X'PRESSIONS
The Dilemma of CAC
CAC alias Capital Account Convertibility is the name of current dilemma which Indian Financial “Think- tank” is facing.
Capital Account Convertibility means freedom to buy financial assets abroad like buying shares, mutual funds, deposits in overseas bank, real estate, gold, silver, etc for public at large and corporate and financial institutions without any currency restrictions by the reserve bank of India.. Currently, the rupee is freely converted for trade in goods and services, but restrictions are placed on international asset acquisition by way of various limits set by RBI.
Pros and Cons of CAC
There are three benefits to India from CAC:
- Rates of return on debt and equity in India are high by world standards. With convertibility, foreign money will come into India to arbitrage this differential away and reduce these rates of return: i.e., the cost of capital faced by the companies of India in equity and debt financing will drop. At a lower cost of capital, more investment projects would be viable, which would generate a faster pace of investment and growth in the economy.
- With convertibility, Indians would be able to diversify their portfolios internationally. Instead of being constrained to only hold Indian real estate, equity and debt, we will reduce our risk by diversifying internationally. This means that in a bad year in India, when Indian financial assets generate a poor return, foreign assets owned by Indians would continue to generate good returns. This reduction in the variability of returns would make Indians happier since they face less risk, and help stabilize India's macro economy.
- Convertibility means that the households and firms of India are not forced to meet each other through India's financial system. The GDR market is one example of the alternative: here Indian firms chose to meet with foreign investors through the markets outside India. This market arose in response to weaknesses of existing markets in India. With convertibility, it will be possible for Indian firms to interact with Indian households in (say) the markets of Singapore. This would provide alternatives for India's households and firms, generate competition for India's financial industry, and elevate the urgency of reforms in the financial sector. For example, if derivatives on the dollar--rupee start trading in Singapore or Chicago, convertibility means that we in India would be able to use them.
If there is fear lurking around the convertibility, it has to do with FII (foreign institutional investor) inflows. Accordingly to SEBI statistics, The FIIs brought in a little over $25 billion or RS 1,15,000 crore into the country in last three years. Experts warn that any sudden depreciation in the rupee-triggered perhaps by the rising trade and current account deficits-will trigger a massive outflow of foreign money, FII funds in the main. Flight of capital could have its serious implications. Some amount of caution is required as a considerable amount of money is likely to flow-in and flow-out of the country post CAC.