Recently the SEBI chief Mr. Damodaran created storm in a teacup when he accused most
directors of corporate India of having made it a habit of getting appointed to the boards of
various companies. The SEBI chief emphasized the following points namely:
Ø Companies must refrain from appointing non shareholder directors
Ø A framework must be developed for proper evaluation of members of the board and to rate their performance
Ø Only professionals must be appointed as directors and not persons who make it a profession of becoming directors.
Ø Over a period of time, every company must aim to align the board mix to the objectivity of the company
Points to be considered by all investors post the SEBI chief’s wake up call:
Ø The present company law allows a person to be a part time director in as many as 15 companies. Allowing a person to hold directorship in 15 companies will only dissipate his energies and dilute his worth. How can he do justice to any one company except in perfunctory form?
Ø Overall independent directors are considered to be disinterested directors and are reduced to mere ornaments in the board
Ø Even Sachin Tendulkar, Kapil Dev and Gavaskar were co opted as directors in a few companies in an unguarded moment and later wisdom dawned upon them, when they reailsed that the companies had used their names to collect funds and siphon them.
Damodaran has sounded the warning bells for Corporate India and for the India growth story to remain intact; it is imperative that the growth drivers of Corporate India act with authority and responsibility instead of envisaging thoughts on the quantum of sitting fees that they would earn by becoming members of innumerable boards!!
About Me
- dharma
- I believe in "Baptism by fire" that will transform me from an average joe to a true blue bee's knees in corporate finance and investment banking
Friday, August 18, 2006
Wednesday, August 16, 2006
My visit to Kalikambal and Kandakottam
Two weeks ago, i took some time off to visit a couple of temples in North Chennai - obviously iam referring to Parry's Corner!! The moment i spell out the word "Paris", people in chennai will start envisaging those dirty, crowded , narrow lanes that lead nowhere!! But to my surprise i discovered two huge, mammoth monuments of pride among those dilapidated lanes of old Madras - yes iam talking about Kalikambal temple and kandakottam - the latter is a temple dedicated to Lord Muruga!! All the idols in both these temples have been beautifully sculpted and the premises is well maintained!! - these temples have been visited by the famous Maratha Warrior Chatrapathi Sivaji 4 centuries ago!! he had invoked the blessings of the lord before proceeding to war against Aurangazeb!!!Both these places are of such historical importance and it really took me by surprise to find such bombastic placs of worship in an area plagued with space constraints!! A must visit for all chennaites and tourists!!
NPV Vs IRR
There have been a lot of questions from my close friends and acquaintances as to the basic difference between NPV and IRR.
The basic difference between Net Present Value and Internal Rate of Return is on account of the reinvestment assumption!!! NPV assumes that intermediate cash flows that arise from the projects are reinvested at the realistic rate of return whereas IRR assumes that cash flows are reinvested at the cut off rate ( which is a very high rate of return ) and therefore leads to distortion, unrealistic project appraisal and decision making!!
The basic difference between Net Present Value and Internal Rate of Return is on account of the reinvestment assumption!!! NPV assumes that intermediate cash flows that arise from the projects are reinvested at the realistic rate of return whereas IRR assumes that cash flows are reinvested at the cut off rate ( which is a very high rate of return ) and therefore leads to distortion, unrealistic project appraisal and decision making!!
PROJECT ON DERIVATIVES
Derivatives are contracts which derive their values from the value of one or more of the underlying assets namely equities, foreign exchange, interest bearing securities and commodities. Some of the most commonly traded derivatives are futures, options, forwards and swaps.
A brief details of futures and options are given below:
FUTURES:
The futures market is a zero sum game. All future market participants taken together as a sample can neither make any loss nor make any gain. The process of operation of a futures contract is described below:
Futures are a contract to buy or sell an underlying instrument at a specified future date at the same price the original contract was entered into. The idea behind financial futures contract is to transfer the future changes in security prices from one party in the contract to the other party. It offers a means to manage the risk in participating financial market. Futures basically transfer value rather than create it. It reduces risk faced by one party while at the same time makes the other party assume risk in anticipation of profit. Every futures contract has a two way willing buyer and a willing seller. As a result if one party to the contract makes profit, the other party to the contract will definitely make a loss. That is why this futures market is called a zero sum game.
For successful futures two types of participants are necessary namely HEDGERS and SPECULATORS. Financial futures contracts may be of various types such as:
Ø Interest Rate futures
Ø Treasury Bill Futures
Ø Euro-Dollar Features
Ø Treasury Bond Futures
Ø Stock Index Futures
Ø Currency Futures
However future prices reflect demand and supply conditions in future markets. As is the case in other markets, an increase or decrease in supply lowers or increases the prices of instruments for future delivery.
OPTIONS:
An option contract conveys the right to buy or sell a specific security or commodity at a specified price within a specified period of time. The right to buy is called a call option whereas a right to sell is called a put option. An option contract will comprise the following:
q Type of the option
q Underlying security date
q Strike price at which option maybe exercised
Options are described basically with reference to the underlying commodity. An option on a common stock is called a stock option, an option on bonds are known as bond option, an option on foreign currency are known as currency options while options on future contracts are called future options. The specified price at which the underlying commodity may be bought or sold in case of call option or put option is called the strike price of the option.
The scheme of mechanism as to how the put and call options work is given below:
The basic purpose of exercising any option is to buy or sell the underlying commodity after entering into the option contract. The options are to be exercised before the expiration date. The buyer of an option pays the seller an amount of money called option premium. In return the buyer of the option receives the privilege or right but there is no obligation to buy (in case of call option) or sell ( in case of put option) the underlying commodity at the exercise price. In case of a call option if the price of the commodity exceeds the exercise price, it is advantageous for the buyer to exercise the call option, thereby earning the difference between the two prices, also known as intrinsic value. However contrary to the above if the exercise price exceeds the price of the underlying commodity, the call option is said to be out of money and intrinsic value will be zero and thereby the call option will not be exercised. But the above situation will be advantageous to the put option buyer. The latter can exercise the option to earn the difference between the exercise price and commodity price. From the above it can be seen that options provide investors an opportunity to hedge investments in share portfolios and underlying shares.
Futures and options allow investors to buy and sell forward or at a future date. However it is the upfront amount or the premium paid by them, which acts as a factor of interest rate depending on the volatility of particular scrip. An investor may not be willing to buy immediately due to uncertain market conditions, but he can always buy an option to pick up the shares at a future date. As for every buyer of shares there will be a corresponding seller thereby creating a liquid demand supply market for shares.
