PROJECT REPORT

ON
CURRENCY CONVERTIBILITY
MASTER OF COMMERCE (ACCOUNTANCY)
PART-1 (SEMESTER-2)
(2015-2016)
INTERNAL ASSESSMENT
EONOMICS OF GLOBAL TRADE AND FINANCE
Submitted To:PROF. KOEL ROY CHOUDHURY.
Submitted By:VANITA SHANKAR BHUJBAL.
ROLL NO:-08
S.I.E.S. (NERUL) COLLEGE OF ARTS, SCIENCE & COMMERCE

AFFILIATED TO UNIVERSITY OF MUMBAI

S.I.E.S (NERUL) COLLEGE OF ARTS, SCIENCE & COMMERCE

CERTIFICATE
(2015-2016)
This is to certify that the project entitled CURRENCY CONVERTIBILITY is a
project work done by VANITA SHANKAR BHUJBAL, ROLL NO-08, in fulfilment of the
requirements for the M.COM in ACCOUNTANCY (PART-1) (SEMESTER-2) during the
academic year 2015-2016 is the original work done of the candidate and completed under
guidance of PROF. KOEL ROY CHOUDHURY.
Date:Place:-

DECLARATION BY STUDENT

I,

VANITA SHANKAR BHUJBAL, ROLL NO-08,

the

student

of

M.COM

in

ACCOUNTANCY (Part-1) (Semester-2) (2015-2016) hereby declares that I have completed

the project on CURRENCY CONVERTIBILITY under the supervision of the internal
guidance of PROF. KOEL ROY CHOUDHURY and that the contents of the project are
not copied any other source such as internet, earlier projects, textbooks etc.
The information submitted is true and original to best of my knowledge.

Thank you,
Yours faithfully,
VANITA BHUJBAL
ROLL NO:-08

ACKNOWLEDGEMENT

I would like to thank all the people who helped me in undertaking the study and
completing the project, by imparting me with valuable information and guidance that was
required at every stage of my project work.
I would like thank our principal,Dr. Rita Basu and Prof. Koel Roy Choudhury who Coordinate for giving me an opportunity and encouragement to prepare the project.
VANITA BHUJBAL
Roll No: 08

INDEX
CURRENCY CONVERTIBILITY

SR.

TOPIC NAME

PG.

NO.
1.

Introduction of currency convertibility

NO.
4.

2.

Types of currency convertibility

9.

3.

Components of current account convertibility

10.

4.

Components of capital account convertibility

13.

5.

Tarapore Committee

24.

6.

Advantages and disadvantages of currency convertibility

30.

7.

Currency Convertibility of INDIAN RUPEE

34.

8.

Conclusion and Bibliography

43.

CHAPTER 1
INTRODUCTION OF CURRENCY CONVERTIBILITY.
For the rapid growth of world trade and capital flows between countries convertibility of a
currency is desirable. Without free and unrestricted convertibility of currencies into foreign exchange trade and capital flows between countries cannot take place smoothly.
Therefore, to achieve higher rate of economic growth and thereby to improve living standards
through greater trade and capital flows, the need for convertibility of currencies of different
nations has been greatly felt. Under Bretton Woods system fixed exchange rate system was
adopted by various countries.
In order to maintain the exchange rate of their currencies in terms of dollar or gold various
countries imposed several controls over the use of foreign exchange. This required some
restrictions on the use of foreign exchange and its allocation among different uses, the currency of
a nation was converted into foreign exchange on the basis of officially fixed exchange rate.
When Bretton Woods system collapsed in 1971, the various countries switched over to the floating
foreign exchange rate system. Under the floating or flexible exchange rate system, exchange rates
between different national currencies are allowed to the determined through market demand for
and supply of them. However, various countries still imposed restrictions on the free convertibility
of their currencies in view of their difficult balance of payment situation.
After liberal economic reforms were introduced in 1991, many significant developments occurred
that impacted the way forex transactions and businesses were conducted. Exporters and importers
were allowed to exchange foreign currencies for the trade of unbanned goods and services, there
was easy access to forex for studying or travel abroad and a relaxation on foreign business and
investments with minimal (or no) restrictions depending on the industry sectors.
However, Indians still require regulatory approvals if they want to invest an amount above a predetermined threshold level for the purpose of investments or purchasing assets overseas. Similarly,
incoming foreign investments in certain sectors (like insurance or retail) are capped at a specific
percentage and require regulatory approvals for higher limits.

As of today, the Indian rupee is partly convertible, which means that although there is a lot of
freedom to exchange local and foreign currency at market rates, a few important restrictions
remain for higher amounts and these still need approvals. The regulators also pitch in from timeto-time to keep the exchange rates within permissible limits, instead of keeping INR as a
completely free-floating currency left to the market dynamics. In the case of extreme volatility in
rupee exchange rates, the RBI swings into action by purchasing/selling U.S. dollars (kept as
foreign reserve) to stabilize the rupee.
MEANING OF CURRENCY CONVERTIBILITY
Let us first explain what is exactly meant by currency convertibility. By convertibility of a
currency we mean currency of a country can be freely converted into foreign exchange at market
determined rate of exchange that is, exchange rate as determined by demand for and supply of a
currency.
For example, convertibility of rupee means that those who have foreign exchange (e.g. US dollars,
Pound Sterlings etc.) can get them converted into rupees and vice-versa at the market determined
rate of exchange. Under convertibility of a currency there are authorised dealers of foreign
exchange which constitute foreign exchange market.
The exporters and others who receive US dollars, Pound Sterlings etc. can go to these dealers
which are generally banks and get their dollars exchanged for rupees at the market determined
rates of exchange. Similarly, under currency convertibility, importers and other who require
foreign exchange can go to these banks dealing in foreign exchange and get rupees converted into
foreign exchange.
Convertibility is the ease with which a country's currency can be converted into gold or another
currency. It indicates the extent to which the regulations allow inflow and outflow of capital to and
from the country.
Until the early 1990s (pre-reform period), anyone willing to transact in a foreign currency would
need permission from the Reserve Bank of India (RBI), regardless of the purpose. People wanting
to engage in foreign travel, foreign studies, the purchase of imported goods or to get cash for

foreign currencies received (like with exports) were all required to go through RBI. All such forex
exchanges occurred at pre-determined forex rates finalized by the RBI.
Indians still require regulatory approvals if they want to invest an amount above a pre-determined
threshold level for the purpose of investments or purchasing assets overseas. Similarly, incoming
foreign investments in certain sectors (like insurance or retail) are capped at a specific percentage
and require regulatory approvals for higher limits.
As of today, the Indian rupee is partly convertible, which means that although there is a lot of
freedom to exchange local and foreign currency at market rates, a few important restrictions
remain for higher amounts and these still need approvals. The regulators also pitch in from timeto-time to keep the exchange rates within permissible limits, instead of keeping INR as a
completely free-floating currency left to the market dynamics. In the case of extreme volatility in
rupee exchange rates, the RBI swings into action by purchasing/selling U.S. dollars (kept as
foreign reserve) to stabilize the rupee.
Full convertibility will mean the rupee exchange rate would be left to market factors, without any
regulatory intervention. There may be no limit on inflow or outflow of capital for various purposes
(including investments, remittances or asset purchase/sale).

