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June 9, 1997


Market divided over the capital account convertibility report's feasibility

The capital account convertibility report submitted by the S S Tarapore committee on June 3 provides a comprehensive package to lead India on the road to convertibility by the beginning of the next millennium and integrate and globalise the Indian foreign exchange market with the world economy.

The recommendations aim to integrate both the real and financial sectors with the international markets. But questions persist in the minds of people whether full convertibility is achievable, given the committee's stringent pre-conditions to achieve the convertibility goal.

The pre-conditions are lowering the budgeted gross fiscal deficit to GDP ratio of 4.5 per cent for 1997-98 to 3.5 per cent in 1999-2000, setting up of a consolidated sinking fund to meet the government's debt repayment needs which is to be financed by increases in the Reserve Bank of India's profit transfer to the government and disinvestment proceeds, ensuring transparent and globally comparable procedures for fiscal accounting, maintaining the inflation rate between 3 per cent and 5 per cent in the 1997-2000 period and bringing down the gross non-performing assets of the public sector banks from 13.7 per cent at present to 5 per cent by 2000.

The other pre-conditions are: bringing down the average capital reserve ratio from the present 9.3 per cent to 3 per cent in 2000, lowering the debt servicing ratio from 25 per cent to 20 per cent, ensuring a minimum 40 per cent net foreign assets to currency ratio and four benchmarks to evaluate adequacy of foreign exchange reserves to safeguard against any contingency.

The CAC report is an academic report and the burden is now on Parliament to implement the report. The budget has to be worked accordingly to bring down the inflation as suggested in the report, said S Surendranath, corporate chief, Batlivala and Karani Forex Management Services.

To enable this link up with the global markets, without any serious or volatile impact on the Indian markets, the report recommends adequate mechanisms to cope with the effect of the external impulses that may occur as a result of the far-reaching changes envisaged in the report.

The monitoring exchange rate band is similar to circuit breakers in the stock markets and aims to provide a more effective control to the central bank in dealing with the fluctuations in the forex markets. The RBI will intervene in the market if the exchange rate firms up or slumps beyond the 5 per cent mark.

Some bankers feel that the 5 per cent band is too high and would prefer a smaller band. The band should have been 2 to 3 per cent. The 5 per cent will make the markets more volatile, said a senior forex dealer. Opinion is also divided whether the band will affect arbitrage opportunities. But most bankers feel that the band is large enough to guarantee arbitrage.

The five per cent band is big enough to ensure arbitrage, said Pramod Maskeri, vice-president, Mecklai Financial and Commercial Services Ltd.

The band is bound to ensure transperancy as the report suggests that the RBI periodically announce the neutral real effective exchange rate, monetary exchange rate band and the changes in the neutral REER. The RBI's intervention is meant to create demand on freedom of currency, Surendranath said.

Convertibility may lead to more capital inflows than outflows, as it will signal India's readiness to foreign investment. According to Surendranath capital inflows in India are definitely going to increase as a consequence of convertibility. ''There is no country better than India for investments. In the bond market we have a credit rating of BBA which is very good... We are still in the transition stage and have a long way to go for which we need a great deal of investment,'' he added.

Some suggest that inflows of foreign currencies may appericiate the rupee in the local forex market thereby hampering the export competitiveness of the country.

Foreign investors will sell the dollar to buy the rupee, so the fluctuations as a result of the foreign currency flowing in will be absorbed, said Maskeri. The CAC report lays down risk management practices to cope with the volatility in the interest and exchange rates in the international markets.

The committee has recommended adoption of the O P Sodhani committee report on forex markets by all entities including corporates. According to the committee this would require strong internal control systems to identify, measure, manage and monitor all types of risks.

''We have the risk management products in India, but what is required is imparting education and orientation of corporates. At present, the volumes we are managing are small compared to international standards. We have to come to their levels to be a part of the global economy,'' said Surendranath.

It is important to have authority, delegation, audit and internal controls to manage risks, Maskeri felt.

The report recommends allowing participants in the spot markets to participate in the forward markets. Foreign institutional investors, non-residents and non-resident banks having rupee assets will be allowed forward cover to the extent of their assets. At present forward contracts can be booked on the basis of trading business projections for exporters and importers. Forward cover is allowed for non-residents for the limited purposes like dividend remittances and freight/ passage collections.

The report suggests inclusion of financial institutions in the first phase (1997-98) as authorised dealers of foreign exchange. At present, only banks are acting as ADs. The non-banking financial companies will function as full-fledged ADs in the third phase on the same criteria as financial institutions.

The implementation of the CAC report will also allow derivatives to emerge in the foreign exchange markets. Currently, the only derivative in the forex market is the forex contract.

In the first phase, all derivatives including rupee-based derivatives shall be allowed. Futures in currencies and interest rates will be introduced with the system of screen-based trading providing transperancy to forex contracts.

An efficient settlement system on lines of the one prevailing in the equity markets will function to settle forex transactions. According to Surendranath, this will be a clearing house. ''The idea of a forex clearing house was mooted way back in 1987 for clearing interbank forex transactions. It is useful in nostro accounts,'' he said.

In the subsequent phases, corporates shall have direct access to the overseas markets for derivatives without routing their funds through authorised dealers. Derivatives in the home markets have to be strong before ''we can think of tapping the overseas markets'', said Surendranath.

The report says that the CAC will logically ensure that the forward premia in the forex markets will reflect interest rate differentials between overseas and domestic markets. The committee has recommended that as part of the exchange rate management greater attention should be focused on ensuring that the forex markets reflect interest rate differentials.

In countries where the forex markets is developed forward premium is determined on the interest rate differentials prevailing in the two countries whose currencies are being exchanged. In India, as the rupee is not convertible forward premia are determined on the basis of demand and supply rather than interest rate differentials. Regarding the four indicators for evaluating the adequacy of forex reserves, Surendranath said that the $ 31 billion forex reserves suggested by the committee are sufficient and achievable to accomplish the prescribed pre-conditions.

The drive on the road to convertibility will depend on the acceptance of the CAC report by the Centre and the RBI. If it is accepted it still undergoes the acid test of fulfilling the pre-conditions laid down by the committee to achieve full convertibility.


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