They were the early days of 1991 when severe macroeconomic imbalances shadowed India’s Balance of Payments. Plummeting of forex reserve was coupled with macroeconomic instability which is now a tale of an economic ordeal – The 1991 Crisis. One thing we learned was to get away with the silos and globalize. Globalization called for currency convertibility, which the government, by 1994, partially allowed in the current account. Capital Account was still a matter of apprehension and reluctance, a fear which is still not allayed. In simpler terms, Capital Account Convertibility (CAC) refers to the freedom of converting domestic currency to a foreign currency for capital account transactions. Post globalization, India embraced current account convertibility but the capital account was still in the queue. In the final years of the last century, the initial fruits of 1991 reforms were ripening with economic variables clawing back and IMF was ‘those days’ championing CAC. With these two ingredients settling, the debate for CAC in India attracted momentum. In the same light, Tarapore Committee (1997) was set up to discern the validity of the teeming debate. The committee highlighted a 3 staged implementation by 2000 since CAC is not an event but a process that requires fundamentals right. With central bankers still contemplating, economies like South Korea and Indonesia confronted massive capital outflow flights. These economies had prematurely implemented CAC and faced the brunt. With the observation that CAC runs in both directions, the Indian economy resorted to backfoot. By 2005, the fruits of 1991 reforms were even sweating with stocks on an upward trajectory, commodity boom, and growth rate approaching 10%. The boom phase caused Banks to practice evergreening of debt, of which NPA’s are a gift we still enjoy. With conditions again ripe, chatters of CAC were back in the field, this time government was likely resolute to implement. Again, a committee was set up (Tarapore Committee 2006) which reiterated that CAC is a process and not an event. For the process, fundamentals should be right – well-controlled fiscal deficit, a degree of financial competitiveness of banks and corporates, controlled inflation, no presence of revenue deficit, and political stability. The government embarked upon the process to get the fundamentals in place, but then the 2008 Sub-prime Crisis poured cold water on the hopes. Advocates of CAC slipped into a slumber and government again on backfoot. So, Capital Account Convertibility is not a new jargon but an aspiration still unfulfilled. But the question is, why the debate is again alive in the pandemic? Probably because India is boasting of all-time high foreign exchange reserves! With 22,5251 million US Dollars of FDI in the first quarter of Financial Year 2021 – 22, the future seems bright for foreign investments in India. The quantum of foreign investment inflows in the form of FDI’s and FPI’s are encouraging and succoring the debates for CAC in India. But at this juncture, when the economy is still not firing on all cylinders after the pandemic shock, won’t it be impetuous?
The prerequisites for CAC were well elucidated by the Tarapore Committee in 2006 – macroeconomic stability with fiscal discipline, sufficient degree of global competitiveness of corporates and banks, clarity in-laws, inflation checked, and no presence of revenue deficit. Fiscal discipline is still left to be achieved and FRBM bears strong testimony. The FRBM requirements are not met even once since its inception and the act is amended every time near the deadline. Other prerequisites also do not seem in their ideal positions. Thus, CAC will be implemented, it has to be, but the time is still under the shadows. Capital Account Convertibility seems enticing for the potential investors, the corporates, and the financial sector. CAC promises greater and deeper integration with the international financial circles and effectuates borderless economies. The corporate sector can have access to large funds through foreign markets and that too at lower interest rates. Reduction in capital costs eventually ends up translating itself into consumer benefit with lower market prices. Apart from lower borrowing costs, the financial sector and the corporates can have international security holdings which might promise higher returns both in the long and short run. The potential and active investors will have access to the international market thus greater financial integration. CAC effectuates borderless economies and clears the impediments for foreign investments. With the advantages being said, global competitiveness seems to benefit with CAC. Banks and corporates might have potentially great opportunities still under the dark. But the fear and apprehension for CAC are also justified, at least for economies like India. The examples of east Asian economies which faced the brunt of outflow flights highlight the vital fact, that CAC runs in both directions and specifically in the direction of economic performance. In the days of boom, CAC might promise quantum of investment inflows but in the days of economic gloom, CAC might cause outflow flights as seen in the East Asian economies. This situation turns even acute when the fundamentals are not in place. Free convertibility has the potential to instigate cost-push inflationary pressure in the economy. Apart from inflation, it might lead to currency depreciation beyond the comfortable range – Real Effective Exchange Rate (REER). Moreover, the advantages are short-lived, in developing economies, and to add a feather in the cap, there is no U-Turn after implementation. Another big fear not allayed pertains to the impossible trinity. A central bank cannot manage three crucial variables at the same time, they are – Inflation, Exchange Rate, and Capital Outflow. We observed that CAC can severely affect all of the three and in times of bad luck, all the three together. At that juncture, the monetary or fiscal policy fails to manage the situation which translates itself into crisis first and economic crash eventually. CAC is still restricted to prevent the impossible trinity brunt.
With India boasting of all-time high forex reserves and economic variables resorting themselves towards the normal, Capital Account Convertibility seems like a reality soon. With the high-net-worth individuals, using illicit means to invest abroad and carry out restricted capital account transactions, the question is, why not give a statutory green signal and avoid the frequent embarrassments like Pandora Paper Leak. But the implementation is crucial. Off-the-cuff implementation won’t take long to translate into catastrophe, getting the fundamentals back on track and creating a conducive investment environment at all levels is the primary concern before luring the foreign investors with their money pools to dive into the Indian market.
The views expressed in this article are the author's own.