Chapter 1

Introduction

1.1 Background of the study

In India, the foreign exchange transactions (transactions in dollars, yen, or any other currency)

are broadly classified into two accounts: current account transactions and capital account

transactions. If an Indian citizen needs foreign exchange of smaller amounts, say $3,000, for

travelling abroad or for educational purposes, she/he can obtain the same from a bank or a

money-changer. This is a current account transaction. But, if someone wants to import plant and

machinery or invest abroad, and needs a large amount of foreign exchange, say $1 million, the

importer will have to first obtain the permission of the Reserve Bank of India (RBI). If approved,

this becomes a capital account transaction. This means that any domestic or foreign investor has

to seek the permission from a regulatory authority, like the RBI, before carrying out any

financial transactions or change of ownership of assets that comes under the capital account.

Thus, the rules regulate currency conversion for foreign entities that want to invest in India and

Indians who want to invest overseas making the Indian rupee only “partially convertible”.

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1.2 Objective of Study

I. To understand the meaning and salient features Capital account convertibility.

II. - To understand Difference b/w Current & Capital account

III. To know how is capital account convertibility different from current account

convertibility.

IV. To understand the concept capital controls benefit economies.

V. To understand in detail about current account and capital account..

VI. To understand Why India went in for CAC.

VII. To understand the advantages & disadvantages of CAC.

VIII. To know Steps towards CAC in India

IX. To understand Recommendations of Tarapore Committee

X. To understand Lessons dawn from India’s approach to Capital Account Capitalization

/Liberalization

XI. To know Experiences of other countries

XII. To know What is the position of CAC in India today

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1.3 Research Design

The descriptive form of research method is adopted for study. The major purpose of descriptive

research is description of a study on detailed concepts related to Capital Account Convertibility.

The study includes a broad based understanding on the Capital Account Convertibility concept

which includes India’s Capital Account Convertibility position, the disequilibrium in Capital

Account Convertibility and the ways of correcting them.

1.4 Limitations of the study

The study is made with the help of the secondary data collected from the newspapers, magazines,

internet etc.

All the limitations of the sources such as the newspapers, magazines and articles on the internet

are applicable to this study.

1.5 Significance of the Research Study

It enables one to understand and know the following: meaning and salient features of

Capital Account Convertibility.

Difference between current & Capital ACCOUNT

Why India went in for Capital Account Convertibility.

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Advantages on easing of capital controls that benefit economies

Lessons dawn from India’s approach to Capital Account Capitalization

Experiences of other countries

1.6 Chapter Scheme:

I. Introduction: This chapter explains the relevance of selecting the topic i.e. Capital

Account Convertibility study. Objective of studying this topic.

II. Conceptual framework: This chapter will conceptualize the idea of Capital Account

Convertibility, difference between capital account & current account, Effects of CAC of

on INDIA

III. Review of Literature: This chapter is an attempt to review the available literature on

Capital Account Convertibility, difference between capital account & current account,

Effects of CAC of on INDIA

IV. Observation: This chapter includes impact of Capital Account Convertibility

V. Suggestion and conclusion: This Chapter lists out the findings of research study and its

importance in the policy implications.

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Chapter 2

2.1 Conceptual Framework

What is Capital Account Convertibility????

In a country’s balance of payments, the capital account features transactions that lead to changes

in the overseas financial assets and liabilities. These include investments abroad and inward

capital flows. Capital account convertibility implies the freedom to convert domestic financial

assets into overseas financial assets at market determined rates. 

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It can also imply conversion of overseas financial assets into domestic financial assets. Broadly,

it would mean freedom for firms and residents to freely buy into overseas assets such as equity,

bonds, property and acquire ownership of overseas firms besides, free repatriation of proceeds by

foreign investors. It is associated with the changes of ownership in foreign/domestic financial

assets and liabilities and embodies the creation and liquidation of claims on, or by the rest of the

world

2.2 Difference b/w Current and Capital Account

Basis Current account Capital Account

Components Includes all transactions which

give rise to or use national

income:

Merchandise imports and

exports

Invisible exports and imports.

Consits of all short term and long term

capital transactions.

Examples Import refrigerators,

Import insurance services,

Export steel Export software,

Receive remittances from a

sibling in England Send

abroad to a attending college

in New Zealand

Capital Inflows:

a) If an Indian company takes a

loan from an American bank.

b) If a UK Company invests in a

factory in India, this is

classified as Foreign Direct

Investment (FDI).

