Time to Revisit

Time to Revisit

The Indian economy is booming, stock markets are buoyant, homegrown entrepreneurs are spreading their wings, exports are growing, and consumerism is rising. In this scenario, it is definitely worth revisiting the issue of full Capital Account Convertibility (CAC). Most likely, CAC would improve the business environment, giving Indian industry access to lost-cost capital and the economy more options for asset allocation, bringing in higher inflows and improving the confidence level among foreign investors.

But is the time right?

When Global imbalances are worsening, commodities are in strong bull cycle, interest rates are rising all over the globe, inflation is looming and asset markets sky rocketing, will introduction of full CAC will bring desired results?

Answer lies in India’s approach…

Though RBI is revisiting the issue of capital account convertibility again after 1997, it will still favor a phased roll out of full CAC in India – probably a time horizon of next 3-4 years- due to its concerns over inflation, quality of credit growth, rising interest rates and some asset markets. The finance minister too does not foresee a full convertibility of rupee before 2009 when India’s revenue deficit could have been be wiped out and fiscal deficit could have been brought down to 3%.

The things have changed.

The fundamentals of Indian economies has changed significantly since RBI first appointed S S Tarapore Committee in 1997 to study Capital Account Convertibility (CAC) issue taking guidance from 1997 Union Budget Speech. At that time, the GDP was growing at lackluster pace of 5% against 8.1% projected for 2005-06. The center’s gross fiscal deficit was also hovering around 5% against 4.1% today. Compare to foreign exchange reserve of USD 26 billion (covering 7 month import) in 1997; India’s foreign exchange reserve currently stands at more than USD 150 billion. Non-performing assets of banks, then at double digits (~14% in 1997) too have come down to below 5% today and to allow greater flexibility to banks the Cash reserve ratio has been lowered from 9% in 1997 to 5% in 2005.

India’s manufacturing exports has also grown from USD 35 billion in 1997-98 to USD +100 billion in 2005-06 whereas its IT & related services exports has grown from less than USD 2 billion in 1997-98 to USD +23 billion in 2005-06. Not only that, India has emerged as one of the most significant global players in IT/ ITES related exports. India is also gaining momentum in manufacturing exports mainly in the areas of Textiles, Auto ancillaries, Engineering and Specialty chemicals. India’s +1 billion population, with young age bias, rising income & growing middle class have also fueled consumption led growth making Indian economy more resilient.

Though in 1997 Tarapore Committee came out with a report laying pre-conditions for CAC by year 1999-2000, the issue of CAC was put on the back burner due to precipitation of financial crisis in South East Asia soon after (blamed to CAC of those countries). Recently RBI has again appointed a committee to set out the framework for fuller CAC, in response to the government’s declaration of revisit the CAC issue. Due to significant improvement of India’s macro fundamentals, most of the pre-conditions laid by 1997 Tarapore committee has already been achieved. (See “Road Map to CAC”)

Progress so far

Though East Asian Crisis put the government’s plan to adopt full CAC on hold, India has achieved a significant progress towards partly CAC since 1997.some of the measures recommended by Tarapore Committee in 1997.For, example, Tarapore Committee recommended that Indian Corporates should be allowed to invest up to USD 50 million in direct investment abroad, where as per present guideline, Indian Corporates can make overseas investments up to 200% their net worth under automatic route. And see the way this facility is used by Indian corporates today: Just in one quarter (first quarter of 2006), Indian companies have acquired more than USD 3 billion worth foreign entities. The overseas borrowings / fund raising by Indian corporates have also been liberalized up to certain extent but with few restrictions like overall cap, company level cap, minimum maturity, and end use. The FDI route is also now open for most of the sectors (retail trading, atomic energy, lottery business, gambling, agriculture and plantations being exceptions) with sectoral cap on few sectors.

However, capital account is still restricted for banks and individual to a large extent. For individuals, there are caps on spending limits for various purposed like foreign travel, foreign education, overseas medical treatment, etc. Individuals too have limited options to invest in overseas assets as the annual limit is US$ 25,000 per individual for overseas investment. Banks are also not allowed to raise fund through ECBs and only allowed to borrow upto 25% of tier I capital that again with certain restrictions. Along with restrictions on borrowings, there are restrictions on assets side too with banks’s money market investment restricted to USD 10 million and debt market investment restricted to USD 25 million.

Why fiscal discipline is important

Success of CAC depends on balanced flow of forex, and for developing countries like India, it means attaining the right balance between exports and consumption led growth, and ensuring adequate investment in infrastructure and new capacities. (See “How India’s forex requirement is balanced”)

It has also become an imperative for India to invest continuously in infrastructure and capacities to attain the higher economic growth. India is relying on three main sources for its investment needs namely foreign investment, domestic savings, and government. Though foreign portfolio investment strong so far in India, foreign direct investment has not picked up compared to other Asian countries. Domestic savings were at 29.1% GDP in 2004-05 but due to strong consumption led credit off take, significant portion of domestic savings are diverted away from investment In this scenario, government’s role to fund India’s investment requirement, particularly in infrastructure sector, is very important. And that is where importance of fiscal discipline comes in to play. The large revenue deficit means increasingly borrowing to finance current expenditure of government rather than investing in growth. It holds the economy back by crowding out private investment, imposing heavy burden on the budget and using the resources that can be directed towards development needs. (See “How India’s Public debt/GDP compares with others”). That is why though our deficit has come down, our finance minister is also not foreseeing a full convertibility of rupee before 2009 when India’s revenue deficit could have been be wiped out and fiscal deficit could have been brought down to 3%(See “Central Government’s fiscal and revenue deficits”).


Experience of few emerging markets suggests that a move towards full CAC could result into large capital inflows and can trigger appreciation of the exchange rate. Strong inflows can definitely have positive effects on economic growth but it also requires a very healthy financial system. Two obvious benefits of a CAC will be reduction in cost of capital and access to larger capital for India corporate At a time when India requires an imnvestment of US$ 1.5 trillion over the next five years to accelerate its growth to +10% from the current 8%, higher capital flows are definitely welcome.

Full CAC will also allow Indian corporates having operations in multiple countries to effectively hedge their risks. Full CAC will also open overseas asset markets for Indian investors/companies thus can provide them with more options and better portfolio diversification. In fact with cross border integration of global markets, capital controls over longer periods are infact costly, ineffective and distortive. A gradual appreciation of Rupee coupled with removal of infrastructure bottlenecks and productivity increase will sustain India’s competitiveness in exports markets coupled with reduction in import bill thus having positive effect on the trade deficit. A gradual appreciation of Rupee will also have a positive effect on inflation and government’s oil subsidies as oil accounts for 30% India’s import. However there are certain external risks which India faces and can result into strong capital out flow (See “Factors that can spoil party”).


A full capital account convertibility will definitely be a welcome move that expected to result into larger inflows of foreign savings and investments at a time when India is needing it the most. But fiscal discipline and safeguards are needed to be in place before that happens.

by Manish Marwah

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