Financial derivatives are important tools that can help organizations to meet there specific risk-management objectives and it is important that the user understand the tools intended function and that the necessary safety precautions be taken before the tool is put to use. Financial derivatives have changed the face of finance by creating new ways to understand, measure, and manage risks. Ultimately, financial
derivatives should be considered part of any firm's risk-management strategy to ensure that value-enhancing investment opportunities are pursued. The freedom to manage risk effectively must not be taken away.
The advantages of derivatives to the capital market as a whole are given below :
A tool for hedging: Derivatives provides an excellent mechanism to hedge the future price risk. Think of a farmer, who doesn’t know what price he is going to get for his crop at the time of harvest. He can sell his crop in the futures’ market & lock in the price. If the future spot price is more than the futures price, he can take the off setting position & can get out of the market (with a marginal loss). Otherwise he will get the locked in price.
Risk management: Derivatives provide an excellent mechanism to Portfolio Managers for managing the portfolio risk and to Treasury Managers for managing interest rate risk. The importance of index futures & Forward Rate Agreement (FRA) in this process can’t be overstated.
Better avenues for raising money: With the introduction of currency & interest rate swaps, Indian corporate will be able to raise finance from global markets at better terms.
Price discovery: These derivative instruments make the spot price discovery more reliable using different models like Normal Backwardation hypothesis. These instruments will cause any arbitrage opportunities to disappear & will lead to better price discovery.
Increasing the depth of financial markets: When a financial market gets such sort of risk-management tools, its depth increases since the Institutional Investors get better ways of hedging their risks against unfavorable market movements.
Derivatives market on Indian underlying elsewhere: These days, with the advent of technology, Indian prices are available globally on Reuters & Knightrider. Nothing prevents any foreign market from launching derivatives on these Indian underlying. This will put Indians in a disadvantageous position as they can’t take the advantages of derivatives of securities or commodities traded in India but someone lese can take. So we will have to move fast in this direction.
Empirical evidence: There is strong empirical evidence from other countries that after derivative markets have come about, the liquidity and market efficiency of the underlying market has improved.
A few disadvantages have also been outlined below :
Speculation: Many people fear that these instruments will unnecessarily increase the speculation in the financial markets, which can have far reaching consequences. The recent Barrings Bank incident is the classic case in point.
Market efficiency: Many people fear that the Indian markets are not mature & efficient enough to introduce these instruments. These instruments require a well functioning & mature spot market. Like recently The Economic Times reported the strong correlation of Indian equity markets to the NASDAQ. Such type of market imperfections makes the functioning of derivatives market all the more difficult.
Volatility: The increased speculation & inefficient market will make the spot market more volatile with the introduction of derivatives.
Counter party risk: Most of the derivative intruments are not exchange traded. So there is a counter party default risk in these intruments. Again the same Barrings case, Barrings declared itself bankrupt when it faced huge losses in these instruments.
Liquidity risk: Liquidity of a market means the ease with which one can enter or get out of the market. There is a continued debate about the Indian market’s capability to provide enough liquidity to derivative trader.
FOREIGN EXCHANGE DERIVATIVES:
The gradual liberalization of Indian economy has resulted in substantial inflow of foreign Capital into India. Simultaneously dismantling of trade barriers has also facilitated the Integration of domestic economy with world economy. With the globalization of trade and relatively free movement of financial assets, risk management through derivatives products has become a necessity in India also, like in other developed and developing countries. As Indian businesses become more global in their approach, evolution of a broad based, active and liquid forex derivatives markets is required to provide them with a spectrum of hedging products for effectively managing their foreign exchange exposures. The global market for derivatives has grown substantially in the recent past.
This tremendous growth in global derivative markets can be attributed to a number of factors. They reallocate risk among financial market participants, help to make financial markets more complete, and provide valuable information to investors about economic fundamentals. Derivatives also provide an important function of efficient price discovery and make unbundling of risk easier.
The forex derivative products that are available in Indian financial markets can be sectored into three broad segments viz. forwards, options, currency swaps.
Rupee Forwards
An important segment of the forex derivatives market in India is the Rupee forward contracts market. This has been growing rapidly with increasing participation from corporates, exporters, importers, banks and FIIs. Till February 1992, forward contracts were permitted only against trade related exposures and these contracts could not be cancelled except where the underlying transactions failed to materialize. In March 1992, in order to provide operational freedom to corporate entities, unrestricted booking and cancellation of forward contracts for all genuine exposures, whether trade related or not, were permitted.Although due to the Asian crisis, freedom to rebook cancelled contracts was suspended, which has been since relaxed for the exporters but the restriction still remains for the importers.
The exposures for which the rupee forward contracts are allowed under the existing RBI notification for various participants are as follows:
Residents:
§ Genuine underlying exposures out of trade/business
· Exposures due to foreign currency loans and bonds approved by RBI
· Receipts from GDR issued
· Balances in EEFC accounts
Foreign Institutional Investors:
· They should have exposures in India .
· Hedge value not to exceed 15% of equity as of 31 March 1999 plus increase in market value/ inflows
Non−resident Indians/ Overseas Corporates:
· Dividends from holdings in a Indian company
· Deposits in FCNR and NRE accounts
· Investments under portfolio scheme in accordance with FEMA
Cross Currency Forwards:
Cross currency forwards are also used to hedge the foreign currency exposures, especially by some of the big Indian corporates. The regulations for the cross currency forwards are quite similar to those of Rupee forwards, though with minor differences. For example, a corporate having underlying exposure in Yen, may book forward contract between Dollar and Sterling. Here even though its exposure is in Yen, it is also exposed to the movements in Dollar vis a vis other currencies.
Currency Futures
Indian forwards market is relatively illiquid as most of the contracts traded are for the month ends only. One of the reasons for the market makers’ reluctance to offer these contracts could be the absence of a well−developed term money market. It could be argued that given the future like nature of Indian forwards market, currency futures could be allowed.
Some of their advantages are :
Ø Their minimal margin requirements and the low transactions costs relative to over−the−counter markets due to existence of a clearinghouse, also strengthen the case of their introduction.
Ø Credit risks are further mitigated by daily marking to market of all futures positions with gains and losses paid by each participant to the clearinghouse by the end of trading session.
Ø Moreover, futures contracts are standardized utilizing the same delivery dates and the same nominal amount of currency units to be traded. Hence, traders need only establish the number of contracts and their price.
Ø Contract standardization and clearing house facilities mean that price discovery can proceed rapidly and transaction costs for participants are relatively low.
Cross currency options :
The Reserve Bank of India has permitted authorised dealers to offer cross currency options to the corporate clients and other interbank counter parties to hedge their foreign currency exposures. Before the introduction of these options the corporates were permitted to hedge their foreign currency exposures only through forwards and swaps route. Forwards and swaps do remove the uncertainty by hedging the exposure but they also result in the elimination of potential extraordinary gains from the currency position. Currency options provide a way of availing of the upside from any currency exposure while being protected from the downside for the payment of an upfront premium.
