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Full Capital Account Convertibility: A Double Edged Sword

Capital Account Convertibility refers to the free flow or the free permission to exchange the domestic currency (Rupee in case of India) for a foreign currency and vice versa. When we talk of capital account, we refer to that portion of the balance of payments account which deals with the provision of loans and purchase and sale of securities. India, after liberalization of the economy, had to allow free convertibility of rupee on the current account. However, when it comes to the capital account, waves of initiatives have been formed and busted. We are still striving towards fuller convertibility of rupee. The major reasons for the aforesaid delay and uncertainty happens to be the scope of impact it can have upon the Indian economy at large.

Prerequisites:
The Tarapore Committee which was headed by Mr. S.S. Tarapore suggested the several preconditions before moving any further towards fuller convertibility. These included the likes of fiscal consolidation, controlling the surging inflation rates, strong and efficient banking and financial system etc. In India's case, most of these figures present a dismal picture. Presently, the fiscal deficit for India is 5.8%1 which is the highest among BRICS nations and way over the budgeted target of 4.6%1. Moreover, the inflation rate also stands high at 7.25%2 at present. The banking sector, though expanding its roots by way of varied services faces a very high level of Non Performing Assets and has been on the rise. The basic pre-requisitions for full capital account convertibility point out that India needs to do its ground work and strengthen the parameters of the economy before it should be thinking about taking the larger plunge.

Benefits :
In a capital deficient developing economy like that of India, the need for the influx of capital cannot be over emphasised. Liberalizing rupee on the capital account may be a boon in this regard. Generally, the following major benefits are expected to arise from capital account convertibility: The reduction of barriers to convertibility can be reasonably expected to influx a greater amount of capital into the economy as the foreign investors would feel greater security given the option to withdraw their purse as and when they feel. It would provide competition to the sources of capital from the private sector firms and thereby the increased supply and competition can ensure that funds are available to the government and the business houses at competitive rates of interest. Full Capital Account Convertibility would imply that the Government of India and The RBI would have to map the domestic policies on lines of foreign policies. This, although a very optimistic expectation, can help in reducing the inefficiencies in Macroeconomic policies of the government. If the convertibility also relaxes the restrictions on the FDI inflows, foreign businesses can be expected to pounce on the mouth watering business opportunities provided by India.

A brief run through of the above tells us that capital account convertibility has the potential to provide a huge positive momentum to the Indian economy. Inflow of capital can fill up the deficiency of capital and thus aid the optimum utilization of the surplus.

Drawbacks :
However, one should accept the benefits with a pinch of salt. They come with their own set of perils which may prove detrimental to the planning and growth, especially for an economy like that of India. To list a few:

Relaxing all the restrictions on the inflow and more importantly over the outflow of funds from the nation would make the economy very volatile. It would leave the economy to e very vulnerable. Any global event would have huge significances over the fate of the transactions within the country. It may provide a vent for the outflow of domestic savings. As a result, the whole process of already low capital formation in the nation would be jeopardised. Consequently, Indian capital would freely flow to other investment destinations even if they become slightly more favourable. Liberalisation even if it is ensued by capital inflows has a disadvantage. The huge demand for Rupee would result in appreciation of the same. This phenomenon might have negative consequences upon the export-based industries of the nation. Moreover, as was the major concern over the FDI in retail issue, it may not really help the cause of the wide disparities in the distribution of income across the nation. We may see an outflow of wealth from the nation by way of returns on foreign invested funds. Planning and budgeting estimation would become highly difficult for the government. The volatility would pose stiff hills for the Finance Ministry to climb when it comes to allocation of funds to different sectors.

This list of consequences is merely illustrative and not exhaustive.

Comments :
Any economic decision taken by the government has huge repercussions over the social life of the citizens as well. When we talk of a nation as colossal as India, it translates into millions of citizens. So, the call can by no stretch of imagination should be a premature one. The following factors and points would be essential in this regard: The global economic scenario should be considered. The turmoil during the sub-prime crisis and the present Euro zone crisis has brought many nations to their knees. One of the major reasons for India not being affected that badly was robust policy making by the RBI. A full convertibility on rupee would mean lower autonomy to regulate the financial flows. One can argue on hindsight, that had that been the case with India we might have been severely affected by the turmoil. Before opening the economy to free exchange of currency, one should stress upon consolidation of the economy and consequently on the financial indicators. Strong fundamentals for the economy would to some extent decrease the vulnerabilities of foreign flows. We should first try to curbs parameters like inflation, fiscal deficit etc. and then only should we try to integrate free foreign cash flows into the economy. Restrictions on convertibility on the capital account provide the government a buffer time to react to economic upheavals and form reactionary policies to cushion the nation. Taking this away would strip the government of this luxury. This was particularly evident in the TIGER economies where the growth rate was initially propelled by foreign cash flows. However, they did not get any time to react once the capital started flowing out. As a result, the economies did suffer a beating.

FIG: Capital Mobility and Incidence of Banking Crisis3

The above figure shows a strong positive correlation between the banking crisis and their incidences upon countries having a very high degree of capital mobility

Conclusion:
It would be advisable to hold the plunge right now. The global economic scenario is not too bright. Moreover, economies like the TIGER economies have suffered in the past due to the free convertibility on the capital account. India has not been performing too well either in the recent past. So, it would be highly advisable to wait for the fundamentals to improve. For a developing and capital deficient economy like that of India, foreign funds are essential to stimulate growth. However, the timing of the move has to be apt to ensure that the move does not backfire. Right now, the scenario is not very encouraging. So the move has to wait.

References 1. Indian Express, June 1, 2012 2. http://www.tradingeconomics.com/india/inflation-cpi 3. This Time is Different: A Panaromic View of Eight Centuries of Financial Crisis by Carmen M. Reinhart & Kenneth S. Rogoff, 2008