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c) When foreigners buy shares in

Indian companies their

investment shows up as

portfolio investment on the

capital account .

Capital Outflows:

a) TATA’s purchased Tetley and

Daewoo.

b) It is where we(Indian

households & firms) invest in

global assets.and global

portfolio invest in Indian

assets.

Convertibility aspect Today,India has “Current

Account Convertibilty” in the

sense that you are free to buy

foreign exchange for the

purpose of importing goods

and services. In other words

the Rupee is not convertible

on current account.

Today the rupee is not fully

convertible on the capital account as

there exist restrictions on money that

comes in to buy assets in India on that

goes out of India to acquire assets

abroad.

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2.3 How is Capital Account Convertibility different from current account

convertibility?  

Current account convertibility allows free inflows and outflows for all purposes other than for

capital purposes such as investments and loans. In other words, 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 and gifts etc. In India,

current account convertibility was established with the acceptance of the obligations under

Article VIII of the IMF’s Articles of Agreement in August 1994.

How does easing of capital controls benefit economies?  

Once a country eases capital controls, typically, there is a surge of capital flows. For countries

that face constraints on savings and capital can utilise such flows to finance their investment,

which in turn stokes economic growth. 

The inflow of capital can help augment domestic resources and boost growth. 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. 

For global investors, capital account convertibility helps them to seek higher returns by sharing

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risks. 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.

With the wave of financial globalization, capital account has been the center of attention for

researchers and policy makers. Most developing countries have begun dismantling the

restrictions on capital account transactions with the objective of achieving the traditional benefits

of CAC identified in the literature. Since most developing countries still have some kind of

restrictions on capital account transactions, capital account openness is a matter of degree. In

terms of theory, one of the primary aims of increasing the degree of capital account openness is

to help countries to obtain the advantages of improved risk sharing and thereby lowering the

volatility in macroeconomic aggregates like output, consumption and investment, which will, in

turn, has welfare enhancing effects. Developing countries, in particular, appear to have benefited

most from risk sharing owing to their highly volatile nature of income and consumption

dynamics. However, contrary to the expectations, the volatility of these aggregates has increased

in the aftermath of CAC leading to crises in many countries at the end of the 1990s. This led to a

widespread debate regarding the costs and benefits of CAC.

Current Account

The current account of the balance of payment statement relates to real and short-term

transactions. It contains receipts and payments on account of exports, or visible and invisible

items. Exports and imports of material goods are visible items; and exports and imports of

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services are invisible items. Transactions in the current account are called real transactions

because they are concerned with actual transfer of goods and services which affect income,

output and expenditure of the country. These are income generating transfers and are not merely

financial transactions.

Items of Current Account

According to the International Monetary Fund (IMF), the current account of the balance of

payment includes the following items:

Merchandise

Exports and imports of goods form the visible account and have dominant position in the current

account of balance of payment. Exports constitute the credit side and import the debit side.

Travel

Travel is an invisible item in the balance of payments. Travel may be for reasons of business,

education, health, international conventions or pleasures. Expenditure by the foreign tourists in

our country forms the credit item and the expenditure by our tourists abroad constitutes the

debit item in our balance of payment.

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Transportation

International transportation of goods is another invisible transaction. It includes warehousing

(while in transit) and other transit expenses. Use of domestic transport services by the foreigners

is the credit item and the use of foreign transport service by domestic traders is the debit item.

Insurance

Insurance premium and payments of claims is also an invisible transaction in a country’s balance

of payment account. Insurance policies sold to foreigners are a credit item and the insurance

policies purchased by domestic users from the foreigners are a debit item.

Investment Income

Another visible item in the current account of the balance of payment is the investment account

which includes interest, rents, dividends and profits. Income received on capital invested abroad

is the credit item and income paid on capital borrowed from abroad is the debit item.

Government Transactions

Government transactions refer to the expenditure incurred by a government for the upkeep of its

organizations abroad (e.g. payment of salaries to the ambassadors, high commissioners, etc).

Such amounts received by a government from abroad constitute the credit item and

made to the foreign governments form the debit item.