Rupee currency options :
Corporates in India can use instruments such as forwards, swaps and options for hedging cross−currency exposures. However, for hedging the USD−INR risk, corporates are restricted to the use of forwards and USD−INR swaps.
Introduction of USD−INR options would enable Indian forex market participants manage their exposures better by hedging the dollar−rupee risk.
Foreign currency − rupee swaps
Another spin−off of the liberalization and financial reform was the development of a fledgling market in FC− RE swaps. A fledgling market in FC− RE swaps started with foreign banks and some financial institutions offering these products to corporates. Initially the market was very small and two way quotes were quite wide, but the market started developing as more market players as well as business houses started understanding these products and using them to manage their exposures. Corporates started using FC−RE swaps mainly for the following purposes:
· Hedging their currency exposures (ECBs, forex trade, etc.)
· To reduce borrowing costs using the comparative advantage of borrowing in local markets (Alternative to ECBs − Borrow in INR and take the swap route to take exposure to the FC currency)
Conclusion:
The Indian forex derivatives market is still in a nascent stage of development but offers tremendous growth potential. The development of a vibrant forex derivatives market in India would critically depend on the growth in the underlying spot/forward markets, growth in the rupee derivative markets along with the evolution of a supporting regulatory structure. Factors such as market liquidity, investor behavior, regulatory structure and tax laws will have a heavy bearing on the behavior of market variables in this market.
A brief details of futures and options are given below:
FUTURES:
The futures market is a zero sum game. All future market participants taken together as a sample can neither make any loss nor make any gain. The process of operation of a futures contract is described below:
Futures are a contract to buy or sell an underlying instrument at a specified future date at the same price the original contract was entered into. The idea behind financial futures contract is to transfer the future changes in security prices from one party in the contract to the other party. It offers a means to manage the risk in participating financial market. Futures basically transfer value rather than create it. It reduces risk faced by one party while at the same time makes the other party assume risk in anticipation of profit. Every futures contract has a two way willing buyer and a willing seller. As a result if one party to the contract makes profit, the other party to the contract will definitely make a loss. That is why this futures market is called a zero sum game.
For successful futures two types of participants are necessary namely HEDGERS and SPECULATORS. Financial futures contracts may be of various types such as:
Ø Interest Rate futures
Ø Treasury Bill Futures
Ø Euro-Dollar Features
Ø Treasury Bond Futures
Ø Stock Index Futures
Ø Currency Futures
However future prices reflect demand and supply conditions in future markets. As is the case in other markets, an increase or decrease in supply lowers or increases the prices of instruments for future delivery.
OPTIONS:
An option contract conveys the right to buy or sell a specific security or commodity at a specified price within a specified period of time. The right to buy is called a call option whereas a right to sell is called a put option. An option contract will comprise the following:
q Type of the option
q Underlying security date
q Strike price at which option maybe exercised
Options are described basically with reference to the underlying commodity. An option on a common stock is called a stock option, an option on bonds are known as bond option, an option on foreign currency are known as currency options while options on future contracts are called future options. The specified price at which the underlying commodity may be bought or sold in case of call option or put option is called the strike price of the option.
The scheme of mechanism as to how the put and call options work is given below:
The basic purpose of exercising any option is to buy or sell the underlying commodity after entering into the option contract. The options are to be exercised before the expiration date. The buyer of an option pays the seller an amount of money called option premium. In return the buyer of the option receives the privilege or right but there is no obligation to buy (in case of call option) or sell ( in case of put option) the underlying commodity at the exercise price. In case of a call option if the price of the commodity exceeds the exercise price, it is advantageous for the buyer to exercise the call option, thereby earning the difference between the two prices, also known as intrinsic value. However contrary to the above if the exercise price exceeds the price of the underlying commodity, the call option is said to be out of money and intrinsic value will be zero and thereby the call option will not be exercised. But the above situation will be advantageous to the put option buyer. The latter can exercise the option to earn the difference between the exercise price and commodity price. From the above it can be seen that options provide investors an opportunity to hedge investments in share portfolios and underlying shares.
Futures and options allow investors to buy and sell forward or at a future date. However it is the upfront amount or the premium paid by them, which acts as a factor of interest rate depending on the volatility of particular scrip. An investor may not be willing to buy immediately due to uncertain market conditions, but he can always buy an option to pick up the shares at a future date. As for every buyer of shares there will be a corresponding seller thereby creating a liquid demand supply market for shares.
Financial derivatives are important tools that can help organizations to meet there specific risk-management objectives and it is important that the user understand the tools intended function and that the necessary safety precautions be taken before the tool is put to use. Financial derivatives have changed the face of finance by creating new ways to understand, measure, and manage risks. Ultimately, financial
derivatives should be considered part of any firm's risk-management strategy to ensure that value-enhancing investment opportunities are pursued. The freedom to manage risk effectively must not be taken away.
The advantages of derivatives to the capital market as a whole are given below :
A tool for hedging: Derivatives provides an excellent mechanism to hedge the future price risk. Think of a farmer, who doesn’t know what price he is going to get for his crop at the time of harvest. He can sell his crop in the futures’ market & lock in the price. If the future spot price is more than the futures price, he can take the off setting position & can get out of the market (with a marginal loss). Otherwise he will get the locked in price.
Risk management: Derivatives provide an excellent mechanism to Portfolio Managers for managing the portfolio risk and to Treasury Managers for managing interest rate risk. The importance of index futures & Forward Rate Agreement (FRA) in this process can’t be overstated.
Better avenues for raising money: With the introduction of currency & interest rate swaps, Indian corporate will be able to raise finance from global markets at better terms.
Price discovery: These derivative instruments make the spot price discovery more reliable using different models like Normal Backwardation hypothesis. These instruments will cause any arbitrage opportunities to disappear & will lead to better price discovery.
Increasing the depth of financial markets: When a financial market gets such sort of risk-management tools, its depth increases since the Institutional Investors get better ways of hedging their risks against unfavorable market movements.
Derivatives market on Indian underlying elsewhere: These days, with the advent of technology, Indian prices are available globally on Reuters & Knightrider. Nothing prevents any foreign market from launching derivatives on these Indian underlying. This will put Indians in a disadvantageous position as they can’t take the advantages of derivatives of securities or commodities traded in India but someone lese can take. So we will have to move fast in this direction.
Empirical evidence: There is strong empirical evidence from other countries that after derivative markets have come about, the liquidity and market efficiency of the underlying market has improved.
