing of the $100-billion mark in India's forex reserves has triggered a debate on whether the time is ripe for the country to go in for capital account convertibility.

Interestingly, the debate on CAC, which began a few years ago, was silenced by the South-East Asian currency crisis of July 1997. Those who advocate full convertibility in capital account list out the possible benefits for the country, including greater confidence levels of global investors in India, the present feel-good factor and strong macro economic parameters of the nation, the reducing NPA levels and so on.

In such arguments, there has been no mention about `the appropriate figure' of forex reserves considered the safe level for any country. The other way of looking at the issue is: What is it that present foreign exchange market lacks that CAC is going to dramatically change? What could be the downside risk and its implications, if the adverse effects of being part of a global financial system hit us? For this, it is necessary to understand the major change ushered in the exchange control law four years ago.

The old law on foreign exchange — the Foreign Exchange Regulation Act, 1973 — controlled all the foreign exchange transactions, regardless of the quantum. Unmindful of the expensive international travel costs, it allowed only up to $250 per day and many transactions required the blessings of the RBI, some capital account transactions requiring multiple approvals at different stages. The law had draconian penal provisions and was quasi-criminal in nature. The Foreign Exchange Management Act, 1999 (FEMA) changed the very focus of the exchange control law. From one of `controlling' and `permitting', it was conceived of as a piece of legislation `to facilitate' external payments and promote the orderly development of the foreign exchange market.

It drastically diluted the penal provisions and is just another civil law now. It seeks to `manage' the exchange control transactions by exception: that is, according to their nature — current or capital account. The forex balance was around $35 billion in June 1999, which has since grown over three times (see Table).

Current account transactions were generally free to be carried out even with bankers, and the RBI does not interfere with them. Only a very few current account transactions are regulated specifically by Rules made for them. There is virtually no business or trade payment, in current account that is regulated by the RBI today.

Payment towards technical know-how in foreign exchange alone is regulated. This again, is intended for the knowledge of the RBI and a very substantial quantum of these payments is under automatic approval. In fact, there is a specific mandate by the RBI to bankers that current account transactions — barring the few regulated ones — shall be permitted regardless of their monetary or percentage ceiling limits.

For instance, Business Travel Quota (BTQ) is permissible up to $25,000 per year. The Finance Minister recently announced that any Indian citizen can now remit or take outside India $25,000 per year for any purpose. Thus, virtually, there is current account convertibility.

Capital account transactions continue to be regulated under the FEMA, but with one important difference. The best parts of capital account transactions are put under automatic route, subject to minimum necessary safeguards. Even these have been progressively liberalised in the last four years.

Foreign direct investment, barring a few strategic industries to arrest possible speculation (like real estate trading), is put on automatic route, with most of the sectors permitted to have 100 per cent foreign equity participation. The foreign portfolio investment by FIIs is already convertible.

The external commercial borrowings (ECB) no longer require the RBI or Ministry approval up to a staggering $50 million. The various multiple approvals that borrowers were required to take six years before are no longer required; nor are the long list of end-use restrictions on such ECB. Now, corporates can avail of ECB for any general business purposes, with the exception of investment in real estate or stock market. These two exceptions are needed to avoid speculative deals, which would unsettle the economy. With world-class Indian companies opting for ventures abroad — as joint ventures or wholly-owned subsidiaries — overseas direct investments (ODI) are allowed without RBI permission, under automatic route, subject to minimum conditions intended for safeguards.

Here, again, the RBI, keeping pace with the market demands, had initially permitted Indian entities to invest 25 per cent of the net worth of investing companies; this was increased to 50 per cent two years ago. This has since been increased up to 100 per cent or entire net worth of investor companies.

The overall financial ceiling of $100 million has also been removed, as announced by the Prime Minister, Mr Atal Bihari Vajpaye, at the recent NRI meet. Likewise, even under NRI deposits account, initially, different amounts were allowed to be repatriated for different purposes.

These restrictions were removed early this year, to freely permit repatriation for educational, medical purposes or remittance of sale proceeds of immovable property in India by such NRIs up to $1 million, every year.

If one looks at the merits of business-related capital account transactions in foreign exchange, as available now, no one is really complaining that they are restricted by exchange control for these transactions at all. Stated another way, how many corporate are frequenting the RBI for either ECB or ODI, beyond the very liberal limits already permitted? Interestingly, capital transactions exceeding these already high ceilings, though not under automatic route, are still considered by the RBI, on merit and disposed of depending on the need.

Thus, insofar as capital account transactions are concerned, the regulations are not restrictions, but necessary safeguards for the economy, in general, or the particular entity proposing such transaction, and the benefits of capital account convertibility in major business transactions are thus already in place.

The formal regime of capital account convertibility, when in place, will additionally allow all residents — companies or individuals or other entities — to invest, disinvest or transact in any property or assets/liability of any country, convert one currency to another or move funds anywhere in the world, according to their personal choice, unrestricted by law.

Given the population, diversity, financial system and other priorities peculiar to India, why are we so eager to usher in full CAC with its marginal benefits? On the contrary, the downside could be devastating.

There is no absolute `comfortable' foreign exchange figure; nor is market sentiment predictable. Global financial markets are volatile, and subject to the influence of several factors — political, country, economic, and so on. Rogue speculators cannot be eliminated from the system, which will gain at the cost of the country. If that happens, as happened in the South-East Asian countries six-and-a-half years ago, it will wipe out years of development and unsettle the overall economy; the cure for this will only be doubly painful. The move towards CAC thus calls for a conservative, cautious and calibrated approach, buttressed by carefully marshalled facts and clinical analysis of data on the global and local markets.

The RBI has the necessary expertise in this area, and, the Tarapore Committee report could be a guiding factor. Undoubtedly, the RBI has done an excellent job in managing our forex reserves, particularly that of short-term foreign currency loans and, more recently, by tactfully honouring its commitment of $5 billion to RIBs without affecting the market in any way.

As a market regulator, the RBI is saddled with the high responsibility of maintaining safety and liquidity of the currency reserve. And when it comes to the timing of CAC, despite the liberal and free advice from all corners, the RBI will likely usher it in at a time it considers appropriate, and probably without too much fuss.

(The author is a Chennai-based advocate and a fellow of the ICAI.)