Capital account convertibility of the rupee is a distant dream because macro economic parameters have to be stable before it is implemented. The low current account deficit should be sustained and the fiscal deficit needs to be contained. * Leads to free exchange of currency at lower rates and an unrestricted mobility of capital * Beneficial for a country because inflow of foreign investment increases * The flip side, though, is that it could destabilise an economy due to massive capital flows in and out of the country
“We are surely on that path but it will take a few more years. The rupee as a currency should be more frequently traded internationally,” said Dwijendra Srivastava, chief investment officer (debt) at Sundaram Mutual Fund.
India’s external sector was vulnerable till recently, with the current account deficit above the comfort level of 2.5 per cent of the gross domestic product. It was 4.2 per cent of gross domestic product (GDP) in 2011-12 and rose to 4.7 per cent in 2012-13. After severe curbs, including restrictions on import of precious metals, the deficit fell to 1.7 per cent in 2013-14. In 2014-15, it continued to stay low, with the third quarter showing a deficit of 1.6 per cent.

The fiscal situation remains fragile. The turning point was in 2007, the year of the global financial crisis. The fiscal deficit of the central government has been 4.6-6.5 per cent in the past six years, before falling to 4.1 per cent in 2013-14. The government is committed to keeping the fiscal deficit low and the target of 3.9 per cent has been retained for this year. The deficit target will be progressively reduced to 3.5 and three per cent in 2016-17 and 2017-18, respectively.

Experts believe utmost care should be taken along the path of convertibility. Ajit Ranade, chief economist at the Aditya Birla Group, who was part of an RBI committee on capital account convertibility in 2006, said many of the recommendations of the committee had been implemented, including raising the amounts resident Indians could remit abroad and the facility for non-residents to use rupee accounts. However, he still suggested caution.
The International Monetary Fund (IMF) was about to make this as a pre-condition for membership but then the East Asian crisis happened and countries which had full convertibility like Indonesia, Thailand etc took a big hit.
"Every time a global economic or financial crisis has hit, we have only gone back. I would say the prerequisites are a comprehensive regulation covering management and monitoring of the flows," said Anindya Banerjee, currency analyst, Kotak Securities.
In fact other committee members like A V Rajwade, a risk management consultant are today completely against it as they believe that in an independent monetary policy a liberal capital account and managed exchange rate cannot survive together.
"In my view exchange rates should be managed because they affect the real economy while floating exchange rate benefits the speculators in the currency market. Speculators want volatility. The IMF is biased towards liberal capital account and market determined exchange rates. I am of a different view because market determined exchange rates can fluctuate widely and they affect the real economy. Jobs are created in the real economy not by the speculators. Speculators gain and the real economy loses. IMFs own research shows that a liberal capital account does not in any case helps growth," he said.

Minister of state for finance Jayant Sinha on Wednesday batted for full capital account convertibility of the rupee.

“If India wants to be a global economy, then the capital account convertibility is needed,” he said at a conference on the National Pension System. He also noted the market feeling that it was not needed right now.
Reserve Bank governor Raghuram Rajan had last week said the rupee might become fully convertible over the next few years. India has current account convertibility, more or less, but not capital account convertibility for the rupee.

“My hope is we will get to full capital account convertibility in a short number of years,” Rajan had said.

He’d added the central bank was fairly open to the inflow of foreign funds but there were a few areas such as debt (short-term flows) in which it preferred tight control.

Many analysts have credited RBI for its policy of partial capital control, which helped it tide over the impact of the currency meltdown, which had hit many Southeast Asian economies with full capital convertibility in 1997-98.

However, unlike those countries, India did not have a higher proportion of foreign short-term debt in its loan portfolio. That crisis erupted since those countries took short-term external debt and used these for long-gestation infrastructure projects.

In fact, data issued by the finance ministry earlier this month had shown that short-term debt to the overall total fell to 18.5 per cent as on end-December 2014 against 20.5 per cent at end-March 2014. In absolute terms, short-term external debt was $85.6 billion at end-December, a fall of 6.7 per cent from the level at end-March

In May-August 2013 as well, capital control helped the country withstand the effects of speculation of the US Federal Reserve tapering its monetary stimulus programme, despite India seeing as much as $20 bn being pulled out by foreign investors.

