Model Answer
0 min readIntroduction
Capital account convertibility (CAC) refers to the free flow of financial capital in and out of a country, without restrictions on the exchange rate. It is a crucial step towards integrating with the global economy, but also carries risks like volatility and financial instability. India has adopted a cautious approach towards CAC, recognizing both its benefits and potential drawbacks. The Tarapore Committee, constituted by the Reserve Bank of India (RBI), played a pivotal role in formulating a roadmap for achieving CAC, with two separate committees established in 1997 (Tarapore I) and 2006 (Tarapore II) to reassess the situation and refine the recommendations.
Defining Capital Account Convertibility
Capital account convertibility implies the removal of restrictions on the inflow and outflow of capital, encompassing foreign direct investment (FDI), portfolio investment, external commercial borrowings (ECB), and resident’s remittances. It essentially allows residents and non-residents to freely invest and transact in financial assets across borders. There are two main types: full convertibility (unrestricted flows) and partial convertibility (some restrictions remain). India currently operates under a regime of managed/partial convertibility.
Tarapore Committee I (1997) Recommendations
The first Tarapore Committee, chaired by S.S. Tarapore, was set up in 1997 to formulate a framework for capital account liberalization. The committee identified several pre-conditions that needed to be met before full capital account convertibility could be implemented. These were:
- Fiscal Consolidation: Reducing the fiscal deficit to 3% of GDP.
- Inflation Control: Bringing down inflation to 3-5%
- Current Account Deficit: Maintaining a current account deficit of less than 3% of GDP.
- Gross Non-Performing Assets (NPAs): Reducing gross NPAs of Public Sector Banks to 3% or less.
- Risk Management: Strengthening the financial system and improving risk management capabilities.
- Legal Framework: Developing a robust legal framework for debt recovery and corporate governance.
The committee recommended a three-year timeframe for achieving full capital account convertibility, contingent upon fulfilling these pre-conditions. It proposed a phased liberalization approach, starting with trade-related capital flows, then moving to investment-related flows, and finally to current account convertibility.
Tarapore Committee II (2006) Recommendations
The second Tarapore Committee, also chaired by S.S. Tarapore, was constituted in 2006 to review the progress made towards capital account liberalization and to revise the recommendations in light of the changed economic scenario. This committee acknowledged that while some progress had been made, the pre-conditions set by the first committee had not been fully met.
Key recommendations of the Tarapore Committee II included:
- Relaxation of Pre-conditions: The committee relaxed some of the pre-conditions, recognizing that achieving them fully might be unrealistic. It suggested a more flexible approach, focusing on maintaining macroeconomic stability rather than adhering to rigid targets. For example, it suggested a fiscal deficit target of 3.5% of GDP.
- Sequencing of Liberalization: It emphasized the importance of sequencing the liberalization process, prioritizing areas where the risks were lower.
- Monitoring and Surveillance: Strengthening monitoring and surveillance mechanisms to identify and manage potential risks associated with capital flows.
- Development of Derivatives Market: Developing a deep and liquid derivatives market to hedge against exchange rate risk.
- Increased FDI Limits: Raising limits on foreign investment in various sectors.
The committee proposed a roadmap for achieving full capital account convertibility within five years, subject to continuous monitoring of macroeconomic conditions and financial sector stability.
Comparative Analysis: Tarapore I vs. Tarapore II
| Feature | Tarapore Committee I (1997) | Tarapore Committee II (2006) |
|---|---|---|
| Fiscal Deficit Target | 3% of GDP | 3.5% of GDP |
| Inflation Target | 3-5% | 3-5% (maintained) |
| Current Account Deficit Target | Less than 3% of GDP | Less than 2.5% of GDP |
| NPAs Target | Less than 3% | Less than 3% (maintained) |
| Approach | More rigid, focused on strict adherence to pre-conditions | More flexible, emphasizing macroeconomic stability and risk management |
| Timeframe | 3 years | 5 years |
The shift in recommendations reflects the evolving understanding of the Indian economy and the global financial landscape. The second committee recognized the challenges in meeting the stringent targets set by the first committee and advocated a more pragmatic approach.
Conclusion
Both Tarapore Committees provided valuable insights into the complexities of capital account convertibility. While full convertibility remains a long-term goal for India, the cautious and phased approach advocated by these committees has helped to mitigate the risks associated with liberalization. The emphasis on macroeconomic stability, financial sector development, and robust risk management remains crucial for successfully navigating the challenges of integrating with the global financial system. The current global economic uncertainties necessitate a continued cautious approach, prioritizing stability over rapid liberalization.
Answer Length
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