CHAPTER-2
TYPES OF CURRENCY CONVERTIBILITY
There are basically only two types of currency convertibility they are as follows i.e Current
Account Convertibility and Capital Account convertibility.
Current account convertibility freedom in respect of Payments and transfers for current
international transactions. In other words, if Indians are allowed to buy only foreign goods and
services but restrictions remain on the purchase of assets abroad, it is only current account
convertibility. As of now, convertibility of the rupee into foreign currencies is almost wholly free
for current account i.e. in case of transactions such as trade, travel and tourism, education abroad
etc.The government introduced a system of Partial Rupee Convertibility (PCR) (Current Account
Convertibility) on February 29, 1992 as part of the Fiscal Budget for 1992-93. PCR is designed to
provide a powerful boost to export as well as to achieve as efficient import substitution. It is
designed to reduce the scope for bureaucratic controls, which contribute to delays and inefficiency.
Government liberalized the flow of foreign exchange to include items like amount of foreign
currency that can be procured for purpose like travel abroad, studying abroad, engaging the service
of foreign consultants etc. What it means that people are allowed to have access to foreign
currency for buying a whole range of consumables products and services. These relaxations
coincided with the liberalization on the industry and commerce front which is why we have Honda
City cars, Mars chocolate and Bacardi in India.
Capital Account Convertibility
It means the freedom to convert local financial assets into foreign financial assets and vice versa at
market determined rates of exchange. It refers to the removal of restraints on international flows
on a country's capital account, enabling full currency convertibility and opening of the financial
system. Capital account convertibility is considered to be one of the major features of a developed
economy. It helps attract foreign investment. At the same time, capital account convertibility
makes it easier for domestic companies to tap foreign markets. It is sometimes referred to as
Capital Asset Liberation.
There is no formal definition of capital account convertibility (CAC). The Tarapore committee set
up by the Reserve Bank of India (RBI) in 1997 to go into the issue of CAC defined it as the
freedom to convert local financial assets into foreign financial assets and vice versa at market
determined rates of exchange.
9

CHAPTER-3
COMPONENTS OF CURRENT ACCOUNT
Covered in the current account are all transactions (other than those in financial items) that
involve economic values and occur between resident non-resident entities. Also covered are offsets
to current economic values provided or acquired without a quid pro quo. Specifically, the major
classifications are goods and services, income, and current transfers.

1. Goods and services:

Goods

General merchandise covers most movable goods that residents export to, or import from,
non residents and that, with a few specified exceptions, undergo changes in ownership (actual
or imputed).

Goods for processing covers exports (or, in the compiling economy, imports) of goods
crossing the frontier for processing abroad and subsequent re-import (or, in the compiling
economy, export) of the goods, which are valued on a gross basis before and after processing.
The treatment of this item in the goods account is an exception to the change of ownership
principle.

Goods procured in ports by carriers covers all goods (such as fuels, provisions, stores,
and supplies) that resident/non-resident carriers (air, shipping, etc.) procure abroad or in the
compiling economy. The classification does not cover auxiliary services (towing, maintenance,
etc.), which are covered under transportation.

Non-monetary gold covers exports and imports of all gold not held as reserve assets
(monetary gold) by the authorities. Non-monetary gold is treated the same as any other
commodity and, when feasible, is subdivided into gold held as a store of value and other
(industrial) gold.

Services

Transportation covers most of the services that are performed by residents for nonresidents (and vice versa) and that were included in shipment and other transportation in the
10

fourth edition of the Manual. However, freight insurance is now included with insurance
services rather than with transportation. Transportation includes freight and passenger
transportation by all modes of transportation and other distributive and auxiliary services,
including rentals of transportation equipment with crew.

Travel covers goods and services: including those related to health and education
acquired from an economy by non resident travellers (including excursionists) for business and
personal purposes during their visits (of less than one year) in that economy. Travel excludes
international passenger services, which are included in transportation. Students and medical
patients are treated as travellers, regardless of the length of stay. Certain othersmilitary and
embassy personnel and non resident workersare not regarded as travellers. However,
expenditures by non resident workers are included in travel, while those of military and
embassy personnel are included in government services

Communications services covers communications transactions between residents and

non-residents. Such services comprise postal, courier, and telecommunications services
(transmission of sound, images, and other information by various modes and associated
maintenance provided by/for residents for/by non residents).

Construction services covers construction and installation project work that is, on a
temporary basis, performed abroad/in the compiling economy or in Extra territorial enclaves
by resident/non resident enterprises and associated personnel. Such work does not include that
undertaken by a foreign affiliate of a resident enterprise or by an unincorporated site office
that, if it meets certain criteria, is equivalent to a foreign affiliate.

Insurance services covers the provision of insurance to non residents by resident

insurance enterprises and vice versa. This item comprises services provided for freight
insurance (on goods exported and imported), services provided for other types of direct
insurance (including life and non-life), and services provided for reinsurance.

Financial services (other than those related to insurance enterprises and pension funds)
covers financial intermediation services and auxiliary services conducted between residents
and non-residents. Included are commissions and fees for letters of credit, lines of credit,
financial leasing services, foreign exchange transactions, consumer and business credit
services, brokerage services, underwriting services, arrangements for various forms of hedging
instruments, etc. Auxiliary services include financial market operational and regulatory
services, security custody services, etc.
11

Government services i.e. covers all services (such as expenditures of embassies and
consulates) associated with government sectors or international and regional organizations and
not classified under other items.

2. Income:

Compensation of employees covers wages, salaries, and other benefits, in cash or in kind,
and includes those of border, seasonal, and other non-resident workers (e.g., local staff of
embassies).

Investment income covers receipts and payments of income associated, respectively, with
residents holdings of external financial assets and with residents liabilities to non-residents.
Investment income consists of direct investment income, portfolio investment income, and
other investment income. The direct investment component is divided into income on equity
(dividends, branch profits, and reinvested earnings) and income on debt (interest); portfolio
investment income is divided into income on equity (dividends) and income on debt (interest);
other investment income covers interest earned on other capital (loans, etc.) and, in principle,
imputed income to households from net equity in life insurance reserves and in pension funds.

3. Current transfers:
Current transfers are distinguished from capital transfers, which are included in the capital and
financial account in concordance with the SNA treatment of transfers. Transfers are the offsets to
changes, which take place between residents and non-residents, in ownership of real resources or
financial items and, whether the changes are voluntary or compulsory, do not involve a quid pro
quo in economic value.
Current transfers consist of all transfers that do not involve (i) transfers of ownership of fixed
assets; (ii) transfers of funds linked to, or conditional upon, acquisition or disposal of fixed assets;
(iii) forgiveness, without any counterparts being received in return, of liabilities by creditors. All of
these are capital transfers.
Current transfers include those of general government (e.g., current international cooperation
between different governments, payments of current taxes on income and wealth, etc.), and other
12

transfers (e.g., workers remittances, premiumsless service charges, and claims on non-life
insurance).