After big-bang economic reforms in 1991, the government and RBI have been progressively lifting curbs on capital flows.
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. The forces of Globalization and Liberalization are cutting across borders, re-integrating the world towards a common goal of development. The liberalization reforms which swept across the country in 1991 changed the face of the Indian economy.
The results are paying off and India has witnessed exceptional growth rates of 9.6% and 9.4% in 2006 and 2007, respectively.
Thus, in the current stream of events, where globalization has become the ‘hot’ word and financial liberalization is synonymous with ‘developed economies’, the key issue that is to be considered, is whether India is ready to take the plunge towards Full Capital Account Convertibility (FCAC).
Capital Account Convertibility (CAC) is the freedom to convert local financial assets into foreign financial assets at market determined exchange rates. Referred to as ‘Capital Asset Liberation’ in foreign countries, it implies free exchangeability of currency at lower rates and an unrestricted mobility of capital. India presently has current account convertibility, which means that foreign exchange is easily available for import and export for goods and services. India also has partial capital account convertibility; such that an Indian individual or an institution can invest in foreign assets upto $25000. Foreigners can also invest along the same lines. At present, there are limits on investment by foreign financial investors and also caps on FDI ceiling in most sectors, for example, 74% in banking and communication, 49% in insurance, 0% in retail, etc.
The First Tarapore Committee was set up by the RBI in 1997 to study the implications of executing CAC in India. It recommended that the before CAC is implemented, the fiscal deficit needs to be reduced to 3.5% of the GDP, inflation rates need to be controlled between 3-5%, the non-performing assets (NPAs) need to be brought down to 5%, Cash Reserve Ratio (CRR) needs to be reduced to 3%, and a monetary exchange rate band of plus minus 5% should be instituted. However, most of the pre-conditions weren’t entirely fulfilled. Thus, CAC was abandoned for the moment.
However, recently there has been a renewed optimism as some of the targets suggested by the First Tarapore Committee have been achieved. Moreover, consolidation of banks, a strong export front, large forex reserves amounting to $300 billion and high growth rates have also instilled within, some hope. Thus, a Second Tarapore Committee was set up in 2006 to look into the PM’s proposal to reevaluate the earlier stand. Although the report hasn’t been released yet, the committee does plan to increase the threshold level for investments from $25000 to $200000 in 3 phases.
CAC can be beneficial for a country as the inflow of foreign investment increases and the transactions are much easier and occur at a faster pace. CAC also initiates risk spreading through diversification of portfolios. Moreover, countries gain access to newer technologies which translate into further development and higher growth rates.
Even though CAC seems to have many advantages, in reality, it can actually destabilize the economy through massive capital flight from a country. Not only are there dangerous consequences associated with capital outflow, excessive capital inflow can cause currency appreciation and worsening of the Balance of Trade. Furthermore, there are overseas credit risks and fears of speculation. In addition, it is believed that CAC increases short term FIIs more than long term FDIs, thus leading to volatility in the system.
However, if we were to judge the implications of CAC in India, independent of its general pros and cons, CAC may not be such a good idea in the near future. The instability in the international markets due to the sub prime crisis and fears of a US recession are adversely affecting the entire world, including India. Moreover, rising oil prices which touched $100 a barrel recently are also fueling inflationary pressures in the economies, worldwide.
Not only is there instability in the international arena, but India’s domestic economy is also going through ups and downs. The rising prices and the appreciation of the rupee are adversely affecting India’s exports and the Balance of Trade. Moreover, the fiscal deficit has been highly underestimated by ignoring the deficits of individual states and through issuance of oil bonds to the public sector oil companies, making severe losses due to the heavy subsidies on oil. The government is yet to compensate these companies and these deferred payments have been left out from the deficit. Also, corruption, bureaucracy, red tapism and in general, a poor business environment, are discouraging the inflow of investment. Poor infrastructure and socio-economic backwardness act as deterrents to FDI inflow.
Hence, India still needs to work on its fundamentals of providing universal quality education and health services and empowerment of marginalized groups, etc. The growth strategy needs to be more inclusive. There is no point trying to add on to the clump at the top of the pyramid if the base is too weak. The pyramid will soon collapse! Thus, before opening up to financial volatility through the implementation of FCAC, India needs to strengthen its fundamentals and develop a strong base.
Hence, India should either wait for a while or implement CAC in a phased, gradual and cautious manner.

