CAPITAL ACCOUNT CONVERTIBILITY

Economic reforms in India have accelerated growth, enhanced stability and strengthened both external and financial sectors. Our trade as well as financial sector is already considerably integrated with the global economy. India's cautious approach towards opening of the capital account and viewing capital account liberalization as a process contingent upon certain preconditions has stood India in good stead. It is interesting to note the difference between Current Account convertibility and Capital Account convertibility

Current Account convertibility means the freedom to convert one currency into other internationally accepted currencies wherein the exporters and importers where allowed a free conversion of rupee. But still none was allowed to purchase any assets abroad. Capital Account Convertibility means that rupee can now be freely convertible into any foreign currencies for acquisition of assets like shares, properties and assets abroad. Further, the banks can accept deposits in any currency.

Capital Account Convertibility (CAC) is the freedom to convert local financial assets into foreign financial assets at market determined exchange rates. Referred to as ‘Capital Asset Liberation’ in foreign countries, it implies free exchangeability of currency at lower rates and an unrestricted mobility of capital. India presently has current account convertibility, which means that foreign exchange is easily available for import and export for goods and services. India also has partial capital account convertibility; such that an Indian individual or an institution can invest in foreign assets up to $25000. Foreigners can also invest along the same lines. At present, there are limits on investment by foreign financial investors and also caps on FDI ceiling in most sectors, for example, 74% in banking and communication, 49% in insurance, 0% in retail, etc.

Given the changes that have taken place over the last two decades, however, there is merit in moving towards fuller capital account convertibility within a transparent framework. There is, thus, a need to revisit the subject and come out with a roadmap towards fuller Capital Account Convertibility based on current realities. In consultation with the Government of India, the Reserve Bank of India has appointed a committee to set out the framework for fuller Capital Account Convertibility.

The First Tarapore Committee was set up by the RBI in 1997 to study the implications of executing CAC in India. It recommended that the before CAC is implemented, the fiscal deficit needs to be reduced to 3.5% of the GDP, inflation rates need to be controlled between 3-5%, the non-performing assets (NPAs) need to be brought down to 5%, Cash Reserve Ratio (CRR) needs to be reduced to 3%, and a monetary exchange rate band of plus minus 5% should be instituted. However, most of the pre-conditions weren’t entirely fulfilled. Thus, CAC was abandoned for the moment.

However due to renewed optimism in the year 2006 as some of the targets suggested by the First Tarapore Committee were achieved along with consolidation of banks, a strong export front, large forex reserves amounting to $300 billion and high growth rates instilled  some hope making way for setting up of a Second Tarapore Committee to look into the PM’s proposal to reevaluate the earlier stand.

Second Tarapore Committee Recommendations:

1. The ceiling for External Commercial Borrowings (ECB) should be raised for automatic approval.

2. NRI should be allowed to invest in capital markets.

3. NRI deposits should be given tax benefits.

4. Improvement of the banking regulations

5. FII should be prohibited from investing fresh money through Participatory notes.

6. Existing PN holders should be given an exit route to phase out completely the PN notes.

At present the rupee is fully convertible on the current account, but only partially convertible on the capital account.

CAC can be beneficial for a country as the inflow of foreign investment increases and the transactions are much easier and occur at a faster pace. CAC also initiates risk spreading through diversification of portfolios. Moreover, countries gain access to newer technologies which translate into further development and higher growth rates.

Even though CAC seems to have many advantages, in reality, it can actually destabilize the economy through massive capital flight from a country. Not only are there dangerous consequences associated with capital outflow, excessive capital inflow can cause currency appreciation and worsening of the Balance of Trade. Furthermore, there are overseas credit risks and fears of speculation. In addition, it is believed that CAC increases short term FIIs more than long term FDIs, thus leading to volatility in the system.

Hence, India still needs to work on its fundamentals of providing universal quality education and health services and empowerment of marginalized groups, etc. The growth strategy needs to be more inclusive. There is no point trying to add on to the clump at the top of the pyramid if the base is too weak. The pyramid will soon collapse! Thus, before opening up to financial volatility through the implementation of FCAC, India needs to strengthen its fundamentals and develop a strong base.

Concluding it can be said that India should either wait for a while or implement CAC in a phased, gradual and cautious manner as enshrined in the present policy.

(Pardeep Kumar)