Capital Account Liberalisation – Road Ahead for India
by: Cashonova - The Finance & Investments Club at IIFT
India embarked on its journey to complete full financial integration with the global markets two decades ago. After 1991, India started to adopt free market policies like liberalisation, privatisation and globalisation. During the same time it also started to shift its exchange rate policy from a pegged exchange rate to a managed float exchange rate system. In the process India achieved full current account convertibility and partial capital account convertibility.
At present, India is facing many problems like high fiscal deficit, inflation, infrastructural bottlenecks etc. And in order to solve these problems there is a need for foreign capital flows. If the Indian economy has to overcome the above stated problems and outperform the growth expectations, it is necessary to have a conducive policy environment in order to attract capital flows. The significance of full Capital Account convertibility in India is gaining importance. It is not India’s first tryst towards capital account convertibility. From 1991 onwards, India is increasingly moving towards this objective. The Indian government had also setup, Tarapore committee to provide guidelines for the implementation of the Full capital account convertibility in 1997.
The economic scenarios in many of the developed economies like U.S.A., Europe are also not rosy. The investors are pessimistic about the economic growth of these countries. Amid these concerns, the global financial flows have started to move from the developed nations to the developing nations. Countries like China, India, Brazil, South East Asian and Latin American countries are going to become the main beneficiaries. The debate of going for Full Capital account convertibility is gaining importance in such circumstances.
Capital account convertibility is defined as the freedom to convert local financial assets into foreign assets in any form and vice versa at market-determined rates of exchange. There are distinct benefits of capital account convertibility such as availability of a larger capital at international prices to supplement domestic resources, risk diversification, efficiency and improvement in intermediation of financial resources, development of financial markets and a disciplined influence on macroeconomic policies.
In spite of its advantages, there are many pitfalls in the implementation of the capital account convertibility. Adopting full capital account convertibility requires a cautious approach. The Mexican Peso crisis in 1994 and the South East Asian crisis in 1997 testify that adopting capital account convertibility without strengthening the financial and banking structures is a suicide for an economy. The implications from these crises can be explained by the concept of impossible trinity. It implies “A country can choose any two options of the available three: Free Capital flows, Fixed Exchange rate and Independent monetary policy”.
If India adopts full capital account convertibility, then India has to choose either fixed exchange rate or the independent monetary policy. In a developing country with India’s size, controlling inflation is very crucial and an effective monetary policy is extremely essential for the same. At the same time a fixed exchange rate will provide stability to the exchange rates; importers and exporters will be the beneficiaries. The better option for India is to sacrifice the fixed exchange rate system (managed float) to have independent monetary policy.
One of the main reasons for the collapse of S.E.Asian nations in 1997 is the free flow of Hot Money. Hot money is the money that flows regularly between financial markets as investors attempt to ensure they get the highest short-term interest rates possible. Hot money increases the volatility of the foreign exchange market and requires frequent intervention of the central bank to maintain the stability in the market. To maintain the stability, country needs huge foreign exchange reserves. The sustainability of this strategy is very difficult, so the better strategy is to levy a tax known as “Tobin Tax” on the hot money. This might reduce the short term flows in to the country and also reduces the volatility.
To conclude, in order to sustain a growth rate above 9-10%, it is inevitable for India to go for Capital account convertibility. Adequate ground work is required before rolling out capital account convertibility. Strong measures and actions are required on the policy front and macroeconomic front. Regarding macroeconomic policies, Fiscal Consolidation and controlling the inflation levels is needed. On the policy front the financial system need to be strengthened. The Cash reserve ratio and the Non performing assets need to be reduced and the weak players in the banking system need to be strengthened. In addition to attract FDIs, the country needs to improve the infrastructure.
India needs to wait for few more years before going for capital account convertibility. India needs to control its macro economic problems and also need to look for stable and conducive global economic conditions for implementing full capital account convertibility.
By: Rama Dheeraj, IIFT Delhi