PROBLEMS WITH CAC
Several economists are of the view that the full Capital Account Convertibility (and allowing the exchange rate to be market determined) has serious consequences on the wellbeing of the country, and this may even lead to extreme sufferings of the common masses. Some of the reasons are highlighted below. * During the good years of the economy, it might experience huge inflows of foreign capital, but during the bad times there will be an enormous outflow of capital under “herd behaviour” (refers to a phenomenon where investors acts as “herds”, i.e. if one moves out, others follow immediately). For example, the South East Asian countries received US$ 94 billion in 1996 and another US$ 70 billion in the first half of 1997. However, under the threat of the crisis, US$ 102 billion flowed out from the region in the second half of 1997, thereby accentuating the crisis. This has serious impact on the economy as a whole, and can even lead to an economic crisis as in South-East Asia. * There arises the possibility of misallocation of capital inflows. Such capital inflows may fund low-quality domestic investments, like investments in the stock markets or real estates, and desist from investing in building up industries and factories, which leads to more capacity creation and utilisation, and increased level of employment. This also reduces the potential of the country to increase exports and thus creates external imbalances. * An open capital account can lead to “the export of domestic savings” (the rich can convert their savings into dollars or pounds in foreign banks or even assets in foreign countries), which for capital scarce developing countries would curb domestic investment. Moreover, under the threat of a crisis, the domestic savings too might leave the country along with the foreign ‘investments’, thereby rendering the government helpless to counter the threat. * Entry of foreign banks can create an unequal playing field, whereby foreign banks “cherry-pick” the most creditworthy borrowers and depositors. This aggravates the problem of the farmers and the small-scale industrialists, who are not considered to be credit-worthy by these banks. In order to remain competitive, the domestic banks too refuse to lend to these sectors, or demand to raise interest rates to more “competitive” levels from the ‘subsidised’ rates usually followed. * International finance capital today is “highly volatile”, i.e. it shifts from country to country in search of higher speculative returns. In this process, it has led to economic crisis in numerous developing countries. Such finance capital is referred to as “hot money” in today’s context. Full capital account convertibility exposes an economy to extreme volatility on account of “hot money” flows. “Capital market liberalization entails stripping away the regulations intended to control the flow of hot money in and out of the country- short term loans and contracts that are usually no more than bets on exchange rate movements. This speculative money cannot be used to build factories or create jobs- companies don’t make long term investments using money that can be pulled out on a moment’s notice- and indeed, the risk that such hot money brings with it makes long-term investments in a developing country even less attractive.”
EXPERIENCES OF DEVELOPING COUNTRIES WITH CAC
Over the past two decades, under the diktat of the IMF-World Bank, several developing countries have undertaken measures to open their capital account as part of a broader process of financial liberalisation and international economic integration. Several developing countries like Argentina, Kenya, Mexico and the South East Asia (Indonesia, South Korea, Malaysia and Thailand) liberalized their capital accounts over the last few years. The early 1990s experienced a boom in capital flows internationally followed by the reversal 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, limited to some Latin American economies and capital flows resumed soon after. The second reversal, which was more severe and enduring, came in 1997 and resulted in the East Asian crisis. This was followed by the Russian default in August 1998 and the Brazilian crisis in 1998-99, followed more recently by the collapse of the Argentine currency in 2001 and the spate of corporate failures and accounting irregularities in the USA in 2002. Needless to say, all the developing countries faced major crisis due to such vagaries of finance capital, whereas the only gainers were the handful of financers who control the flows of such capital. But, these crises did not affect the Indian economy since India had regulations on capital account. Even a conservative economist like Jagadish Bhagwati recognized this point when he argued that “It is noteworthy that both India and China escaped the Asian Financial crisis; (since) they did not have Capital Account Convertibility.” – (US House of Representatives Committee on Financial Services, April, 2003). WHO BENEFITS FROM “CAC”?
The class which benefits from the CAC primarily compromises the big business houses and the finance capitalists, who invest in the stock market for speculations. The policies like CAC are pursued mainly to gain the confidence of the speculators and punters in the Stock Markets, and do not have any beneficial effects on the real sector of the economy, like increasing the employment level, eliminating poverty and decreasing the inequality gap. However, the irony is that under a crisis, the burden is borne primarily by the common masses. This may come in the form of a sharper reduction in subsidies, less investment for social welfare projects by the government and an increase in the privatisation process. The foreign speculators and the domestic players may walk out of the market (by converting their assets to foreign currency) and insulate themselves from any damage.
BACKGROUND OF CAC IN INDIA
