Capital Account Convertibility A Boon Or A Bane Economics Essay

Currency Convertibility means ease with which a particular currency or domestic currency can be converted into any other international currency and vice versa. Based on their convertibility currencies can be categorized into three groups namely:

Non Convertible currencies are those which cannot be converted into other internationally accepted currencies and vice versa i.e. countries of such currencies do not participate in FOREX Markets.

Partially Convertible currencies are those which can be traded in the market with some restrictions from central bank of the country i.e. they can’t be freely traded.

Fully Convertible currencies are those which can be freely traded without any restrictions from the central bank of the country.

Currency convertibility can be talked about in terms of two specific things which are Current Account Convertibility which refers to freedom in conversion in respect of payments and transfers of current international transactions and Capital Account Convertibility which refers to convertibility in respect of capital transactions in terms of inflows and outflows. In India Full Current account convertibility is already present which means that small transactions for any specific purpose such as travelling abroad or study purpose but currently India has restriction over Capital Account Convertibility which means that before doing any financial transaction or sale/purchase of assets which come under capital account one will have seek the permission of Reserve Bank of India.

In more specific terms Capital Account Convertibility according to Tarapore Committee Report 1997 means “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”. 

TARAPORE COMMITTEE RECOMMENDATIONS

The committee on Capital Account Convertibility headed by S.S. Tarapore setup by RBI to provide the roadmap to guide Indian Economy to full capital account convertibility presented its report on 03-June-1997. The committee was of the view that CAC should be phased over a period of three years ending 2000. However, committee highlighted that this was doable on if the following conditions were met:

Reduction of gross fiscal deficit to GDP ratio to 3.5% by 2000 accompanied by reduction in state deficit.

The mandate rate of inflation for the period of three years should be an average of 3-5%.

The purpose of these preconditions was to make Indian macroeconomic conditions stable enough to cope up with vulnerabilities/fluctuation of free forex regime, which CAC implies.

After these recommendations India did open up with respect to Capital Account Convertibility but the issue of full capital account convertibility still remained there since soon after the recession struck in year 2000 as Asian Crisis cropped up which led to increase in fiscal deficit which was one of the pre-condition to go with full capital account convertibility.

On March 18, 2006, the prime minister Dr. Manmohan Singh, stated in inaugural function of 16th Asian Corporate Conference that there is a merit in India moving towards fuller capital account convertibility in response to which RBI again set up a committee under the chairmanship of S.S. Tarapore to pave the way for FCAC.

The presented its report on July 31, 2006. The committee was of the view that FCAC should be implemented in three phases ending at 2011. So the committee was of the view that India should gradually move towards the Full Capital account convertibility by 2011.

FCAC is an important decision that has to be taken by the Indian government in the near future. Every decision has its pros and cons which should be looked into. To start with let’s have a look at the advantages and disadvantages of FCAC.

ADVANTAGES OF FCAC

The availability of capital would increase which would result in decrease in cost of capital.

Free movement of capital i.e. freedom to trade in financial assets will lead to gains just as there are gains from trade.

Financial system would become more efficient and spreads will decline for banks due to increase in competition from foreign banks.

Fiscal deficit will reduce as cost of government borrowing will reduce in light of reduced interest rates.

Accelerated rate of growth due to more and more investments coming from around the world economies without any restrictions.

FCAC will give India the access to the global pool of savings in the sense that once the global doors are opened than one could invest in global portfolio giving him chance to have more internationally diversified portfolio thereby reducing the vulnerability of income streams to shocks in domestic market.

FCAC will help increase the investment in Infrastructure development through foreign investors helping in improving the infrastructure to support their businesses. This would also result in increase the level of employment by providing more and more opportunities of employment for lower class people.

DISADVANTAGES OF FCAC

During the good years the economy might see the huge inflows of foreign capital, but during the bad times there will be an atleast equal amount of cash outflow from the country under the “Herd Behavior”( it refers to the phenomena under which investors acts as the “herds” i.e. if one moves out, another one follows) as these foreign investors will try and make sure that they do not incur much of the losses and will pull back their investments from the country.

There is a huge possibility of misallocation of capital inflows which means such capital inflows may fund low-quality domestic investments instead of investing in building up industries which leads to more capacity creation and utilization, and increased level of employment. This can also reduce the potential of country to increase exports and will thus create external imbalances.

This can also lead to the export of domestic savings which one would have invested in domestic market otherwise but will now think of investing in foreign markets to reduce the risk.

Entry of foreign banks would result in increased competitiveness in terms of accessing the loan proposals as the foreign banks will shy away from giving loans to farmers and the small scale industrialists as they find them less credit worthy and Indian Banks will also follow the same route to be competitive.

International finance capital is highly volatile as the investor move from country to country in search for higher returns for their investments. This process has led to crisis in numerous developing countries. Such finance capital is referred to as “Hot Money “. FCAC exposes an economy to the risk of volatility on account on “Hot Money” flows in and out of the country.

Doing business in such environment will become that much more competitive and will lead to the downfall of domestics companies which cannot match with the capacity of the foreign players which are huge in size and have huge market at their disposal.

CONCLUSION

As we say that every coin has its two sides, Fuller Capital Account Convertibility is no exception it also has some pros and cons. Having a closer look at the advantages and disadvantages of FCAC it can be inferred that it can be a boon to our country if managed properly. India should not move into it in hurry instead they should take their own time and first consolidate their fiscal deficit and regulations. They should learn from the mistakes that other Emerging Market Economies did in 90’s and what happened to them during the Asian Crisis. In my view India can go ahead with Fuller Account Convertibility but they should still keep some restriction or control over it i.e. they should allow Capital Account Convertibility with reasonable limits on some transactions. After saying this I would also like to add that India and China survived the East Asian Crisis only because they didn’t had fuller capital account convertibility and if we open up our economy by allowing FCAC we will increase the susceptibility to economic crisis. Thus any decision taken by RBI and the government will be another wishful thinking that all would go right if some pre-conditions are fulfilled and FCAC will trigger the growth of the economy but there still are some problems with FCAC which will come roaring if there is any global crisis and all the measures taken by government will not be sufficient to avoid such crisis in India. The topic Is Capital Account Convertibility – A Boon or a Bane is a debatable one and has been debated in India for decades. There are people who say that India should go for FCAC and other who are against it. So, Whatever happens in the next few years as Tarapore Committee has already set a road map for FCAC let’s hope that everything goes as per the plans of UPA government and our economy gets that much needed boost through FCAC.