How Capital Account Convertibility is Beneficial for the Economical Development in India?
It also provides domestic investors a greater choice and he can hold a judicious mix of domestic and international debt and equity. Moreover, it facilitates resident Indians to invest their surplus funds in foreign markets for better investment portfolio, i.e., wide range of derivatives and management products, in order to reduce the investment “risk factor”. It also integrates our economy with the global economy.
But CAC also brings with it the risk of exposing the domestic economy to international shocks. The South East Asian economic crisis is a good example in this respect. CAC means not only easy inflow but also easy outflow of foreign investments and these can lead to collapse of the economy.
The major risk is the possibility of capital flight. Another risk is the possibility of macroeconomic instability arising from the movement of short term capital movements described as ‘hot money’.
After the East Asian currency crisis in 1997, merits and demerits of capital account convertibility (CAC) were re-debated. Tarapore Committee on CAC submitted its report in mid-1997 and recommended a phased implementation of CAC over the period 1997 to 2000.
It anticipated the following advantages by the introduction of the CAC in stages:
1. Foreign investment – FDI and FII will be available more as restrictions will be reduced.
2. Risk diversification and a locative efficiency for Indian investors as they can invest abroad.
3. More investment opportunities as there will be more financial players.
4. More competition means better customer service in the financial sector.
5. Macroeconomic discipline will be more rigorous to gain from globalisation and retain the foreign investor.
6. Interest rates will come down as freely inflows resources.
7. Easier access to global capital market for raising resources.
The Tarapore Committee laid down a ‘road map’ for introducing the CAC when certain macro- economic prerequisites like reasonable levels of inflation, interest rates, fiscal deficit, forex reserves, financial sectors reforms maturing etc. are satisfied.
The following are the important pre-conditions for implementing the CAC:
1. Slash of subsidies provided by the Government to different sectors of the economy.
2. Control or cut down of non-plan expenditure to the barest minimum level.
3. Reduction in the deficit in the Annual Fiscal Budgets.
4. Fast or quick implementation of disinvestment of Forex.
5. Deploying foreign funds for productive use, i.e., in growth oriented sectors.
6. Increasing the base levels of forex reserves of the country.
7. Strengthening of the Balance of Payments, in particular, current account transactions.
8. Controls of or reduction in the inflation rate in the economy within manageable levels.
9. Gearing up the economic or financial sector reforms in the country.
10. Strengthening the capital base levels of Indian banks on par with International banks.
11. Improvement in the standard assets of the Banking sector and the reduction in NPAs to internationally accepted levels.
12. Increase in the efficiency of commercial banks, reduction in their operating costs, developing risk management skills, modernizing management, pressing into service modern technology to raise productivity, etc.
13. Implementing reforms both in primary and secondary capital markets in order to attract foreign capital from NRIs, OCBs and FIIs for development of infrastructure projects and industries such as cement, steel, road and bridge construction, capital goods, telecom etc, in the country.
14. Implementation of International reporting such as International Accounting Standards, GAAP, etc in Indian companies to attract inflow of foreign capital through ADRs or GDRs etc.
The global context in which the Tarapore Committee recommended CAC is very different from what it has been because of the east Asian currency crisis, Argentinian crisis in 2001; global economic slowdown, increasing capital market volatility all over the world etc.
So severe has the crisis been that the World Bank and the IMF are suggesting caution in graduating to CAC. It is argued that China which receives about $45 billion of FDI annually and has $ 200 billion in forex reserves does not have CAC and has only trade account convertibility.
It even controls portfolio capital inflows. The fears regarding CAC are:
1. Volatile capital movement can destabilise the equity market and banking sector, (as was seer temporarily a free NDA lost the electron in may 2004).
2. To save the external value of the currency the Central Bank has to intervene in a costly way.
3. Imports will become too expensive to finance.
4. Interest rates will be high to hold the foreign capital and also to curb speculative activities.
5. Unemployment will result from the steep recession that will follow.
6. The Indian Government does not have the resources to defend the rupee against a determined speculative attack.
7. The banking sector is vulnerable in India though not as much as the east Asian banks and may not be able to withstand consequences of free float.
8. Flight of capital cannot be ruled out.
It is also observed that since there is no correlation between FDI and CAC and also because much higher level of domestic savings can be tapped in the country by appropriate financial reforms, it is suggested that adoption of full convertibility of rupee on capital account be postponed until the preconditions for implementing the CAC is fulfilled.
The following are the important relaxation in the CAC so far:
1. Accessing capital markets abroad through GDRs and ADRs.
2. Issue of foreign currency convertible bonds or floating rate notes.
3. Liberalised norms for External Commercial Borrowings (ECBs).
4. Loans for non-residents.
5. Direct investment abroad (wholly owned subsidiaries).
6. Liberalised norms for Foreign Direct Investment.
7. Increase in FII’s portfolio investments.
8. Replacement of Foreign Exchange Regulation Act (FERA) by Foreign Exchange Management Act (FEMA).
In a move towards CAC, the Budget 2002-03 made all deposit schemes for NRIs fully convertible from April 1, 2002. NRIs are free to their savings in foreign currency as well as their current earnings in India such as rent, pension, interest, and dividend etc., based on appropriate certification.
Indian companies can now invest abroad up to $ 100 million (it was $ 50 million earlier) annually through the automatic route. Further in January 2003 the government allowed Indian citizens to invest in foreign companies that have at least 10% stake in a listed Indian company. So Indians can now invest abroad in blue chips like Unilever, Nestle, P and G etc. Corporates have also been allowed to acquire land and property abroad.
Although there are problems with full convertibility, India should have a cautious approach towards capital account liberalization. This is because India as a developing country needs foreign investments to boost her economy.
But it should be remembered that the attractiveness of a country for foreign investment, depends on many factors, and a free currency policy is just one of them.