By August 1994, India was forced to adopt full current account convertibility under the obligations of IMF’s article of agreement (Article No. VII). The committee on Capital Account Convertibility, under Dr S S Tarapore’s chairmanship, submitted its report in May 1997 and observed that international experience showed that a more open capital account could impose tremendous pressures on the financial system. Hence, the committee recommended certain signposts or preconditions for Capital Account Convertibility in India. However, the agenda of Capital Account Convertibility was put on hold following the South-East Asian crisis. Even the finance minister acknowledged this point that “...the idea of Capital Account Convertibility was floated in 1997 by the Tarapore Committee, but could not be implemented as the Asian Crisis cropped up”. (The Hindu, March 25, 2006). The RBI over a period of time has accepted the point that the South East Asian crisis was a bad example for Capital Account Convertibility and that India had been insulated from the crisis because it had not allowed Capital Account Convertibility. “The growing global macroeconomic imbalance – as evidenced by the large and sustained current account deficit of the US – suggests that markets may at times allocate global saving differently from what is perceived by the policy makers as appropriate and sustainable in the long-run. Like the effect on resource allocation, the beneficial effects of capital account liberalisation on growth are ambiguous.” – (Report on Currency and Finance 2002-03, RBI.) But at the same time, the RBI had started talking about Capital Account relaxations, under pressure from the business classes in India. However, given the obvious pitfalls of CAC policies, the RBI talked about a cautious approach to CAC. “In India, it is recognised that the pace of liberalisation of the capital account would depend on both domestic factors (especially progress in the financial sector reform), and the evolving international financial architecture. The regulatory framework is being used in several combinations to address problems of excessive inflows and pressures towards outflows. In this regard, an integrated view of the state of development of activities in financial markets needs to be taken.” - (Report on Currency and Finance 2002-03, RBI.) It is interesting to note here that there already exists a great amount of freedom in transacting foreign currencies today: * Indian residents and companies (listed in the share markets) can invest in foreign companies, provided a) the foreign company has 10 per cent share holding in some Indian company and b) the domestic country does not invest an amount more than 25 per cent of the company’s total valuation. However, if an Indian company has a “proven track record” it can invest an amount up to 100 per cent of its total valuation in a foreign entity engaged in a “bonafide” business activity. * There is no monetary limit on such aforesaid investments by individuals. * Indian banks can invest their “unutilised” FCNR(B) funds (Foreign Currency (Non-Resident) Accounts (Banks)- accounts in which NRI’s and PIO’s can deposit in any Indian bank)abroad in only long term fixed income securities which have some minimum ratings (read credibility) internationally. * An Indian exporter can give “loans” out of its foreign earnings to foreign importers without any limit; i.e. the foreign exchange earned need not necessarily be deposited in the country. * Indians can have Residents Foreign Currency (domestic) Accounts in which they can hold their savings in foreign currency without any limit. They can also remit these foreign currencies to acquire foreign securities (from foreign stock markets) under Employees Stock Option Plan (ESOP) without any limits. * NRI, PIO and non residents can take up to US$1 million per year out of the country from balances held in Non Resident Ordinary (NRO) accounts/ sales of Indian assets. Such assets may include those acquired through inheritance/legacy. Any further relaxations would render the Indian economy susceptible to the kind of crisis faced by the other developing countries. Why then is the government interested in introducing Capital Account Convertibility? The UPA government, since its inception, had has been pursuing the policies of liberalistion and privatisation, which underscore its commitment to neo-liberalism. Notwithstanding certain policy announcements in the NCMP, the government is unwilling to change course and is in essence pursuing the same policies as the NDA. A policy like Capital Account Convertibility is a reflection of this. Such policies solely benefit the rich business houses, investors in the stock markets and those who control the international finance markets. The prime minister and the finance minister are more than eager to serve the vested interests of these classes. Dani Rodrik, an eminent Harvard economist, has argued that
“The greatest concern I have about canonizing capital-account convertibility is that it will leave economic policy in the typical “emerging market” hostage to the whims and fancies of two dozen or so thirty-something country analysts in London, Frankfurt, and New York. A finance minister whose top priority is to keep foreign investors happy will be one who pays less attention to developmental goals. We would have to have blind faith in the efficiency and rationality of international capital markets to believe that these two sets of priorities will regularly coincide.”--- (“Who Needs Capital Account Convertibility?” February 1998.) CONCLUSION The moral of the story is that with Capital Account Convertibility financial crises will always be with us; and there is no magic wand to stop them. These conclusions are important because they should make us appropriately wary about statements of the form, “we can make free capital flows safe for the world if we do x at the same time,” where x is the currently fashionable antidote to crisis. In India today the x is “strengthening the domestic financial system and improving the prudential standards.” Tomorrow’s x is anybody’s guess. If we are forced to look for a new series of policy errors each time a crisis hits, we should be extremely cautious about our ability to prescribe a policy regime that will sustain a stable system of capital flows. Hence any conclusions by the special RBI committee would be just another such wishful thinking that others before us have undertaken, whereas such policies may not be enough from preventing a crisis in India. The only way to avoid such a crisis is to have regulated capital inflow into the economy, the purpose of which is defeated by CAC. http://www.yourarticlelibrary.com/economics/foreign-exchange/currency-convertibility-advantage-benefits-and-preconditions-for-capital-account-convertibility/38177/ http://www.economywatch.com/indianeconomy/cac-indian-economy.html Who’s afraid of full capital account convertibility?
Posted by Subir Gokarn on July 6, 2015