CHAPTER-4
COMPONENTS OF CAPITAL ACCOUNT
1. Foreign Investment(FDI, FII)
2. Banking Capital (NRI Deposits)
3. Short term credit
4. External Commercial Borrowings(ECB

13

Present Regulation

Foreign Direct
Investment (FDI)

FDI is restricted in the following sectors:

a) Multi brand retailing.
b) Lottery (public, private, online), gambling, betting and casino.
c) Chit funds and Nidhi Company.
Trading in Transferable Development Rights in real estate business
d) or
construction of farm houses.
Manufacturing of Cigars, cheroots, cigarillos and cigarettes, of
e)

tobacco or
of tobacco substitutes
f) Atomic energy and Railway transport
In rest other sectors such as agriculture, mining, manufacturing,
broadcasting,
print media, aviation, courier services, construction, telecom, banking,
insurance etc; the limits of FDI range from 26% to 100%. All the
foreign
operators have to abide by the sectoral restrictions of the statutory
regulators
in addition to FDI rules.
Indian companies can raise additional
ADRs/ GDRs by Indian

finances
abroad through the issue
of ADRs/ GDRs, in accordance with guidelines issued by the

companies

Government
of India. Unlisted companies, which have not so far accessed the
ADR/GDR
route for raising funds in the global market, would require prior listing
in the
domestic market.
Unlisted companies, which have already issued ADRs/GDRs in the
international market, have to list in the domestic market on making
profit or
within three years of such issue of ADRs/GDRs, whichever is earlier.
A Limited two way fungibility scheme is also operationalised through
14

the
custodians of securities and stock brokers under SEBI.
The ECB limit under the automatic route is enhanced to USD 750
External Commercial
Borrowings (ECBs)/

million
(Circular No. 27 dated September 23, 2011). The maturity guidelines have

Foreign
Currency Convertible

also
been revised (Circular No.64 January 05,

Bonds

2012).
ECBs up to $20 million in a financial year should have a minimum

(FCCBs)

a)

average
maturity of three years.
ECBs of more than $20 million and up to $750 million or equivalent

b) should
have a minimum average maturity of 5
years.
Eligible borrowers under the automatic route can raise Foreign
c)

Currency
Convertible Bonds (FCCBs) up to USD 750 million or equivalent
per
financial year for permissible end-uses.
Corporates in services like hotel, hospital and software, can raise

d) FCCBs
up to USD 200 million or equivalent for permissible end-uses
during a
financial but the proceeds of the ECB should not be used for

e)

acquisition of
land.
ECB / FCCB availed of for the purpose of refinancing the existing
outstanding FCCB should be viewed as part of the limit of USD 750
million
available under the automatic route.

Non Resident Indians (NRI)/Persons of Indian Origin (PIO) are

Foreign Institutional

allowed to
make direct investment in Indian companies under the automatic

Investment (FII)

route.
FII/ NRI/ PIO/HNIs are allowed to invest in the following:
15

a) Securities in the primary and secondary markets including shares,

debentures, and warrants of companies, unlisted, listed, or to be
listed on
a recognized stock exchange in India
Units of schemes ?oated by domestic mutual funds including the
b) Unit
Trust of India, whether listed or not listed on a recognized stock
exchange
c) Government securities
d) Derivatives
e) Commercial paper
f) Security receipts
g) Indian Depository Receipts
Investments in shares or
convertible
debentures of an Indian company
engaged in the following type of activities are not permitted:
a) Chit fund or Nidhi company;
b) Agricultural or plantation activities
c) Real estate business;
d) Construction of farm houses

CURRRENT ACCOUNT CONVERTIBILITY

Current account convertibility opens up the domestic economy to foreign capital. Foreign capital
augments investible resources of the home country and facilitates faster growth. Cost of capital
for domestic firms is lowered and access to global capital markets is enhanced. Just as there are
gains from international trade in goods and services, there are gains from trade in financial
assets. It allows residents to hold globally diversified portfolios improving their risk return trade
off. It lowers the funding cost for resident borrowers.
Economists talk of capital output ratio. In order for the GDP to grow at 8-9 percent, 25 percent
more investment is required. Twenty to 25 percent of the countrys gross income should be
invested in various infrastructural assets. Indias investment rate has not been more than 20-25
percent of GDP at best of times. The remaining five to six percent must come from foreign
16

investments otherwise we will not be able to achieve a high growth rate. Our savings rate should
be 32-34 percent but in actuality it is only 26 percent. The gap has to be filled by foreign
investment.
Take the case of Japan, Scandinavia and Europethere the opportunities for investment are
limited. They are looking for more attractive investments abroad which will give say, eight
percent return as against the three percent they get in their own country. So money is lying idle in
those countries. Developing countries are short of funds; therefore, the opening up of capital
account does augment the investible resources of the home country. Our companies can access
the capital and their cost of capital will come down. If we are to rely only on domestic capital,
the cost would be high. Some investments will simply not be undertaken.
Export and import of goods and services is good for the welfare of all countries engaged in it.
For example, software services from India, we do it much better than developed countries. But
we have to import a lot of goods either because other countries produce it better. Then why not
apply the same logic to capital. The major fear is not only about foreigners investing here but
what if domestic investors start investing abroad. But why should they do it. As a wise investor,
who will be tempted to invest abroad and earn three percent when the same investment can yield
eight percent in the domestic market? Why should you park your investments abroad if the rate
of return is low? Rate of return on investment has come to two percent in Japan.
In India it is 4.6 percent. Unless we fear a massive crisiseither a political or economic
collapse, the fear about capital account convertibility is not justified. Our political system is
working well,
government is functioning well, and no major political crises are also foreseen? We also do not
expect an economic crisis as in Thailand. Foreign capital in India constitutes a very small part of
the total capital. Particularly short term capital that has a maturity of six month. That constitutes
a much small portion. Even if all of that leaves tomorrow, Indian economy is not going to
collapse. Our total foreign debt as a percentage of GDP is very small. Short term debt component
in that is still smaller. So this fear about taking foreign capital away from India if capital account
17

convertibility comes is totally unjustified. Today India and China offer the best investment
opportunity globally in manufacturing, services and infrastructure. Because of wrong policies in
power, roads, ports, investments are not flowing in. Current account convertibility also means,
competition among financial intermediaries, improves efficiency, cuts transaction costs, deepen
financial markets.
Large deficits show up on current account as debits and running up large current account deficits
will lose the confidence of foreign investors in meeting our liabilities. When there is current
account deficit, it means imports are more than exports. In normal situations it should not exceed
1.5-2 % of GDP. Anything beyond that is not sustainable and quite dangerous also. In Thailand,
the current account deficit for three years was nine percent of GDP. If we have to keep current
account under control then budget deficits should also be under control. They must raise more
resources by way of taxation not by way of borrowing. Borrowing creates problems for the
future as interest burden will increase. Large deficits will also lead to depreciation of currency.
Imposes discipline on domestic macroeconomic policy making. Monetary policy must work
within the constraints of uncovered interest rate regime must be in tandem with what is
happening and cannot be arbitrary.

