Model Answer
0 min readIntroduction
Capital account convertibility (CAC) refers to the free flow of capital in and out of a country. India adopted a phased approach towards CAC starting with the Tarapore Committee recommendations in 1997. Currently, India follows a regime of partial CAC, with restrictions on certain capital flows like foreign currency deposits and investments in real estate. While this partial liberalization has facilitated increased foreign investment and economic growth, the question arises whether it is sufficient to truly integrate the Indian economy with the global financial system. This answer will critically examine the limitations of partial CAC in achieving this integration, considering both its benefits and drawbacks.
Current Status of Capital Account Convertibility in India
India’s journey towards CAC has been cautious. The Tarapore Committee (1997 & 2006) laid down preconditions for full CAC, including a fiscal consolidation, a mandated rate of profit on exports, and a certain level of foreign exchange reserves. While some progress has been made, full convertibility remains elusive. Currently, restrictions exist on:
- Foreign Direct Investment (FDI): Sectoral caps exist in certain industries.
- Portfolio Investment: Limits on investment by Foreign Portfolio Investors (FPIs).
- External Commercial Borrowings (ECB): Restrictions on end-use and borrower eligibility.
- Resident Individuals’ Investments Abroad: Limits under the Liberalised Remittance Scheme (LRS).
Why Partial CAC is Insufficient for Full Integration
The statement that partial CAC cannot serve the purpose of integrating the Indian economy with the world economy holds considerable weight. Several factors contribute to this:
- Limited Capital Flows: Restrictions hinder the efficient allocation of capital globally. Indian firms may not be able to access cheaper foreign capital, and Indian investors are limited in their ability to diversify internationally.
- Currency Volatility: Without full convertibility, managing exchange rate volatility becomes more challenging. The Reserve Bank of India (RBI) frequently intervenes in the foreign exchange market to stabilize the rupee, which can be costly and distort market signals.
- Reduced Financial Deepening: Restrictions on capital flows limit the development of sophisticated financial markets in India. A deeper and more integrated financial system is crucial for sustained economic growth.
- Hindrance to Global Competitiveness: Indian companies may find it difficult to compete with global firms that have easier access to capital and can operate more efficiently in international markets.
- Arbitrage Opportunities & Round-Tripping: Partial convertibility creates opportunities for arbitrage and round-tripping of funds, leading to inefficiencies and potential illicit financial flows.
Arguments for Full Capital Account Convertibility
Advocates of full CAC argue that it offers several benefits:
- Increased Efficiency: Free flow of capital leads to a more efficient allocation of resources globally, boosting economic growth.
- Financial Innovation: Greater integration with global financial markets fosters innovation and the development of new financial products and services.
- Reduced Cost of Capital: Access to cheaper foreign capital lowers the cost of borrowing for Indian firms.
- Enhanced Risk Sharing: Diversification of investment across borders reduces systemic risk.
Risks Associated with Full Capital Account Convertibility
However, full CAC also carries significant risks, particularly for emerging economies like India:
- Sudden Capital Outflows (Hot Money): A sudden reversal of capital flows can lead to a currency crisis and economic instability. The Asian Financial Crisis of 1997-98 serves as a cautionary tale.
- Exchange Rate Volatility: Unrestricted capital flows can exacerbate exchange rate fluctuations, impacting trade and investment.
- Contagion Effects: India could be vulnerable to external shocks and financial crises in other countries.
- Regulatory Challenges: Managing a fully convertible capital account requires a robust regulatory framework and effective supervision.
A Nuanced Approach
A pragmatic approach involves a gradual and well-sequenced liberalization of the capital account, coupled with strengthening macroeconomic fundamentals and regulatory oversight. This includes:
- Fiscal Consolidation: Reducing the fiscal deficit to enhance macroeconomic stability.
- Strengthening the Financial Sector: Improving the health and resilience of the banking system.
- Developing Robust Regulatory Frameworks: Implementing effective regulations to manage capital flows and prevent financial crises.
- Building Foreign Exchange Reserves: Maintaining adequate reserves to cushion against external shocks.
Conclusion
In conclusion, while partial capital account convertibility has facilitated some integration with the global economy, it is insufficient to achieve full integration due to inherent limitations in capital flow management and financial deepening. A complete shift to full convertibility presents substantial risks, particularly for an economy like India. Therefore, a cautious, phased approach, prioritizing macroeconomic stability and regulatory strengthening, is crucial. The path forward requires a delicate balance between the benefits of liberalization and the need to safeguard against potential vulnerabilities.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.