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Miscellaneous

Miscellaneous invisible items include expenditure incurred on services like advertisement,

commissions, films rental, patent fees, royalties, subscriptions to the periodicals, membership

fees, etc. Such payments received by a country from abroad are a credit item and sent to the

foreign countries are the debit item in the balance of payment account. Donations and gifts are

unilateral transfers or ‘un-required payment’.

Capital Account

The capital account of the balance of payment of a country deals with the financial transactions.

It includes all types of short-term and long term international movements of capital. Gold

transactions also form part of capital account. If a country invests or lends abroad, it is a

payment and will be recorded on the debit side. On the other hand, capital inflows in the form of

borrowings from abroad or the foreign investments in the home country are entered on the credit

side of the balance of payment account. These are all financial transactions relating only to the

transfer of money and therefore have no direct impact on the level of income and output of the

economy.

Direct investment

Basic data are obtained from the exchange control records, but information on noncash inflows

and reinvested earnings is taken from the Survey of Foreign Liabilities and Assets, supplemented

by other information on direct investment flows. Up to 1999/2000, direct investment in India and

direct investment abroad comprised mainly equity flows. From 2000/2001 onward, the coverage

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has been expanded to include, in addition to equity, reinvested earnings, and debt transactions

between related entities. The data on equity capital include equity in both unincorporated

business (mainly branches of foreign banks in India and branches of Indian banks abroad) and

incorporated entities. Because there is a lag of one year for reinvested earnings, data for the most

recent year (2003/2004) are estimated as the average of the previous two years. However, as

intercompany debt transactions were previously measured as part of other investment, the change

in methodology does not make any impact on India's net errors and omissions.

Portfolio investment

Basic data are obtained from the exchange control records. These are supplemented with

information from the Survey of Foreign Liabilities and Assets. In addition, the details of the

issue of global depository receipts and stock market operations by foreign institutional investors

are received from the RBI.

Most of the information on transactions in other investment assets and liabilities is obtained from

the exchange control records, supplemented by information received from the departments of the

RBI and various government agencies. Entries for transactions in external assets and liabilities of

commercial banks are obtained from their periodic returns on foreign currency assets and rupee

liabilities. Data on nonresident deposits with resident banks are obtained from exchange control

records, the survey of unclassified receipts, and information.

Transactions under reserve assets are obtained from the records of the RBI. They comprise

changes in its foreign currency assets and gold, net of estimated valuation changes arising from

exchange rate movement and revaluations owing to changes in international prices of

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bonds/securities/gold. They also comprise changes in SDR balances held by the government and

a reserve tranche position at the IMF, also net of revaluations owing to exchange rate movement.

Items of Capital Account

The main items of capital account are:

Private Loans

Foreign loans received by the private sector (credit item) and foreign loans repaid by the private

sector (debit items).

Movements in Banking Capital

Inflow of banking capital excluding the central bank (credit item); and outflow of banking capital

excluding the central bank (debit items).

Official Capital Transactions

Loans

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Foreign loans and credits received by the official sector including thedrawings from the IMF

(credit item); and loans extended to the other countries as well as repurchase of the drawings

from the IMF (debit item).

Amortization

Repayment of official loans by other countries (credit items) and repayment of official loans by

home country (debit item).

Miscellaneous

All other official receipts including those of central bank (credit item); and all other official

capital payments including those of central bank (debit items).

Reserve and Monetary Gold

Changes in the official foreign exchange holdings, gold reserves of the central bank and Special

Drawing Rights (SDR) holdings of the government, purchases from the IMF and similar other

capital transactions; all such receipts represent credit item and payments represent debit item.

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Advantages:

Though countries have fears about plunging into CAC, there exist a host of distinct advantages:

There would be more and more capital available to the country, and the cost of capital would

decline;

Just as there are gains from trade, there are advantages to the free movement of capital,

which is, in a way, the freedom to trade in financial assets;

The spreads of banks and non bank financial institutions would come down due to growing

competition, rendering the financial system more efficient;

Tax levels would move closer to international levels thereby reducing evasion and capital

flight

The cost of government borrowing would fall in response to lower interest rates, thus

lowering the fiscal deficit;

It would become quite difficult for a country to follow unwise macroeconomic policies,

because, under CAC, markets would pre-emptorily punish imprudence.

Costs/Disadvantages:

Critics have also spelled out a number of costs associated with CAC. In the first place, an

open capitalaccount could lead to the export of domestic savings, which for capital scarce

developing countries woulddisrupt the financing of domestic investment.

