PROJECT REPORT ON

CAPITAL ACCOUNT CONVERTIBILITY

UNIVERSITY OF MUMBAI

MASTER OF COMMERCE
(Banking & Finance)
SEMESTER 3
2016-17

SUBMITTED BY

Name: KHUSHBOO ZAGADA

Roll No.: 10

PROJECT GUIDE
Ms. SHITAL MODY

K.P.B HINDUJA COLLEGE OF COMMERCE

315, NEW CHARNI ROAD, MUMBAI-400 004

M.Com (Banking & Finance)

 3rd SEMESTER

CAPITAL ACCOUNT CONVERTIBILITY

SUBMITTED BY
KHUSHBOO ZAGADA
Roll No.: 10

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 CERTIFICATE

This is to &certify
(Banking that Ms.
Finance) KHUSHBOO
Semester D. ZAGADA
3rd [2016-2017] of M.Com
has ACCOUNT
successfully
completed the Project on
CONVERTIBILITY under the guidance of CAPITAL
Ms. SHITAL MODY.

________________ ________________

Project Guide Co-coordinator

________________ ________________

Internal Examiner External Examiner

________________ ________________

Principal College Seal

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 DECLARATION

Ifinance,
Mr. / Ms.
3rdonKHUSHBOO
semester D. ZAGADA
(2016-2017), hereby student that
declare of M.com-Banking &
I have completed
the project CAPITAL ACCOUNT CONVERTIBILITY

The information submitted is true and original copy to the best of

our knowledge.

(Signature)
Student

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 CONTENTS

1. INTRODUCTION 6-7

2. CURRENCY CONVERTIBILITY 8-12

3. TRADE ACCOUNT CONVERTIBILITY 13-26

4. ADVANTAGES AND DISADVANTAGES OF 27-34

CAPITAL ACCOUNT CONVERTIBILITY
5. ROLE OF IMF IN CAPITAL ACCOUNT 35-36
CONVERTIBILITY
6. CONCLUSION 37

7. BIBLIOGRAPHY 38

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 Chapter 1
INTRODUCTION
Economic growth and development of a nation is always
coupled with the progress of its tradable sector. In times of
today all economies is finding themselves integrated to each
other in some or the other way through forces of liberalization
and globalization? In context of these sweeping
advancements capital account convertibility has been widely
persuaded by developed and developing countries around the
world. India too is persistently poignant on the path of
liberalization, by opening up its markets & loosening its
controls over economic & financial matters.
CAC refers to the freedom of converting local financial assets
into foreign financial assets & vice versa at market
determined rates of exchange. It refers to the elimination of
restraints on international flows of a countrys capital
Accounts facilitating full currency convertibility & opening of
the financial system.
Practically there is a mix & match of experiencing with the
countries those who have liberalized their capital account. All
developed countries have adopted full convertibility, but the
2008 crisis of USA & current turmoil of European Union have
raised several questions while China has written its success
story without full capital account convertibility. India has found
itself fairly successful in the matter with its gradualist
approach. Indias conduct & experiences with the liberalization
of capital account are the subject matter of elaboration.

Objectives of the Study

1. To study the concept of currency convertibility.
2. To study the trade account convertibility.
3. To study the journey and progress of Capital Account
Convertibility in India.
4. To understand the Role of IMF in Capital Account
Convertibility.

Methodology
This project is only concerned with the secondary data
collection such as book references, journals, articles, RBI
website, and other web links.

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 Significance of the Study
The findings of this study will redound to the benefit of the
society considering that capital account convertibility plays
an important role in an economy. It is fair to say that there is
widespread agreement that domestic financial as well as
capital account liberalizations are beneficial. Differences of
view typically arise about the scope, pace and sequence of
liberalization, not on its ultimate desirability.

Scheme of the Study

The scheme of the thesis is as follows: The first chapter
contains introduction, objectives of the study & methodology
of the study. In chapter II, Currency Convertibility is outlined.
In chapter III, Trade account convertibility is underlined which
consists of capital account convertibility and current account
convertibility. In chapter IV, Capital account convertibility in
India is highlighted. In chapter V, Role of IMF in capital
account convertibility is detailed.

Limitations of the Study

This study is concerned about the capital account

convertibility in India which also includes advantages and
disadvantages of CAC, Role of IMF for CAC in India.

This study does not cover the areas of other currency

convertibility other than India.