CAPITAL ACCOUNT CONVERTIBILITY

Capital Account Convertibility (CAC) means freedom to convert domestic financial assets into
overseas financial assets at market-determined rates. Simply put, the regime of full convertibility
allows any Indian resident to go to a foreign exchange dealer or bank and freely convert rupees
into dollars, pounds or Euros to acquire assets abroad. The overseas assets can be anything;
equity, bonds, property or ownership of overseas firms.
It refers to the abolition of all limitations with respect to the movement of capital from India to
different countries across the globe. In fact, the authorities officially involved with CAC (Capital
Account Convertibility) for Indian Economy encourage all companies, commercial entities and
individual countrymen for investments, divestments, and real estate transactions in India as well
as abroad. It also allows the people and companies not only to convert one currency to the other,
but also free cross-border movement of those currencies, without the interventions of the law of
the country concerned.
18

Capital Account convertibility in its entirety would mean that any individual, be it Indian or
Foreigner will be allowed to bring in any amount of foreign currency into the country. Full
convertibility also known as Floating rupee means the removal of all controls on the cross-border
movement of capital, out of India to anywhere else or vice versa. Capital account convertibility
or CAC refers to the freedom to convert local financial assets into foreign financial assets or vice
versa at market-determined rates of interest. If CAC is introduced along with current account
convertibility it would mean full convertibility.
Complete convertibility would mean no restrictions and no questions. In general, restrictions on
foreign currency movements are placed by developing countries which have faced foreign
exchange problems in the past is to avoid sudden erosion of their foreign exchange reserves
which are essential to maintain stability of trade balance and stability in their economy. With
Indias forex reserves increasing steadily, it has slowly and steadily removed restrictions on
movement of capital on many counts.
The last few steps as and when they happen will allow an Indian individual to invest in Microsoft
or Intel shares that are traded on NASDAQ or buy a beach resort on Bahamas or sell home or
small industry and invest the proceeds abroad without any restrictions.
Accounting of total inflow and outflow of Funds is as follows: Increase in foreign ownership of domestic assets Increase of domestic ownership of
foreign assets = FDI + Portfolio Investment + Other investments.
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.
Need for Capital Account Convertibility
2. Capital account convertibility is considered to be one of the major features of a developed
economy. It helps attract foreign investment. It offers foreign investors a lot of comfort as
they can re-convert local currency into foreign currency anytime they want to and take their
19

money away.
3. Capital account convertibility makes it easier for domestic companies to tap foreign markets.
At the moment, India has current account convertibility. This means one can import and
export goods or receive or make payments for services rendered. However, investments and
borrowings are restricted.
4. It also helps in the efficient appropriation or distribution of international capital in India. Such
allocation of foreign funds in the country helps in equalizing the capital return rates not only
across different borders, but also escalates the production levels. Moreover, it brings about a
fair allocation of the income level in India as well.
5. For countries that face constraints on savings and capital can utilise such flows to finance
their investment, which in turn stokes economic growth.
6. Local residents would be in a position to diversify their portfolio of assets, which helps them
insulate themselves, better from the consequences of any shocks in the domestic economy.
7. For global investors, capital account convertibility helps them to seek higher returns by
sharing risks.
8. It also offers countries better access to global markets, besides resulting in the emergence of
deeper and more liquid markets.
Capital account convertibility is also stated to bring with it greater discipline on the part of
governments in terms of reducing excess borrowings and rendering fiscal discipline.
BENEFITS OF CAC
1) It leads to more inflow of capital into domestic financial system. Thus firms have access to
more capital, and this reduces their cost of capital. A reduced COC induces firms to invest more,
expand more and thus output, employment and income expand in medium- to long-run.
20

a) Full CAC leads to freedom to trade in financial assets. Investors can choose from a wider range
of financial products across multiple countries.
b) Entry of foreign financial institutions results in eventual efficiency in domestic financial system,
since such entry increases the number of players in the market, and fosters competition. In some
cases, the market could see a transition from the near-monopoly to near-perfectly competitive
market. In order to survive stiffer competition, (domestic) firms are forced to become more
efficient. This also ensures compliance with international standards of reporting, disclosure and
best practices.
c) As a consequence of full CAC, tax levels converge to international levels.
d) As more capital flows in, domestic interest rates are reduced, thus cost of governments
domestic
borrowing is reduced, and so fiscal deficit shrinks.
DISADVANTAGES OF CAC
e) An open capital account causes an export of domestic savings abroad, to more attractive
destinations. In capital-starved countries, such outbound savings flight can be ill afforded.
f) Increased capital inflows also lead to appreciation of real exchange rate. It shifts resources from
tradable to non-tradable sectors.
g) Premature liberalization and CAC lead to an initial stimulation of capital outflows, which by
appreciating the real exchange rate, destabilizes the economy.
h) Another possible side-effect is generation of financial bubbles. A sudden burst could replicate the
Asian crisis once again.

21

i) But the oft-cited argument against CAC is concerning movements of short-term capital. It is
considered to be extremely volatile, highly sensitive to domestic and/or international economic,
political and financial events, and once such an event starts, the extent increases as in a chainreaction
such investors invest their capital only lured by the prospect of short-term windfall gains
precipitated by interest-rate differentials (in most cases). And once some investors withdraw their
capital, the herd mentality is displayed other arms length investors also follow suit and
withdraw their money. This is known as capital flight. Once capital flight takes place,
international investors lose confidence on the host countrys economy. Creditworthiness
diminishes, too.
And the most dangerous consequence of capital flight is that the government has to deploy its
Forex Reserves to the investors who withdraw the capital, and this brings the domestic economy
to a highly vulnerable state. This may well start a financial disruption and/or currency crisis.