A few disadvantages have also been outlined below :
Speculation: Many people fear that these instruments will unnecessarily increase the speculation in the financial markets, which can have far reaching consequences. The recent Barrings Bank incident is the classic case in point.
Market efficiency: Many people fear that the Indian markets are not mature & efficient enough to introduce these instruments. These instruments require a well functioning & mature spot market. Like recently The Economic Times reported the strong correlation of Indian equity markets to the NASDAQ. Such type of market imperfections makes the functioning of derivatives market all the more difficult.
Volatility: The increased speculation & inefficient market will make the spot market more volatile with the introduction of derivatives.
Counter party risk: Most of the derivative intruments are not exchange traded. So there is a counter party default risk in these intruments. Again the same Barrings case, Barrings declared itself bankrupt when it faced huge losses in these instruments.
Liquidity risk: Liquidity of a market means the ease with which one can enter or get out of the market. There is a continued debate about the Indian market’s capability to provide enough liquidity to derivative trader.
FOREIGN EXCHANGE DERIVATIVES:
The gradual liberalization of Indian economy has resulted in substantial inflow of foreign Capital into India. Simultaneously dismantling of trade barriers has also facilitated the Integration of domestic economy with world economy. With the globalization of trade and relatively free movement of financial assets, risk management through derivatives products has become a necessity in India also, like in other developed and developing countries. As Indian businesses become more global in their approach, evolution of a broad based, active and liquid forex derivatives markets is required to provide them with a spectrum of hedging products for effectively managing their foreign exchange exposures. The global market for derivatives has grown substantially in the recent past.
This tremendous growth in global derivative markets can be attributed to a number of factors. They reallocate risk among financial market participants, help to make financial markets more complete, and provide valuable information to investors about economic fundamentals. Derivatives also provide an important function of efficient price discovery and make unbundling of risk easier.
The forex derivative products that are available in Indian financial markets can be sectored into three broad segments viz. forwards, options, currency swaps.
Rupee Forwards
An important segment of the forex derivatives market in India is the Rupee forward contracts market. This has been growing rapidly with increasing participation from corporates, exporters, importers, banks and FIIs. Till February 1992, forward contracts were permitted only against trade related exposures and these contracts could not be cancelled except where the underlying transactions failed to materialize. In March 1992, in order to provide operational freedom to corporate entities, unrestricted booking and cancellation of forward contracts for all genuine exposures, whether trade related or not, were permitted.Although due to the Asian crisis, freedom to rebook cancelled contracts was suspended, which has been since relaxed for the exporters but the restriction still remains for the importers.
The exposures for which the rupee forward contracts are allowed under the existing RBI notification for various participants are as follows:
Residents:
§ Genuine underlying exposures out of trade/business
· Exposures due to foreign currency loans and bonds approved by RBI
· Receipts from GDR issued
· Balances in EEFC accounts
Foreign Institutional Investors:
· They should have exposures in India .
· Hedge value not to exceed 15% of equity as of 31 March 1999 plus increase in market value/ inflows
Non−resident Indians/ Overseas Corporates:
· Dividends from holdings in a Indian company
· Deposits in FCNR and NRE accounts
· Investments under portfolio scheme in accordance with FEMA
Cross Currency Forwards:
Cross currency forwards are also used to hedge the foreign currency exposures, especially by some of the big Indian corporates. The regulations for the cross currency forwards are quite similar to those of Rupee forwards, though with minor differences. For example, a corporate having underlying exposure in Yen, may book forward contract between Dollar and Sterling. Here even though its exposure is in Yen, it is also exposed to the movements in Dollar vis a vis other currencies.
Currency Futures
Indian forwards market is relatively illiquid as most of the contracts traded are for the month ends only. One of the reasons for the market makers’ reluctance to offer these contracts could be the absence of a well−developed term money market. It could be argued that given the future like nature of Indian forwards market, currency futures could be allowed.
Some of their advantages are :
Ø Their minimal margin requirements and the low transactions costs relative to over−the−counter markets due to existence of a clearinghouse, also strengthen the case of their introduction.
Ø Credit risks are further mitigated by daily marking to market of all futures positions with gains and losses paid by each participant to the clearinghouse by the end of trading session.
Ø Moreover, futures contracts are standardized utilizing the same delivery dates and the same nominal amount of currency units to be traded. Hence, traders need only establish the number of contracts and their price.
Ø Contract standardization and clearing house facilities mean that price discovery can proceed rapidly and transaction costs for participants are relatively low.
Cross currency options :
The Reserve Bank of India has permitted authorised dealers to offer cross currency options to the corporate clients and other interbank counter parties to hedge their foreign currency exposures. Before the introduction of these options the corporates were permitted to hedge their foreign currency exposures only through forwards and swaps route. Forwards and swaps do remove the uncertainty by hedging the exposure but they also result in the elimination of potential extraordinary gains from the currency position. Currency options provide a way of availing of the upside from any currency exposure while being protected from the downside for the payment of an upfront premium.
Rupee currency options :
Corporates in India can use instruments such as forwards, swaps and options for hedging cross−currency exposures. However, for hedging the USD−INR risk, corporates are restricted to the use of forwards and USD−INR swaps.
Introduction of USD−INR options would enable Indian forex market participants manage their exposures better by hedging the dollar−rupee risk.
Foreign currency − rupee swaps
Another spin−off of the liberalization and financial reform was the development of a fledgling market in FC− RE swaps. A fledgling market in FC− RE swaps started with foreign banks and some financial institutions offering these products to corporates. Initially the market was very small and two way quotes were quite wide, but the market started developing as more market players as well as business houses started understanding these products and using them to manage their exposures. Corporates started using FC−RE swaps mainly for the following purposes:
· Hedging their currency exposures (ECBs, forex trade, etc.)
· To reduce borrowing costs using the comparative advantage of borrowing in local markets (Alternative to ECBs − Borrow in INR and take the swap route to take exposure to the FC currency)
Conclusion:
The Indian forex derivatives market is still in a nascent stage of development but offers tremendous growth potential. The development of a vibrant forex derivatives market in India would critically depend on the growth in the underlying spot/forward markets, growth in the rupee derivative markets along with the evolution of a supporting regulatory structure. Factors such as market liquidity, investor behavior, regulatory structure and tax laws will have a heavy bearing on the behavior of market variables in this market.
Issues India needs to address in Capital account convertibility
The finance minister in his various confabulations with the media has been indicating on the need to press on with full capital account convertibility for the Indian rupee. This isn’t the first time that the country is talking about CAC (Capital Account Convertibility). The chapter is being revisited by the incumbent bureaucrats of the country after none other than the PM Mr.Manmohan Singh’s clarion call on this issue. Therefore the objective of this article is to examine the relevance of this topic for our country per se, in light of the developments in the International economy.