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Secondly, CAC could expose the economy to larger macroeconomic instability

emanating from the volatility of short-term capital movements and the risk of massive

capital outflows.

Thirdly, premature liberalisation (that is, if the speed and sequencing of reforms are not

appropriate) could initially stimulate capital inflows that would lead to appreciation of

real exchange rate and thereby destabilise an economy undergoing the fragile process of

transition and structural reform. Fourthly, because of higher capital inflows preceding

CAC, the appreciating realexchange rate would shift resources from tradable to non-

tradable sectors (such as construction, housing, hotels and tourism, etc.) and this would

happen in the backdrop of rising external liabilities.

Finally, a convertible capital account could generate financial bubbles, especially through

irrational investment in real estate and equity market financed by unrestrained foreign

borrowing.

PRE-CONDITIONS

Generally, there are a number of prerequisites that need to be fulfilled prior to moving to

CAC. One, aprudent fiscal policy is an important element in achieving and maintaining

capital convertibility.

Large fiscal deficits that require financing through money creation may destabilize the

exchange rate and discourage both foreign and domestic investment. Reliance on foreign

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loans with high interest rates creates debt-management problems, reduces

creditworthiness, and weakens an economy’s ability to manage external shocks.

A sound monetary policy that complements and is facilitated by fiscal discipline is

another critical element, because excess liquidity expansion will spill over into the

external sector.

Moreover, a market-clearing exchange rate is essential to ensure external balance.

Furthermore, to avoid wide exchange rate fluctuations, prudent macroeconomic policies

need to be coupled with adequate international reserves.

An efficient and sound financial sector is an essential ingredient of capital account

convertibility, enabling banks to invest capital inflows prudently and weather shocks.

Efficiency requires market-based monetary instruments and a liberal regulatory

framework.

The sector’s soundness depends on, among other things,effective banking supervision

and observance of prudential ratios.Finally, a well-functioning price mechanism is

essential to avoid distortions that reduce the efficiency of resource allocation, affect

capital flows adversely and hinder growth. Thus, subsidies, tax concessions and price

controls need to be phased out.

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Why India went in for CAC???

a) India started its path towards CAC because moving towards CAC was regarded as a mark

of a developing country graduating into a developed country. There were many reasons

given in favour of implementing CAC.

b) Greater Capital Mobility – If CAC is allowed, it is argued that foreign fund inflows to the

country become easier thus increasing the availability of large capital stock. Developing

nations, which are usually capital-scarce, are blessed under unhindered mobility of

capital and this capital can be used in long term investments thus raising the national

income.

c) Access to global pool of savings – Once the door to investing in international securities

gets opened up, CAC will allow residents to hold internationally diversified portfolios

thereby reducing the vulnerability of income streams to shocks in the domestic market.

d) Effective Financial Intermediation - Capital account liberalization provides the domestic

and foreign players more choice of financial products, firms, and markets. The resulting

competition benefits the consumer of financial services since the services offered will

become more efficient raising the bar to service to international levels.

e) Check on Distortionary policies – It is argued that with CAC in place, the economy

comes under vigilant watch by foreign players. Thus any distortionary policies taken by

the Government will be put under extreme scrutiny and it might lead to a currency crisis

if such policies elicit unfavorable responses from such international players.

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LESSONS FROM COUNTRY EXPERIENCES

The early 1990s witnessed a boom in capital flows internationally followed by thereversal of

such flows especially in the second half of the 1990s. The first reversal occurred in the aftermath

of Mexico’s currency crisis in December 1994. It was, however, restricted to some Latin

American economies and capital flows resumed soon after. The second reversal, which was more

severe, came in 1997 and led to the East Asian crisis. This was followed by the Russian default

in August 1998, the Brazilian crisis in 1998-99 and by the collapse of the Argentine currency in

2001.

A number of lessons can be drawn from the experiences of various currency crises in the past

sixteen years:

In the first place, liberalisation of the capital account was gradual in most of the economies in

the run up to full convertibility, combined with strengthened financial systems and prudential

regulations. Even after “completely” liberalising the capital account these countries continue

to impose certain capital controls.

Secondly, the gradual process of capital account liberalization does not eliminate the risks of

crisis or pressures in the foreign exchange market. These risks, however, get minimized when

an integrated approach to reform is pursued involving macroeconomic stabilization and

institutional strengthening. Along with other reform measures, another import lesson is that

exchange rate flexibility is important while undertaking capital account liberalization. Under

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a flexible exchange rate scenario, monetary policy flexibility can be an instrumental

mechanism to help maintain macro-economic stability.