The issue of a completely open capital account, or full capital convertibility, saw a significant change in perspectives and positions after the financial crisis of 2008. Up until the crisis, the predominant global view on this issue, perhaps best reflected in the institutional stance of the International Monetary Fund (IMF), was that more convertibility and a floating exchange rate were unambiguously good. All economies should move towards this objective, though they must be mindful of the macroeconomic, institutional and regulatory context in which it work to the economy’s advantage.

However, after the crisis, the perspective changed. It shifted from focusing on the efficiency gains to highlighting the risks. The IMF played a significant role in this transition, raising questions about the merits of unconditional and absolute convertibility. Massive volatility in capital flows and, consequently, in exchange rates could have significant and persistent impacts on the domestic economy in both the financial and the real sectors. A more pragmatic view on the convertibility issue would suggest that in such situations, governments and central banks must consider the use of some form of controls and market interventions to gain control over a potentially spiralling situation.

In other words, while the efficiency gains from convertibility may swing the argument under normal circumstances, the risks come to the forefront, particularly in countries in which an underdeveloped ecosystem does not provide adequate buffers to protect stakeholders against extreme volatility. If one is to characterise the current state of the debate, it would be in terms of this pragmatism. Don’t lock yourself into positions that might cost you heavily in turbulent times. Always retain the capacity and instruments to protect domestic stakeholders from extreme volatility. And make sure that both domestic and foreign stakeholders know this and believe it.

India has moved steadily down the path towards full convertibility. In the pre-crisis paradigm, it was often criticised for being too slow and cautious. However, with the paradigm itself changing, there really isn’t a clear benchmark to assess where India’s, or for that matter, any country’s capital account management framework stands currently. Both theory and practice in this domain are in a state of evolution, as reflected in the essays in a recent book* co-edited by Bruno Carrasco, Hiranya Mukhopadhyay and myself.

Theoretical developments are taking the debate in the direction of identifying capital account management instruments and time frames for their use that will most effectively deal with different sources of capital account and exchange rate turbulence. Practical perspectives, coming from central bankers who were directly involved in managing external turbulence, provide insights from the experiences of different countries about how specific instruments were used in different situations and how effective they were.

One might have thought that the pragmatic middle ground was now the dominant position in the debate and that research efforts were focused on refining the understanding on what kind of controls might work when and why and, very importantly, what will not work and why. Going by this yardstick, the Indian regime appears to be an eminently sensible one. There is a broad acceptance of the benefits of free capital movements. There is also an understanding of the different level of risks that different kinds of capital flows pose. Exchange rate flexibility is also part of the framework, but within certain boundaries. And the willingness to step in with a variety of interventions, both market-based and administrative, in order to deal with extreme volatility has been demonstrated.

Against this backdrop, the recent statements emanating from both the finance ministry and the Reserve Bank of India (RBI) about the aspiration to move towards full convertibility are significant. Equally significant are the apparently contradictory messages from the central bank, highlighting the risks intrinsic to a more open capital account. Based on the background provided above, I think that the debate has shifted from “more open versus less open”, which was essentially a pre-crisis formulation, to “matching vulnerabilities with toolkits”, which is the tagline for the post-crisis pragmatism.

