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The Debate on Capital Account Convertibility in India
Capital Account Convertibility is considered the hallmark of a developed economy. CAC, as defined by Tarapore committee is the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange.
CAC is in line with the classical theory of economics where markets clear itself and attain equilibrium prices by creating demand for the given supply levels. This assumes the presence of an invisible hand enabling the market clearance. But patrons of the Keynesian economics believe that the markets are governed more by market sentiments than fundamentals in the short term. This short term perspective of the investors can destabilize the economy and create volatility in the market. Hence it is important that the country has strong macroeconomic factors to support the volatility.
In late 1980’s India faced a balance of payment crisis due to fiscal imbalances. India’s credit rating was downgraded and access to external funds became bleak. By early 1991, foreign exchange reserves were almost depleted, and India was on the verge of default. IMF came to the rescue and provided the necessary funds to pull India out of the crisis. In 1994, as a part of Article VIII of IMF, India implemented Current Account Convertibility and accepted to implement Capital Account Convertibility.
Under the supervision of IMF other developing economies had implemented CAC. They had fixed exchange rate system pegged to the USD. When the Dollar rose, consequently the ASEAN currencies grew too, resulting in lower exports. This resulted in a decline in export earnings of these countries and thus increasing their trade and current account deficit. The crisis first emerged in Thailand in 1997 when a loan repayment crisis led to fears of loan defaults and foreign short-term creditors withdrew funds from Thai financial institutions. This withdrawal of led to pressure on forex reserves and the value of Baht. The Bank of Thailand in its attempt to save the Baht lost all its Reserves and had to request assistance from the IMF. This eventually spread to Philippines, Malaysia and Indonesia and thus led to the outbreak of the South East Asian crisis. After taking important learning from the CAC crisis in South East Asian countries, India has adopted a gradual phased approach towards the implementation of CAC. Tarapore committee which was set up for this purpose had suggested certain pre-conditions for the implementation of CAC. India has been consistent in its commitment towards CAC and has shown marked improvements in some of the factors mentioned in the Tarapore committee. But India’s march towards CAC needs to be dealt with caution as the risks involved in capital inflows into the country are huge.
IMF has predicted the Indian economy to grow at a rate of 8.9% which puts India on the path of growth along with other emerging economies. India stands to gain by implementing CAC provided all the measures are in place to effect a successful implementation and the macroeconomic factors of the country are strong enough to support the surge in capital inflows. To start with the interest rates in India are higher compared to US and other developed economies. This results in inflow of foreign currency into India to artibitrage the differential interest rates. This inflow of money will reduce the cost of capital for the Indian companies and this in turn could be utilized for growing the economy further. It would also enable Indian investors to diversify their portfolios and reduce their risk.
It should be noted that the capital inflows will put immense pressure on the foreign exchange market and the volatility of the dollar and rupee is bound to increase....