Capital Account Convertibility in India

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“FULLER” CAPITAL ACCOUNT CONVERTIBILITY
A boon or a bane!

Abstract

This is the era of competitive economies and India is one of the pioneers. In the recent years, India has been consistently moving towards becoming a developed nation with its IT and technical advancement, intellectual capital, off shoring and outsourcing to boast of. Capital account convertibility is one of the main features of developed economy. India’s inclination towards CAC, when the Tarapore committee first suggested it in 1997 and after their latest report in 2006, indicates that it is aiming to cash on this opportunity to realize the potential of the economy to the maximum possible extent. Fuller Capital Account Convertibility implies the freedom to convert domestic financial assets into overseas financial assets and vice-versa co-exists with reforms, restrictions and regulatory measures. Thus FCAC brings what is most required today in India-cheaper capital to accelerate the pace of investment, diversification of investment to reduce risk and integration with the global markets alongwith the urgency for strengthening the macroeconomic framework. In this paper, we have studied the prerequisites for implementing FCAC, India’s position and efforts so far, the Asian crisis and lessons learnt from it, and finally, would it be worth taking the risk!

INTRODUCTION

In India, the foreign exchange transactions (transactions in dollars, yen, or any other currency) are broadly classified into two accounts: current account transactions and capital account transactions. If an Indian citizen needs foreign exchange of smaller amounts, say $3,000, for traveling abroad or for educational purposes, she/he can obtain the same from a bank or a moneychanger. This is a current account transaction. But, if someone wants to import plant and machinery or invest abroad, and needs a large amount of foreign exchange, say $1 million, the importer will have to first obtain the permission of the Reserve Bank of India (RBI). If approved, this becomes a capital account transaction. This means that any domestic or foreign investor has to seek the permission from a regulatory authority, like the RBI, before carrying out any financial transactions or change of ownership of assets that comes under the capital account. Thus, the rules regulate currency conversion for foreign entities that want to invest in India and Indians who want to invest overseas making the Indian rupee only “partially convertible”.

By “Capital Account Convertibility” (CAC), we mean “the freedom to convert the local financial assets into foreign financial assets and vice-versa at market determined rates of exchange. It is associated with the 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. …” (Report of the Committee on Capital Account Convertibility, RBI, 1997) At this point of time, it is essential to ascertain which all financial transactions would fall in the “partially convertible” bucket. The financial transactions mentioned above can include but not limited to FDI, FII, and Foreign Portfolio investment, ECB and bank deposits of NRIs.

The following sections briefly summarize the sequence of events that lead India towards the path of CAC. In 1990-91, the Indian economy faced an unprecedented external payments crisis. Due to this, there was paucity in capital inflows into the country and the withdrawals of deposits by non-resident Indians aggravated the situation to massive proportions. The response to the crisis was in the form of the simultaneous implementation of measures of stabilization and structural reform. Current account convertibility and capital account convertibility comes under structural reforms and was one of the many “recommendations” suggested by IMF under its “Articles of Agreement” in August 1994. In 1997 when the first Tarapore Committee on Capital Account...
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