Let’s start with “What is Full Capital Account Convertibility”:
Ø India already has current account convertibility (though partial in a few cases), meaning resident Indians and companies can import or export goods, receive consideration and make payments in foreign currency for travel, trade, education etc., though the extent of transactions are decided by RBI specified limits.
Now think of buying properties in US, shares of Microsoft in the NYSE (New
York Stock Exchange). Yes we are nearing the D Day -full CAC could turn out
to be a reality pretty soon.
Ø The PM in early 2006 constituted the second Tarapore Committee to prepare the road map for full CAC. The first Tarapore Committee was constituted in 1997 to look into this nebulous issue but post the East Asian crisis (discussed later in this article) CAC was put on the backburner.
Ø The 1997 Tarapore Committee has defined Full CAC as the freedom to convert local financial assets into foreign financial assets at market determined rates. It involves change in ownership and free, unconditional exchange of financial assets and liabilities across the globe without any restrictions whatsoever.
Ø Going forward, full CAC will also mean that a domestic individual can pay in foreign currency for purchases made within the country itself, thereby giving him the advantage of holding a strong hard currency say US $ or Yen.
Ø However care needs to be taken by the enforcing authorities to ensure that legitimate flow of money takes place. Dubious inflow/ outflow of money and money laundering activities can be curbed through proper KYC (Know Your Customer) guidelines being put into effect.
Ø One of the significant advantages of full CAC is that a fully convertible currency can be convertible even in a non-convertible country i.e. for e.g. US$, Euro is convertible in India whereas Indian rupee is not convertible in UK or US.
Whether the stage is set right for India to embrace full CAC:
One aspect on which all economic pundits agree is that implementation of Full CAC is axiomatic to steady economic growth and development. Full CAC will result in major influx of foreign direct investment, spur industrial growth, job creation and an overall improvement in the macro economic parameters.
Nobody can predict or gauge as to what is the most opportune moment for ushering in an era of Full CAC. All this resurfaced talk on CAC almost after a decade has mainly arisen due to the following factors:
Ø The forex reserves have already crossed the $100 billion mark and are poised to touch the double.
Ø Economic growth engines are in full steam
Ø Great amount of confidence that the global investors and various investment gurus are placing upon India
Ø A steady rise in the Business Confidence Index of the country (Refer NCAER reports)
Ø The sound macro and micro economic levers, increase in the Tax- GDP ratio (an increasing ratio indicates robust corporate earnings which augurs well for the future of an emerging market)
Deducing logic from the above factors, Full CAC is obviously considered to be the ultimate panacea for economic backwardness. Even a plethora of government agencies, international organizations have advocated and glorified the concept of Full CAC (A point that would be well appreciated here is that most international organizations thrive on the support from western powers and it would do well for countries across the globe to hold hard currencies once CAC comes into play).
The table below indicates the recommendations made by Tarapore Committee in 1997 for preparing a roadmap for Full CAC and also the current position of the economy vis a vis the recommendations – Source: Business line
We have complied with most of the parameters indicated by the committee, but are we ready for the final plunge?
In this regard let us examine the East Asian Crisis of 1997 in detail. The East Asian countries like Thailand, Indonesia and Malaysia (also referred to as Asian Tigers) opened up their economies way back in early 1990’s. These countries embraced liberalization, globalization and as a result full CAC with such fervor and vigor that rapid economic development was witnessed in the region. A major shift in manufacturing activity of products like Cars, textiles and ancillary goods took place from regions in the US to East Asia. Even companies like General Motors shut down their plants in North America and set up shop in South East Asia. This outsourcing led economic development (similar to what is being witnessed in our country now) resulted in a lot of influx of dollar forex reserves. The problem with huge inflows of forex reserves is that it results in a direct appreciation of the domestic currency, imports become cheaper and exports become uncompetitive over a period of time. For forex inflow to sustain, export competitiveness is a very important factor and it is the function of the Central bank of any country to regulate its monetary policy to maintain the exchange rate stability (for e.g., both RBI and Bank of China follow a policy of buying dollars to maintain exchange rate stability and export competitiveness). The policy makers of East Asian countries failed to regulate their currency fluctuations and had to pay a heavy price. The demand for their goods ebbed a little with their exports becoming costlier over a period due to continuous surge in their domestic currency vis a vis the dollar. This led to the sudden slowdown in dollar inflow; foreign investors and FII’s became bearish on the economy and there began a huge exodus of forex reserves to alternative investment destinations. Even the citizens of these countries followed suit and parked their money elsewhere. The Malaysian Ringgits, South Korean Won, Indonesian Rupiah, faced steep devaluation. The Asian tigers, ten yrs down the line, have still not recovered from the dead cat onslaught. The problem with these economies was that there was growth happening in all sectors except the real sector i.e.: Infrastructure, Engineering and Capital Goods. The growth in other sectors like banking and finance was fuelled by free capital mobility and arbitrage opportunities and such capital carries the risk of being pulled out any time in a fully convertible environment. The real growth of the economy is reflected only through investments in the form of FDI in capital goods and infrastructure.
Since early 1970’s there have been several crises triggered by speculative capital movements like the Southern Cone financial crisis of 1970, Mexican crisis of 1994 and Tequila Effect, East Asian crisis of 1997, Brazil’s flop show in late 90’s and the ensuing Latin American collapse, Russian crisis of 1999 and in the recent past, Argentina in 2001.
The damning experience of these countries show the dangers of making our rupee fully convertible based on short-term increase in forex reserves. RBI would do well to study the factors that led to the misadventures of the East Asian economies in detail while drafting the policy framework for Full CAC.
So what is necessary to usher in Full CAC, what should be done and what needs to be done?
Making the rupee convertible would bring forth demand for dollars from private investors and would largely relieve RBI of the pressure to buy dollars endlessly to maintain stability in exchange rates. But the long term consequences of this policy needs to be examined:
Ø Once our citizens are allowed to start buying dollars for investments abroad, the possibility of capital flight cannot be ignored in the event of any short term financial crisis in the country as the country is getting more and more integrated with the global economy.
Ø RBI can continue to buy dollars and build our foreign exchange reserves similar to the policy being followed by China. But this policy can only exacerbate our woes in future. The dollar as such is a currency waiting on the hinges to take a heavy beating; the value of the dollar is bound to fall with mounting trade deficits and failure of the US to convince Chinese authorities to allow the remninbi (yuan) to appreciate. The value of our forex reserves will definitely fall in line with the depreciation of the dollar. Though China will also be partially affected by the fall in dollar, she has not made the yuan convertible and more so acts as the credit card for the US economy. China constitutes 40 % of US imports and also parks all its money in US treasury bills and money market instruments. Therefore to preserve Chinese interests, the Bank of China will continue to mop up excess dollar from the market to the extent it protects the yuan rates. However how long this process can be durable is anybody’s guess, as the Asian Superpower cannot tide against reality for times immemorial!!!
