Capital account convertibility (CAC) refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. It is associated with 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.
At present, India allows full convertibility in the current account but only partial convertibility in the capital account.
Benefits of full CAC:
• Access to global market: Full CAC will simplify the entry of Indian businesses into international markets. It can offer Indian entities new sources of funding opportunities and diversified investment options.
o For instance, Indian corporates could pursue external commercial borrowings without the approvals from the RBI or the government.
• Attracting foreign investment: With full CAC in place, global investors will have the assurance that they can repatriate profits and move capital in and out of India with ease. This could significantly enhance India’s appeal as a destination for foreign investment.
• Flexibility in foreign currency transactions: With full CAC, residents will have the flexibility to hold and transact in foreign currencies through domestic banks. This could simplify international trade and personal finance management for Indians.
• Development of the financial sector: Full CAC will allow Indian banks and financial institutions to expand their services internationally as it will allow inflow and outflow of capital at international rates.
Challenges of full CAC:
• Exposure to volatile international market: Full CAC will expose the Indian economy to the volatile international capital market. For example, the East Asian financial crisis demonstrated that the removal of capital controls can be dangerous for developing countries with relatively weak financial institutions and markets.
• Risk of capital flight : Full CAC can subject the domestic economy to the risks of capital flight during adverse conditions or during policy changes in developed countries like interest rate adjustments by the USA’s Federal Reserve.
• Exchange rate volatility: With unrestricted capital flows, exchange rates can become more volatile. Sudden inflows or outflows may impact the rupee’s value and affect trade competitiveness.
• Impact on policy autonomy: The adoption of CAC may limit the ability of policymakers to control the Indian economy, making the economic well-being of a country dependent on decisions made in developed countries.
Considering the benefits and challenges of full CAC, India needs to strengthen its domestic markets and address the current account deficit before adopting full CAC. Additionally, it is essential to fulfil all the preconditions suggested by the Tarapore Committee to avoid situations similar to the Mexican and East Asian crises.