Capital account convertibility - Indian Case

Capital account convertibility is one of the essential parameter not only for an effective integration of the financial market of domestic economy to the world economy but also for India's maturing as mega world economic power in the prevailing environment of competition, deregulation and diffusion of information technology. Capital account convertibility of full convertibility in simple term refers to an economic tool expected to engender more efficient capital flows and catalyse growth impulses and enable the society to achieve a stable balance between its internal and external prices. The basic objective of capital account convertibility is to:

1. Deepen and integrate financial markets;
2. Raise the access to global savings;
3. Discipline domestic policy markets; and
4. Allow greater freedom to individual decision making.

A more open capital account will facilitate higher availability of larger capital stock, supplementing domestic resources thereby leading to higher growth and reducing the cost of capital and also facilitating access to the international financial market.

In a developing economies aspiring for high rate of economic growth and development, capital account convertibility brings capital account liberalization i.e. no restrictions on capital inflows and capital outflows. This exposes the economy to the volatility of cross border capital movements. The experiences of Latin America demonstrates that useless macro-economic fundamentals are in line with those in the rest of the world, such capital account liberalization is not sustainable. The macro-economic fundamentals include rate of infiction, interest rate, fiscal deficits, balance of payments equilibrium and adequate supervision over bank. India has a long way to go before all this is ensured, primarily because the domestic economic reforms have yet to take full hold. Indian Government have already permitted the full convertibility of rupee on current account. Full convertibility on capital account is yet to be materialized.

The Reserve Bank of India on 29.02.1997, appointed a Committee on Capital Account Convertibility under the Chairman of S.S. Tarapore. The Committee submitted its report for consideration of the Government and Reserve bank on 30.05.1997.

The Committee on Capital Account Convertibility was give the following terms of reference: (i) to review the International experience in relation to capital account convertibility (CAC), (ii) to recommend measures for achieving CAC, (iii) to specify the sequence and time-frame for such measures, and (iv) to suggest domestic policy measures and changes in institutional framework.

Against the backdrop of stable and sustainable growth in India and progress achieved in entrenching structural reforms, the Committee has recommended a phased implementation of CAC over a three-year-period: Phase I (1997-98), Phase II (1998-99) and Phase III (1999-2000). The committee has suggested that the implementation for each phase should be on a careful and continuous monitoring of certain preconditions/signposts and certain important attendant variables identified from the lessons of the International experiences and the specifics of the Indian situation.

The preconditions/signposts recommended by the committee include:

i) Fiscal consolidation in the form of gradual reduction in the Centre's Gross fiscal deficit to GDP ration to 3.5 percent in 1999-2000 accompanied by a reduction in the States' deficit as also a reduction in the quasi fiscal deficit, introduction of a Consolidated Sinking Fund (CSF);

ii) Mandated inflation rate for the three-year period at an average of 3-5 percent with an early empowering of the Reserve Bank to have full independence to achieve the inflation rate mandated by the Parliament,

iii) Consolidation of financial system with full deregulation in interest rate in 1997-98, gradual reduction in the average effective cash reserve ration (CRR) to 3 percent in 1999-2000, reducing in gross non-performing assets (NPAs) to 5 percent in 1999-2000 and conversion of the weak banks into narrow banks;

iv) Monitoring of attendant macro-economic indicators e.g. the exchange rate, the balance of payments, the adequacy of reserves while determining the appropriate timing and sequencing of CAC and strengthening of the financial system; and

v) Prepare the financial system for CAC in terms of bringing about a level playing field between various participants in the financial system, removing market segmentation, uniform treatment of resident and non-resident liabilities for purpose of reserve requirements, improving risk management systems in the financial system, introduction of more stringment capital adequacy standards and prudential norms, effective supervisory system and greater autonomy for banks and financial institutions.

On the exchange rate policy, the Reserve Bank should have a monitoring band of +/-5 percent around the neural Real Effective Exchange Rate (REER). While the REER band would be declared, the Reserve bank should ordinarily intervene as and when REER is outside the band. In view of growing internationalisation of the Indian Economy, over the three-year period, external sector policies should be designed to ensure a rinsing trend in the current receipts (CR) to GDP ratio from the resent level of 15 percent as well as to reduce the debt-service ratio to 20 percent..