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 Chapter 2

CURRENCY CONVERTIBILITY

It is the ease with which a countrys currency can be

converted into gold or another currency. Currency
convertibility is the quality that allows one currency (or money
or other financial instruments) to be converted into another
currency (or other liquid stores of value).
International trade relies upon exchange of instruments
valued in different currencies (of different nations). So, it is
crucial for international trade and commerce. When a currency
is inconvertible, it poses a risk and barrier to trade with
foreigners who have no need of domestic currency (what
would they do with someone elses currency to their country
where it cannot be used!).
Factors Affecting convertibility
a. Availability of foreign currency reserves in a given country.
b. Domestic regulations seeking to protect local investors
from bad investment decisions in, say, a currency
undergoing a period of hyperinflation.
c. Overall policies of the government.

Advantages of Currency Convertibility:

Convertibility of a currency has several advantages

which we discuss briefly:
1. Encouragement to exports:
An important advantage of currency convertibility is that it
encourages exports by increasing their profitability. With
convertibility profitability of exports increases because market
foreign exchange rate is higher than the previous officially

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fixed exchange rate. This implies that from given exports,
exporters can get more rupees against foreign exchange (e.g.
US dollars) earned from exports. Currency convertibility
especially encourages those exports which have low import-
intensity.
2. Encouragement to import substitution:
Since free or market determined exchange rate is higher than
the previous officially fixed exchange rate, imports become
more expensive after convertibility of a currency. This
discourages imports and gives boost to import substitution.
3. Incentive to send remittances from abroad:
Thirdly, rupee convertibility provided greater incentives to
send remittances of foreign exchange by Indian workers living
abroad and by NRI. Further, it makes illegal remittance such
hawala money and smuggling of gold less attractive.
4. A self balancing mechanism:
Another important merit of currency convertibility lies in its
self-balancing mechanism. When balance of payments is in
deficit due to over-valued exchange rate, under currency
convertibility, the currency of the country depreciates which
gives boost to exports by lowering their prices on the one
hand and discourages imports by raising their prices on the
other.
In this way, deficit in balance of payments get automatically
corrected without intervention by the Government or its
Central bank. The opposite happens when balance of
payments is in surplus due to the under-valued exchange rate.
5. Specialisation in accordance with comparative
advantage:
Another merit of currency convertibility ensures production
pattern of different trading countries in accordance with their
comparative advantage and resource endowment. It is only
when there is currency convertibility that market exchange
rate truly reflects the purchasing powers of their currencies
which is based on the prices and costs of goods found in
different countries.
Since prices in competitive environment reflect that prices of
those goods are lower in which the country has a comparative
advantage, this will encourages exports. On the other hand, a
country will tend to import those goods in the production of
which it has a comparative disadvantage. Thus, currency
convertibility ensures specialisation and international trade on

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the basis of comparative advantage from which all countries
derive benefit.
6. Integration of World Economy:
Finally, currency convertibility gives boost to the integration of
the world economy. As under currency convertibility there is
easy access to foreign exchange, it greatly helps the growth of
trade and capital flows between the countries. The expansion
in trade and capital flows between countries will ensure rapid
economic growth in the economies of the world. In fact,
currency convertibility is said to be a prerequisite for the
success of globalisation.

EXTERNAL AND INTERNAL CONVERTIBILITY

When all holdings of the currency by non-residents are freely

exchangeable into any foreign (non-resident) currency at
exchange rate within the official margins, then that currency is
said to be externally convertible. All payments that residents
of the country are authorized to make to non-residents may
be made in any externally convertible currency that residents
can buy in foreign exchange markets. If there are no
restrictions on the ability of the country to use their holdings
of domestic currency to acquire any foreign currency and hold
it, or transfer it to any non-resident for any purpose, that
countrys currency is said to be internally convertible currency.
Thus external convertibility is the partial convertibility and
total convertibility is the sum of external and internal
convertibility.
Non convertible currency is also known as a Blocked
Currency. It refers to any currency that is used primarily for
domestic transactions and is not openly traded on forex
market. This usually is the result of government restrictions,
which prevent it from being exchanged for foreign currencies.
As the name implies, it is virtually impossible to convert a
nonconvertible currency, into other legal tender, except in
limited amounts on the black market. When a nations
currency is nonconvertible, it tends to limit the countrys
participation in international trade as well as distort its
balance of trade. Thus it is unable to acquire the foreign
capital it needs to achieve improvements in productivity,
income and human welfare among its people.

