Capital Account Convertibility (CAC): Opportunities and Challenges
May 31, 2006 New Delhi
Messages emerging from the Conference
Capital account convertibility is a welcome goal, but we need to tread on this path with
care. This was the dominant view that emerged from a vibrant discussion on the issue
by a group of eminent economists, forex experts, corporates and SMEs in the
Conference organized by ASSOCHAM on “Capital Account Convertibility (CAC):
Opportunities and Challenges”.
Challenges Relating to CAC
India has made considerable progress on the macroeconomic front in the recent years.
However, the sustainability of our current economic strength may be questionable both
on account of domestic as well as international factors. The combined fiscal deficit of
the Centre and States at around 7.7% (Centre contributing 4.1% and the rest, of the
States) is still a cause of concern while the ratio of public debt to GDP has increased
from under 65% in 1997-98 to over 83% in 2005-06. There are states whose financial
condition is not sound on account of high public debt, unproductive expenditure and
much desired need for improved governance.
The poor state of infrastructure can be a stumbling block for higher GDP growth. India
needs investment of over USD 1.50 trillion in the next five years to sustain 8% growth.
The government needs to create necessary environment and improve the current
regulatory framework to attract investments in infrastructure. India can also take a cue
from the Chinese economic model to build a credible infrastructure that spurs
manufacturing and employment intensive industries.
As regards international trade, though India is the 4th largest economy in the world in
terms of purchasing power parity (PPP), its share in global trade is abysmally low at
less than 1.5%. Government policy needs to be directed towards greater participation in
global trade of goods and services.
Capital controls can be useful in insulating the economy from volatile capital flows
during transitional periods and in providing authorities time to pursue discretionary
domestic policies to strengthen initial conditions. India’s progressive structural reforms
have liberalised foreign investment in many sectors and markets. Restrictions effectively
exist on external commercial borrowings and that too mainly in the short end of the
maturity spectrum; and on portfolio flows, which are limited to Foreign Institutional
A systemic crisis in the banking sector may occur through a sharp deterioration in the
risk-adjusted lending portfolios of domestic banks as prime borrowers shift to lower cost
international debt upon liberalisation of the ECB restrictions. This can also adversely
impact domestic savings. Over-borrowing abroad results and makes the financial
system more fragile. Controls can go fully when correct incentive structures are in place
in the domestic economy to induce responsible behaviour. Cleansing the banking
system to gain confidence that capital inflows would be efficiently intermediated to
profitable investment destinations and correlated with the social returns to such
investment, is a pre-requisite.
There is another risk of excess inflows. If CAC were to be implemented now, India may
attract such large capital inflows with the result that the system may move into
disequilibrium with the economy’s inability to absorb such large flows in a short span of
time. Excessive inflows of capital cause exchange rate appreciation and thereby affect
the competitiveness of the host country in the international goods market, on the one
hand, and widen the trade deficit by increasing imports, on the other. RBI’s intervention
to avoid these effects will have an adverse impact on independent monetary policy
operation. Foreign capital influx because of growth expectations can suddenly turn to
capital flight if growth collapses or overheating occurs. Policy administration has to
maintain a fine balance of such influx by efficiently regulating exchange rate, liberalizing
Foreign exchange reserves:
India’s current foreign exchange reserves have crossed the milestones set by Tarapore
in 1997-98. However, the economy has witnessed globalisation over the last 7-8 years
with the result that foreign capital can move in and out of the system more easily. Our
reserves, as a proportion of GDP, are considerably lower than those of many other
Asian countries. Foreign exchange reserves have to be larger to cover a potential
outflow, not just of foreign short-term debt but also of domestic savings.
Although India has achieved credible development of financial system over the last 15
years, substantial work is still required to make the architecture robust enough to cope
with new market dynamics post implementation of CAC. Our prudential norms,
effectiveness of regulation and institutions need to be further strengthened before
liberalising the capital account. Our equity market is fairly developed but debt market
and interest rate derivatives leave much to be desired. Free inflows are allowed into
equity but not private debt. This is because corporate debt market lacks depth as well
as breadth and any big flow of capital can cause yields to drop sharply making conduct
of monetary policy difficult. Corporate debt market has to be liberalised in a phased
manner allowing investments from foreign funds. A healthier debt market will be better
equipped to handle large swings in capital flow as it would not create excessive volatility
The Securities and Exchange Board of India’s (SEBI) preparation of new norms for
private placement and listing of debt is a welcome move. Nevertheless, markets may
take a couple of years to fully utilise the benefits of implementing the framework.
Subsequently, RBI may progressively relax norms for FII investment in Indian debt in a
staggered fashion. It is expected that RBI’s larger objective will be to gradually move
away from holding excess dollars and prepare corporates and individuals to hold and
manage foreign exchange assets.
In the light of aforesaid analysis of benefits and limitations of implementing CAC at this
stage of development in India, the broad consensus was that although the country has
come a long way in its pursuit of reforms, our economic framework needs to be made
more robust to withstand and fully exploit the opportunities thrown up by CAC.
To sum up, the views of the house can be reflected in terms of recommendations, as
1. CAC must be pursued as a long term goal, and should not be rushed into.
2. Adequate attention must be given to keep fiscal deficit under check. The
rules of the FRBM Act need to be sufficiently internalized. Stringent
discipline in public expenditure is a sin qua non to ensure that capital
inflows do not provide an easy way of perpetuating what is ultimately
3. Forex and interest markets must be gradually liberalised through more
sophisticated hedging instruments.
4. Steps must be in place to control money laundering.
5. For the desperately poor a social security net is needed, as increasing
competition can mean greater and unexpected hardship.
6. Gross inequalities in the system, such as charging SMEs much higher
rates than large corporates, need to be smoothened. In other words,
a scientific credit appraisal system needs to be instituted.
7. Increasing domestic production and further improving current account
convertibility demand greater focus and attention.
8. Regulatory bodies like the RBI and SEBI need to be strengthened so that
pursuit of an inflation target remains the Central mandate of RBI and the
banking sector can upgrade their performance; and
9. Most importantly, the government must ensure that it attracts longer term
capital like FDI before it widens the door for volatile flows like FIIs and