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.