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Almost all nations allow for some method of currency
conversion; Cuba and North Korea are the only exceptions.
They neither participate in the international forex markets nor
allow conversion of their currencies by individuals or
companies. As a result, these currencies are known as blocked
currencies; the North Korean won and the Cuban national peso
cannot be accurately valued against other currencies and are
only used for domestic purposes and debts. So obviously, such
nonconvertible currencies present an obstruction to
international trade for companies that reside in these
countries.
Thus, we have non- convertible currencies (Cuban Peso and
North Korean Won), partly convertible currencies (Indian
rupee) and fully convertible currencies (US dollar).

CONVERTIBILITY OF INDIAN RUPEE

Officially, the Indian rupee has a market-determined exchange

rate. However, the RBI trades actively in the USD/INR currency
market to impact effective exchange rates. Thus, the currency
regime in place for the Indian rupee with respect to the US
dollar is a de facto controlled exchange rate. This is
sometimes called a "managed float". Other rates (such as the
EUR/INR and INR/JPY) have the volatility typical of floating
exchange rates, and often create
persistent arbitrage opportunities against the
RBI. Unlike China, successive administrations (through RBI,
the central bank) have not followed a policy of pegging the
INR to a specific foreign currency at a particular exchange
rate. RBI intervention in currency markets is solely to ensure
low volatility in exchange rates, and not to influence the rate
(or direction) of the Indian rupee in relation to other
currencies.
Also affecting convertibility is a series of customs regulations
restricting the import and export of rupees. Legally, foreign
nationals are forbidden from importing or exporting rupees;
Indian nationals can import and export only up to 7,500 at a
time, and the possession of 500 and 1,000 rupee notes
in Nepal is prohibited. In 2014 India allowed to take 500
and 1,000 rupee notes to be taken to Nepal.
RBI also exercises a system of capital controls in addition to
intervention (through active trading) in currency markets. On
the current account, there are no currency-conversion

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restrictions hindering buying or selling foreign exchange
(although trade barriers exist). On the capital account, foreign
institutional investors have convertibility to bring money into
and out of the country and buy securities (subject to
quantitative restrictions). Local firms are able to take capital
out of the country in order to expand globally. However, local
households are restricted in their ability to diversify globally.
Because of the expansion of the current and capital accounts,
India is increasingly moving towards full de facto convertibility.
There is some confusion regarding the interchange of the
currency with gold, but the system that India follows is that
money cannot be exchanged for gold under any
circumstances due to gold's lack of liquidity;[citation
needed] therefore, money cannot be changed into gold by the
RBI. India follows the same principle as Great Britain and the
US.
Reserve Bank of India clarifies its position regarding the
promissory clause printed on each banknote:
"As per Section 26 of Reserve Bank of India Act, 1934, the
Bank is liable to pay the value of banknote. This is payable on
demand by RBI, being the issuer. The Bank's obligation to pay
the value of banknote does not arise out of a contract but out
of statutory provisions. The promissory clause printed on the
banknotes i.e., "I promise to pay the bearer an amount of X" is
a statement which means that the banknote is a legal tender
for X amount. The obligation on the part of the Bank is to
exchange a banknote for coins of an equivalent amount."

For almost a century since the Great Recoinage of 1816 until

the outbreak of World War I, the Indian rupee sustained parity
with the U.S. dollar while pegged to the pound sterling that
was exchanged at 12a 10ps (or 50 old pence per rupee).
Effectively, the rupee bought 1s 4d (or 15 per sterling) during
1899-1914.
Thereafter, both the rupee and the sterling gradually declined
in worth against the U.S. dollar due to deficits in trade, capital
and budget. In 1966, the rupee was devalued and pegged to
the dollar. The peg to the pound was at 13.33 to a pound
(approx. 40 rupees to 3), and the pound itself was pegged
to US$4.03. That means officially speaking the USD to INR rate
would be closer to 4. In 1966, India changed the peg to dollar
at 7.50.

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 Chapter 3
TRADE ACCOUNT CONVERTIBILITY

The first step of final account is trading account. Trading

account is nominal account which is prepared at the end of
accounting year. Trading account helps to find out gross profit
or gross loss during the accounting period. Trading account
consists of two sides 'debit and credit'. All direct expenses are
debited and direct incomes are credited in trading account.
Trading account contains mainly purchase of goods, sale of
goods and expenses relating to the daily operation of an
industry.

Importance of Trade Account

It is very important to find out gross profit or loss for the

business to know whether purchasing, manufacturing and
sales are sufficient for earning or not. The main objectives
or important of trading account are as follows.

1. Trading account helps to know gross profit or loss.

2. Trading account provides information about the direct

expenses.

3.Trading account provides safety against possibilities of loss.

4. Trading account helps in comparison of closing stock with

last year's stock.

