Do you believe that capital account convertibility is feasible under the present circumstances in India? Explain.

Understanding Capital Account Convertibility

Capital account convertibility entails removing restrictions on the inflow and outflow of capital, including foreign direct investment (FDI), portfolio investment, and external commercial borrowings (ECB). Currently, India follows a managed float exchange rate regime with some capital controls, such as limits on foreign investment in certain sectors and restrictions on outward remittances by residents.

Arguments in Favour of Capital Account Convertibility

• Increased Capital Inflows: CAC can attract larger volumes of foreign capital, boosting investment and economic growth.
• Efficient Capital Allocation: Allows capital to flow to its most productive uses globally, enhancing efficiency.
• Reduced Transaction Costs: Eliminates costs associated with circumventing capital controls.
• Development of Financial Markets: Promotes the development of sophisticated financial instruments and markets.
• Exchange Rate Flexibility: Facilitates a more market-determined exchange rate, improving competitiveness.

Arguments Against Capital Account Convertibility

• Volatility and Financial Instability: Sudden capital outflows (hot money flows) can lead to exchange rate volatility, financial crises, and economic disruption. The Asian Financial Crisis of 1997-98 serves as a cautionary tale.
• Loss of Monetary Policy Autonomy: Large capital flows can complicate monetary policy management, limiting the central bank’s ability to control inflation and maintain financial stability.
• Speculative Attacks: CAC can make the economy vulnerable to speculative attacks on the currency.
• Exacerbation of Inequality: Benefits of capital flows may not be evenly distributed, potentially widening income inequality.
• Regulatory Arbitrage: May encourage regulatory arbitrage, where entities exploit differences in regulations across countries.

India’s Present Circumstances and Preparedness

Macroeconomic Stability

India’s macroeconomic fundamentals have improved significantly in recent years. However, concerns remain regarding:

• Fiscal Deficit: The fiscal deficit remains relatively high, making the economy vulnerable to external shocks. (As of FY23, fiscal deficit was 5.9% of GDP)
• Current Account Deficit: A persistent current account deficit can create pressure on the exchange rate. (Current Account Deficit was 1.2% of GDP in FY23)
• Inflation: While inflation has moderated, it remains a concern, particularly given global commodity price volatility.

Financial Sector Development

The Indian financial sector has undergone significant reforms, but challenges persist:

• Non-Performing Assets (NPAs): High levels of NPAs in the banking sector continue to pose a risk to financial stability.
• Financial Inclusion: Financial inclusion remains incomplete, with a significant portion of the population lacking access to formal financial services.
• Regulatory Capacity: Strengthening regulatory capacity is crucial to effectively manage the risks associated with CAC.

Institutional Framework

India needs to strengthen its institutional framework to manage capital flows effectively:

• Exchange Rate Management: Developing a robust exchange rate management framework is essential.
• Capital Flow Management Measures: Having appropriate capital flow management measures in place to mitigate risks is crucial.
• Early Warning Systems: Establishing effective early warning systems to detect and respond to potential crises is vital.

The Tarapore Committee Recommendations

Committee	Year	Key Recommendations
Tarapore Committee I	1997	Fiscal consolidation, current account deficit below 3% of GDP, gross forex reserves to cover 3 months of imports, net forex assets of RBI to be positive.
Tarapore Committee II	2006	Strengthen financial sector, improve banking efficiency, develop foreign exchange and derivatives markets, manage capital flows effectively.

Phased Approach

Given the complexities and risks involved, a phased approach to CAC is more prudent. This could involve gradually relaxing capital controls, starting with less volatile forms of capital flows, while closely monitoring the impact on the economy. A complete and immediate shift to full convertibility is not advisable under the current circumstances.