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Capital Account Convertibility: There is Still Time1

Meaning and definition:

In India, the foreign exchange transactions (transactions in dollars, pounds, or any other
currency) are broadly classified into two accounts: current account transactions and capital
account transactions. If an Indian citizen needs foreign exchange of smaller amounts, say $3,000,
for travelling abroad or for educational purposes, she/he can obtain the same from a bank or a
money-changer. This is a “current account transaction”. But, if someone wants to import plant
and machinery or invest abroad, and needs a large amount of foreign exchange, say $1 million,
the importer will have to first obtain the permission of the Reserve Bank of India (RBI). If
approved, this becomes a “capital account transaction”. This means that any domestic or
foreign investor has to seek the permission from a regulatory authority, like the RBI, before
carrying out any financial transactions or change of ownership of assets that comes under the
capital account. Of course there are a whole range of financial transactions on the capital account
that may be freed from such restrictions, as is the case in India today. But this is still not the
same as full capital account convertibility2.

Effects:

• CAC is widely regarded as one of the hallmarks of a developed economy. It is a major


comfort factor for overseas investors, who feel confident that at any time, they will be
able to repatriate the proceeds and gains from business and commerce3.

• Indian business will be able to access cheap external credit without having to ask
permission of the Reserve Bank of India.

1
The Author, Niladree Chatterjee is an associate working in Singh&Associates, New Delhi.
2
Inputs taken from Capital Account Convertibility: Neo-liberalism’s New Threat to India,
Amitayu Sen Gupta and Shouvik Chakraborty.
3
Capital Account Convertibility for India – Current Concerns, S. Narayan, ISAS Brief No.5, 10th
April 2006.
• Allocation of foreign funds in the country helps in equalizing the capital return rates not
only across different borders, but also escalates the production levels. Moreover, it brings
about a fair allocation of the income level in India as well.

• Along with the financial capitalists, the reputed commercial firms in India jointly derive
and enjoy the benefits of the CAC policy, which speculate the stock markets through
investments.

• It is considered to be a signal of the openness of the economy and aimed at encouraging


global capital flows into the country.

• During the good years of the economy, it might experience huge inflows of foreign
capital, but during the bad times there will be an enormous outflow of capital.

• Full capital account convertibility may encourage arbitrage operation. It is so because


banks, non-banking financial institutions and individual borrowers will prefer to borrow
global capital cheap which would not only increase the external debt burden of the
country but also encourage the functioning of the "black economy" and financial
instability because of the heavy investment in physical and financial assets4.

• Market risks such as interest rate and foreign exchange risks become more complex as
financial institutions and corporate gain access to new securities and markets, and foreign
participation changes the dynamics of domestic markets. For instance, banks will have to
quote rates and take unhedged open positions in new and possibly more volatile
currencies5.

4
The Hindu Business Line, May 27 2004.
5
Capital Account Convertibility and Risk Management in India, Amadou N. R. Sy, IMF
Working Paper, October 2007
• An open capital account can lead to “the export of domestic savings” (the rich can
convert their savings into dollars or pounds in foreign banks or even assets in foreign
countries), which for capital scarce developing countries would curb domestic
investment. Moreover, under the threat of a crisis, the domestic savings too might leave
the country along with the foreign ‘investments’, thereby rendering the government
helpless to counter the threat.

• International finance capital today is “highly volatile”, i.e. it shifts from country to
country in search of higher speculative returns. In this process, it has led to economic
crisis in numerous developing countries. Such finance capital is referred to as “hot
money” in today’s context. Full capital account convertibility exposes an economy to
extreme volatility on account of “hot money” flows.

Development by the government in this regard:

Up to 1991, when India faced a major foreign exchange crisis, there had been very rigid controls
on both the external capital as well as the current account. The liberalization process that started
after 1991 and the terms of the IMF conditionality helped to relieve the current account
transactions and the resulting growth and investments in the economy augmented the forex
reserves of the country. The improvements encouraged the government to set up a committee in
1997 to spell out a road map for the full convertibility of the rupee6.
It suggested many preconditions for introducing full CAC like:
• Fiscal deficit of the GDP should go down.
• The annual rate of inflation should remain low and constant. It was maintained and
achieved.
• The foreign exchange reserves of the country should be sufficient for six months’
imports. At present, foreign exchange reserves are equal to two years import cover.

6
The committee was headed by Mr. S. S. Tarapore, Former Deputy Governor of RBI and it
suggested many things for the convertibility of rupee.
• Non-performing assets of banks should not be more than five percent of the deposits7.

But before all the objects could be fulfilled the South Asian Monetary crisis propped up and the
recommendations could not be implemented but the government again set up the committee
headed by Mr. S. S. Tarapore in 2006 it also recommended management of better liquidity risks
and credit risks by the banks before FCAC by monitoring the liquidity levels through a
centralized internal mechanism of the banks and through different currencies. It also stressed on
the increase of more derivative instruments, proper accounting framework, and proper
disclosures to be made and comprehensive guidelines for the derivatives should be framed to
mitigate the possible risks of FCAC but the significant results could not be achieved8.

7
Inputs taken from the Tarapore Committee Report, RBI Press Release dated June 3, 1997
8
Inputs taken from the Tarapore Committee Report, RBI Press Release dated January 31,
2006.