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UPSC MainsECONOMICS-PAPER-II201915 Marks
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Q13.

Examine the role of capital account convertibility in controlling deficit in the current account of India's Balance of Payments (BOPs).

How to Approach

This question requires a nuanced understanding of the Balance of Payments (BOP), capital account convertibility, and their interplay. The answer should begin by defining key terms, explaining the BOP and capital account convertibility. It should then detail how capital inflows, facilitated by convertibility, can offset current account deficits. Discuss the risks and benefits of full convertibility, India’s cautious approach, and recent trends. Structure the answer by first explaining the theoretical link, then India’s experience, and finally, the current challenges and future prospects.

Model Answer

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Introduction

India’s Balance of Payments (BOP) reflects the country’s transactions with the rest of the world. A persistent current account deficit (CAD), where imports exceed exports, can strain foreign exchange reserves and potentially lead to economic instability. Capital account convertibility, the free flow of capital in and out of a country, is often seen as a tool to manage this deficit. While full capital account convertibility remains a debated topic in India, understanding its potential role in controlling the CAD is crucial. The recent volatility in global capital flows and its impact on the Indian Rupee underscores the relevance of this discussion.

Understanding the Balance of Payments and Capital Account Convertibility

The Balance of Payments (BOP) is a systematic record of all economic transactions between the residents of a country and the rest of the world. It comprises two main accounts: the current account and the capital account. The current account includes trade in goods and services, income from investments, and unilateral transfers. A deficit in the current account implies that a country is importing more than it is exporting.

The capital account records all transactions related to the acquisition or disposal of assets. This includes foreign direct investment (FDI), portfolio investment (FII), external commercial borrowings (ECB), and changes in foreign exchange reserves. Capital account convertibility refers to the degree to which a country allows the free flow of capital for investment purposes.

The Role of Capital Account Convertibility in Controlling CAD

Capital account convertibility can help control a current account deficit through several mechanisms:

  • Attracting Foreign Investment: A convertible capital account can attract foreign investment, including FDI and FII. These inflows increase the supply of foreign exchange, offsetting the demand created by the CAD.
  • Financing the Deficit: Capital inflows can directly finance the current account deficit. For example, if a country imports more than it exports, the difference can be covered by inflows of foreign capital.
  • Exchange Rate Adjustment: Capital inflows can appreciate the domestic currency, making exports cheaper and imports more expensive, thereby reducing the trade deficit.

India’s Experience with Capital Account Liberalization

India has adopted a gradual approach to capital account liberalization since the early 1990s, triggered by the 1991 BOP crisis. The Tarapore Committee (1992, 1996, 2006) recommended full capital account convertibility, but with certain preconditions, including a comfortable level of foreign exchange reserves, a cap on the current account deficit, and a healthy fiscal consolidation.

India has liberalized several aspects of the capital account, including:

  • FDI: Significant liberalization of FDI norms across various sectors.
  • FII: Allowing FIIs to invest in Indian equity and debt markets.
  • ECB: Easing restrictions on external commercial borrowings by Indian companies.

However, full convertibility has been deferred due to concerns about macroeconomic stability, particularly the potential for volatile capital flows (the “sudden stop” phenomenon). The Asian Financial Crisis (1997-98) highlighted the risks associated with rapid capital account liberalization.

Recent Trends and Challenges

In recent years, India has experienced fluctuating capital flows. While FDI inflows have remained relatively stable, FII flows have been more volatile, influenced by global economic conditions and investor sentiment. The Russia-Ukraine war and subsequent global economic slowdown led to significant FII outflows in 2022, putting pressure on the Indian Rupee. The Reserve Bank of India (RBI) intervened in the foreign exchange market to manage volatility and maintain stability.

Challenges to full convertibility include:

  • Macroeconomic Vulnerability: India’s relatively high fiscal deficit and current account deficit make it vulnerable to sudden reversals in capital flows.
  • Financial Sector Development: The Indian financial sector needs further strengthening to handle the risks associated with large capital flows.
  • Regulatory Capacity: Effective regulation and supervision are crucial to prevent speculative activities and maintain financial stability.

The Way Forward

A cautious and calibrated approach to capital account liberalization remains the most prudent strategy for India. Prioritizing macroeconomic stability, strengthening the financial sector, and enhancing regulatory capacity are essential preconditions for further liberalization. Focusing on attracting long-term, stable capital flows, such as FDI, is preferable to relying on volatile short-term flows. Continued monitoring of global economic developments and proactive risk management are crucial to navigate the challenges of capital account liberalization.

Conclusion

In conclusion, capital account convertibility can play a significant role in controlling India’s current account deficit by attracting foreign investment and financing the gap. However, India’s experience demonstrates the need for a gradual and cautious approach, prioritizing macroeconomic stability and financial sector development. While full convertibility remains a long-term goal, a pragmatic strategy focused on attracting stable capital flows and managing risks is essential for sustainable economic growth.

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.

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Additional Resources

Key Definitions

Balance of Payments (BOP)
A systematic record of all economic transactions between the residents of a country and the rest of the world over a given period.
Foreign Direct Investment (FDI)
An investment made by a company or citizen of one country into the business interests located in another country.

Key Statistics

India’s current account deficit widened to 2.8% of GDP in FY23.

Source: RBI Report on Development of the Indian Economy (2023-24)

India received USD 84.835 billion in FDI during the financial year 2022-23.

Source: Department for Promotion of Industry and Internal Trade (DPIIT), Government of India (as of knowledge cutoff)

Examples

East Asian Financial Crisis (1997-98)

The rapid liberalization of capital accounts in Thailand, Indonesia, and South Korea without adequate regulatory frameworks contributed to the severity of the crisis, demonstrating the risks of premature convertibility.

Frequently Asked Questions

▶What are the risks of sudden capital outflows?

Sudden capital outflows can lead to a depreciation of the domestic currency, increased inflation, and a decline in economic activity. They can also trigger a financial crisis if the country has a large external debt.

Topics Covered

EconomyInternational RelationsBalance of PaymentsForeign ExchangeEconomic Policy
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