From this perspective, I would argue that a constructive debate on the appropriate capital account management framework for India needs to address three major issues, each of which involves trade-offs. First, should all inflows be made completely free? Currently, there are restrictions, mostly in the form of limits on amounts invested by foreign investors in government and corporate bonds. These limits have been steadily raised, but caps remain. That outflows of debt investments can be destabilising was demonstrated in the 2013 episode. But if domestic market conditions for these securities are appropriately structured, foreign investments can contribute to increasing depth and efficiency. The policy objective here should be to create domestic market conditions that will minimise the potentially destabilising effects of foreign investment. We need to figure out if such conditions exist and can realistically be created; if not, some prudence, in the form of caps, may continue to be justified.

Second, intervention by the RBI in the currency market achieves multiple objectives, but they are not necessarily aligned. Is it being done for the purposes of reserve accumulation, which then provides a bigger buffer against external shocks? An unobjectionable motive, but in the process, the RBI shoulders the responsibility of containing exchange rate risks, thus absolving other, particularly private, stakeholders from mitigating them. The critical question is: how is exchange rate risk most efficiently managed? Do market-traded hedging products offer the best prospect, in which case the policy focus needs to be on rapidly developing these options and ensuring that they are being used for purposes of risk mitigation. Or, all things considered, is there a public good aspect to exchange rate risk, which justifies a major role for the central bank in the process?

Third, in episodes of high turbulence, what is the right sequence of intervention and where should the process stop? On the one hand, there are enormous reputation risks for the policy establishment if an attempted defence of the currency should fail. On the other, there are equal risks associated with not trying at all. Further, there are longer-term consequences of steps taken during the management of a crisis. Obligations taken will have to be met some time and risks may be pushed from one part of the system to another, manifesting much later.

The short point is that a debate on convertibility in the current context needs to be exploring answers to questions such as these.
India has been moving from a regime of extreme capital controls to a much liberalised foreign exchange regime in a calibrated manner. The rupee is partially convertible whereby some capital account transactions are freely permitted, some allowed within parameters like sectoral caps and a few transactions remain prohibited. Partial convertibility has provided a balance between control and liberalisation, and has paved the way for a stable economy over the last 15 years.
Today we are hearing a lot of buzz on moving toward full convertibility which includes capital account convertibility (CAC). The arguments in favour of CAC are many; from making an economy globally competitive, to fuelling growth by increasing investment, to creating confidence in the global marketplace. Almost all developed economies have had full convertibility for several decades. Over the past 25 years, various emerging markets have been moving toward CAC with Latin America leading the way. Peru has full liberalisation while Argentina, Brazil, Chile and Mexico are largely liberalised. Morocco, Nigeria, Egypt, Pakistan, and South Korea, among others, have achieved a large degree of convertibility.
In most of these cases, the initial move towards convertibility saw a huge outward flight of capital with concomitant effects on currency volatility and inflationary trends but, over three to five years, inflows matched the outflows and they achieved some stability in forex reserves.
In India, the move toward currency liberalisation started in 1991 when the country was facing a balance of payment crisis. The call for full CAC is now gaining strength. Some of its advantages can be summarised as follows:
For companies: Companies face a number of challenges in moving across borders; whether it be raising debt, investing overseas, doing M&A globally and even some trading transactions. Full CAC will allow them to match global competitors in terms of structuring their business, raising funds, and transferring resources to where they are required.
For individuals: Individuals have a number of restrictions in moving money for legitimate reasons of education, health or even investment. Full convertibility will give them huge flexibility of owning assets and incurring expenditure for their needs.
For the economy: With the skewed balance of trade position and our dependence on critical imports, full CAC is expected to bring about additional inflows that ensure an overall surplus balance of payments. It is also a strong signal to the global markets that India is now a free trade economy and the economy has achieved scale and strength to go for full convertibility, and that itself will increase investors' confidence and should result in significant capital inflows.
It must be cautioned, however, that the costs associated with the move need to be evaluated carefully. The global crisis of 2008 showed the weaknesses of the control-free currency policy. India was fairly insulated during the period due to its controls and monitoring system.
Any move towards full convertibility could potentially result in an outflow of capital in the short run, creating a drain on our forex reserves. Uncontrolled inflows and outflows will also cause high rupee volatility. Also, unbridled overseas borrowings by companies could lead to payment defaults. Companies may end up taking risks beyond their capability due to their lack of understanding.
In conclusion, while full CAC is desirable as a long-term objective, it is not a magic potion as proved by the China success story. To ensure that convertibility does not become a recipe for disaster, strict macroeconomic controls are needed coupled with a strong monitoring system and fiscal discipline. The Indian model of partial convertibility and calibrated movement toward full CAC has worked.
(Harish H.V. is Partner at Grant Thornton India)