22

CHPTER-5
TARAPORE COMMITTEE
Tarapore Committee-I
The first Tarapore committee report on capital account convertibility (CAC), which came out in
May 1997, wanted CAC to be phased in over three years (1997-2000). The five-member
committee has recommended a three-year time frame for complete convertibility by 1999-2000.
The highlights of the report including the preconditions to be achieved for the full float of money
are as follows:Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5 per cent in 1997-98
to 3.5% in 1999-2000.
A consolidated sinking fund has to be set up to meet government's debt repayment needs; to
be financed by increased in RBI's profit transfer to the govt. and disinvestment proceeds.
Inflation rate should remain between an average 3-5 per cent for the 3-year period 1997-2000
Gross NPAs of the public sector banking system needs to be brought down from the present
13.7% to 5% by 2000. At the same time, average effective CRR needs to be brought down from
the current 9.3% to 3%.
RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a neutral
Real Effective Exchange Rate RBI should be transparent about the changes in REER.
Tarapore Committee -II
23

In the Year 2006 under Manmohan Singh Government the Tarapore Committee reappointed to
give suggestion on adoption of Fuller Capital Account Convertibility (FCAC). The Committee
has given the following recommendation and the whole process was divided into 3 phases:
Phase - I (2006-07)
Phase - II (2007-09)
Phase - III (2009-11)
Tarapore-II makes wide-ranging recommendations on the strengthening of the banking sector. At
times, it appears to over-step its brief. It is one thing to argue that governments holdings in
public sector banks should be brought down to 33% as this would help banks augment their
capital
Proposed Changes by Tarapore Committee
Investmenta
Relaxation

Phase-I
2006-07

ECB

Status quo on
ECB limit of
$18 billion

Resident
individuals
overseas
investment
MFs overseas
investment

$ 25000 limit
should be hiked to
$ 50000 per
calendar year
$2 billion
investment limit
to
be raised to $3

Phase-II
2007-09
Gradual increase,
but automatic
limit
to be raised from
$500 million to
$750 million

Phase-III
2009-11
Gradual increase,
but limit to be
raised to $1
billion
per financial year

Raised to $
100000

Raised to $
200000

Further raised to
$4
billion

Further raised to
$5 billion

billion

24

Investment
Relaxation
FII investment
FIIs debt
investment

JVs / Whollyowned
subsidiary
abroad
investment

Phase-I
2006-07
Fresh participatory notes
should be banned
G-Sec investment limit of
$2
billion to be modified as 6
per cent of gross
borrowing
200 per cent of net worth
limit should be raised to
250
percent

Phase-II
2007-09

Phase-III
2009-11

Ban to continue

Ban to continue

8 per cent of
total
gross borrowing

10 per cent of
gross borrowing
J

Further raised to
300 per cent of
net
worth

Further raised to
400 per cent

Source: RBI appointed Tarapore Committee Report 2006

FULLER CAPITAL ACCOUNT CONVERTIBILITY

Capital Account convertibility in its entirety would mean that any individual, be it Indian or
Foreigner will be allowed to bring in any amount of foreign currency into the country.
Full convertibility also known as Floating rupee means the removal of all controls on the crossborder movement of capital, out of India to anywhere else or vice versa.
Capital account convertibility or CAC refers to the freedom to convert local financial assets into
foreign financial assets or vice versa at market-determined rates of interest. If CAC is introduced
along with current account convertibility it would mean full convertibility.
Complete convertibility would mean no restrictions and no questions. In general, restrictions on
foreign currency movements are placed by developing countries which have faced foreign
25

exchange problems in the past is to avoid sudden erosion of their foreign exchange reserves
which are essential to maintain stability of trade balance and stability in their economy. With
Indias Forex reserves increasing steadily, it has slowly and steadily removed restrictions on
movement of capital on many counts.
Capital account convertibility means that an investor is allowed to move freely from the local
currency to a foreign currency. India has limited capital account convertibility to prevent shocks
to the capital account and maintain a stable exchange rate, by stipulating sectoral norms that
ensure a lock-in period for investments.
FDI Norms
The press notes simplify the method for calculating FDI and broadly state that as long as Indian
promoters hold a majority stake (more than 51 per cent) in any operating-cum-investing
company, it can bring investment up to 49.9 per cent through FDI. This company would be
treated as an Indian company and it can invest through a joint venture in any other company that
may be engaged in industries in which FDI has a sectoral limit.
Several companies like retailer Pantaloon and media house UTV have restructured their
organizations to raise FDI in their businesses through step-down joint ventures FDI is
prohibited in multi-brand retail and is restricted to 26 per cent for media
Risks Involved In FCAC

Market Risk

Credit Risk

Liquidity Risk

Derivative Transaction Risk

Operational Risk

26

Market risks such as interest rate and foreign exchange risks become more complex as
financial institutions and corporate gain access to new securities and markets, and foreign
participation changes the dynamics of domestic markets. For instance, banks will have to quote
rates and take unheeded open positions in new and possibly more volatile currencies. Similarly,
changes in foreign interest rates will affect banks interest sensitive assets and liabilities.
Foreign participation can also be a channel through which volatility can spill-over from foreign
to domestic markets.
Credit risk will include new dimensions with cross-border transactions. For instance, transfer
risk will arise when the currency of obligation becomes unavailable to borrowers. Settlement risk
(or Herstatt risk) is typical in foreign exchange operations because several hours can elapse
between payments in different currencies due to time zone differences. Cross-border transactions
also introduce domestic market participants to country risk, the risk associated with the
economic, social, and political environment of the borrowers country, including sovereign risk.
With FCAC, liquidity risk will include the risk from positions in foreign currency denominated
assets and liabilities. Potentially large and uneven flows of funds, in different currencies, will
expose the banks to greater fluctuations in their liquidity position and complicate their assetliability management as banks can find it difficult to fund an increase in assets or accommodate
decreases in liabilities at a reasonable price and in a timely fashion.
Risk in derivatives transactions becomes more important with capital account convertibility as
such instruments are the main tool for hedging risks. Risks in derivatives transactions include
both market and credit risks. For instance, OTC derivatives transactions include counterparty
credit risk. In particular, counterparties that have liability positions in OTC derivatives may not
be able to meet their obligations, and collateral may not be sufficient to cover that risk.
Collecting and analyzing information on all these risks will become more challenging with
FCAC because the number of foreign counterparts will increase and their nature change.
Operational risk may increase with FCAC.4 For instance; legal risk stemming from the
27

difference between domestic and foreign legal rights and obligations and their enforcements
becomes important with fuller capital account convertibility. For instance, differences in
bankruptcy codes can complicate the assessment of recovery values. Similarly, differences in the
legal treatment of secured transactions for repos can lead to unanticipated loss.
Regulatory issues include the risk of regulatory arbitrage as differences in regulatory and
supervisory regimes among countries may create incentives for capital to flow from countries
with higher standards to those with lower ones. FCAC can also bring a proliferation of new
instruments and market participants, complicating the task of financial supervisors and
regulators. The entry of large and complex institutions operating in different countries will
increase the need for cooperation and coordination between domestic regulatory and supervisory
agencies and also with their foreign counterparts.

