Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Capital Account Convertibility 2.0

The Reserve Bank of India (RBI) has published the report
of the Committee on Fuller Capital Account Convertibility chaired by
S. S. Tarapore. A
committee with the same chairman and almost the
same set of members gave a report on Capital Account Convertibility to
the RBI in 1998. Therefore, in line with phrases like Web 2.0 and
Bretton Woods 2.0, I have chosen to call it CAC 2.0.

I resolved not to blog about CAC 2.0 until I had read the report
fully. Since the report is over 200 pages long, it was only with great
difficulty that I have managed to adhere to this resolve. My first set
of comments are as follows:

  • The dissent notes by Surjit Bhalla and A. V. Rajwade are more
    interesting and thought provoking than the main report itself.
  • CAC 1.0 at 80 pages was less than half the length of CAC 2.0. It was also
    characterized by much greater conceptual clarity and internal
    consistency. In fact, CAC 1.0 could be summarized in two sentences:
    “Based on an assessment of macro economic conditions, the
    Committee is of the considered view that the time is now apposite to
    initiate a move towards CAC. … Fiscal consolidation, a mandated
    inflation target and strengthening of the financial system
    should be regarded as crucial preconditions/signposts for CAC in
    India.” Everything in CAC 1.0 reflected this philosophy and
    while I disagreed with CAC 1.0 for being too cautious, I could not
    fault its internal consistency. One would struggle to find a similar
    succint philosophy for CAC 2.0
  • CAC 1.0 took place in the backdrop of the Asian crisis. CAC 2.0
    takes place in the backdrop of a much stronger external position and
    greater optimism about India. Yet a high degree of timidity permeates
    CAC 2.0.
  • The most controversial recommendation of CAC 2.0 is about
    Participatory Notes (PNs). A PN is a cash settled OTC derivative sold
    by a registered foreign institutional investor (FII) to entities outside
    India. Though these instruments are traded between foreigners outside
    India, Indian regulators have exercised jurisdiction over them relying
    on the fact that the FII which issues these PNs is registered with
    Indian regulators. CAC 2.0 recommends a complete ban on new PNs and
    the liquidation of existing PNs within one year. The argument given is
    that “In the case of Participatory Notes (PNs), the nature of
    the beneficial ownership or the identity is not known unlike in the
    case of FIIs”. In the same breath,
    CAC 2.0 recommends that foreign corporate and individual investors
    should be allowed to invest in India through entities registered with
    the Indian regulators. On the face of it, therefore, a US hedge fund would be
    able to invest in India through an Indian stock broker who would be
    responsible for enforcing the Know Your Client norms. Or perhaps,
    the hedge fund would come through an Indian portfolio manager
    offering a non discretionary portfolio management service. In either
    case, the foreign entity is not now registered with the Indian
    regulator and not subject to its jurisdiction. How the Indian
    regulator would now enforce a ban on that unregulated entity selling
    cash settled OTC derivatives outside India is beyond my
    comprehension. Finally, if any foreign entity can invest in India
    directly, it is difficult to see what is gained by banning PNs. A
    foreign investor can easily hide behind several layers of special
    purpose vehicles and corporate entities that make it impossible to
    determine beneficial ownership even if all Know Your Client norms are
    adhered to. The recommendations lack internal consistency.
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