CURRENT ACCOUNT CONVERTIBILITY

Current account convertibility refers to freedom in respect of

payments and transfers for current international transactions.
In other words, if Indians are allowed to buy only foreign goods
and services but restrictions remain on the purchase of assets
abroad, it is only current account convertibility. As of now,
convertibility of the rupee into foreign currencies is almost
wholly free for current account i.e. in case of transactions such
as trade, travel and tourism, education abroad etc.

The Government of India introduced a system of Partial

Rupee Convertibility (PCR) (Current Account Convertibility)
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 on February 29, 1992 as part of the Fiscal Budget for 1992-93.
PCR is designed to provide a powerful boost to export as well
as to achieve as efficient import substitution. It is designed to
reduce the scope for bureaucratic controls, which contribute to
delays and inefficiency. Government liberalized the flow of
foreign exchange to include items like amount of foreign
currency that can be procured for purpose like travel abroad,
studying abroad, engaging the service of foreign consultants
etc. What it means that people are allowed to have access to
foreign currency for buying a whole range of consumables
products and services. These relaxations coincided with the
liberalization on the industry and commerce front which is why
we have Honda City cars, Mars chocolate and Bacardi in India.

Components of Current Account

Covered in the current account are all transactions (other
than those in financial items) that involve economic values
and occur between resident non-resident entities. Also
covered are offsets to current economic values provided or
acquired without a quid pro quo. Specifically, the major
classifications are goods and services, income, and current
transfers.
1. Goods and services
Goods
General merchandise covers most movable goods that
residents export to, or import from, non residents and that,
with a few specified exceptions, undergo changes in
ownership (actual or imputed).
Goods for processing covers exports (or, in the compiling
economy, imports) of goods crossing the frontier for
processing abroad and subsequent re-import (or, in the
compiling economy, export) of the goods, which are valued on
a gross basis before and after processing. The treatment of
this item in the goods account is an exception to the change
of ownership principle.
Repairs on goods covers repair activity on goods provided to
or received from non residents on ships, aircraft, etc. repairs
are valued at the prices (fees paid or received) of the repairs
and not at the gross values of the goods before and after
repairs are made.
Goods procured in ports by carriers covers all goods
(such as fuels, provisions, stores, and supplies) that
resident/non resident carriers (air, shipping, etc.) procure

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 abroad or in the compiling economy. The classification does
not cover auxiliary services (towing, maintenance, etc.), which
are covered under transportation.
Non-monetary gold covers exports and imports of all gold
not held as reserve assets (monetary gold) by the authorities.
Non-monetary gold is treated the same as any other
commodity and, when feasible, is subdivided into gold held as
a store of value and other (industrial) gold.

Services
Transportation covers most of the services that are
performed by residents for non residents (and vice versa) and
that were included in shipment and other transportation in the
fourth edition of the Manual. However, freight insurance is
now included with insurance services rather than with
transportation. Transportation includes freight and passenger
transportation by all modes of transportation and other
distributive and auxiliary services, including rentals of
transportation equipment with crew.
Travel covers goods and servicesincluding
those related to health and educationacquired from an
economy by non resident travellers (including excursionists)
for business and personal purposes during their visits (of less
than one year) in that economy. Travel excludes international
passenger services, which are included in transportation.
Students and medical patients are treated as travellers,
regardless of the length of stay. Certain othersmilitary and
embassy personnel and non resident workersare not
regarded as travellers. However, expenditures by non resident
workers are included in travel, while those of military and
embassy personnel are included in government services
Communications service covers communications
transactions between residents and non residents. Such
services comprise postal, courier, and telecommunications
services (transmission of sound, images, and other
information by various modes and associated maintenance
provided by/for residents for/by non residents).
Construction services covers construction and installation
project work that is, on a temporary basis, performed
abroad/in the compiling economy or in extra territorial
enclaves by resident/non resident enterprises and associated

