Fully Convertible Capital Account: Is India prepared for it?

"Capital account convertibility is not an event but a process": RBI Governor Shaktikanta Das

WHAT IS A CAPITAL ACCOUNT?

The balance of payment account, which records all the transactions made between a country and the rest of the world, consists of two accounts - a current account and a capital account. The matter of concern is the capital account which deals with the cross-border movement of capital by way of investments and loans.

Illustration by Team Geostrata

Capital account convertibility refers to the transactions and investments carried out without any legal barriers. In simple terms, there would be no constraints on the conversion of foreign currency into Indian rupees and vice versa. Also, there would be no restraints in acquiring an Indian asset by foreigners or acquiring any foreign asset by Indians.

WHY IS IT IMPORTANT?

One of the most important features of full capital account convertibility is that the large capital stock would be available at international prices to amplify the domestic resources and this would further develop the financial markets of the nation. Also, foreign interactions would discipline the macroeconomic policies of the government.

With full capital account convertibility, the Indian economy would witness risk diversification and there will be an increase in savings and investments. An open capital account imposes efficiency in the allocation and negotiation of financial resources. It will also induce large capital inflows which would lead to appreciation in the exchange rate.

S.S. TARAPORE COMMITTEE

The S.S. Tarapore committee was established by the Reserve Bank of India on 28th February 1997 to propose a timetable for full capital account convertibility and its other important aspects. The four main agendas of the committee were to: review the international experience on capital account convertibility and based on this recommend the preconditions to be followed by India, recommend the measures and levels to achieve capital account convertibility, prepare a roadmap or timetable to be followed by India, suggest changes in the domestic policies and the institutional changes.

The report was submitted on 30 May 1997, which comprised the preconditions and a road map or ground plan for the capital account convertibility and condition of the capital account in 1997.

WHAT ARE THE PRECONDITIONS OF FULL CAPITAL ACCOUNT CONVERTIBILITY?

First of all, there has to be macroeconomic stability in the domestic sector of the country and the suitability to compete against foreign goods.

Second, the government of the country must give incentives for the growth of export units and also implement various strategies for trade-oriented development.

Third, the country's investment environment must be friendly and there should be an attractive industrial policy. Lastly, the current account balance of the home country should be favourable and the country should have enough foreign exchange reserves.

WHY IS THERE A NEED TO FOLLOW THESE PRECONDITIONS?

Even though Full capital account convertibility promotes an increase in the capital inflow in the country, it simultaneously also increases the risk of capital outflows in adverse situations which can lead to a currency crisis.

S.S. Tarapore committee argued that the countries that had apparently better fiscal positions than India also faced currency crises when the economic growth of the country declined. Another reason for most of the currency crises arose out of the extended over-evaluation of the exchange rates leading to current account deficits reaching unsustainable levels.

Hence it becomes necessary for India to follow the preconditions and stabilise the current account of the country before converting the capital account fully.

GROUND PLAN OF FULL CAPITAL ACCOUNT CONVERTIBILITY

In India, a 3-year roadmap was prepared by the S.S.Tarapore Committee for capital account convertibility which was foreseen to end by 1999-2000. However, the committee noted that timeline may be delayed or advanced depending on the fulfilment of preconditions which included strengthening the financial system, less inflationary rate, fiscal consolidation, strong financial markets, a low current account and a low level of non-performing assets. According to the committee, these magnitudes would determine the Capital account convertibility in India even after decades.

For the prevention of the currency crisis, the committee suggested some determinants which included systems for monitoring capital flow, increased efficiency of the financial sector and efficient policies in favour of economic growth.

WHAT IS THE CURRENT CONDITION OF FULL CAPITAL ACCOUNT CONVERTIBILITY IN INDIA?

With the recommendations made by S.S. Tarapore Committee, India is taking one step at a time towards full capital account convertibility with necessary precautions. India is still a country with a partial capital account i.e. in India there are some restrictions in the global exchanges which include large amounts of money.

There have been ample reforms and the country has achieved a complete capital account convertibility to specific levels of foreign exchange. Some of these measures were highlighted by Aditi Nayar, Chief Economist of ICRA, in one of her interviews with Business Standard. These include the measures taken by the government and RBI to get India included in Global Bond Indices and liberalising norms related to Government security investments.

EXPERT'S OPINION

Gaurang Shah, Senior Vice President of Geojit Financial Services in an interview with Business Standard gave some precautionary measures before making the capital account fully convertible.

First, it should be done in a phased manner and not with immediate effect. Second, India must have checks and balances in place for keeping a check on the inflow of overvalued currencies which are more stabilised than Indian currency as it can lead to the process of hyperinflation where currencies from foreign sources could replace the local currencies, according to Gresham's law. Only after these measures India would be prepared for the conversion front.

In an interview with WION, Ex-Deputy Governor of RBI, Rama Subramaniam Gandhi, on the question of full convertibility answered that full convertibility is a process someday India would reach and every step would be closer to that but any point in time so far has not come to that conclusion that India is ready for it.

Though the country is in a reasonable situation in terms of inflation of a single digit number and government fiscal deficit within target there is still a negative situation in the current account deficit as there is yet to have a leap forth in export earnings.

CONCLUSION

Given the present condition of the current account and capital account, India is not fully prepared for capital account convertibility. The country needs to strengthen the domestic markets and fix the current account deficit along with fulfilling all the preconditions suggested by the S.S. Tarapore Committee to avoid a situation like that of the Mexican and East Asian crises.

These crises highlighted the problems which arose from the combination of high current account deficits, and high dependence on short term capital flows, finally leading to currency crises.

To prevent the currency crisis caused by the high current account deficit and dependence on short-term capital flows, India is moving at a slow but steady pace. It is putting all the security checks in place and is defining every step towards unrestricted global exchanges. The country's growth in the economic sector would surely make fully convertible capital account a reality.

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NIDHI SONI

TEAM GEOSTRATA

info@thegeostrata.com