{mosimage}'IT CAN BE RISKY AT THIS JUNCTURE'
Gaurav Gupta What did radically transform at the Reserve Bank of India between April 15, 2012, and April 10, 2015, to take a diametrically opposite view on full capital account convertibility (CAC), that too in a country as ill-prepared as ours? Was Governor Raghuram Rajan misquoted or quoted out of context as he was talking to students and explaining the basics of monetary policy and other concepts. Or perhaps, being an academic of his stature, he was floating a discussion idea. But the debate is on.
We cannot also ignore Union Minister of State for Finance Jayant Sinha, who stated that "definitely we have to play our rightful, responsible role in the global economy, and to do that we have to move in the direction of CAC".
To put things in perspective, Rajan's predecessor, Duvvuri Subbarao, on April 15, 2012, spoke against CAC, while Rajan on April 10, 2015, after the paper-launch of the International Financial Services Centre (IFSC) in Ahmedabad, expressed optimism that any resident citizen could convert his rupees into dollars or any other currency at will "in a very few short years", which is what CAC means.
Rajan did not elaborate on the merits or demerits of such a step, but Subbarao was very vocal against CAC with specific reasons. Subbarao advocated a gradual move towards CAC only after preconditions like fiscal consolidation and current account surplus are met. "There is no evidence the world over that CAC, regardless of macroeconomic circumstances, has been a positive force? on the contrary, evidence suggests that premature capital account liberalisation can create macroeconomic imbalances with huge costs to growth and welfare," he had said.
To me, there are more reasons to say CAC, at this juncture, could be risky for India. Our combined fiscal deficit is a shade below eight per cent with the Centre's alone at 4.1 per cent in 2014/15. We have a history of running high current account deficit (one per cent of GDP in 2014/15 is due largely to a 65 per cent fall in crude prices), and our import cover is low - at six-and-a-half months with $343 billion in forex reserves. We heavily depend on hot foreign funds to bridge the current account deficit, the trade deficit is widening, we have a fundamentally weak rupee whose strength is mostly determined by the quantum of fund inflows, and we have structurally and fundamentally weak banks with a whopping 12.5 per cent of their assets being dud loans - the list of inclement conditions far outweigh those of conducive situations for CAC.
Moreover, the memories of the plight of the East Asian tiger economies, especially those with full CAC during the 1997-99 currency crisis (we were unscathed with $1 billion in outflows, thanks to our capital controls) should restrain the very thought of CAC. From being a votary of CAC, the IMF now supports selective capital control as the Asian crisis began one year after the then IMF chief Michel Camdessus sought full CAC for all its members. If China, with close to $4 trillion in forex reserves and close to half-a-trillion dollars in current account surplus, and all other economic muscle, is averse to CAC, can we think of CAC? After all, the hottest money in our country is not FII funds, but the rupee. Our insecure psyche will see us convert all our rupees into dollars and empty our meagre forex reserves pronto.
It is a little too ambitious to say that a formal launch of an IFSC can elevate us into a global league. CAC at this juncture can spell bad times for our economy, if we do not get the above-cited inclement conditions corrected before.
After all, our decades-old selective capital control methods - full convertibility on current account and partial on capital account - has stood us in good stead during and after the 1997-99 Asian crisis. If the existing controls are not broke, why should we think of CAC now?
(Gaurav Gupta is Managing Director and Head, Macquarie Capital India. Views are personal.) Green shoots have begun to appear and the weeds of the past blown away. The International Monetary Fund or IMF has assessed that the Indian economy is poised to grow around 7.9 per cent this financial year, after a 7.4 per cent growth in the last fiscal.
They have also said that India will be fastest growing economy in the world, higher than even China whose growth rate is expected to taper off to 6.4 per cent.
Given the present economic scenario, the government is contemplating permitting capital account convertibility in the next few years. This means that an average citizen could walk up to a bank with Indian rupees and request them to convert to US dollars at the prevailing exchange rate (with no limit on the amount to be converted). This indeed is a most welcome step towards liberalising the use of foreign exchange. If and when it happens, we will join the big leagues comprising developed countries where currency conversion is a day-to-day occurrence.
However, the question to ponder is whether India is ready to take this big step and what the impact on the capital outflow and rupee exchange rate would be. Also, will RBI take a 'laissez-faire' attitude and allow the rupee value to be completely market-determined?