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 personnel. Such work does not include that undertaken by a
foreign affiliate of a resident enterprise or by an
unincorporated site office that, if it meets certain criteria, is
equivalent to a foreign affiliate.
Insurance service covers the provision of insurance
to non residents by resident insurance enterprises and vice
versa. This item comprises services provided for freight
insurance (on goods exported and imported), services
provided for other types of direct insurance (including life and
non-life), and services provided for reinsurance.
Financial services (other than those related to insurance
enterprises and pension funds) cover financial intermediation
services and auxiliary services conducted between residents
and non residents. Included are commissions and fees for
letters of credit, lines of credit, financial leasing services,
foreign exchange transactions, consumer and business credit
services, brokerage services, underwriting services,
arrangements for various forms of hedging instruments, etc.
Auxiliary services include financial market operational and
regulatory services, security custody services, etc.
Computer and information services covers resident/non
resident transactions related to hardware consultancy,
software implementation, information services (data
processing, data base, news agency), and maintenance and
repair of computers and related equipment.
Royalties and license fees covers receipts
(exports) and payments (imports) of residents and non-
residents for (i) the authorized use of intangible non produced,
nonfinancial assets and proprietary rightssuch as
trademarks, copyrights, patents, processes, techniques,
designs, manufacturing rights, franchises, etc. and (ii) the use,
through licensing agreements, of produced originals or
prototypessuch as manuscripts, films, etc.
Other business services provided by residents to
non residents and vice versa cover merchanting and other
trade-related services; operational leasing services; and
miscellaneous business, professional, and technical services.
Personal, cultural, and recreational
services covers (i) audio visual and related services and (ii)
other cultural services provided by residents to non-residents
and vice versa. Included under (i) are services associated with
the production of motion pictures on films or video tape, radio
and television programs, and musical recordings. (Examples of

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 these services are rentals and fees received by actors,
producers, etc. for productions and for distribution rights sold
to the media.) Included under (ii) are other personal, cultural,
and recreational servicessuch as those associated with
libraries, museumsand other cultural and sporting activities.
Government services i.e. covers all services (such
as expenditures of embassies and consulates) associated with
government sectors or international and regional
organizations and not classified under other items.
2. Income
Compensation of employees covers wages,
salaries, and other benefits, in cash or in kind, and includes
those of border, seasonal, and other non-resident workers
(e.g., local staff of embassies).
Investment income covers receipts and payments of income
associated, respectively, with residents holdings of external
financial assets and with residents liabilities to non residents.
Investment income consists of direct investment income,
portfolio investment income, and other investment income.
The direct investment component is divided into income on
equity (dividends, branch profits, and reinvested earnings)
and income on debt (interest); portfolio investment income is
divided into income on equity (dividends) and income on debt
(interest); other investment income covers interest earned on
other capital (loans, etc.) and, in principle, imputed income to
households from net equity in life insurance reserves and in
pension funds.
3. Current transfers
Current transfers are distinguished from capital transfers,
which are included in the capital and financial account in
concordance with the SNA treatment of transfers. Transfers are
the offsets to changes, which take place between residents
and non residents, in ownership of real resources or financial
items and, whether the changes are voluntary or compulsory,
do not involve a quid pro quo in economic value.
Current transfers consist of all transfers that do not involve
(i) Transfers of ownership of fixed assets;
(ii) Transfers of funds linked to, or conditional
upon, acquisition or disposal of fixed assets; (iii)
forgiveness, without any counterparts being received
in return, of liabilities by creditors. All of these are
capital transfers.

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Current transfers include those of general government (e.g.,
current international cooperation between different
governments, payments of current taxes on income and
wealth, etc.), and other transfers (e.g., workers remittances,
premiumsless service charges, and claims on non-life
insurance).

CAPITAL ACCOUNT CONVERTIBILITY

Capital account and, by extension, full convertibility of the

rupee has emerged as an often debated issue in the context of
the liberalization process in India .It is worth nothing, at the
outset, that India is not alone in its endeavour to make its
currency convertibility, nor is it the only country which is facing
the daunting task of overcoming several hurdles on its way to
full currency convertibility. Indeed, only the developed
economics of North America, Western Europe, Japan and
Australia have joined the race towards full convertibility. A
number of Latin American, Central European and Asian
Countries, however, have joined the race towards full
convertibility. Aside from India, the list of these countries
includes Argentina, China, Chile, Columbia, Indonesia,
Malaysia, Philippines, Republic of Korea and Thailand.
Importantly, these countries are not at the same stage of
currency convertibility. The Korean currency, for example, is
much convertible than the Chinese currency. Indeed, it is
important to note at the outset that the issue is not a matter of
choice between convertibility and non-convertibility. There
exists a wide spectrum between these two extremes, and India
and the aforementioned countries lie at various points of this
spectrum. The important issue, in other words, is to decide the
extent to which a currency (say, the rupee) will be convertible
at a point of time, and the pace at which it will attain higher
levels of convertibility in the future.
In order to appreciate the meaning and the implication of
currency convertibility, however, one has to first take into
consideration two different aspects. A currency, it has to be
noted, can be convertible on the current account of balance of
payments (BOP), and/or on the capital account of BOP. The
currency is deemed fully convertible if it is convertible on both
these accounts. A clear understanding of the notion of
convertibility, therefore, entails an understanding of the
current and capital accounts of BOP.