Ø China and India were the only exceptions to the Asian Crisis. This was because both the countries did not open up their economies and embrace CAC too fast and too soon. Therefore neither did they witness rapid economic development in the 1990’s nor did they suffer the huge exodus of foreign capital and the resultant economic meltdown towards the close of the decade. Rapid economic development should not be solely based on inflow of foreign capital is a lesson India needs to imbibe before ushering CAC.
Ø Full CAC can either be benign or malignant to any country based on the inherent strengths and weaknesses in the economy. India is experiencing a deluge of foreign funds, the stock markets reached a historic high and are trading at a premium valuation, we even edged out the Dow Jones index before falling back to realistic levels, but the moot point is whether the Indian economy is as strong as the US economy? The votaries of convertibility, apart from the PM and FM consist of external forces like IMF and World Bank, hedge funds and FII’s who seek to capitalize on the growth stories of the emerging markets to profit from arbitrage opportunities and money market operations. Both the PM and FM (Both men of reputed pedigree – atleast the former’s words can be taken seriously) are confident that even after a full and free float of the currency the economy is resilient enough to withstand pressures and fissures in the international fiscal and monetary markets.
Ø India still needs to travel a long distance as far as infrastructure growth is concerned. The basic concerns of Bijli, sadak and pani have still not been addressed for a vast majority of the population. Many areas of the country are facing acute power shortage and we have our own RBI sitting on a pile of US$ 100 billion forex reserves. The basic idea of holding forex reserves is to address the import needs of the country and to provide cover for current account deficits. Even RBI has openly acknowledged that around $40 billion would be enough to provide a 6-month import cover. Apart from this, RBI may need to provide for fluctuation in international exchange rates and maintaining monetary stability. Even discounting the above factors, the central bank will still be left with a huge surplus of forex reserves. A few questions may arise in the readers mind which have not yet been addresses by RBI:
§ Why hasn’t the surplus reserves been used for domestic growth and development? What’s the purpose in keeping the reserves idle?
§ Has RBI undertaken an incremental cost – benefit analysis on the additional forex reserves it keeps accumulating? What is the rate of return being earned on these reserves considering the fact that interest rates in US are pretty low? Will we better off holding reserves in some other hard currency, which would earn a higher return?
Ø Another factor critics point out against Full CAC is that it permits Indian citizens to invest abroad and hold dollar denominated assets. What purpose does it serve to invest abroad when domestic savings are not being channelised into domestic investments? Retail participation in our own stock markets is still at an infancy level. Most individuals still consider small savings, LIC schemes and fixed deposits as safe avenues for investment. After the recent waterloo at the stock markets in May 2006, most retail investors close their ears when they hear the word “Sensex”. So even after a robust Q1 performance by corporate India, though the sensex has retraced to around 60 % of its old highs, volumes are still pathetic which only reflects the conservative outlook of our retail participants. When they cannot withstand a minor shakeout in our domestic markets, how can we expose them to the vagaries of the international financial markets by allowing them to hold assets abroad?
Ø India has still not addressed problems related to fiscal deficit with mounting government expenditure, transparency, accountability and financial prudence are words still considered Greek and Latin by the government agencies.
Ø Our country’s macro economic fundamentals though considered good by many, is yet to reach the stage to warrant a full CAC – Fiscal deficit at the end of Q1 has already reached 50% of the target deficit for the whole year, banks still have to address their NPA concerns (more so now in light of Basel II norms), reforms process has largely slowed down with the current coalition finding it difficult to push them through amidst a lot of cat calls from coalition partners, the country has not yet been able to address its energy concerns (with rising crude oil prices, the RBI covers up supply side shocks by raising interest rates which in the author’s humble opinion has no correlation). The alternative sources of energy like ethanol, bio gas have to be harnessed on a large scale and products like ethanol can be produced on a large scale only if sugar companies are allowed to function freely. Until Mr.Sharad Pawar stops deciding as to what quantum of sugar needs to be released in the market, generating fuel from ethanol will remain a distant dream. The country is still unsure as to when the benefits from The Indo –US civilian nuclear agreement will begin to accrue.
Ø Coming back to this debatable topic of CAC, there has been no empirical evidence in the past to suggest that Full CAC has benefited the economies that have implemented it. We only have stories of the downside floating around like the East Asian Crisis, Latin American Crisis etc due to unforeseen capital flight. The downside risk is indeed very high for any economy implementing full CAC as it wipes out years of economic development.
Ø Also another point which we would need to appreciate is that most of the inflow is happening in India due to recessional conditions elsewhere and this inflow would soon become the outflow once the arbitrage opportunity narrows down.
Should India then usher in full capital account convertibility:
Yes, India is an emerging market, a developing nation and a growing economy. Enforcing full CAC is a must, a necessity from which we cannot extricate ourselves with our ever-increasing presence in the global arena. A number of Indian companies are promoting joint ventures abroad and a lot of overseas companies are on Corporate India’s shopping list. Therefore with increased integration into the global economy the rupee should be made freely convertible but not before we set our house in order.
Lets welcome CAC without much fuss but after addressing the following issues
Ø Improve the fiscal prudence of the economy and deepen our financial system to withstand any shocks or meltdown in the global economy. Create institutions of growth and development.
Ø As an alternative to full CAC, the country can allow the rupee to appreciate and liberalize imports. The imports will prove to be cheap, the cost of production will come down and our exports will become competitive in the global arena. In the current scenario, even in spite of a devalued rupee our export competitiveness is less than 1, which does not augur well for a growing economy.
Ø Expedite the economic and policy reform process, and revamp the entire legal, judiciary system to ensure accelerated dispute settlement process.
Ø Increased infrastructure spending in the form of greater Public Private Partnerships (PPP)
Ø Ensuring more retail participation in the financial markets
Ø Allow the economy to be run by market-determined factors, without providing scope for subsidies (which can only hamper industrial growth and conceal reality)
Ø Allow the rupee to locate its real value against the dollar; a strong rupee is a sign of a strong economy.
Ø Open up different sectors of the economy, which act as engines of economic growth whereby FDI can be pumped in on a large scale, as FDI is the most rewarding form of investment for any economy, representing foreign funds that will stay invested within the country and lend stability to foreign inflows.
To conclude, what is required is a careful, cautious and calibrated approach by RBI buttressed by a full study of historical facts and clinical analysis of the current Indian and global scenario without drawing a blank as to the safeguards that must be put in place for free convertibility of the rupee.