Chapter-6
ADVANTAGES AND DISADVANTAGES OF CURRENCY
28

CONVERTIBILITY:
Advantages of Currency Convertibility:
Convertibility of a currency has several advantages which we discuss briefly:
1. Encouragement to exports:
An important advantage of currency convertibility is that it encourages exports by increasing
their profitability. With convertibility profitability of exports increases because market foreign
exchange rate is higher than the previous officially fixed exchange rate. This implies that from
given exports, exporters can get more rupees against foreign exchange (e.g. US dollars) earned
from exports. Currency convertibility especially encourages those exports which have low
import-intensity.
2. Encouragement to import substitution:
Since free or market determined exchange rate is higher than the previous officially fixed
exchange rate, imports become more expensive after convertibility of a currency. This
discourages imports and gives boost to import substitution.
3. Incentive to send remittances from abroad:
Thirdly, rupee convertibility provided greater incentives to send remittances of foreign exchange
by Indian workers living abroad and by NRI. further, it makes illegal remittance such hawala
money and smuggling of gold less attractive.
4. A self balancing mechanism:
Another important merit of currency convertibility lies in its self-balancing mechanism. When
balance of payments is in deficit due to over-valued exchange rate, under currency convertibility,
the currency of the country depreciates which gives boost to exports by lowering their prices on
the one hand and discourages imports by raising their prices on the other.

29

In this way, deficit in balance of payments get automatically corrected without intervention by
the Government or its Central bank. The opposite happens when balance of payments is in
surplus due to the under-valued exchange rate.
5. Specialisation in accordance with comparative advantage:
Another merit of currency convertibility ensures production pattern of different trading countries
in accordance with their comparative advantage and resource endowment. It is only when there
is currency convertibility that market exchange rate truly reflects the purchasing powers of their
currencies which is based on the prices and costs of goods found in different countries.
Since prices in competitive environment reflect that prices of those goods are lower in which the
country has a comparative advantage, this will encourages exports. On the other hand, a country
will tend to import those goods in the production of which it has a comparative disadvantage.
Thus, currency convertibility ensures specialisation and international trade on the basis of
comparative advantage from which all countries derive benefit.
6. Integration of World Economy:
Finally, currency convertibility gives boost to the integration of the world economy. As under
currency convertibility there is easy access to foreign exchange, it greatly helps the growth of
trade and capital flows between the countries. The expansion in trade and capital flows between
countries will ensure rapid economic growth in the economies of the world. In fact, currency
convertibility is said to be a prerequisite for the success of globalisation.

Disadvantages of Currency Convertibility:

High volatility: Amid a lack of suitable regulatory control and rates subject to open markets with
large number of global market participants, high levels of volatility, devaluation or inflation in
forex rates may happen, challenging the countrys economy.

30

Foreign debt burden: Businesses can easily raise foreign debt, but they are prone to the risk of
high repayments if exchange rates become unfavourable. Imagine an Indian business taking a
U.S. dollar loan at a rate of 4%, compared to one available in India at 7%. However, if the U.S.
dollar appreciates against Indian rupee, more rupees will be needed to get same number of
dollars, making the repayment costly.
Affects balance of trade, and exports: A rising unregulated rupee makes Indian exports less
competitive in the international markets. Export-oriented economies like India and China prefer
to keep their exchanges rates lower to retain the low-cost advantage. Once the regulations on
exchange rates go away, India risks losing its competitiveness in the international market. (For
more, see: The Reasons Why China Buys U.S. Treasury Bonds.)
Lack of fundamentals: Full capital account convertibility has worked well in well-regulated
nations that have a robust infrastructure in place. Indias basic challengeshigh dependence on
exports, burgeoning population, corruption, socio-economic complexities and challenges of
bureaucracymay lead to economic setbacks post-full rupee convertibility

PROBLEMS OF CURRENCY CONVERTIBILITY:

It may be noted that convertibility of currency can give rise to some problems.
Firstly, since market determined exchange rate is generally higher than the previous officially
fixed exchange rate, prices of essential imports rise which may generate cost-push inflation in
the economy.
31

Secondly, if current account convertibility is not properly managed and monitored, market
exchange rate may lead to the depreciation of domestic currency. If a currency depreciates
heavily, the confidence in it is shaken and no one will accept it in its transactions. As a result,
trade and capital flows in the country are adversely affected.
Thirdly, convertibility of a currency sometimes makes it highly volatile. Further, operations by
speculators make it more volatile. Further, operations by speculators make it more volatile and
unstable. When due to speculative activity, a currency depreciates and confidence in it is shaken
there is capital flight from the country as it happened in 1997-98 in case of South East Asian
economies such as Thailand, Malaysia, Indonesia, Singapore and South Korea.
This adversely affects economic growth of the economy. In the context of heavy depreciation of
the currency not only there is capital flight but inflow of capital in the economy is discouraged as
due to depreciation of the currency profitability of investment in an economy is adversely
affected.
ANOTHER PERSONES VIEW : RELATED TO C C
Currency convertibility means that currency of a country can be freely converted into foreign
exchange at market determined rate of exchange that is, exchange rate as determined by demand
for and supply of a currency.
For example, convertibility of rupee means that those who have foreign exchange (e.g. US
dollars, Pound Sterlings etc.) can get them converted into rupees and vice-versa at the market
determined rate of exchange.
Rupee is both convertible on capital account and current account.

CHAPTER-7
CURRENCY CONVERTIBILITY OF INDIAN RUPEE:

32

In the seventies and eighties many countries switched over to the free convertibility of their
currencies into foreign exchange. By 1990, 70 countries of the world had introduced currency
convertibility on current account; another 10 countries joined them in 1991.
As a part of new economic reforms initiated in 1991 rupee was made partly convertible from
March 1992 under the Liberalised Exchange Rate Management scheme in which 60 per cent of
all receipts on current account (i.e., merchandise exports and invisible receipts) could be
converted freely into rupees at market determined exchange rate quoted by authorised dealers,
while 40 per cent of them was to be surrendered to Reserve Bank of India at the officially fixed
exchange rate.
These 40 per cent exchange receipts on current account was meant for meeting Government
needs for foreign exchange and for financing imports of essential commodities. Thus, partial
convertibility of rupee on current account meant a dual exchange rate system.
This partial convertibility of rupee on current account was adopted so that essential imports
could be made available at lower exchange rate to ensure that their prices do not rise much.
Further, full convertibility of rupees at that stage was considered to be risky in view of large
deficit in balance of payments on current account.
As even after partial convertibility of rupee foreign exchange value of rupee remained stable, full
convertibility on current account was announced in the budget for 1993-94. From March 1993,
rupee was made convertible for all trade in merchandise. In March 1994, even indivisibles and
remittances from abroad were allowed to be freely convertible into rupees at market determined
exchange rate. However, on capital account rupee remained nonconvertible.

