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Towards Complete Capital Convertibility

  • IASbaba
  • January 20, 2022
  • 0
UPSC Articles
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ECONOMY/ GOVERNANCE

  • GS-3: Indian Economy & challenges
  • GS-2: Government policies and interventions for development in various sectors and issues arising out of their design and implementation. 

Towards Complete Capital Convertibility

Context: The process of capital account convertibility is likely to receive a further push this year, as the government and RBI move towards allowing greater foreign participation in domestic bond markets.

What is the capital account convertibility?

  • The balance of payments account, which a statement of all transactions made between a country and the rest of the world world, consists of two accounts 
    • Current account: deals mainly with import and export of goods and services
    • Capital account: It is made up of cross-border movement of capital by way of investments and loans.
  • Capital account convertibility (CAC) means the freedom to conduct investment transactions without any constraints.
  • In other words, CAC means there is no restrictions on the amount of rupees an Indian resident can convert into foreign currency to enable to acquire any foreign asset. 
  • Similarly, there should be no restraints on the NRI relative bringing in any amount of foreign currency to acquire an asset in India.

How did the capital account convertibility evolve?

  • In 1991 put India adopted the path of economic liberalisation (set in motion by the Narasimham Committee’s recommendations). Within five years, the country had moved to a market-determined exchange rate and full current account convertibility.
  • Though this also marked the beginning of the process of liberalising the capital account, in the three decades since liberalisation began, progress on this aspect has remained gradual. 
  • While the current position is a partially open capital account, non-residents essentially have complete freedom to engage in most investment and other capital transactions in India
  • Capital account convertibility has mostly been in a single direction since 1991—with more flexibility around inflows rather than outflows.
  • Foreign Exchange Management Act, 1999 further liberalised current account, and to some extent, capital account transactions, albeit maintaining strong control over the latter.
  • Gradually, foreign investors have been allowed to participate in the domestic equity, debt and bond markets over the past two decades.
  • As a result, foreign direct investment in India now is largely unrestricted, and its impact is stark: in the past five years, the flow of FDI has accounted for almost 50% of total FDI inflows since 1991.
  • Foreign Portfolio investors (FPIs) have also been active in the equity, debt and G-sec markets. During 2021, FPIs invested $10.8 billion in initial public offerings (IPOs) of Indian firms—the highest ever amount
  • According to latest data on India’s international investment position, direct overseas investments total around $200 billion, while portfolio investments are below $8 billion, after several years of moderate growth.
  • To be fair, liberalisation of the capital account has been consistent through business cycles in the past three decades. This suggests that institutional capacity and political willingness to achieve capital account convertibility is strong.

What are the challenges associated?

  • The two Tarapore Committee Reports—1997 and 2006—laid out a path to full convertibility. However, both reports did set a number of preconditions for convertibility to be achieved. These include 
    • gross fiscal deficit being less than 3.5% of GDP
    • Inflation rate of 3-5% over three years
    • Effective CRR being 3% 
    • Gross NPAs of 5% or less. 
  • India has yet to fully meet all of these criteria.
  • Inflows and outflows of the foreign and domestic capital, which are prone to volatility, can lead to excessive appreciation/depreciation of their currency and impact the monetary and financial stability.
  • The 2006 Tarapore committee’s report on fuller capital account convertibility released argued that even countries that had comfortable fiscal positions have experienced currency crises and rapid deterioration of the exchange rate.
  • The report further points that an excessive appreciation of the exchange rate causes exporting industries to become unviable, and imports to become much more competitive, causing the current account deficit to worsen. 
  • However, there has been an improvement in the economy. India’s foreign reserves today stand at $635 billion, the fourth largest in the world.

How fuller convertibility would benefit India?

  • Large foreign exchange reserves lead to high sterilisation costs. In 2018, SBI estimated the sterilisation coefficient at -0.93. If some control is brought over India’s sterilisation costs through an opening of the capital account, it is estimated this could free up almost 1% of GDP in sterilisation costs over time
    • Sterilization is a form of monetary action in which a central bank seeks to limit the effect of inflows and outflows of capital on the money supply.
  • Gurther liberalisation of the capital account is needed to power the next stage of India’s economic development.

Way Forward

  • Limiting sovereign debt to 60% of GDP (as recommended by the NK Singh panel) should be part of economic policy in a post COVID-19 world.
  • RBI governors have been cautious time and again, calling for convertibility to be seen as a process, and not a single event. Thus, the process towards full convertibility will not be linear and India looks set to continue moving gradually
  • RBI can bank on India’s current economic strengths and macro stability to further the cause of capital account convertibility in 2022. 

Connecting the dots:

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