Model Answer
0 min readIntroduction
Capital account convertibility (CAC) refers to the free flow of capital in and out of a country, without restrictions on the exchange rate. It is a key component of financial globalization. India has been gradually liberalizing its capital account since the 1990s, starting with the balance of payments crisis. However, full CAC remains a contentious issue. While proponents argue it can boost investment and economic growth, concerns remain about potential volatility, currency crises, and macroeconomic instability. The recent global economic uncertainties and geopolitical risks necessitate a careful evaluation of whether India is adequately prepared for such a significant step.
India’s Journey Towards Capital Account Liberalization
India’s liberalization began in 1991 with the balance of payments crisis. The initial steps focused on trade liberalization and limited capital account opening. The Tarapore Committee reports (1992, 1996, 2006) provided roadmaps for CAC, outlining preconditions like fiscal consolidation, inflation control, and a robust financial system. The liberalization process has been gradual and phased, covering areas like foreign direct investment (FDI), foreign portfolio investment (FPI), and external commercial borrowings (ECB). Currently, India follows a managed floating exchange rate regime with some capital controls.
Preconditions for Full Capital Account Convertibility
Several preconditions are generally considered essential for a country to successfully implement full CAC. These can be categorized as follows:
- Macroeconomic Stability: Low and stable inflation, sustainable fiscal deficit, and manageable current account deficit.
- Financial Sector Development: A well-regulated and supervised financial system, robust banking sector, and developed capital markets.
- Exchange Rate Flexibility: A flexible exchange rate regime capable of absorbing shocks.
- Strong Institutional Framework: Independent regulatory bodies, effective legal system, and transparent governance.
- Adequate Foreign Exchange Reserves: Sufficient reserves to manage potential capital outflows.
Assessing India’s Readiness
Evaluating India’s readiness requires examining its performance against the aforementioned preconditions:
Macroeconomic Stability
India’s macroeconomic stability has been mixed. While inflation has been relatively contained in recent years (averaging around 5-6% pre-pandemic), it remains susceptible to global commodity price shocks. The fiscal deficit, though declining, remains elevated (around 5.9% of GDP in FY24-25). The current account deficit has also widened due to rising oil prices and trade imbalances.
Financial Sector Development
India’s financial sector has witnessed significant development, but challenges remain. Non-Performing Assets (NPAs) in the banking sector have decreased but are still a concern. Capital markets are growing, but their depth and breadth need further improvement. Financial inclusion has improved significantly with initiatives like Jan Dhan Yojana, but access to credit remains uneven.
Exchange Rate Flexibility
India follows a managed floating exchange rate regime, allowing the Reserve Bank of India (RBI) to intervene in the foreign exchange market to manage volatility. While this provides some stability, it also limits the full benefits of exchange rate adjustment.
Institutional Framework
India’s institutional framework has improved, but governance issues and regulatory gaps persist. The independence of regulatory bodies like the RBI is crucial, but concerns about government influence occasionally arise. Enforcement of contracts and dispute resolution mechanisms need further strengthening.
Foreign Exchange Reserves
India holds substantial foreign exchange reserves (over $600 billion as of November 2023). This provides a buffer against external shocks, but it is not unlimited. Sustained capital outflows could deplete reserves quickly.
Potential Benefits and Risks
| Benefits of Full CAC | Risks of Full CAC |
|---|---|
| Increased foreign investment (FDI & FPI) | Increased vulnerability to volatile capital flows |
| Lower cost of capital | Currency crises and exchange rate volatility |
| Enhanced economic growth | Macroeconomic instability |
| Greater financial integration with the global economy | Contagion from global financial shocks |
Recent Developments and Expert Views
The RBI has consistently maintained a cautious approach towards full CAC, emphasizing the need for adequate preconditions. The Economic Survey 2022-23 highlighted the importance of strengthening the financial sector and managing macroeconomic risks before considering full convertibility. Several economists, including members of past Tarapore Committees, have also advocated for a gradual and calibrated approach.
Conclusion
India has made significant progress in liberalizing its capital account, but full convertibility is not yet advisable. While the benefits of increased investment and economic growth are attractive, the risks of volatility and macroeconomic instability are substantial. Strengthening macroeconomic fundamentals, deepening financial sector reforms, and enhancing institutional capacity are crucial prerequisites. A phased and carefully managed approach, guided by continuous monitoring and assessment, remains the most prudent strategy for India. The current global economic climate further reinforces the need for caution.
Answer Length
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