Thirdly, limiting fiscal imbalances and preventing excessive build-up of domestic debt is

essential to avoid chances of backtracking subsequent to capital account liberalization.

Though fiscal consolidation may not by itself be a sufficient condition to prevent crises, it

has been a necessary component of liberalization and its absence can create instability.

The fourth lesson from country experiences is that avoiding real exchange rate misalignment

could minimize the impact of the crisis. This also calls for pursuing autonomous monetary

policy. It would force market participants to hedge their positions that would be beneficial

for forex market development.

Rapid easing of capital controls and subsequent backtracking seen in the case of many Asian

and Latin American countries, clearly indicate the need for a more cautious and calibrated

approach, and ensuring enough regulatory and prudential safeguards before moving towards

capital account liberalization.

Given the growing risks that are prevalent in a deregulated environment, it is important to

focus on effective risk management strategies, improve prudential supervision and develop

proper reporting standards to meet the emerging challenges.

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STEPS TOWARDS CAC IN INDIA

India started liberalizing its capital account as part of comprehensive economic reforms initiated

in the early 1990s that reversed its 40-year experiment with centrally planned development. The

hallmark of the reform process has been a gradual, cautious approach that has been carefully

phased and sequenced across the economy. As a result, India has come a long way from its pre-

1991 highly restrictive exchange control regime. With gradual liberalization of both Foreign

Direct Investment (FDI) and portfolio investment, the rupee has been made convertible for

foreign investors. However, some controls remain in place to varying degrees for both foreign

and domestic corporates and individuals, with resident corporates facing a more liberal regime

than resident individuals.

In India, the current account convertibility was achieved in August 1994 by accepting Article

VIII of theArticles of the International Monetary Fund (IMF).

It was the Tarapore Committee on “Capital AccountConvertibility” that defined the framework

for forex liberalization in May 1997. This Committee had chalked out three stages, to be

completed by 1999-2000. It had indicated certain signposts to be achieved for the introduction of

CAC. The three most important of them were: fiscal consolidation, a mandated inflation target

and strengthening of the financial system. However, the timetable was abandoned in the wake of

the 1997-98 Asian financial crisis.

In April, 2006 a committee was formed again under the chairmanship of former Deputy

Governor of the Reserve Bank of India (RBI) Mr. S. S. Tarapore to revisit the issue of CAC and

suggest a road map for it. The committee proposed that India shift to Fuller Capital Account

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Convertibility (FCAC) in five years beginning 2006/07. In its report submitted to the RBI on

July 31, 2006, the committee suggested that the proposed regime be embraced in three phases—

2006-07 (phase I), 2007-08 and 2008-09 (phase II) and 2009-10 and 2010-11 (phase III).The

committee has pointed out that the concomitants for a move to fuller CAC would be

fiscalconsolidation, setting of medium-term monetary policy objectives, strengthening of the

banking system, maintaining an appropriate level of current account deficit as well as reserve

adequacy.

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Recommendations of Tarapore Committee:

1. The centre and states should graduate from the present system of computing fiscal deficit

to a new measure of Public Sector Borrowing Requirement (PSBR).

2. Substantial part of the revenue surplus of the centre should be earmarked for meeting the

repayment liability under the centre’s market borrowing programme, thereby reducing

the gross borrowing requirement.

3. Revenue deficits of the states should be eliminated by 2008-09 and fiscal deficits of the

states should be reduced to 3 percent of GDP.

4. To strengthen the banking system, the minimum share of the government/RBI in the

capital of Public Sector Banks (PSBs) should be reduced from 51 percent (55 percent for

State Bank Of India) to 33 percent.

5. All commercial banks should be subject to a single legislation and all banks, including

state owned banks, be incorporated under the Companies Act.

6. The RBI should evolve policies to allow, on merit, industrial houses to have stakes in

Indian banks or promote new banks.

7. The limits for banks’ overseas borrowing should be linked to their paid-up capital and

free reserves, and not to unimpaired tier I capital at present, and raised to 50 percent in

phase I, 75 percent in phase II and 100 percent in phase III.

