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SS Tarapore chaired the special committee on CAC for The Reserve Bank of India

There are several benefits of a more open capital account : the 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. Capital Account Convertibility (CAC) allows residents to hold an internationally diversified portfolio which reduces the vulnerability of income streams and wealth to domestic real and financial stocks, lower funding costs for borrowers and prospects of higher yields for savers. An associated gain from CAC is the dynamic gains from financial integration.

Allocative efficiency improves as a result and this can stimulate innovation and improves productivity. CAC provides the impetus for domestic tax regimes to rationalise and converge to international tax structures, thus removing inducements for domestic agents towards evasion and capital flight. We believe capital controls turn progressively ineffective, costly and even distortive

The Committee recognised that the institution of financial sector reforms in India brought into the open weaknesses which had been in the system for a long time. The introduction of CAC will require more proactive policy action as an open capital account could bring these weaknesses under sharper focus. It would impose a strong discipline upon the financial system and would expedite the early rectification of infirmities in the system and lead to widening/deepening of markets to enable the spreading/distribution of risks.

The International Experience

The Committee's survey of the international experience with CAC revealed that countries which initiated the conversion on the basis of strong fundamentals were able to modulate the pace of instituting change without undertaking large and dramatic shifts in the stance of macro-economic policies. Furthermore, these countries were less vulnerable to backtracking and the reimposition of controls. Countries with weak initial conditions were constrained to adopt drastic macro-economic policies to facilitate the move. Some of these countries had to face interruptions and reintroduce capital controls in the evolution of CAC.

Most countries considered a strong balance of payments position as a necessary precondition for the move to CAC and universally built up reserves. Strengthening of the financial system emerged as the most important precondition for CAC, but fiscal consolidation is another important precondition among all countries. An important The conduct of an appropriate exchange rate policy is also important.

Preconditions/Signposts for CAC

The Committee recommended that the implementation of CAC be spread over a three year period 1997-98, 1998-99 and 1999-2000. Implementation of measures towards CAC should be sequenced along with the authorities making an assessment of the progress towards the attainment of the preconditions/signposts stipulated for the relevant year and depending on this assessment the implementation of measures could be accelerated or decelerated.

Fiscal consolidation, a mandated inflation target and strengthening of the financial system should be regarded as crucial preconditions/signposts for CAC in India. In addition, a few important macro-economic indicators should also be assessed on an on-going basis. These are : the conduct of exchange rate policy, the balance of payments and the adequacy of foreign exchange reserves

Exchange Rate Policy

The RBI should have a Monitoring Exchange Rate Band of +/- 5.0 per cent around the neutral Real Effective Exchange Rate (REER). The RBI should ordinarily intervene as and when the REER is outside the band. The Committee stressed that credibility of the exchange rate policy would be vital in the context of CAC and to this extent there must be transparency in exchange rate policy.

Balance of Payments

The Committee recognised that in view of the growing degree of integration of the Indian economy, the size of the current account deficit (CAD) which can be sustained without encountering external constraint is a function of the degree of openness of the economy which can be defined in terms of the ratio of current receipts (CR) to GDP. Accordingly, as a broad rule of thumb, over the three year period 1997-98 to 1999-2000, external sector policies should be designed to ensure a rising trend in the CR/GDP ratio from the present level of 15 per cent and the endeavour should be to reduce the debt service ratio gradually from 25 per cent to 20 per cent. The CAD/GDP ratio would need to be consistent with the above parameters.

A uniform regulatory system needs to be put in place for banks and non banks particularly FIs in relation to prudential norms, market participation, reserve requirements and the interest rate regime. The Committee emphasised that risk management is a critical area, to which banks and non banks (including FIs) must bestow immediate attention.

As risks faced by the financial sector are much higher in developing countries, the RBI should consider the imposition of even more stringent capital adequacy standards than the Basle norms and income recognition and asset classification norms should be tightened expeditiously.

Much more needs to be done to enable public sector banks to operate with a greater degree of autonomy to cope with the rapidly changing environment. The Committee recommended that the more efficient public sector banks need to be allowed, nay actively encouraged, to break away from the pack and their activities should not be hemmed in by concerns for the weak banks. FIs should also be given a greater degree of operational freedom within the framework of strict prudential norms.

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©Kensington Publications 1997