Capital Account Convertibility of Rupee:

As explained above, under Capital Account Convertibility any Indian or Indian company is
entitled to move freely from the Rupee to another currency to convert Indian financial assets into
33

foreign financial assets and back, at an exchange rate fixed by the foreign exchange market and
not by RBI.
In a way, capital account convertibility removes all the restrains on international flows on Indias
capital account. There is a basic difference between current account convertibility and capital
account convertibility. In the case of current account convertibility, it is important to have a
transaction importing and exporting of goods, buying and selling of services, inward or
outward remittances, etc. involving payment or receipt of one currency against another currency.
In the case of capital account convertibility, a currency can be converted into any other currency
without any transaction.
The Reserve Bank of India appointed in 1997 the Committee on Capital Account Convertibility
with Mr. S.S. Tarapore, former Deputy Governor of RBI as its chairman. Tarapore Committee
defined capital account convertibility as the freedom to convert local financial assets with
foreign financial assets and vice-versa at market determined rates of exchange.
In simple language, capital account convertibility allows anyone to freely move from local
currency into foreign currency and back. The purpose of capital convertibility is to give foreign
investors an easy market to move in and move out and to send a strong message that Indian
economy was strong enough and that India had sufficient forex reserves to meet any flight of
capital from the country to any extent.
Under the system of capital account convertibility proposed by this committee the following
features are worth mentioning:
(a) Indian companies would be allowed to issue foreign currency denominated bonds to local
investors, to invest in such bonds and deposits, to issue Global Deposit Receipts (GDRs) without
RBI or Government approval to go in for external commercial borrowings within certain limits,
etc.
(b) Indian residents would be permitted to have foreign currency denominated deposits with
banks in India, to make financial capital transfers to other countries within certain limits, to take
loans from non-relatives and others upto a ceiling of $ 1 million, etc.
34

(c) Indian banks would be allowed to borrow from overseas markets for short-term and longterm upto certain limits, to invest in overseas money markets, to accept deposits and extend loans
denominated in foreign currency. Such facilities would be available to financial institutions and
financial intermediaries also.
(d) All-India financial institutions which fulfill certain regulatory and prudential requirements
would be allowed to participate in foreign exchange market along with authorised dealers (ADs)
who are, at present, banks. In a later stage, certain select NBFCs would also be permitted to act
as ADs in foreign exchange market.
(e) Banks and financial institutions would be allowed to operate in domestic and international
markets and they would also be allowed to buy and sell gold freely and offer gold denominated
deposits and loans.
CURRENCY CRISIS
Emerging Market Economies (EME)

The East Asian currency crisis began in Thailand in late June 1997 and afflicted other
countries such as Malaysia, Indonesia, South Korea and the Philippines and lasted up to the
last quarter of 1998. The major macroeconomic causes for the crisis were identified as:
current account imbalances with concomitant savings-investment imbalance, overvalued
exchange rates, high dependence upon potentially short-term capital flows. These
macroeconomic factors were exacerbated by microeconomic imprudence such as maturity
mismatches, currency mismatches, moral hazard behaviour of lenders and borrowers and
excessive leveraging.

The Mexican crisis in 199495 was caused by weaknesses in Mexico's economic position
from an overvalued exchange rate and current account deficit at 6.5 per cent of Gross
Domestic Product (GDP) in 1993, financed largely by short-term capital inflows.

Brazil was suffering from both fiscal and balance of payments weaknesses and was affected in
35

the aftermath of the East Asian crisis in early 1998 when inflows of private foreign capital
suddenly dried up. After the Russian crisis in 1998, capital flows to Brazil came to a halt.

Difficulties in meeting huge requirements for public sector borrowing in 1993 and early 1994,
led to Turkey's currency crisis in 1994. As a result, output fell by 6 percent; inflation rose to
three-digit levels, the central bank lost half of its reserves, and the exchange rate depreciated
by more than 50 per cent. Turkey faced a series of crisis again beginning 2000 due to a
combination of economic and noneconomic factors. Some Lessons from Currency Crisis in
Emerging Market Economies: -

Most currency crises arise out of prolonged overvalued exchange rates, leading to
unsustainable current account deficits. As the pressure on the exchange rate mounts, there is
rising volatility of flows as well as of the exchange rate itself. An excessive appreciation of
the exchange rate causes exporting industries to become unviable, and imports to become
much more competitive, causing the current account deficit to worsen.

Large unsustainable levels of external and domestic debt directly led to currency crises.
Hence, a transparent fiscal consolidation is necessary and desirable, to reduce the risk of
currency crisis.

Short-term debt flows react quickly and adversely during currency crises. Receivables are
typically postponed, and payables accelerated, aggravating the balance of payments
position.

CAC and South-East Asian Crisis

The Asian Crisis of 1997-98 originated from Thailand. The Baht was at that time pegged with
US Dollar. As dollar appreciated, so did Baht, and exports decreased, export competitiveness
36

also reduced, leading to increased current account deficit and trade deficit. Thailand was heavily
reliant on foreign debt with its huge CAD being dependent on foreign investment to stay afloat.
Thus there was an increased forex risk.
As US increased its domestic interest rate, the investors started investing more in the US. It led
to capital flight. Forex reserves rapidly depleted, and the Thai economy tumbled down. At this
juncture, Thai government decided to dissociate Baht from the US currency and floated Baht.
Concurrently, the export growth in Thailand slowed down visibly.
Combination of these factors led to heavy demand for the foreign currency, causing a downward
pressure on Baht. Asset prices also decreased. But, that time Thailand was dominated by crony
capitalism, so credit was widely available. This resulted in hike of asset prices to an
unsustainable level and as asset prices fell, there was heavy default on debt obligations. Credit
withdrawal started.
This crisis spread to other countries as a contagion effect. The exchange markets were flooded
with the crisis currencies as there were few takers. It created a depreciative pressure on the
exchange rate. To prevent currency depreciation, the governments were forced to hike interest
rates and intervene in forex markets, buying the domestic currencies with their forex reserves.
However, an artificially high interest rate adversely affected domestic investment, which spread
to GDP, which declined, and eventually economies crashed.
In this backdrop, the most vicious argument offered by the opponents of full CAC had been the
role of free currency convertibility. In the absence of any capital control, no restrictions were
kept on capital outflow, and thus the herd behavior of investor led to economic cash of the entire
region.
Thus the Asian currency has taught the following observations and lessons:
1) Most currency crises arise out of prolonged overvalued X-rate regime. As the pressure on the
X-Rate increases, there is an increased volatility of the capital flows as well as of the X-Rate
37

itself. If the X-rate appreciates too high, the economys export sector becomes unviable by losing
export-competitiveness at a global level. Simultaneously, imports become more competitive, thus
CAD increases and becomes unsustainable after a certain limit.
2) Large and unsustainable levels of external and domestic debt had added to the crises, too. Thus,
the fiscal policies need to be more transparent and forward looking.
3) During the crises, short term flows reacted quickly and negatively. Either receivables were
postponed by debtors and/or payables were accelerated by creditors. Thus BOP situation
worsened.
4) Domestic financial institutions need to be strong and resilient to absorb and minimize the hocks
so that the internal ripple effect is least.
5) Gradual CAC is the safest way to adopt. However, even a gradual CAC cannot fully eliminate
the risk of crisis or pressure on forex market.
Capital Convertibility and its effects on India
As most of us know, resident Indians cannot move their money abroad freely. That is, one has to
operate within the limits specified by the Reserve Bank of India and obtain permission from RBI
for anything concerning foreign currency.
For example, the annual limit for the amount you are allowed to carry on a private visit abroad is
$10,000: of which only $5,000 can be in cash. For business travel, the yearly limit is $25,000.
Similarly, you can gift or donate up to $5,000 in a year.
The RBI raises the limit if you are going abroad for employment, or are emigrating to another
country, or are going for studies abroad: the limit in both these cases is $100,000.
You are also allowed to invest into foreign stock markets up to the extent of $25,000 in a year.
38

