Capital Account Convertibility in India

INTRODUCTION

The objective of this paper is to discuss the highly intensified debate on the issue of Capital Account Convertibility (CAC) in India. There is no formal definition of Capital Account convertibility but the Tarapore committee set up in February 1997 gave a pragmatic working definition of CAC as “CAC refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. It is associated with changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by, the rest of the world. CAC can be, and is, coexistent with restrictions other than on external payments. It also does not preclude the imposition of monetary/fiscal measures relating to foreign exchange transactions which are of a prudential nature”. So this means that CAC will result in free and unregulated inflow and outflow of Capital funds. India has since long adopted the Current Account Convertibility wherein the exporters and importers can have easy conversion to and forth in foreign currency where they trade.

Benefits of Capital Convertibility

The implementation of CAC opens up the economy in terms of capital inflows and outflows:

1. Greater Capital Mobility: If CAC is allowed, it is argued that foreign fund inflows to the country become easier thus increasing the availability of large capital stock. Developing nations, which are usually capital-scarce, are blessed under unhindered mobility of capital and this capital can be used in long term investments thus raising the national income.

2. Access to global pool of savings: Once the door to investing in international securities gets opened up, CAC will allow residents to hold internationally diversified portfolios thereby reducing the vulnerability of income streams to shocks in the domestic market.

3. Effective Financial Intermediation: CAC helps institutions access to various financial products and services across the globe where in they can look at getting returns effectively. The resulting competition benefits the consumer of financial services since the products and services offered will have to become more efficient raising the bar to service at higher levels.

4. Check on Distortionary policies: It is argued that with CAC in place, the economy comes under vigilant watch by foreign players. Thus any distortionary policies taken by the Government will be put under extreme scrutiny and it might lead to a currency crisis if such policies elicit unfavorable responses from such international players. So the nation can be in a way guarded from political instabilities.

If India goes for fuller Capital Account Convertibility then it is going to prove beneficial for her in the following terms:

a) As there will be inflow of capital, then it can be used for overall development of the country.

b) Forex inflows can be used for specific purposes like infrastructural development which is outmost importance.

c) It can be used for developing the country’s untapped human resources which again can be used for the country’s development.

d) It will increase the country’s goodwill in comparison to other developed countries of the world.

e) It will increase the country’s foreign reserve also which can put to use for different purposes like balance payments, investment in foreign country, etc.

f) Indian investors can divert their surplus saving to other investments in foreign countries to get better returns.

g) During any financial crisis, India could be in safe position as the country’s money which is invested in foreign countries can be used in the country as there will be flexibility for Indian investors

Problems with implementing CAC in India:

Implementing CAC along with its advantages brings a lot of risks and problems. Let us first look at the broader picture of the different types of risk that CAC implementation brings on the countries economy. Looking at the various risk factors associate with CAC implementation, these risks may be classified into five types:

(i) Currency Risk

(ii) Capital Flight Risk

(iii) Fragility Risk

(iv) Contagion risk

(v) Sovereignty Risk.

(vi) Allocation Risk

(vii) Domestic