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As such, the current account of the BOP comprises trade in
goods and services. In other words, the current account
balance takes into account exports, imports, and net foreign
income from unilateral transfers. The capital account of the
BOP, on the other hand, takes into account cross-border flow of
funds that are associated with financial or other assets in the
trading countries. For example, the direct and portfolio
investments made by foreign investors, in India, are captured
by the capital account balance of the BOP. The capital account
also encompasses foreign investments of Indian companies,
foreign aid and bank deposits of Non-resident Indians (NRI).
A currency is deemed convertible on the current account if it
can be freely converted into other convertible currencies for
purchase and sale of commodities and services. For example, if
the rupee is convertible on the current account an Indian firm
should be able to freely convert rupee into Yen (JPY) to
purchase mods from Japanese Company. Similarly, a German
company should be able to freely convert the mark (DM) into
rupee to pay an Indian software consultancy firm for its
services. It is evident that the ideal of free trade lies at the
heart of current account convertibility.

Capital account convertibility, on the other hand, implies the

right to transact in financial and other assets with foreign
countries without restriction. For example, if a currency is
convertible on the capital account, the residents of the
domestic currency may freely convert it into other
(convertible) currencies to purchase and maintain bank
accounts abroad. Similarly, residents of other countries should
also be able to freely convert their currencies into the domestic
currency to purchase domestic capital and money market
instruments. In other words, capital account convertibility is
associated with the vision of free capital mobility.
Convertibility as an issue, and subsequently as a goal, was a
priority in the agenda of the member countries of the
International Monetary Fund (IMF) which was born out of the
Bretton Woods Agreement. During the Bretton Woods period,
the term convertibility is used in two different contexts:
convertibility into gold and convertibility into other currencies.
Only the United States maintained gold convertibility during
Bretton woods. Convertibility into other currencies for current
account transaction purposes was a main goal of Bretton
Woods and was reached, to a large extent, early on in the

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system; however, the agreements to the IMF allowed more
flexibility with regard to the imposition of exchange controls on
capital account transactions. The flexibility was partly a result
of a prevailing feeling that short-run speculative capital flows
could be potentially destabilising and governments should
therefore have the freedom to resist them.
Owing to other reasons, developing countries have historically
not had convertible currencies. Typically, their currencies have
been partially convertible on the current account and the
capital of the BOP, the rationale for the choice being
embedded in the macroeconomic realities and the policy
perspectives of the countries concerned. In India, the rupee
was made convertible on the current account in August 1994.
However, the currency as yet has limited convertibility on the
capital account, and that indeed is the center of a countrywide
debate. What might be the rationale behind the
aforementioned choice: making rupee convertible on the
current account while maintaining exchange control for capital
account transactions? What, indeed, are the policy implications
of free capital mobility that is associated with capital account
and have full convertibility? Is India ready for full currency
convertibility?

Evolution of CAC in India Economic and

Financial Scenarios:

In 1994 August, the Indian economy adopted the present form

of Current Account Convertibility, compelled by the
International Monetary Fund (IMF) Article No.VII, the article of
agreement. The primary objective behind the adoption of CAC
in India was to make the movement of capital and the capital
market independent and open. This would exert less pressure
on the Indian financial market. The proposal for the
introduction of CAC was present in the recommendations
suggested by the Tarapore Committee appointed by the
Reserve Bank of India.

Reasons for the introduction of CAC in India:

The logic for the introduction of complete capital account

convertibility in India, according to the recommendations of
the Tarapore Committee, is to ensure total financial mobility in
the country. It also helps in the efficient appropriation or

