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Nod for total convertibility on capital account soon

The stage is set for India to go in for total convertibility on capital account with a high-powered Reserve Bank of India committee recommending that the rupee should fully float in three years beginning current financial year.

The Committee on Capital Account Convertibility headed by S S Tarapore, in its report presented to RBI Governor C Rangarajan on Tuesday, said given certain weaknesses in the system the implementation schedule should be based on ''careful and continuous monitoring of certain preconditions/ signposts.''

Important variables identified from international experience and specifics of the Indian situation should also be taken into account while introducing the CAC. The timing and sequencing could be accelerated or decelerated depending on assessment of various milestones.

The pre-conditions include fiscal consolidation, a mandated inflation target and strengthening of the financial system.

''The CAC is a continuous process and further measures could be under taken in the light of experience gained,'' the committee said.

India already has convertibility of the rupee on the current account. Finance Minister Palaniappan Chidambaram had announced in his last Budget the setting up of the Tarapore committee on the CAC.

The foreign institutional investors made hectic buying in Indian stocks as the Tarapore committee report was released.

According to the Tarapore committee on CAC, the mandated rate of inflation for the three-year period should be an average of 3 to 5 per cent. ''There should be an early empowering of the RBI on the inflation mandate approved by Parliament and only Parliament should alter that mandate.''

Once the mandate is given, the RBI should be given freedom to attain the target and there should be clear and transparent guidelines on the circumstances under which the mandate could be changed.

The committee said the Centre's gross fiscal deficit to gross domestic product ratio should be reduced from a budgeted 4.5 per cent in 1997-98 to 4 per cent in 1989-99 and further to 3.5 per cent in 1999-2000 accompanied by a reduction in the states' deficit as also a reduction in the quasi-fiscal deficit.

It viewed the strengthening of the financial system as the single most important precondition to the move to CAC. Interest rates should be fully deregulated in 1997-98 and there should be no formal or informal interest rate controls.

Certain important macro-economic indicators -- the exchange rate, the balance of payments and the adequacy of reserves should be monitored while determining the appropriate timing and sequencing of CAC. ''In the conduct of exchange rate policy, the RBI should have a monitoring band of plus or minus five per cent around the real effective exchange rate and ordinarily intervene as and when the REER is outside the band.''

Recognising certain weaknesses in the Indian system, the committee suggested a phased implementation of CAC over a three-year period with a careful and continuous monitoring of preconditions. And depending on the attainment of these preconditions, the timing and sequencing of the measures of CAC could be accelerated or decelerated. Since the CAC is a continuous process, a stock-taking measure should be undertaken at the end of three years in order to assess the impact of the policy measures already implemented.

The committee said that the timing and sequencing of CAC would be greatly facilitated by the proposed changes in the legislative framework governing foreign exchange transactions as envisaged in the Foreign Exchange Management Act.

It also made several recommendations for bringing about a level playing field between various participants in the financial system, removing market segmentation, bringing about uniform treatment of resident and non-resident liabilities for purposes of reserve requirements, improving risk management systems in the financial system, introduction of more stringent capital adequacy norms, prudential standards, effective supervisory system and greater autonomy for banks and financial institutions.

Recognising that the practice of financing the amortisation of government borrowings out of fresh borrowings is clearly unsustainable and would inevitably result in a crisis, the committee has recommended introduction of a Consolidated Sinking Fund as part of a more transparent fiscal system.

The government has urged that any increase in the profit transfer from the RBI to the government as well as the proceeds from disinvestment should be used entirely towards building up a CSF. Furthermore, there should be an early introduction of a system of fiscal transparency and accountability on the lines of the New Zealand Fiscal Responsibility Act. The government should set up its own office of public debt. The RBI should totally eschew from participating in the primary issues of government borrowing.

As a broad rule of thumb, over the three-year period, external sector policies should be designed to ensure a rising trend in the current receipts to GDP ratio from the present level of 15 per cent. The endeavour should be to reduce the debt service ratio from 25 to 20 per cent. The current account deficit (CAD) to GDP ratio would need to be consistent with these parameters.

In the context of CAC, the committee noted that since capital flows would have a more significant effect on the balance of payments, the conventional indicator of reserves in terms of import cover does not provide a good measure of the adequacy of reserves.

The committee has recommended that to prevent an unbridled increase in currency without adequate backing of foreign exchange reserves, a minimum net foreign assets (NFA) to currency ratio of 40 per cent should be stipulated by law in the RBI Act.

The committee said the Indian joint ventures/ wholly owned subsidiaries -- JVs/ WOSs -- should be allowed to invest up to $ 50 million in ventures abroad at the level of the authrorised dealers in phase I with transparent and comprehensive guidelines set out by the RBI. The existing requirement of repatriation of the amount of investment by way of dividend within a period of five years may be removed.

Furthermore, JVs/WOSs should not be restricted to only exporters/exchange earners. Exporters/ exchange earners may be allowed 100 per cent retention of earnings in exchange foreign currency accounts with complete flexibility in operation of these accounts including cheque writing facility in phase I.

Also, individual residents may be allowed to invest in assets in financial market abroad up to $ 25,000 in phase I with progressive increase to $ 50,000 in phase II and $ 100,000 in phase III. Similar limits may be allowed for non-residents out of their non-repatriable assets in India.

The other recommendations are: (i) SEBI-registered Indian investors may be allowed to set up funds for investments abroad subject to overall limits of $ 500 million in phase I, $ 1 billion in phase II and $ 2 billion in phase III.

(ii) Banks may be allowed much more liberal limits in regard to borrowings from abroad and deployment of funds outside India. Borrowings (short- and long-term) may be subject to an overall limit of 50 per cent of unimpaired capital in phase I, 75 per cent in phase II and 100 per cent in phase III with a sub-limit for short-term borrowing.

(iii) In case of deployment of funds abroad, the requirement of section 25 of the Banking Regulation Act and the prudential norms for open position and gap limits would apply. Foreign direct and portfolio investment and disinvestment should be governed by comprehensive and transparent guidelines, and prior RBI approval at various stages may be dispensed with. All non-residents may be treated on par for purposes of such investments.

(iv) In order to develop and enable the integration of forex, money and securities market, all participants in the spot market should be permitted to operate in the forward markets. FIIs, non-residents and non-resident banks may be allowed forward cover to the extent of their assets in India. Currency futures may be introduced with screen-based trading and efficient settlement systems. Participation in money markets may be widened, market segmentation removed and interest rates deregulated.

The RBI should withdraw from the primary market in government securities. The role of primary and satellite dealers should be increased. Fiscal incentives should be provided for individuals investing in government securities. The government should set up its own office of public debt.

(v)There is a strong case for liberalising the overall policy regime on gold banks and FIs. Those fulfilling well-defined criteria may be allowed to participate in gold markets in India and abroad and deal in gold products.