Capital Account Convertibility

Syllabus: GS3/ Economy

Context

• The Chairman of the 16th Finance Commission, Arvind Panagariya, said that India should not rush into full capital account convertibility at its current per capita income level.

Capital Account Convertibility (CAC)

• Capital account convertibility refers to converting local financial assets into foreign ones freely and vice versa without restrictions. 
• It allows unrestricted capital movement for foreign investments, asset purchases, and remittances.

Current Status of Capital Account Convertibility

• India follows a partial capital account convertibility regime. 
• While current account transactions (such as trade in goods and services) are fully convertible, capital account transactions are regulated. 
• Key aspects of India’s capital account framework include;
  • Foreign Direct Investment (FDI) is largely liberalized but still subject to sectoral caps and government approvals in sensitive areas.
  • Foreign Portfolio Investment (FPI) is permitted with restrictions on ownership limits in certain sectors.
  • Outward investments by Indian residents are allowed but within prescribed limits under the Liberalized Remittance Scheme (LRS).

Advantages of Full CAC

• Greater Capital Inflows: Free capital movement attracts more foreign investments, boosting economic growth and infrastructure development.
• Integration with Global Markets: Increased financial integration enhances India’s competitiveness and access to international financial markets.
• Improved Credit Rating: A more open capital account can signal economic maturity and stability, enhancing investor confidence.

Challenges of Full CAC

• Macroeconomic Instability: Unrestricted capital flows can lead to excessive volatility in exchange rates and inflation, affecting economic stability.
• Risk of Capital Flight: In times of economic uncertainty, rapid outflows of capital could destabilize financial markets and drain foreign exchange reserves.
• Exposure to External Shocks: Open capital accounts make an economy vulnerable to global financial crises and sudden capital reversals.
• Banking Sector Vulnerabilities: A fully convertible capital account requires a strong financial system capable of handling external shocks without excessive government intervention.

Tarapore Committee Recommendations

• Fiscal consolidation: Maintain fiscal deficit around 3-3.5% of GDP for macroeconomic stability.
• Monetary Policy Objectives: Align inflation rates to global levels and ensure interest rates reflect inflation differentials.
• Institutional Strengthening: Enhance monetary policy framework for better decision-making.
• Banking System Reforms: Strengthen banks through restructuring, safeguards, and capacity-building for liberalized capital flows.
• Adequacy of reserves: With implementation of full CAC, adequacy of reserves would be an important parameter in gauging an economy’s ability to absorb external shocks.

Concluding remarks

• While capital account convertibility offers potential benefits, India must adopt a pragmatic approach considering its economic conditions. 
• A premature shift to full convertibility could expose the economy to financial instability. 
• A well-calibrated strategy focusing on financial sector reforms, exchange rate stability, and macroeconomic resilience will be essential in determining the right path toward greater capital account openness.

Source: TH