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 distribution of international capital in India. Such allocation of
foreign funds in the country helps in equalizing the capital
return rates not only across different borders, but also
escalates the production levels. Moreover, it brings about a fair
allocation of the income level in India as well.
Jumping into capital account convertibility game without
considering the downside of the step can harm the economy.
The Committee on Capital Account Convertibility (CAC)
or Tarapore Committee was constituted by the Reserve Bank
of India for suggesting a roadmap on full convertibility of
Rupee on Capital Account. The committee submitted its report
in May 1997. The committee observed that there is no clear
definition of CAC. The CAC as per the standards refers to the
freedom to convert the local financial assets into foreign
financial assets or vice versa at the market determined rates of
exchange.
The Tarapore committee observed that the Capital controls can
be useful in insulating the economy of the country from the
volatile capital flows during the transitional periods and also in
providing time to the authorities, so that they can pursue
discretionary domestic policies to strengthen the initial
conditions.
The CAC Committee recommended the implementation of
Capital Account Convertibility for a 3 year period viz. 1997-98,
1998-99 and 1999-2000. But this committee had laid down
some pre conditions as follows:
1. Gross fiscal deficit to GDP ratio has to come down from a
budgeted 4.5 per cent in 1997-98 to 3.5% in 1999-2000.
2. A consolidated sinking fund has to be set up to meet
governments debt repayment needs; to be financed by
increased in RBIs profit transfer to the govt. and
disinvestment proceeds.
3. Inflation rate should remain between an average 3-5 per cent
for the 3-year period 1997-2000.
4. Gross NPAs of the public sector banking system needs to be
brought down from the present 13.7% to 5% by 2000. At the
same time, average effective CRR needs to be brought down
from the current 9.3% to 3%
5. RBI should have a Monitoring Exchange Rate Band of plus
minus 5% around a neutral Real Effective Exchange Rate RBI
should be transparent about the changes in REER

~ 22 ~
6. External sector policies should be designed to increase current
receipts to GDP ratio and bring down the debt servicing ratio
from 25% to 20%
7. Four indicators should be used for evaluating adequacy of
foreign exchange reserves to safeguard against any
contingency. Plus, a minimum net foreign asset to currency
ratio of 40 per cent should be prescribed by law in the RBI Act.

On March 18, 2006, the prime minister Dr. Manmohan Singh,

stated in inaugural function of 16th Asian Corporate
Conference that there is a merit in India moving towards fuller
capital account convertibility in response to which RBI again
set up a committee under the chairmanship of S.S. Tarapore to
pave the way for FCAC.
The presented its report on July 31, 2006. The committee was
of the view that FCAC should be implemented in three phases
ending at 2011. So the committee was of the view that India
should gradually move towards the Full Capital account
convertibility by 2011.
FCAC is an important decision that has to be taken by the
Indian government in the near future. Every decision has its
pros and cons which should be looked into. To start with let's
have a look at the advantages and disadvantages of FCAC.

The above committees report was not translated into any

actions. India is still a country with partial convertibility.
However, some important measures in that direction were
taken and they are summarized as below:
1.The Indian Corporate was allowed full convertibility in an
automatic route up to the $ 500 million overseas ventures.
This means that the limited companies were allowed to invest
in foreign countries.
2. Indian corporate was allowed to prepay their external
commercial borrowings via automatic route if the loan is
above $ 500 million.
3. Individuals were allowed to invest in foreign assets, shares up
to $ 2, 00,000 per year.
4. Unlimited amount of Gold was allowed to be imported.

The last measure, i.e. allowing unlimited amount of Gold is

equal to allowing the full convertibility in capital account via
current account route

~ 23 ~
 The Second Tarapore Committee on Capital Account
Convertibility
Reserve Bank of India appointed the second Tarapore
committee to set out the framework for fuller Capital
Account Convertibility. The committee was established by
RBI in consultation with the Government to revisit the subject
of fuller capital account convertibility in the context of the
progress in economic reforms, the stability of the external
and financial sectors, accelerated growth and global
integration.

The report of this committee was made public by RBI on 1st

September 2006. In this report, the committee suggested 3
phases of adopting the full convertibility of rupee in capital
account.
1. First Phase in 2006-7
2. Second phase in 2007-09
3. Third Phase by 2011.
Following were some important recommendations of this
committee:
1. The ceiling for External Commercial Borrowings (ECB) should
be raised for automatic approval.
2. NRI should be allowed to invest in capital markets
3. NRI deposits should be given tax benefits.
4. Improvement of the Banking regulation.
5. FII (Foreign Institutional Investors) should be prohibited from
investing fresh money raised to participatory notes.
6. Existing PN holders should be given an exit route to phase
out completely the PN notes.
At present the rupee is fully convertible on the current
account, but only partially convertible on the capital
account.

Under the system of capital account convertibility proposed

by this committee the following are the features:
(a) Indian companies would be allowed to issue foreign
currency denominated bonds to local investors, to invest in
such bonds and deposits, to issue Global Deposit Receipts
(GDRs) without RBI or Government approval to go in for
external commercial borrowings within certain limits, etc.
(b) Indian residents would be permitted to have foreign
currency denominated deposits with banks in India, to make

~ 24 ~
financial capital transfers to other countries within certain
limits, to take loans from non-relatives and others up to a
ceiling of $ 1 million, etc.
(c) Indian banks would be allowed to borrow from overseas
markets for short-term and long-term up to certain limits, to
invest in overseas money markets, to accept deposits and
extend loans denominated in foreign currency. Such facilities
would be available to financial institutions and financial
intermediaries also.
(d) All-India financial institutions which fulfil certain
regulatory and prudential requirements would be allowed to
participate in foreign exchange market along with
authorised dealers (ADs) who are, at present, banks. In a
later stage, certain select NBFCs would also be permitted to
act as ADs in foreign exchange market.
(e) Banks and financial institutions would be allowed to
operate in domestic and international markets and they
would also be allowed to buy and sell gold freely and offer
gold denominated deposits and loans.

