Capital Account Convertibility

The setting up of a six-member panel headed by former RBI deputy governor S S Tarapore, to
draw up the road map to capital account convertibility (CAC) has brought the issue once agian
to the front-burner. An earlier committee, also headed by Mr Tarapore, had provided a three-
year frame-work for transition to full capital account convertibility by 2000. Are we ready for
CAC? We take a Closer Look at CAC and its implications:

What is capital account convertibility?

There is no formal definition of capital account convertibility (CAC). However, the Tarapore
committee set up by RBI to go into the question of CAC in 1997 defined it as the freedom to
convert local financial assets into foreign financial assets and vice versa at market determined
rates of exchange. Simply put, CAC allows anyone to freely move from local currency into
foreign currency and back.

How is CAC different from current account convertibility?

Current account convertibility allows free inflows and outflows for all purposes other than for
capital purposes such as making investment and loans. It allows residents to make and receive
trade-related payments—receive dollars (or any other foreign currency) for export of goods and
services and pay dollars for import of goods and services, make sundry remittances, access
foreign currency for travel, studies abroad, medical treatment, etc. In India, current account
convertibility was established with the acceptance of obligations under Article VIII of IMF’s
Articles of Agreement in 1994.

Can CAC coexist with restrictions?

Contrary to general belief, CAC can coexist with restrictions other than on external payments.
For instance it does not preclude the imposition of policy restrictions on foreign holding in any
sector. The US,, for example, restricts how much foreigners can own in the airlines industry even
though the dollar is fully convertible on capital account.

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Why is CAC such an emotive issue?

CAC is widely regarded as one of the hallmarks of a developed economy. It is also seen as a
major comfort factor for overseas investors since they know that at anytime they will be able to
re-convert local currency back into foreign currency and take out their money.

To attract foreign investment, many developing countries went in for CAC in the 1980s, not
realising that free mobility of capital leaves countries open to both sudden and huge inflows and
outflows, both of which can be potentially destabilising. More important, unless you have the
institutions, particularly financial institutions capable of dealing with such huge flows, countries
may not be able to cope as was demonstrated by the East Asian crisis of the late 90s.

Following the crisis, even the most ardent votaries of CAC in the World Bank and the IMF
realised that the result of going in for CAC without adequate preparation could be catastrophic.
Since then, the received wisdom has been to move slowly but cautiously towards CAC, with
priority being accorded to fiscal consolidation and financial sector reform.

In India, the Tarapore committee had laid down a three-year road-map, ending 1999-2000, for
CAC. It also cautioned that this time-frame could be speeded up, or delayed, depending on the
success achieved in establishing the pre-conditions—primarily fiscal consolidation,
strengthening of the financial system and low rate of inflation. With the exception of the last, the
other two pre-conditions have not been achieved.

What is the position in India today?

Convertibility of capital for non-residents has been a basic tenet of India’s foreign investment
policy all along, subject, of course, to fairly cumbersome administrative procedures and the
government’s policy on foreign direct investment. It is only residents—both individuals and
corporate - who have been and continue to be subject to capital controls.

However, as part of the liberalisation process, the government has been relaxing these controls.
Thus, residents have been allowed to invest through the MF route and corporates have also been
given much greater freedom to invest abroad. Limits on external commercial borrowings have
also been steadily relaxed.

Buoyed by India’s healthy forex reserves, comfortable external debt position, improved showing
on the fiscal front, strong GDP growth and the fact that progressive relaxations on the forex front
have not led to a flight of capital, the government has now appointed another committee to draw
up a roadmap to move to full CAC.

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