Thoughts on the Indian Economy

Thinking about assorted economic issues in India.

Monday, March 27, 2006

Capital Account Convertibility

Prime Minister Manmohan Singh has appointed the Tarapore Committee to design a roadmap to put India on the path to full capital account convertibility (CAC).

Let's get some basics on CAC straight. Full CAC means that individuals and corporations will be able to convert rupees to dollars (or some other foreign currency) freely wihout any limits or permission from the central bank-- the Reserve Bank of India (RBI). Under current regulations, an individual can only engage in transaction upto $25,000/year and companies also have limits in amounts they can invest without any permission. If full CAC is implemented then, people and businesses (Indian and foreign) can invest in each other's stock-markets, take loans and do foreign direct investment, no holds barred. Right now, India has full current (not capital) account convertibility only. This means that when it comes to export or import that is, payments in the trade sector, there are no limits or permission required. By going to CAC, the financial sector will also be free of any restriction.

Economist who favor full convertibility argue that restrictions on capital transactions create costs. By being able to invest wherever they want, companies or individuals can diversify their portfolios and spread risk optimally. In a world with capital controls, the distribution of capital ends up inefficient (i.e not where it is earning its highest return). Moreover, proponents say, protecting domestic financial markets also leads to irresponsible macroeconomic policies. That is, if the financial markets are playing watchdog to the government, there is less likelihood of inflationary policies (to put it in the crudest of terms-- the government is not going to print money to service its debt).

Opponents of full CAC emphasize the dangers of financial crises associated with no controls. The East Asian crisis of the 1990s is the most recent in memory. Basically, with CAC, there is no control on the inflow and outflow of investment especially short-term investment. So, much of a country's markets are subject to the whims of investors. And we all know how speculative the stock market can be, how quickly crashes happen and thus how a crisis can develop if one big foreign investor decides that its capital is better invested somewhere else. The risk of a crisis is enhanced when a country's financial system is not fully developed. For example, if banks are giving out a lot of bad loans, then the risk of cris is exacerbated. Also, heavy inflow of foreign currency can lead to an appreciation of the domestic currency which hurts exports and this is an important issue for export-oriented economies.

Starting to think about full capital account convertibility is a good step for India, but the reform process is not at a stage where full CAC should be implemented in the near future. Indeed India is in a very good macroeconomic position (with a stockpile of foreign exchange reserves) but full CAC is a path strewn with dangers, and policymakers must tread carefully.


Blogger Ankur said...

hmm.. two things:
1. i wonder what is the political game behind this announcement. Esp, the manner in which it was done raises quite a few eyebrows. the last committee (in 1997, i think) was formed an year after the announcement. this time it was hardly 2-3 days! everything doesnt really smell right. (and not necessarily in a negative way).
2. on a more theoritical note, how _exactly_ can one measure the level/ability of "institutions" in India? because CAC's progress should depend on the percieved evolution of these institutions yeah?

6:21 AM  
Blogger Ankur said...

This comment has been removed by a blog administrator.

6:21 AM  
Blogger Ishani said...

1. In terms of political motivations, I think one could be that India has always been cozy with the IMF. Many of the economic policymakers have done a stint at the Fund. IMF tends to be a proponent of capital market liberalization. But it is hard to say if there is any "political game" as such. Actually, Chindabaram announced today that full CAC is not possible till at least 2009.

2. In terms of "institutions" relevant to CAC, one could be an independent central bank. A central bank that does not bow to pressures of the government to finance its debt thus causing inflationary pressures. Financial institutions like a strong banking sector that evaluates risk well and makes healthy loans is important to CAC as well.

2:37 PM  
OpenID Allen Miller said...

Capital account convertibility will head for a scenario where violent swings in interest and exchange rate are possible.

Capital Accounts Collection

8:24 PM  
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