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5 things to know about capital account convertibility
In the last few weeks, the idea of full capital account convertibility has gathered force. This was especially since the Reserve Bank of India Governor Raghuram Rajan spoke about the need for full convertibility.
It may sound like a complex issue, but is not. Here are five points that explain the concept of full capital account convertibility:
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What is capital account convertibility:
If you have ever considered buying equity or property abroad, you would know there are limitations. Mostly, this deals with how much rupees you can convert into dollars. This is because India's capital account is not completely free.The capital account is like a ledger-it accounts for all the transactions related to assets between India and other countries. This includes all kinds of investment assets like shares, debt, and property, or even corporate assets like the goods produced by an Indian subsidiary of a foreign company. When foreigners purchase assets in India, the money is treated as capital inflows. Currently, there are limitations to how much capital can flow in and out of the country. So, India's capital account is only partially convertible. When there are no restrictions, our capital account would be fully convertible.
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Why it matters:
The capital account is very important, especially for the rupee as well as the Indian market. For example, foreign capital inflows are a big reason why our stock market is flourishing. Every day, scores of foreign investors buy Indian shares, which fuel the Sensex to touch new lifetime highs. On the other hand, a sudden drop in foreign inflows-when FIIs sell Indian assets-can lead to a market crash or rupee fall like it happened in 2013. Capital flows also affect the economy. When foreign companies set up subsidiaries in India and produce goods locally, it adds more jobs, improves productivity and spreads technological knowledge. So, capital flows-of all kinds-have a varied, but definite impact.
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Benefits of full convertibility:
There are a number of benefits. For starters, a free capital account would make the rupee fully convertible. This can reduce the cost of transactions and allow them to be conducted at a faster pace. Ease of access is always good for the industry. Secondly, it will allow global capitals to move freely. This allows developing countries to access more money for investments, RBI Executive Director, G Padmanabhan, said in a speech recently. This in turn helps improve savings and investments within the country; allows companies to borrow at cheaper rates, and thus accelerate growth. Moreover, the threat of FII sell-off can often force governments to take the right decisions like narrowing fiscal deficit (the amount government borrows from the market).
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Risks of full convertibility:
Yet, there are many risks of full convertibility. Many argue that capital flows are not always productive, according to the RBI executive director. For example, if foreigners are investing in a country only for tax-savings, then the flows may not lead to increased productivity and growth. Second, it increases exposure to the risk of sell-off. "Any deterioration in fiscal conditions, inflation management, balance of payments, or any other macroeconomic shock may cause a cessation or reversal of capital flows," the RBI executive director said in his speech. Third, many argue that a free capital account was not necessary for high growth in countries across the world, G Padmanabhan said. This means a limited convertibility is more than enough to ensure growth while also limiting the risks. Lastly, an open capital account can lead to drastic volatility in the rupee exchange rate.
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Is India ready?
Full capital account convertibility is 'inescapable' for the Indian economy, according to the RBI executive director. This is because the Indian economy cannot remain isolated due to capital controls in a globalised world. This may even prove counterproductive, G Padmanabhan said. First, it will be more difficult to maintain closed capital accounts. More investors would try to bypass the restrictions, defeating its purpose. Secondly, free capital account needs two key factors - low inflation and little overspending by the government. India is on the right path with respect to both. So, India should look to open the account and concentrate on controlling the risks, according to the RBI director.
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Is India ready for full Capital Account Convertibility? Read the RBI Executive Director's speech here. Read more
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The model backed by IMF has been to have a liberal capital account, an independent monetary policy, forgoing, out of the Impossible Trinity, a managed exchange rate in favour of a market-determined, or floating, one Read more
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$28.8 billion
India saw inflows worth $28.8 billion through the Foreign Direct Investment (FDI) route in 2014-15, 40% more than the previous year. However, while the growth is significant, Indian FDI inflows account for only 3% of the total FDI investments around the world, according to a Business Line report. China received a whopping $128 billion in investments, while Brazil and Singapore saw inflows of $62 billion and $81 billion respectively.