Before any action is taken, we need to look at all the possibilities. First, currently our foreign exchange reserves stand at $343 billion. This is relatively a huge reserve and can easily support 8 to 10 months of imports even assuming zero exports. Also, if all goes well with economic growth, the foreign direct investment or FDI into India will keep coming in large amounts; more so given the free-market orientation of the Modi government.
This will send a positive signal to foreign investors that Indian trade activities are set to expand in a big way. Some of the reluctance to act in the past on capital account convertibility is understandable because of the sudden upsurge in the current account deficit, which exceeded 4 per cent of the GDP in the last year.
At that time, Brent crude was trading above $120 to a barrel. Today, we are looking at a price of around $60 per barrel. The price of crude is further likely to stabilise and result in a major savings in our import bill. Further, when our government's 'Make in India' policy gains momentum, it will bring the current account deficit down to no more than around 2 per cent of GDP. All these are positive signs for India's foreign exchange reserves to go up.
This said, the extreme volatility that appeared in the East Asia Currencies in the second half of 1997 (Asian currency crisis) is a point of consideration. At that time, the emerging market economies faced the reverse flow of funds back to the US because of the change in the US interest rate. The outcome was a massive depreciation of the local currencies along with very high levels of volatility. Hedge funds used non-deliverable forward contracts and decimated the values of currencies like the Thai Baht, Malaysian Ringgit and the Indonesian Rupiah. Could that happen to us, too? The answers is Yes and No.
Yes, there is a remote possibility. But by exercising caution, putting an initial limit on the size of convertibility and later removing the barriers could be a solution. And no, our currency is not overvalued except perhaps marginally. The market price discovery pricing of the currency will automatically take care of this problem.
Besides, our overseas activity is approximately 15 per cent and so our exposure to the world economy is very limited as a proportion of the total economy. Also, our foreign trade is less than 2 per cent of the global trade. Compared to China's 15 per cent, it is relatively small. So any apprehension in this regard is seriously misplaced.
Currently, the FIIs are having a bonanza by investing in our market. We had set a limit of $30 billion for the FII investment in our bond market, yet it was oversubscribed multi-fold. Our stock market with the current price earnings ratio of 18 is extremely attractive given the 10-year US treasury is yielding a measly 1.5 per cent. Besides, the large part of the FII money is here to stay for many years to come.
In all likelihood, the Indian economy will continue to forge ahead with a growth percentage of above 8 per cent. In that growth environment, corporate profit growth can be expected to be about 15 per cent. For the FIIs, the math is simple - compared to the other emerging markets, (Russia, China and Brazil) India will be the best bet. It will, therefore, not be a big surprise if in the next few years our reserve reaches $400-450 billion.
Our government must have a clear understanding of the source and use of funds. They are in the process of passing the GST bill, which will enhance revenues to the government. The fiscal and the cash deficit will definitely move to lower levels as a proportion of GDP. Thus, many of the concerns related to current account convertibility will become irrelevant.
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Given the right fiscal and monetary policies, we can expect our rupee to actually appreciate. Therefore, it is about time that the government looks into capital account convertibility and takes a proactive stand. A precautionary approach to start with will be very helpful. First a set of limits may be set for convertibility like total amount and frequency. As our economic growth picks momentum, the need for foreign capital will increase significantly. Currency convertibility will infuse much confidence into both local and foreign investors, who may therefore choose to invest here for a longer period of time.
Lastly, setting pre-requisites like low currency value volatility and preventing hedge fund intervention may not be realistic, given that all currencies face the same possibilities. Volatility is a part of the game and the Indian rupee is certainly not an exception. However, our currency may not be subject to large fluctuations since we are a fast-growing economy. Capital account conversion will certainly lead to the globalisation of Indian currency. Indian companies, whose activities are limited due to limited gross capital formation and domestic savings rate, will now be in a position to borrow rupees (not the dollars) overseas. This will help them realistically compare their real cost of capital since no foreign exchange risk is involved.
Bala V. Balachandran is Founder, Dean and Chairman; and Bobby Srinivasan is Distinguished Professor - Finance at Great Lakes Institute of Management