• UGI USER
  • Oct 07, 2023
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Q. What do you understand about capital account convertibility? State the merits and demerits of full capital account convertibility for India.

 

Approach

  • Define Capital Account Convertibility (CAC).
  • Substantiate the pros and cons for moving towards the path of fuller CAC in the context of India.
  • Conclude accordingly.

Answer

  • Capital account convertibility (CAC) means the freedom to conduct investment transactions without any constraints. Typically, it would mean that there would be no restrictions on the number of rupees (local currency) that can be converted into foreign currency.
  • It implies freedom of currency conversion related to capital inflows and outflows, and therefore sometimes referred to as Capital Asset Liberalisation. At present, India allows full convertibility in the current account but only partial convertibility in the capital account.

The two Tarapore Committee Reports—1997 and 2006—laid out a path to move towards full CAC. However, the process of liberalizing the capital account, in the last three decades since liberalization began, has remained a gradual and cautious one.

Merits of full CAC

  • Improved access to international markets: CAC would facilitate further liberalization and attract foreign investments.
  • Bring in financial efficiency: An open capital account could bring with it greater specialization and innovation by exposing the financial sector to global competition. It may reduce the cost of capital.
  • Increase the choices for investments: Residents get the opportunity to base their investment and consumption decisions on global interest rates and global prices for tradeables, which could enhance their interests and welfare. For instance, Indian investors would be able to invest in foreign securities and assets.
  • Hedging investment risks: By offering the opportunity of using the world market to diversify portfolios, an open capital account permits both savers and investors to protect the real value of their assets through risk reduction.

Arguments against full CAC

  • Export of domestic savings: Speculative activity can lead to an outflow of capital from the country as seen in the case of some South-East Asian economies during 1997-98.
  • Tax avoidance: CAC could weaken the ability of the authorities to tax domestic financial activities, income, and wealth.
  • Cost-push inflation: Mostly the market-determined exchange rates are higher than officially fixed exchange rates. Thus, CAC could raise import prices and cause cost-push inflation.
  • Disruptions in the economy: Improper management of CAC can lead to currency depreciation and affect trade and capital flows. Still, the preconditions for convertibility set out in the Tarapore committee (gross fiscal deficit being less than 3.5% of GDP, an inflation rate of 3-5% over three years, the effective CRR being 3%, and gross NPAs of 5% or less) remains to be achieved.

Thus, efforts must be made in this regard if the benefits of CAC need to be achieved.