What are the risks in having CAC? Where might trouble arise?
In the international experience with convertibility, the weakest link tends to be banking. Banks have very high debt – they have a debt-equity ratio of 20. This extreme leverage goes with extreme risk. Slight mistakes by the CEO can lead to bankruptcy. As an example, banks themselves generally refuse to lend to a private company which has a debt equity ratio of more than 2. Though the level of loans gone bad – called Non Performing Assets or NPAs – with banks in India is not very high, it is well understood that the incentive structure of a bank owned by the government could be warped. A bank owned by the government knows that it will not be allowed to go bankrupt. This is a serious problem in India, where 80% of bank deposits are with PSU banks. A bank could easily take on a lot of currency risk. So, for example, a bank could borrow cheaply abroad in yen and lend at much higher interest rates in India. Its calculations about the profits it expects to make could go horribly wrong if th
