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Convertibility in India
“My hope is that we will get to full capital account convertibility in a short number of years,” said Raghuram. G. Rajan, ex-governor of the Reserve Bank of India (RBI) on 10 April 2015.
The International movement of capital is not always free; countries restrict flows of capital as and when needed to safeguard their markets from erratic flows of capital. In India, for example, there are restrictions on the movement of foreign capital and the rupee is not fully convertible on capital account.
What does Capital Account Convertibility mean?
CAC means the freedom to convert rupee into any foreign currency (Euro, Dollar, Yen, Renminbi etc.) and foreign currency back into rupee for capital account transactions. In very simple terms it means, Indian’s having the freedom to convert their local financial assets into foreign ones at market determined exchange rate. CAC will lead to a free exchange of currency at a lower rate and an unrestricted movement of capital.
How is Capital Account Convertibility different from Current Account Convertibility?
Current Account Convertibility allows free inflows and outflows of foreign currency for all purpose including resident Indians buying foreign goods and services (imports), Indians selling foreign goods and services (exports), Indians receiving and sending remittances, accessing foreign currency for travel, study abroad, medical tourism purpose etc.
On the other hand, Capital Account Convertibility is widely regarded as the hallmark of developed countries. It is also seen as the major comfort factor for foreign investors since it allows them to reconvert local currency back into their own currency and move out from India.
To attract foreign investment, many developing countries went in for CAC in the 1980s, not realising that free mobility of capital leaves countries open to both sudden and huge inflows and outflows, both of which can be potentially destabilising. More important, unless you have the institutions, particularly financial institutions capable of dealing with such huge flows, countries may not be able to cope as was demonstrated by the East Asian crisis of the late 90s.
Present Situation in India
In India, the Tarapore committee had laid down a three-year road-map, ending 1999-2000, for CAC. It also cautioned that this time-frame could be speeded up, or delayed, depending on the success achieved in establishing the pre-conditions primarily fiscal consolidation, strengthening of the financial system and low rate of inflation. With the exception of the last, the other two preconditions have not been achieved. The Capital Account Convertibility in India will depend on how fast the country meets the preconditions put forward by Tarapore Committee such as fiscal consolidation, inflation control, low level of Non-Performing Assets, low Current account deficit and strengthen financial markets. Sound policies, robust regulatory framework promoting a strong and efficient financial sector, and effective systems and procedures for controlling capital flow greatly enhanced the chances of ensuring that such flows fostered sustainable growth and did not lead to disruption and crisis.
- Current Account Convertibility: Current account is today fully convertible (operationalized on August 19, 1994). It means that the full amount of the foreign exchange required by someone for current purposes will be made available to him at the official exchange rate and there could be an unprohibited outflow of foreign exchange (earlier it was partially convertible). India was obliged to do so as per Article VIII of the IMF which prohibits any exchange restrictions on current international transactions (keep in mind that India was under pre-conditions of the IMF since 1991).
- Capital Account Convertibility: After the recommendations of the S.S. Tarapore Committee (1997) on Capital Account Convertibility, India has been moving in the direction of allowing full convertibility in this account, but with required precautions. India is still a country of partial convertibility (40:60) in the capital account, but inside this overall policy, enough reforms have been made, and to certain levels of foreign exchange requirements, it is an economy allowing full capital account convertibility. Following steps have been taken in the direction of capital account convertibility.
- Indian corporate is allowed full convertibility in the automatic route up to $ 500 million overseas ventures (investment by Ltd. companies in foreign countries allowed).
- Indian corporate is allowed to prepay their external commercial borrowings (ECBs) via automatic route if the loan is above $ 500 million.
- Individuals are allowed to invest in foreign assets, shares, etc., up to the level of $ 2,50,000 per annum.
- Unlimited amount of gold is allowed to be imported (this is equal to allowing full convertibility in the capital account via current account route, but not feasible for everybody) which is not allowed now.
The Second Committee on the Capital Account Convertibility (CAC)— again chaired by S.S. Tarapore— handed over its report in September 2006 on which the RBI/the government is having consultations.
Pros and cons of Capital account Convertibility
| Advantages | Disadvantages |
| Availability of large funds by improved access to international financial markets. | Market determined exchange rates being higher than officially fixed exchange rates can raise import prices and cause Cost-push inflation. |
| Reduction in cost of capital. | Improper management of CAC can lead to currency depreciation and affect trade and capital flows. |
| The incentive for Indians to acquire and hold international securities and assets. | The advantages have been found to be short lived as per studies, and also International financial institutions are skeptical about CAC post-2008 crisis. |
| Greater financial competitiveness. | Speculative activity can lead to capital flight from the country as in case of some South East Asian economies during 1997-98. |
| Will help Indian corporate to use External commercial borrowing route without RBI or Govt approval. | Imposing control would become difficult in a globalized environment once CAC is introduced. |
| Indian residents can hold and transact foreign currency denominated deposits with Indian banks. | |
| A Certain class of financial institutions and later NBFCs can access global financial market. | |
| Banks and financial institutions can trade in Gold globally and issue loans. |
By
Himanshu Arora
Doctoral Scholar in Economics & Senior Research Fellow, CDS, Jawaharlal Nehru University
What is this partial convertibility of (40:60) in capital account?