For the average Indian, these 'limits' seem generous and might not affect him at all. But for heavy
spenders and those with visions of buying a house abroad or a Van Gogh painting, it will mean a
lot.But with the markets opening up further with the advent of capital account convertibility, one
would be able to look forward to more and better goods and services.
Evolution of CAC in India economic and financial scenarios
In early 1990s India was facing foreign reserve crisis, the foreign reserves were only sufficient to
pay off two weeks import; therefore India was forced to liberalize the economy. In 1994 August,
the Indian economy adopted the present form of Current Account Convertibility, compelled by
the International Monetary Fund (IMF) Article No. VII. The primary objective behind the
adoption of CAC in India was to make the movement of capital and the capital market
independent and open. This would exert less pressure on the Indian financial market. The
proposal for the introduction of CAC was present in the recommendations suggested by the
Tarapore Committee appointed by the Reserve Bank of India.

POLICY IMPLICATIONS FOR INDIA

The experience with liberalisation of inward capital flows in India has been similar to the
economies of Latin America and East Asia, only the magnitude of these flows has not been large
enough to cause serious macro and micro management problems.
Based on the experience of other countries, the following issues are of concern for India:
Flexibility in exchange rate: To prevent a nominal appreciation because of the capital inflows,
the RBI has been adding billions of dollars to its reserves; the foreign exchange reserves with the
RBI are a whopping $69 billion.
1) However, intervening foreign currency purchases to stabilise the exchange rate and accumulation
of forex reserves have implications for domestic monetary management, which can be seriously
impaired by divided short-term monetary responses during a capital surge.
2) On the other hand, the option of a more flexible exchange rate would cause an appreciation in
the value of the rupee, which may hurt exports.
39

3) Hence, the usual macroeconomic trilemma (Obstfield, M and A. M Taylor 2001) where only two
of the three objectives of a fixed exchange rate capital mobility and an activist monetary
policy can be chosen. Since the government has already liberalised inflows of capital to a
large extent, the authorities could attempt to deal with this problem in one of the following ways:
It could begin relaxing capital controls, allowing individuals to exchange rupees for dollars.
Indeed, some piecemeal measures in this direction have already been taken. But this, perhaps, is
a risky proposition.
4) For one thing, the embrace of full convertibility is itself likely to bring more dollars into the
country in the initial phase and add to the existing upward pressure on the rupee. More
important, given the lack of regulatory capacity, such convertibility runs the risk of a future
financial crisis that may scuttle the growth process.
5) Alternatively, the government could tap this opportunity to liberalise imports. Further
liberalisation will stimulate imports and create the necessary demand for dollars, mopping up the
excess supply of dollars and relieving the government of the burden of low-yielding foreign
exchange reserves.
6) In as much as the imports are used as inputs for further exports, the move will kill two birds with
one stone it will relieve the upward pressure on the rupee, and bring the usual efficiency
gains. In this regard, therefore, import liberalisation seems to be a distinctly better option.
7) Banking and capital market regulatory system: The relatively greater contribution of portfolio
capital towards India's capital account, and the fact that these inflows could increase to
significant levels in the future as India's financial markets get integrated globally, show that an
important sphere of concern is their skilful management to facilitate smooth intermediation.
8) Banks intermediate a substantial amount of funds in India over 64 per cent of the total
financial assets in the country belong to banks. However, many Indian banks are
undercapitalised, and their balance sheets characterised by large amounts of non-performing
assets (NPAs).
40

9) Unless banking standards are duly brushed up, viable competition introduced and government
interference reduced, it would be reckless to go in for full capital account convertibility, which
requires flexibility, dynamism and foresight in the country's banking and financial institutions.
10) Transparency and discipline in fiscal and financial policies: It is well known that the last thing
that a government wanting to gain the confidence of investors should do is to be fiscally
imprudent. However, New Delhi does not seem to be paying heed to this consideration at all.
The ratio of gross fiscal deficit to GDP (including that of states) increased to 10.4 per cent in
1999-2000 from 6.2 per cent in 1996-97 and 8.5 per cent in 1998-99, and has hovered around the
10 per cent figure since then. Such high fiscal deficits can prove to be unsustainable and frighten
away investors.
11) Hence, there is an immediate need for putting brakes on government expenditure, and until
that has been satisfactorily done; opening up the capital account fully would carry with it a big
risk of sudden loss of faith of investors and capital flight.

CHAPTER-8
CONCLUSION
Whatever the apparent theoretical benefits of capital account convertibility, they have not yet
been indicated by the actual empirical evidence; rather, the experience of the countries in the
41

developing world that have experimented with capital account convertibility has been that of
increased market volatility and financial crises.
Moreover, at least a part of the large inflows of capital into India are a consequence of the
recessionary conditions elsewhere. The country's macroeconomic fundamentals, though better
than before, are not good enough to warrant long-lasting confidence from foreign investors. The
reform process is not proceeding with adequate speed, banks are saddled with large volumes of
non-performing assets, the financial system is not deep or liquid enough and the country ranks
high in the list of corrupt nations.
Once the conditions in the rest of the world improve, and the interest rate differentials between
India and the rest of the world narrow further, this capital may move on to greener pastures.
Hence, one cannot bank on the continuous supply of foreign capital to finance whatever outflows
occur from the country.
Therefore, we believe that India should be extremely cautious in liberalizing capital outflows any
further.
While it should leave no stone unturned to promote inward FDI, which, because of its very
nature, is less susceptible to sudden withdrawals and also tends to promote productive use of
capital and economic growth, it should be wary of short-term capital flows that have the potential
to destabilise financial markets
The `slow and steady' stance that the RBI has taken towards capital account convertibility is to
be appreciated.
It must be emphasized that only over time will the Indian economy be mature enough to be
comfortable with full capital account convertibility financial markets will deepen,
macroeconomic and regulatory institutions grow more robust and the government will learn from
past mistakes.
The Government would do well to focus at present on the fundamental processes of institutional
development and policy reform because, in the long run, these would serve the country better
than an early move towards full capital account convertibility.
Economists realize that directly jumping into fuller capital account convertibility without taking
into consideration the downside or the disadvantages of the steps could harm the economy.

42

BIBLIOGRAPHY
www.yourarticlelibrary.com
www.mbaknol.com
www.investopedia.com
www.iiem.com
www.careerride.com

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