Capital account convertibility (CAC) refers to the unrestricted ability to conduct investment transactions. It implies the absence of limitations on converting local currency into foreign currency, allowing for freedom in capital inflows and outflows. It is often referred to as Capital Asset Liberalisation.
Currently, India permits full convertibility in the current account but only partial convertibility in the capital account. The Tarapore Committee Reports of 1997 and 2006 outlined a path towards complete CAC. However, the process of liberalizing the capital account over the past three decades has been gradual and cautious.
Advantages of full CAC include:
- Enhanced access to international markets, which promotes liberalization and attracts foreign investments.
- Increased financial efficiency through exposure to global competition, leading to specialization, innovation, and potentially lower capital costs.
- Expanded investment choices for residents, enabling them to base decisions on global interest rates and prices, benefiting their interests and welfare. This allows Indian investors to participate in foreign securities and assets.
- Hedging investment risks by diversifying portfolios in the world market, thereby safeguarding the real value of assets and reducing risks.
Arguments against full CAC include:
- The possibility of capital outflows and the export of domestic savings through speculative activities, as witnessed in certain Southeast Asian economies during the 1997-98 financial crisis.
- Weakening of the authorities’ ability to tax domestic financial activities, income, and wealth, potentially leading to tax avoidance.
- Potential cost-push inflation due to market-determined exchange rates being higher than official fixed rates, resulting in increased import prices.
- Disruptions in the economy caused by mismanagement of CAC, leading to currency depreciation and impacting trade and capital flows.
Conclusion:
However, the preconditions for convertibility outlined by the Tarapore committee, such as maintaining a gross fiscal deficit below 3.5% of GDP, an inflation rate of 3-5% over three years, an effective Cash Reserve Ratio (CRR) of 3%, and gross Non-Performing Assets (NPAs) of 5% or less, have yet to be met. Therefore, efforts must be made to fulfill these conditions to realize the benefits of full CAC.