Economy
Capital Account Convertibility
Currency Convertibility
- Currency convertibility refers to the freedom of currency holders to convert their domestic currency into foreign currencies and vice versa at the prevailing market exchange rate.
- For example, if the Indian Rupee is convertible, a person holding rupees can exchange them for foreign currencies such as the US Dollar, Euro or Pound.
Types of Currency Convertibility
All transactions between India and the rest of the world are broadly recorded under the Current Account and the Capital Account. Accordingly, currency convertibility is of two types:
- Current Account Convertibility
- Capital Account Convertibility
Current Account Convertibility
- Current Account Convertibility means the freedom to convert rupees into foreign currency, or foreign currency into rupees, for current account transactions such as:
- Import and export of goods
- Import and export of services
- Travel and education expenses
- Interest and dividend payments
- Remittances and other current transfers
- Example: An Indian importer needs US dollars to pay an American company for imported machinery.
- As part of the economic reforms initiated in 1991, the Indian Rupee was made fully convertible at current account in 1994.
Capital Account Convertibility
- Capital Account Convertibility is the ability or freedom to convert domestic currency for capital account transactions. The Tarapore Committee (2006), for instance, defined capital account convertibility as the “freedom to convert local financial assets into foreign financial assets and vice versa.”
- Capital Account Convertibility means freedom to convert domestic currency into foreign currency and vice versa for capital account transactions, such as:
- Foreign Direct Investment
- Portfolio Investment
- Purchase of foreign shares and securities
- Foreign borrowing and lending
- Purchase of assets abroad
- Example: If an Indian resident converts rupees into dollars to purchase shares of a US company, it involves a capital account transaction.
- India does not have full capital account convertibility.
- The RBI does not allow the rupee to be freely converted into foreign currencies for all capital account transactions. There are certain rules and limits on how much money can be invested, borrowed or transferred across countries. Therefore, the Indian Rupee is said to be partially convertible on the capital account.
Tarapore Committee
- The Reserve Bank of India established the Committee on Capital Account Convertibility (CAC) or S.S Tarapore Committee to propose a roadmap for full convertibility of the rupee on the capital account. In May 1997, the committee submitted its report.
- The Terms of Reference of the Committee were to:
- review the international experience in relation to capital account convertibility (CAC) and to indicate the preconditions for CAC,
- recommend measures for achieving CAC,
- specify the sequence and time frame for such measures, and
- suggest domestic policy measures and changes in institutional framework.
- The Committee has, in its Report, noted that India had already adopted current account convertibility in August 1994 by formally accepting the obligations under Article VIII of the Articles of Agreement of the International Monetary Fund (IMF). Furthermore, CAC is already instituted for foreign investors, both direct and portfolio, non resident depositors and resident corporates contracting external commercial borrowings (ECB).
- Recognising that there are certain weaknesses in the system and that the entrenchment of preconditions can be achieved over a period of time the Committee had recommended a phased implementation of CAC over a three year period: Phase I (1997-98), Phase II (1998-99) and Phase III (1999-2000).
Tarapore II
- Reserve Bank of India appointed the Second Tarapore committee to set out the framework for fuller Capital Account Convertibility.
- The Tarapore Committee (2006) defined capital account convertibility as the “freedom to convert local financial assets into foreign financial assets and vice versa.”
- The committee suggested 3 phases of adopting the full convertibility of rupee in capital account.
- First Phase in 2006-7
- Second phase in 2007-09
- Third Phase by 2011.
- The committee report sought a ban on participatory notes as a mode of investment in Indian equities and easing the direct investment routes for foreigners.
- It suggested that foreign individual investors should be brought at par with non-resident Indian investors.
- The committee recommended the restrictions on overseas borrowings by Indian firms and banks be eased.
- It said that the limit on outbound remittances by Indian citizens should be increased.
- It proposed the formation of a monetary policy committee (MPC) which has since been set up and operating.
Progress Towards Capital Account Convertibility in India
Following the recommendations of the S.S. Tarapore Committee (1997), India has gradually moved towards greater capital account convertibility while maintaining necessary safeguards.
India still follows partial capital account convertibility. However, over the years, several restrictions have been relaxed, allowing relatively free movement of capital for many transactions, subject to prescribed limits and conditions.
- Foreign Direct Investment (FDI): FDI has been largely liberalised, although sectoral limits and government approval requirements continue in certain sectors.
- Foreign Portfolio Investment (FPI): Foreign investors are allowed to invest in Indian financial markets, subject to prescribed investment and ownership limits.
- Overseas Investment by Indian Residents: Indian residents are allowed to invest abroad, but such investments are subject to prescribed rules and limits, including those under the Liberalised Remittance Scheme (LRS) for resident individuals.
Benefits of Capital Account Convertibility
- Access to Global Capital: It allows domestic businesses and investors to access funds from international capital markets, increasing the resources available for investment beyond domestic savings.
- Lower Cost of Capital: Access to a larger global pool of savings can increase the availability of funds and reduce the cost of raising capital, thereby supporting investment and economic growth.
- Efficient Allocation of Capital: Free movement of capital allows savings to move across countries towards investments offering better returns and potentially more productive uses.
- Supports International Trade and Investment: Easier movement of capital provides more channels through which international trade and cross border investment can be financed.
- Portfolio Diversification: Domestic investors can invest in foreign assets, while foreign investors can invest in domestic assets, allowing both to diversify their portfolios and spread risk.
- Encourages Macroeconomic Discipline: Greater exposure to international capital markets can create pressure on governments to maintain sound fiscal, monetary and macroeconomic policies, as weak policies may lead investors to withdraw capital.
Downsides of Capital Account Convertibility
- Capital May Not Flow towards Productive Uses: International capital movements may sometimes be driven by considerations such as tax advantages or short term returns rather than investment in productive activities.
- Capital Inflows Are Not Guaranteed: Simply opening the capital account does not ensure that foreign capital will enter the country. Investors also consider economic stability, institutions, infrastructure and investment opportunities.
- Capital Flows May Not Automatically Promote Growth: Even when foreign capital enters a country, its contribution to economic growth depends on the quality of domestic institutions and how effectively the funds are used.
- Risk of Sudden Capital Outflows: Foreign investors can quickly withdraw their investments when economic conditions or market expectations change, creating instability in financial and foreign exchange markets.
- Greater Exchange Rate Volatility: Large and sudden movements of capital can lead to sharp appreciation or depreciation of the domestic currency.
- Reduced Policy Autonomy: Governments may face greater pressure from international financial markets while framing fiscal and monetary policies, as policies viewed unfavourably by investors can trigger capital outflows.
