Discuss the issues involved in Capital Account Convertibility. In the light of this, explain India's important Capital Account Liberalization measures.

Issues Involved in Capital Account Convertibility

Full capital account convertibility is not without its challenges. Several issues need careful consideration:

• Volatility of Capital Flows: Unrestricted capital flows can lead to sudden surges and reversals, disrupting macroeconomic stability. ‘Hot money’ flows, driven by speculative motives, can create asset bubbles and financial crises.
• Exchange Rate Volatility: CAC can exacerbate exchange rate fluctuations, impacting trade competitiveness and increasing the cost of external debt.
• Financial Sector Vulnerability: A weak financial system may not be able to withstand large capital inflows or outflows, leading to banking crises and systemic risk.
• Loss of Monetary Policy Autonomy: Large capital inflows can appreciate the exchange rate, limiting the effectiveness of monetary policy in controlling inflation.
• Regulatory Arbitrage: CAC can facilitate regulatory arbitrage, where entities exploit differences in regulations across countries to engage in risky activities.
• Supervisory Challenges: Monitoring and supervising capital flows requires sophisticated regulatory frameworks and international cooperation.

India’s Capital Account Liberalization Measures

India’s approach to capital account liberalization has been gradual and carefully sequenced, guided by the recommendations of various committees, notably the Tarapore Committee. Key measures include:

Phase I (Early 1990s - 1997): Initial Steps

• Foreign Direct Investment (FDI) Liberalization (1991): Restrictions on FDI were eased, allowing greater foreign participation in various sectors. The initial focus was on attracting FDI to promote economic growth and technology transfer.
• Portfolio Investment Liberalization (1992-93): Foreign Institutional Investors (FIIs) were allowed to invest in the Indian stock market, subject to certain ceilings and registration requirements.
• External Commercial Borrowings (ECB) (1994): Indian companies were permitted to borrow from international markets, providing access to cheaper funds.

Phase II (1997 - 2004): Consolidation and Expansion

The Tarapore Committee (1997) recommended a three-year timeframe for achieving full CAC, subject to certain preconditions. However, the Asian Financial Crisis of 1997-98 led to a reassessment of this approach.

• Liberalization of ECB norms: The scope of ECBs was expanded, and the permissible end-use was broadened.
• Increased FII investment limits: Investment limits for FIIs in Indian equities were gradually increased.
• Resident Indians’ Investment Abroad (RIIA): Liberalization of rules governing investments by Indian residents in foreign assets.

Phase III (2005 onwards): Further Liberalization

The Tarapore Committee (2006) reiterated the need for a cautious approach to CAC, emphasizing the importance of strengthening the financial sector and exchange rate management.

• Automatic Route for FDI in most sectors: The approval process for FDI was simplified, with most sectors being brought under the automatic route.
• Increased limits for FII investment in government bonds: FII investment limits in government securities were raised to attract foreign capital.
• Liberalization of outward FDI: Indian companies were allowed to make overseas investments more freely.
• Qualified Foreign Investors (QFIs) (2011): Introduction of QFIs to broaden the investor base and reduce reliance on FIIs.
• Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs) (2016): Allowing these investment vehicles to attract foreign investment into real estate and infrastructure sectors.

Phase	Years	Key Measures
Phase I	1991-1997	FDI Liberalization, Portfolio Investment Liberalization, ECB introduction
Phase II	1997-2004	ECB Norms Expansion, Increased FII limits, RIIA liberalization
Phase III	2005 onwards	Automatic Route for FDI, Increased FII limits in bonds, REITs/InvITs