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What is currency convertibility

Is India ready for Full Capital Account Convertibility?

Before the voyages of discovery, the earth was believed to be flat, such that people feared that once one reached the end of the world, one would fall off the edge of the Earth. Soon, it was discovered that the Earth was actually a sphere and one could safely go around it. However, more recently, the Earth is said to be becoming flat again, a theory propounded by Thomas Friedman in his bestseller book ‘The World is Flat ’. The forces of Globalization and Liberalization are cutting across borders, re-integrating the world towards a common goal of development. The liberalization reforms which swept across the country in 1991 changed the face of the Indian economy.

The results are paying off and India has witnessed exceptional growth rates of 9.6% and 9.4% in 2006 and 2007, respectively.

Thus, in the current stream of events, where globalization has become the ‘hot’ word and financial liberalization is synonymous with ‘developed economies’, the key issue that is to be considered, is whether India is ready to take the plunge towards Full Capital Account Convertibility (FCAC).

Capital Account Convertibility (CAC) is the freedom to convert local financial assets into foreign financial assets at market determined exchange rates. Referred to as ‘Capital Asset Liberation’ in foreign countries, it implies free exchangeability of currency at lower rates and an unrestricted mobility of capital. India presently has current account convertibility, which means that foreign exchange is easily available for import and export for goods and services. India also has partial capital account convertibility; such that an Indian individual or an institution can invest in foreign assets upto $25000. Foreigners can also invest along the same lines. At present, there are limits on investment by foreign financial investors and also caps on FDI ceiling in most sectors, for example, 74% in banking and communication, 49% in insurance, 0% in retail, etc.

The First Tarapore Committee was set up by the RBI in 1997 to study the implications of executing CAC in India. It recommended that the before CAC is implemented, the fiscal deficit needs to be reduced to 3.5% of the GDP, inflation rates need to be controlled between 3-5%, the non-performing assets (NPAs) need to be brought down to 5%, Cash Reserve Ratio (CRR) needs to be reduced to 3%, and a monetary exchange rate band of plus minus 5% should be instituted. However, most of the pre-conditions weren’t entirely fulfilled. Thus, CAC was abandoned for the moment.

However, recently there has been a renewed optimism as some of the targets suggested by the First Tarapore Committee have been achieved. Moreover, consolidation of banks, a strong export front, large forex reserves amounting to $300 billion and high growth rates have also instilled within, some hope. Thus, a Second Tarapore Committee was

set up in 2006 to look into the PM’s proposal to reevaluate the earlier stand. Although the report hasn’t been released yet, the committee does plan to increase the threshold level for investments from $25000 to $200000 in 3 phases.

CAC can be beneficial for a country as the inflow of foreign investment increases and the transactions are much easier and occur at a faster pace. CAC also initiates risk spreading through diversification of portfolios. Moreover, countries gain access to newer technologies which translate into further development and higher growth rates.

Even though CAC seems to have many advantages, in reality, it can actually destabilize the economy through massive capital flight from a country. Not only are there dangerous consequences associated with capital outflow, excessive capital inflow can cause currency appreciation and worsening of the Balance of Trade. Furthermore, there are overseas credit risks and fears of speculation. In addition, it is believed that CAC increases short term FIIs more than long term FDIs, thus leading to volatility in the system.

However, if we were to judge the implications of CAC in India, independent of its general pros and cons, CAC may not be such a good idea in the near future. The instability in the international markets due to the sub prime crisis and fears of a US recession are adversely affecting the entire world, including India. Moreover, rising oil prices which touched $100 a barrel recently are also fueling inflationary pressures in the economies, worldwide.

Not only is there instability in the international arena, but India’s domestic economy is also going through ups and downs. The rising prices and the appreciation of the rupee are adversely affecting India’s exports and the Balance of Trade. Moreover, the fiscal deficit has been highly underestimated by ignoring the deficits of individual states and through issuance of oil bonds to the public sector oil companies, making severe losses due to the heavy subsidies on oil. The government is yet to compensate these companies and these deferred payments have been left out from the deficit. Also, corruption, bureaucracy, red tapism and in general, a poor business environment, are discouraging the inflow of investment. Poor infrastructure and socio-economic backwardness act as deterrents to FDI inflow.

Hence, India still needs to work on its fundamentals of providing universal quality education and health services and empowerment of marginalized groups, etc. The growth strategy needs to be more inclusive. There is no point trying to add on to the clump at the top of the pyramid if the base is too weak. The pyramid will soon collapse! Thus, before opening up to financial volatility through the implementation of FCAC, India needs to strengthen its fundamentals and develop a strong base.

Hence, India should either wait for a while or implement CAC in a phased, gradual and cautious manner.

Category: Bank

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