Capital Account Convertibility: A Double-Edged Sword for India

Capital Account Convertibility (CAC) means domestic currency can be exchanged for foreign currencies and vice versa with regard to investing activities such as foreign direct investment, portfolio investment, and external commercial borrowing. In India while the current account remains completely convertible, capital account is only partially convertible.

Some Advantages of Full Convertibility of Capital Account:

Heightened Globalization: A fully obtainable CAC would lead to huge amounts of FDI, thus boosting economic growth and creating more jobs. It also enhances trade as well as financial flows, thus making the country’s economy more globalized.
Financial Efficiency: Full liberalisation of the capital account means that other countries would open up the competitive environment within which the local businesses in the economy operate. This may lead to innovation and even reduction in the capital cost which will in turn improve the financial efficiency and growth potential of the region.

More investment options: There will be a chance for the Indian resident to invest more in foreign securities by more volatile portfolios enhancing returns on investment, as a result, the Indian economy will improve in global investments performance.

In CAC Risi’s Investment Portfolio diversification: In full CAC, Investors would follow country risk diversification strategy as a measure of hedging their investment risks whilst investing in different asset classes.

Disadvantages of Full Capital Account Convertibility:

The element of volatility that comes with movements of capital flows cause a sudden and unexpected change in financial resources resulting in an unstable exchange rate and an unsound financial regime, which most of the times works against economic progress and creates volatility in operational activities of the firms.
Enhanced Management of Economic Shocks: External economic shocks like the global financial crisis are more likely to affect the economy of India.

Capital outflows may be a factor during recession, which may lead to depreciation of the rupee and also depletion of FOREX reserves.

Need for Strong Regualtory Framework: Achieving close to full cac tolerance will not evade the need for a regulatory or policy design that aims at mitigating risks posed by speculative behaviours and laundering of funds.

Prerequisites for Completion of Capital Account Convertibility:

The Tarapore Committee had identified a number of factors which need to be addressed before applying full CAC back in the day when there was a lot of controversy in enabling the capital account liberalization of India.

Fiscal Discipline: Ideally, the economy should be able to manage a little budget deficit without affecting overall psychological equilibrium of the management.
Price Stability: There is need for the economy to ensure that the levels of inflation do not become rampant in the economic setup.
Have adequate capital and efficiency levels of operations in the banking sector so as to avoid any losses into the financial systems.
There is also a credible infrastructure to govern the financial matrix and the interests of the players are safeguarded.

For the all those advantages that come with the surrender of the capital account, there exist also a number of difficult issues that need to be addressed first. Step by step, India’s capital account has been opened. And while one would argue that a careful approach is necessary in order to assess the costs and benefits associated with such a move, these considerations cannot be ignored. Nevertheless, once the prerequisite and adequate safeguards are in place, it is possible for India to realize the full gains from a risk bearing capital account closure.