Let’s start with “What is Full Capital Account Convertibility”:
Ø India already has current account convertibility (though partial in a few cases), meaning resident Indians and companies can import or export goods, receive consideration and make payments in foreign currency for travel, trade, education etc., though the extent of transactions are decided by RBI specified limits.
Now think of buying properties in US, shares of Microsoft in the NYSE (New
York Stock Exchange). Yes we are nearing the D Day -full CAC could turn out
to be a reality pretty soon.
Ø The PM in early 2006 constituted the second Tarapore Committee to prepare the road map for full CAC. The first Tarapore Committee was constituted in 1997 to look into this nebulous issue but post the East Asian crisis (discussed later in this article) CAC was put on the backburner.
Ø The 1997 Tarapore Committee has defined Full CAC as the freedom to convert local financial assets into foreign financial assets at market determined rates. It involves change in ownership and free, unconditional exchange of financial assets and liabilities across the globe without any restrictions whatsoever.
Ø Going forward, full CAC will also mean that a domestic individual can pay in foreign currency for purchases made within the country itself, thereby giving him the advantage of holding a strong hard currency say US $ or Yen.
Ø However care needs to be taken by the enforcing authorities to ensure that legitimate flow of money takes place. Dubious inflow/ outflow of money and money laundering activities can be curbed through proper KYC (Know Your Customer) guidelines being put into effect.
Ø One of the significant advantages of full CAC is that a fully convertible currency can be convertible even in a non-convertible country i.e. for e.g. US$, Euro is convertible in India whereas Indian rupee is not convertible in UK or US.
Whether the stage is set right for India to embrace full CAC:
One aspect on which all economic pundits agree is that implementation of Full CAC is axiomatic to steady economic growth and development. Full CAC will result in major influx of foreign direct investment, spur industrial growth, job creation and an overall improvement in the macro economic parameters.
Nobody can predict or gauge as to what is the most opportune moment for ushering in an era of Full CAC. All this resurfaced talk on CAC almost after a decade has mainly arisen due to the following factors:
Ø The forex reserves have already crossed the $100 billion mark and are poised to touch the double.
Ø Economic growth engines are in full steam
Ø Great amount of confidence that the global investors and various investment gurus are placing upon India
Ø A steady rise in the Business Confidence Index of the country (Refer NCAER reports)
Ø The sound macro and micro economic levers, increase in the Tax- GDP ratio (an increasing ratio indicates robust corporate earnings which augurs well for the future of an emerging market)
Deducing logic from the above factors, Full CAC is obviously considered to be the ultimate panacea for economic backwardness. Even a plethora of government agencies, international organizations have advocated and glorified the concept of Full CAC (A point that would be well appreciated here is that most international organizations thrive on the support from western powers and it would do well for countries across the globe to hold hard currencies once CAC comes into play).
The table below indicates the recommendations made by Tarapore Committee in 1997 for preparing a roadmap for Full CAC and also the current position of the economy vis a vis the recommendations – Source: Business line
We have complied with most of the parameters indicated by the committee, but are we ready for the final plunge?
In this regard let us examine the East Asian Crisis of 1997 in detail. The East Asian countries like Thailand, Indonesia and Malaysia (also referred to as Asian Tigers) opened up their economies way back in early 1990’s. These countries embraced liberalization, globalization and as a result full CAC with such fervor and vigor that rapid economic development was witnessed in the region. A major shift in manufacturing activity of products like Cars, textiles and ancillary goods took place from regions in the US to East Asia. Even companies like General Motors shut down their plants in North America and set up shop in South East Asia. This outsourcing led economic development (similar to what is being witnessed in our country now) resulted in a lot of influx of dollar forex reserves. The problem with huge inflows of forex reserves is that it results in a direct appreciation of the domestic currency, imports become cheaper and exports become uncompetitive over a period of time. For forex inflow to sustain, export competitiveness is a very important factor and it is the function of the Central bank of any country to regulate its monetary policy to maintain the exchange rate stability (for e.g., both RBI and Bank of China follow a policy of buying dollars to maintain exchange rate stability and export competitiveness). The policy makers of East Asian countries failed to regulate their currency fluctuations and had to pay a heavy price. The demand for their goods ebbed a little with their exports becoming costlier over a period due to continuous surge in their domestic currency vis a vis the dollar. This led to the sudden slowdown in dollar inflow; foreign investors and FII’s became bearish on the economy and there began a huge exodus of forex reserves to alternative investment destinations. Even the citizens of these countries followed suit and parked their money elsewhere. The Malaysian Ringgits, South Korean Won, Indonesian Rupiah, faced steep devaluation. The Asian tigers, ten yrs down the line, have still not recovered from the dead cat onslaught. The problem with these economies was that there was growth happening in all sectors except the real sector i.e.: Infrastructure, Engineering and Capital Goods. The growth in other sectors like banking and finance was fuelled by free capital mobility and arbitrage opportunities and such capital carries the risk of being pulled out any time in a fully convertible environment. The real growth of the economy is reflected only through investments in the form of FDI in capital goods and infrastructure.
Since early 1970’s there have been several crises triggered by speculative capital movements like the Southern Cone financial crisis of 1970, Mexican crisis of 1994 and Tequila Effect, East Asian crisis of 1997, Brazil’s flop show in late 90’s and the ensuing Latin American collapse, Russian crisis of 1999 and in the recent past, Argentina in 2001.
The damning experience of these countries show the dangers of making our rupee fully convertible based on short-term increase in forex reserves. RBI would do well to study the factors that led to the misadventures of the East Asian economies in detail while drafting the policy framework for Full CAC.
So what is necessary to usher in Full CAC, what should be done and what needs to be done?
Making the rupee convertible would bring forth demand for dollars from private investors and would largely relieve RBI of the pressure to buy dollars endlessly to maintain stability in exchange rates. But the long term consequences of this policy needs to be examined:
Ø Once our citizens are allowed to start buying dollars for investments abroad, the possibility of capital flight cannot be ignored in the event of any short term financial crisis in the country as the country is getting more and more integrated with the global economy.
Ø RBI can continue to buy dollars and build our foreign exchange reserves similar to the policy being followed by China. But this policy can only exacerbate our woes in future. The dollar as such is a currency waiting on the hinges to take a heavy beating; the value of the dollar is bound to fall with mounting trade deficits and failure of the US to convince Chinese authorities to allow the remninbi (yuan) to appreciate. The value of our forex reserves will definitely fall in line with the depreciation of the dollar. Though China will also be partially affected by the fall in dollar, she has not made the yuan convertible and more so acts as the credit card for the US economy. China constitutes 40 % of US imports and also parks all its money in US treasury bills and money market instruments. Therefore to preserve Chinese interests, the Bank of China will continue to mop up excess dollar from the market to the extent it protects the yuan rates. However how long this process can be durable is anybody’s guess, as the Asian Superpower cannot tide against reality for times immemorial!!!