8. To make Indian corporates compete in the global arena on an equal footing, the limits for

corporate investments abroad should be raised in phases from 200 per cent of net worth

to 400 per cent.

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9. Other than Non-Resident Indians (NRIs) who are allowed to invest in companies on

Indian bourses, all individual non-residents should be allowed to invest in the Indian

markets through Sebi-registered entities.

10. Non-resident corporates should be allowed to invest in the Indian stock markets through

Sebi-registered entities, including mutual funds and portfolio management schemes.

11. Apart from multilateral institutions being allowed to raise rupee bonds in India, other

institutions/corporate should also be permitted to raise such bonds (with an option to

convert into foreign exchange), subject to an overall ceiling, which should be slowly

raised.

12. The annual limit of remittance by individuals to open foreign currency accounts overseas

be raised to US$ 50,000 in phase one from the current level of $25,000 and further raised

to US$ 100,000 in phase two and US$ 200,000 in phase three.

13. The limit for mutual funds to invest overseas should be increased from the present level

of US$ 2 billion to US$ 3 billion in phase one, to US$ 4 billion in phase two and to US$

5 billion in phase three and these facilities should be available to SEBI registered

portfolio management schemes apart from mutual funds.

How far has India moved towards capital account convertibility?  

25

Capital account convertibility is in vogue in terms of freedom to take out proceeds relating to

FDI, portfolio investment for overseas investors and NRIs besides leeway for firms to invest

abroad in JVs or acquisition of assets, and for residents and mutual funds to invest abroad in

stocks and bonds with some restrictions. India seems to be taking the approach that easing of

capital controls would be marked by removal of capital outflow restrictions on NRIs first,

corporates next, followed by banks and freedom for residents in the last stage. 

Lessons drawn from India’s approach to capital account liberalization:

One, capital account liberalization is regarded as a process and not an event.

Two, it is recognized that there may be links between the current and capital accounts

and, hence, procedures should be intact to avoid capital flows in the guise of current

account transactions.

Thirdly, capital account liberalization is maintained in line with other reforms. The

degree and timing of capital account liberalization need to be sequenced with other

reforms, such as strengthening of banking systems, fiscal consolidation, market

development and integration, trade liberalization, and the changing domestic and external

economic environments.

Fourth, a hierarchy has been made with regard to the sources and types of capital flows.

The focus in India has been to liberalize inflows relative to outflows, but all outflows

related to inflows have been completely freed. Among the kinds of inflows, FDI is

preferred for stability, while excessive short-term external debt needs to be avoided. A

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separation is made between corporates, individuals, and banks. For outflows, the

hierarchy for liberalization has been corporates first, followed by financial intermediaries,

and finally individuals. For individuals, residents are treated separate from nonresidents,

and nonresident Indians have a clear intermediate status between residents and

nonresidents.

Fifth, the speed and sequencing of liberalization is responsive to domestic developments,

particularly in the monetary and financial sectors, and to the developing international

financial architecture. As liberalization proceeds, administrative measures need to be

lowered and price-based measures should be increased, but the freedom to change the

mix and reimpose controls should be available.

Experience of some of the countries

The initial experience has been that of an improvement in their balance of payments position. In

Malaysia, Indonesia, Mexico and Argentina, the surge in capital flows meant a widening of their

current accounts. Inflation was also subdued for some time and the reserves were also bolstered. 

But after the current account deficit could be not sustained, some of these countries introduced

some controls. Mexico and Argentina reintroduced controls in the 80s, while Chile also placed

fetters after it faced a crisis between ’82 and ’89. However, all of them subsequently opened up.

What is the position of CAC in India today?

27

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. It is only

residents — both individuals as well as corporates — who continue to be subject to capital

controls. However, as part of the liberalisation process the government has over the years been

relaxing these controls. Thus, a few years ago, residents were allowed to invest through the

mutual fund route and corporates to invest in companies abroad but within fairly conservative

limits.

Pitfalls of easing of capital controls

One of the main problems an economy that has opted for a free-float has to contend with is, the

prospects of outflow of what is termed as speculative short-term flows. Denomination of a

substantial part of local assets in foreign currencies poses the threat of outward flows and higher

interest rates, which could de-stabilise economies. 

The volatility in exchange and interest rates in the wake of capital inflows can lead to unsound

funding and large unhedged foreign liabilities. This is especially so for economies that go in for a

free-float without following prudent macro-economic policies, and ensuring financial reforms. 

