Model Answer
0 min readIntroduction
In the context of economic liberalization, the convertibility of a country’s currency is a crucial aspect of its integration with the global economy. Convertibility refers to the ease with which a country’s currency can be exchanged for other currencies. There are two main types: current account convertibility and capital account convertibility. India achieved current account convertibility in 1994, as part of its broader economic reforms. However, capital account convertibility remains a subject of debate and has been pursued cautiously. The Tarapore Committee-I, constituted in 1996, laid down a set of preconditions for moving towards capital account convertibility, aiming to ensure macroeconomic stability and prevent financial crises.
Current Account Convertibility vs. Capital Account Convertibility
Both current and capital account convertibility deal with the exchange of currency, but they differ significantly in what transactions they cover.
- Current Account Convertibility: This refers to the freedom to exchange currency for transactions related to trade in goods and services, income (like remittances), and unilateral transfers. India achieved current account convertibility in 1994, allowing residents to freely exchange rupees for foreign currency for legitimate current account transactions.
- Capital Account Convertibility: This involves the freedom to convert domestic currency into foreign currency for investment purposes – buying assets like stocks, bonds, and real estate, or making loans abroad. It allows for the free flow of capital in and out of the country. India has not fully adopted capital account convertibility, maintaining certain restrictions to manage capital flows.
The following table summarizes the key differences:
| Feature | Current Account Convertibility | Capital Account Convertibility |
|---|---|---|
| Transactions Covered | Trade in goods & services, income, unilateral transfers | Investment in assets (stocks, bonds, real estate), loans |
| India’s Status | Achieved in 1994 | Partially liberalized, not fully achieved |
| Impact on Balance of Payments | Affects the current account balance | Affects the capital account balance |
| Volatility Risk | Relatively lower | Higher, susceptible to speculative flows |
Preconditions for Capital Account Convertibility – Tarapore Committee-I
The Tarapore Committee-I (1996), headed by S.S. Tarapore, identified several preconditions that needed to be met before India could safely move towards capital account convertibility. These were categorized into three groups:
1. Macroeconomic Stability (Quantitative Preconditions)
- Fiscal Consolidation: The fiscal deficit should be reduced to 3% of GDP. This is crucial to ensure government debt sustainability and reduce the need for borrowing from external sources.
- Inflation Rate: The inflation rate should be brought down to 3-5%. Stable prices are essential for maintaining investor confidence and preventing capital flight.
- Gross Non-Performing Assets (NPAs): NPAs of Public Sector Banks (PSBs) should be reduced to 3% of their total advances. A healthy banking system is vital for absorbing shocks and channeling capital efficiently.
2. Financial Sector Strengthening (Structural & Regulatory Preconditions)
- Banking Sector Reforms: PSBs needed to be reformed to improve their efficiency, profitability, and risk management capabilities. This included recapitalization, improved governance, and adoption of international best practices.
- Development of Money and Bond Markets: Deep and liquid money and bond markets were considered essential for absorbing capital flows and providing alternative investment avenues.
- Strengthening of Regulatory Framework: The regulatory framework for the financial sector needed to be strengthened to effectively supervise and regulate capital flows, prevent speculation, and maintain financial stability. This included strengthening the role of the Reserve Bank of India (RBI).
- Tax Reforms: Rationalization of the tax system to enhance its efficiency and attractiveness for foreign investment.
3. Exchange Rate Management (Operational Preconditions)
- Managed Exchange Rate Regime: The Committee recommended a managed exchange rate regime, allowing for some flexibility while preventing excessive volatility. A freely floating exchange rate was considered too risky in the absence of strong macroeconomic fundamentals.
- Adequate Foreign Exchange Reserves: India needed to maintain adequate foreign exchange reserves (equivalent to at least 3 months of imports) to cushion against external shocks and manage capital outflows.
The Tarapore Committee-I emphasized that these preconditions were not merely targets to be achieved but were interconnected and mutually reinforcing. Progress on one front would facilitate progress on others, creating a virtuous cycle of macroeconomic stability and financial sector development.
Conclusion
Differentiating between current and capital account convertibility is fundamental to understanding India’s economic liberalization journey. While current account convertibility was achieved relatively smoothly, the cautious approach towards capital account convertibility, guided by the recommendations of the Tarapore Committee-I, reflects the inherent risks associated with large and volatile capital flows. Although some progress has been made in meeting the preconditions, achieving full capital account convertibility remains a complex challenge, requiring sustained macroeconomic stability, robust financial sector regulation, and effective exchange rate management. The evolving global economic landscape and the increasing integration of financial markets necessitate a continuous reassessment of India’s capital account liberalization strategy.
Answer Length
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