Ø China and India were the only exceptions to the Asian Crisis. This was because both the countries did not open up their economies and embrace CAC too fast and too soon. Therefore neither did they witness rapid economic development in the 1990’s nor did they suffer the huge exodus of foreign capital and the resultant economic meltdown towards the close of the decade. Rapid economic development should not be solely based on inflow of foreign capital is a lesson India needs to imbibe before ushering CAC.
Ø Full CAC can either be benign or malignant to any country based on the inherent strengths and weaknesses in the economy. India is experiencing a deluge of foreign funds, the stock markets reached a historic high and are trading at a premium valuation, we even edged out the Dow Jones index before falling back to realistic levels, but the moot point is whether the Indian economy is as strong as the US economy? The votaries of convertibility, apart from the PM and FM consist of external forces like IMF and World Bank, hedge funds and FII’s who seek to capitalize on the growth stories of the emerging markets to profit from arbitrage opportunities and money market operations. Both the PM and FM (Both men of reputed pedigree – atleast the former’s words can be taken seriously) are confident that even after a full and free float of the currency the economy is resilient enough to withstand pressures and fissures in the international fiscal and monetary markets.
Ø India still needs to travel a long distance as far as infrastructure growth is concerned. The basic concerns of Bijli, sadak and pani have still not been addressed for a vast majority of the population. Many areas of the country are facing acute power shortage and we have our own RBI sitting on a pile of US$ 100 billion forex reserves. The basic idea of holding forex reserves is to address the import needs of the country and to provide cover for current account deficits. Even RBI has openly acknowledged that around $40 billion would be enough to provide a 6-month import cover. Apart from this, RBI may need to provide for fluctuation in international exchange rates and maintaining monetary stability. Even discounting the above factors, the central bank will still be left with a huge surplus of forex reserves. A few questions may arise in the readers mind which have not yet been addresses by RBI:
§ Why hasn’t the surplus reserves been used for domestic growth and development? What’s the purpose in keeping the reserves idle?
§ Has RBI undertaken an incremental cost – benefit analysis on the additional forex reserves it keeps accumulating? What is the rate of return being earned on these reserves considering the fact that interest rates in US are pretty low? Will we better off holding reserves in some other hard currency, which would earn a higher return?
Ø Another factor critics point out against Full CAC is that it permits Indian citizens to invest abroad and hold dollar denominated assets. What purpose does it serve to invest abroad when domestic savings are not being channelised into domestic investments? Retail participation in our own stock markets is still at an infancy level. Most individuals still consider small savings, LIC schemes and fixed deposits as safe avenues for investment. After the recent waterloo at the stock markets in May 2006, most retail investors close their ears when they hear the word “Sensex”. So even after a robust Q1 performance by corporate India, though the sensex has retraced to around 60 % of its old highs, volumes are still pathetic which only reflects the conservative outlook of our retail participants. When they cannot withstand a minor shakeout in our domestic markets, how can we expose them to the vagaries of the international financial markets by allowing them to hold assets abroad?
Ø India has still not addressed problems related to fiscal deficit with mounting government expenditure, transparency, accountability and financial prudence are words still considered Greek and Latin by the government agencies.
Ø Our country’s macro economic fundamentals though considered good by many, is yet to reach the stage to warrant a full CAC – Fiscal deficit at the end of Q1 has already reached 50% of the target deficit for the whole year, banks still have to address their NPA concerns (more so now in light of Basel II norms), reforms process has largely slowed down with the current coalition finding it difficult to push them through amidst a lot of cat calls from coalition partners, the country has not yet been able to address its energy concerns (with rising crude oil prices, the RBI covers up supply side shocks by raising interest rates which in the author’s humble opinion has no correlation). The alternative sources of energy like ethanol, bio gas have to be harnessed on a large scale and products like ethanol can be produced on a large scale only if sugar companies are allowed to function freely. Until Mr.Sharad Pawar stops deciding as to what quantum of sugar needs to be released in the market, generating fuel from ethanol will remain a distant dream. The country is still unsure as to when the benefits from The Indo –US civilian nuclear agreement will begin to accrue.
Ø Coming back to this debatable topic of CAC, there has been no empirical evidence in the past to suggest that Full CAC has benefited the economies that have implemented it. We only have stories of the downside floating around like the East Asian Crisis, Latin American Crisis etc due to unforeseen capital flight. The downside risk is indeed very high for any economy implementing full CAC as it wipes out years of economic development.
Ø Also another point which we would need to appreciate is that most of the inflow is happening in India due to recessional conditions elsewhere and this inflow would soon become the outflow once the arbitrage opportunity narrows down.
Should India then usher in full capital account convertibility:
Yes, India is an emerging market, a developing nation and a growing economy. Enforcing full CAC is a must, a necessity from which we cannot extricate ourselves with our ever-increasing presence in the global arena. A number of Indian companies are promoting joint ventures abroad and a lot of overseas companies are on Corporate India’s shopping list. Therefore with increased integration into the global economy the rupee should be made freely convertible but not before we set our house in order.
Lets welcome CAC without much fuss but after addressing the following issues
Ø Improve the fiscal prudence of the economy and deepen our financial system to withstand any shocks or meltdown in the global economy. Create institutions of growth and development.
Ø As an alternative to full CAC, the country can allow the rupee to appreciate and liberalize imports. The imports will prove to be cheap, the cost of production will come down and our exports will become competitive in the global arena. In the current scenario, even in spite of a devalued rupee our export competitiveness is less than 1, which does not augur well for a growing economy.
Ø Expedite the economic and policy reform process, and revamp the entire legal, judiciary system to ensure accelerated dispute settlement process.
Ø Increased infrastructure spending in the form of greater Public Private Partnerships (PPP)
Ø Ensuring more retail participation in the financial markets
Ø Allow the economy to be run by market-determined factors, without providing scope for subsidies (which can only hamper industrial growth and conceal reality)
Ø Allow the rupee to locate its real value against the dollar; a strong rupee is a sign of a strong economy.
Ø Open up different sectors of the economy, which act as engines of economic growth whereby FDI can be pumped in on a large scale, as FDI is the most rewarding form of investment for any economy, representing foreign funds that will stay invested within the country and lend stability to foreign inflows.
To conclude, what is required is a careful, cautious and calibrated approach by RBI buttressed by a full study of historical facts and clinical analysis of the current Indian and global scenario without drawing a blank as to the safeguards that must be put in place for free convertibility of the rupee.
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