How far has India moved towards capital account convertibility?  

28

Capital account convertibility is in vogue in terms of freedom to take out proceeds relating to

FDI, portfolio investment for overseas investors and NRIs besides leeway for firms to invest

abroad in JVs or acquisition of assets, and for residents and mutual funds to invest abroad in

stocks and bonds with some restrictions. India seems to be taking the approach that easing of

capital controls would be marked by removal of capital outflow restrictions on NRIs first,

corporates next, followed by banks and freedom for residents in the last stage. 

2.2 Review of Literature

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The Prime Minister’s recent announcement has refocused attention on the issue of full capital

account convertibility. The new Tarapore Committee needs to weigh the gains from removing

the remaining restrictions against the macroeconomic vulnerabilities that remain. In the

discussion, it has been argued that external accounts and the financial system by themselves

should be able to take the stresses of free capital.

The government recently decided to re-evaluate the possibility of full Capital Account

Convertibility. The country has steadily eased controls since 1991 but significant restrictions

remain. The total removal of restrictions would end half a century of varying levels of capital

controls and would be a fundamental shift in India’s exchange rate and monetary policy

framework. A committee has now been set up to look into the issue. It is headed by former RBI

Deputy Governor Tarapore who headed a similar committee in 1997. The new committee is

expected to submit its findings by end-July.

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Chapter 3

3.1 Observations

a) 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.

b) It is only residents — both individuals as well as corporates — who continue to be

subject to capital controls.

c) However, as part of the liberalisation process the government has over the years been

relaxing these controls.

d) Thus, a few years ago, residents were allowed to invest through the mutual fund route

and corporates to invest in companies abroad but within fairly conservative limits.

e) One of the main problems an economy that has opted for a free-float has to contend with

is, the prospects of outflow of what is termed as speculative short-term flows.

f) Denomination of a substantial part of local assets in foreign currencies poses the threat of

outward flows and higher interest rates, which could de-stabilise economies. 

g) The volatility in exchange and interest rates in the wake of capital inflows can lead to

unsound funding and large unhedged foreign liabilities.

h) This is especially so for economies that go in for a free-float without following prudent

macro-economic policies, and ensuring financial reforms. One, capital account

liberalization is regarded as a process and not an event.

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i) Two, it is recognized that there may be links between the current and capital accounts

and, hence, procedures should be intact to avoid capital flows in the guise of current

account transactions.

j) Thirdly, capital account liberalization is maintained in line with other reforms. The

degree and timing of capital account liberalization need to be sequenced with other

reforms, such as strengthening of banking systems, fiscal consolidation, market

development and integration, trade liberalization, and the changing domestic and external

economic environments.

k) Fourth, a hierarchy has been made with regard to the sources and types of capital flows.

The focus in India has been to liberalize inflows relative to outflows, but all outflows

related to inflows have been completely freed. Among the kinds of inflows, FDI is

preferred for stability, while excessive short-term external debt needs to be avoided. A

separation is made between corporates, individuals, and banks. For outflows, the

hierarchy for liberalization has been corporates first, followed by financial intermediaries,

and finally individuals. For individuals, residents are treated separate from nonresidents,

and nonresident Indians have a clear intermediate status between residents and

nonresidents.

l) Fifth, the speed and sequencing of liberalization is responsive to domestic developments,

particularly in the monetary and financial sectors, and to the developing international

financial architecture. As liberalization proceeds, administrative measures need to be

lowered and price-based measures should be increased, but the freedom to change the

mix and reimpose controls should be available.

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Chapter 4

4.1 CONCLUSION

India should be extremely cautious in liberalising capital outflows any further. 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.

However, it should be wary of short-term capital flows that have the potential to destabilize

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 if it at present

focuses 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 CAC.

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4.2Bibliography

Books

Bhagwati Jagdish. 1997. The Global Age: From Skeptical South to a Fearful North.

World Economy 20(3): 259–84.

India’s Balance of Payments Problem by Rakesh Raman

Working papers on Global Markets Research by Deutsche Bank

Working papers on features Capital account convertibility by RBI

India’s Foreign Trade & Balance of Payments by V.S.Mahajan

Websites

http://www.cac.org/external/pubs/ft/bopman/bopman.pdf

www.economist.com/node/21554523

www.rbi.org.in

articles.economictimes.indiatimes.com

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