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Towards full capital account convertibility?

Srabani Guha

Last month the Reserve Bank of India took a bold step in the direction of Full Capital Account Convertibility by allowing domestic residents to hold on to their unspent foreign currency notes/drafts without limit in Resident Foreign Currency (Domestic) Account (RFCDA) to be used later in permissible applications instead of having to surrender and deposit it in the rupee account.

It is a welcome move - long overdue for thousands of Indian residents travelling abroad who can save some trouble - financial and otherwise - every time one needs foreign currency. Are we expecting anything more? A simple answer is no - not as yet.

It all depends on how this piece of regulation or lack of it affects functioning of the hawala market and, in turn, the value of the rupee.

There are two possible sources of dollar flow into the RFCDA - the balance in the current account under the invisible head and the hawala market.

Since the current foreign currency (FC) account for the purpose will earn no interest, and the FC income earned is not tax-exempt, this is not exactly a saving incentive, and will not have a substantial impact on the hawala market as far as inflows are concerned although some entries under the invisible head will now be counted as part of capital flow.

Neither source will be affecting price of the rupee per se, but the additional liquidity that the banking system will have to hold as a cover for their exposure certainly will.

In other words, although, holders of forex will not be converting them back into rupee currency, yet when deposited in the FC account, it will add to the market supply of FC same way as before when converted into rupee and will have no additional impact on the value of rupee from the supply side of the foreign exchange market.

However, since banks issuing FC deposit accounts will have to acquire equivalent amount of FC reserves, the associated demand pressure will cause the rupee to depreciate at least in the short-run.

As for the remnants of the forces of the hawala market -that is an open-ended issue. Although considerably weakened, this parallel market still gets enough funds to keep it going.

If foreign exchange reserves that are being held illegally or absorbed in the hawala market makes legal entry as capital inflow and are held in the RFCDA, the rupee will depreciate even more and any substantial withdrawal crashing the currency market remains a real possibility.

Besides, each of the FC account holders will now be able to transmit foreign exchange legally without much difficulty. Earlier, any such transmission by a rupee account holder had to be through the hawala route now rendered unnecessary by legalising holding of FC.

Provision of this legal channel may actually increase outflow of forex - this time, through the official channel, driving the official rate for the rupee further down.

Further, a substantial part of business, particularly in the outbound direction would now shift away from the hawala market to the official market, reducing premium and legitimacy of the parallel market.

The outcome in terms of the exchange rate depends on the size of the legal versus the hawala market, impacting forex accumulation through the legal channel after netting out increased outflow.

Since 1996-97, the nominal exchange rate has depreciated at an annual average rate ranging from less than 1 per cent to 4 per cent and the real exchange rate fluctuated between a depreciation of 1 per cent to an appreciation of less than 3 per cent.

With the latest relaxation of the provisions, the rupee may depreciate or appreciate depending on the relative strength of forex drain versus accumulation. If on balance, supply of forex increases, then the rupee will appreciate.

A sure loser in this game will be the last participants in the hawala market who are the hardcore illegal operators with questionable forex sources and end uses and hopefully easier for the authorities to deal with.

The exact size of this potential resident foreign currency account is not known but could just be as large as the current invisible account which is of the order of $9-14 billion or a fraction thereof.

The RFCDA together with the stock of NRI deposits outstanding that already constitute more than 50 per cent of the stock of reserves will increase our external exposure considerably and an increased market volatility cannot be ruled out.

But if the hawala market stays unaffected, introduction of 'desi FC account' will be counted only as a minor technical adjustment and a smart move by the RBI towards easing of capital control that would pacify the IMF lobbyists without risking increased exposure to international market volatility before our markets are ready.

The bottomline is that the provision RFCDA is far from achieving FCAC as residents would still not have the legal right to remit sale proceeds of capital assets and gains thereon which (god forbid) probably will never happen without at least a double digit growth driven by a mighty competitive industrial sector.

However, provision of FC account to the residents can provide the essential litmus test for the ongoing hoopla about FCAC.

The next logical step would be to liberalise trade further that would by default force the badly needed element of competitiveness into all our potential growth sectors that could not come at a better time when the world is reeling under recession. More importantly now we can afford it.

The writer is officiating as Deputy Adviser, Planning Commission.

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