Jagran Josh Logo

An overview of Capital Account Convertibility in India

Feb 14, 2016 18:00 IST

In simple terms, currency convertibility means currency of a country can be freely converted into foreign exchange at market determined exchange rate. It is a precondition for rapid growth of world trade and smooth capital flows.

In an economy, the status of currency convertibility can be better understood by assessing policy framework related to the capital account convertibility and current account convertibility.

Primarily, the current account records exports and imports of goods and services, while the capital account is a record of the inflows and outflows of capital that directly affect a country’s foreign assets and liabilities.

Capital Account Convertibility

Capital account convertibility (CAC) means that capital flows - flows of portfolio capital, direct investment flows, flows of borrowed funds and dividends and interest pay¬able on them - is freely convertible into foreign exchange and vice-versa at market determined exchange rate.

In India, since the implementation of the New Economic Policy (NEP) of 1991 and the associated currency reforms currency convertibility has been allowed with respect to both the accounts.

However, fuller convertibility has been in force since 1993-94 with respect to the current account, currency on account of the capital account is only partially allowed in the country.

In order to study the feasibility of the CAC, the Reserve Bank of India (RBI) set up the Committee on Capital Account Convertibility with S S Tarapore as its head in 1997.

Benefits of Capital Account Convertibility

The Tarapore Committee defined CAC as the freedom to convert local financial assets with foreign financial assets and vice-versa at market determined rates of exchange and mentioned the following as its benefits.

• Availability of large funds to supplement domestic resources and thereby promote economic growth

• Improved access to international financial markets and reduction in cost of capital

• Incentive for Indians to acquire and hold international securities and assets

• Improvement of the financial system in the context of global competition

Keeping in mind the above advantage, the committee recommended the adoption of CAC.

Preconditions for CAC

However, the committee also laid down certain preconditions for the introduction of the CAC. They were,

• Fiscal deficit should be reduced to 3.5 per cent.

• The Governments should fix the annual inflation target between 3 to 5 per cent. This was called mandated inflation target

• The Indian financial sector should be strengthened. Gross non-paying assets (NPAs) should be reduced to 5 per cent; the average effective CRR should be reduced to 3 per cent and weak banks should either be liquidated or be merged with other strong banks.

• RBI should have a monitoring exchange rate band of 5 per cent around Real Effective Exchange Rate (REER) and should intervene only when the RER is outside the band

• The size of the current account deficit should be within manageable limits

• To meet import and debt service payments, forex reserves should be Aadequate

• The Government should remove all restrictions on the movement of gold

The major difficulty with the Tarapore Committee recommendation was that the current account convertibility to be achieved in a 3 year period that is between 1998 and 2000.

The period was too short and the pre-conditions and the macroeconomic indicators could not be achieved in such short period.

As a result, the RBI constituted the Committee on Fuller Capital Account Convertibility with S S Tarapore again as chairman. The Tarapore Committee II submitted its report in September 2006.

The second Tarapore Committee had drawn up a roadmap for 2011 as the target date for fuller capital convertibility of rupee.

However, economic events, especially global financial crisis of 2007-09, made policy makers to rethink on the introduction of the CAC.

Present macroeconomic scenario

India’s external sector was vulnerable till recently, with the current account deficit above the comfort level of 2.5 per cent of the gross domestic product. It was 4.2 per cent of GDP in 2011-12 and rose to 4.7 per cent in 2012-13.

After severe curbs, including restrictions on import of precious metals, the deficit fell to 1.7 per cent in 2013-14. In 2014-15, it continued to stay low, with the third quarter showing a deficit of 1.6 per cent.

The fiscal deficit of the Union Government has been 4.6-6.5 per cent in the past six years, before falling to 4.1 per cent in 2013-14. The government is committed to keeping the fiscal deficit low and the target of 3.9 per cent has been retained for this year. The deficit target will be progressively reduced to 3.5 and 3 per cent in 2016-17 and 2017-18, respectively.

Despite the fact that the macro economic situation is conductive for CAC, there are still certain apprehensions for its introduction. They are,

• It is recognised that capital flows are sensitive to macroeconomic conditions. Any deterioration in fiscal conditions, inflation management, balance of payments, or any other macroeconomic shock may cause a cessation or reversal of capital flow

• Volatile capital flows can lead to extreme volatility in the exchange rate and large departures from its equilibrium value

Conclusion

There is no denying the fact that sound capital controls have worked well in the Indian case and helped the economy sail through financial and currency crisis. A truly globalised economy, which the Indian economy is likely to become in the future, cannot afford to remain isolated for a very long period of time.

However, the most important preconditions like fiscal consolidation, inflation control, low level of NPAs, low and sustainable current account deficit, strengthening of financial markets, prudential supervision of financial institutions, etc. should be met before India embarks on the path of full capital account convertibility.

Now get latest Current Affairs on mobile, Download # 1  Current Affairs App

Is this article important for exams ? Yes4 People Agreed

DISCLAIMER: JPL and its affiliates shall have no liability for any views, thoughts and comments expressed on this article.

Latest Videos

Register to get FREE updates

    All Fields Mandatory
  • (Ex:9123456789)
  • Please Select Your Interest
  • Please specify

  • ajax-loader
  • A verifcation code has been sent to
    your mobile number

    Please enter the verification code below

Newsletter Signup
Follow us on
This website uses cookie or similar technologies, to enhance your browsing experience and provide personalised recommendations. By continuing to use our website, you agree to our Privacy Policy and Cookie Policy. OK