Preconditions for Capital Account Convertibility:

The Tarapore Committee recommended that, before
adopting capital account convertibility (CAC), India should
fulfil three crucial pre-conditions:
(i) Fiscal deficit should be reduced to 3.5 per cent. The
Government should also set up a Consolidated Sinking Fund
(CSF) to reduce Government debt.
(ii) The Governments should fix the annual inflation target
between 3 to 5 per cent. This was called mandated inflation
target and give foil freedom to RBI to use monetary
weapons to achieve the inflation target.
(iii) The Indian financial sector should be strengthened. For
this, interest rates should be folly deregulated, gross non-
paying assets (NPAs) should be reduced to 5 per cent, the
average effective CRR should be reduced to 3 per cent and
weak banks should either be liquidated or be merged with
other strong banks.

Benefits and drawbacks of CAC:

To sum up, CAC is concerned about the ownership changes
in domestic or foreign financial assets and liabilities. It also
represents the formation and liquidation of financial claims

~ 25 ~
on or by the remaining world. It enables relaxation of the
Capital Account, which is under tremendous pressure from
the commercial sectors of India. Along with the financial
capitalists, the reputed commercial firms in India jointly
derive and enjoy the benefits of the CAC policy, which
speculate the stock markets through investments. In fact,
the CAC policy in India is pursued primarily to gain the
speculator's and the punter's confidences in the stock
markets.
However, CAC does not serve the purposes of the real
sectors of Indian economy, like eradication of poverty,
escalation of the employment rates and other inequalities.
In spite of CAC being present in Indian economy, there will
be a co-existence of financial crises. Despite several
benefits, CAC has proved to be insufficient in solving the
Indian financial crises, the complete solution of which lies in
having a regulated inflow of capital into the economy.
Unlike current account convertibility, capital account
convertibility does not come without a downside. But before
we discuss the downside it will be in order to point out that
reservations have been expressed about the most important
contribution of capital account convertibility, that is, its role
in better allocation of global savings. It has been pointed out
that often capital movement is guided by considerations
such as tax savings which improve the returns to the
investor but does not contribute to increased productivity.
Secondly, neither open capital account constitute sufficient
conditions to ensure capital flows into a country nor do
capital flows, in absence of appropriate institutional
framework in the receiving country, contribute to growth
and welfare. On the other hand, it has been argued that free
capital accounts were not necessary for the phenomenal
growth recorded by countries in the diverse parts of the
world. As Jagdish Bhagwati observes in his celebrated 1998
paper, After all, China and Japan, different in politics and
sociology as well as historical experience, have registered
remarkable growth rates. Western Europes return to
prosperity was also achieved without capital account
convertibility. Elsewhere in the same paper he remarks, 7
Substantial gains (from capital account convertibility) have
been asserted, not demonstrated, and most of the payoff
can be obtained by direct equity investment.

~ 26 ~
Views of Bretton woods institutions
It is also important to note the significant shift in the view of
Bretton Woodss institutions on capital account
liberalization. IMF, which was a strong votary of capital
account liberalization in the pre global financial crisis period,
adopted a new institutional view in December 2012 on
capital account liberalization and the management of capital
flows. The institutional view recognizes that 8 full capital
accounts liberalization may not be an appropriate goal for
all countries at all times, and that under certain
circumstances capital flow management measures can have
a place in the macroeconomic policy toolkit. It has done
much to change the public image of the Fund as a
doctrinaire proponent of free capital mobility. The Fund thus
now endorses, though in a limited way, the perspective of
many emerging and developing countries. The IMF now
recognizes that capital flows carry risks, and that the
liberalization of capital flows before nations reach a certain
threshold of financial and institutional development can
accentuate those risks. It also acknowledges that under
certain circumstances, cross-border capital flows should be
regulated to avoid the worst effects of capital flow surges
and sudden stops. It further says that nations that are the
source of excessive capital flows should pay more attention
to the potentially negative spillover effects of their
macroeconomic policies. Finally, the IMF notes that its new
view on capital flow management may be at odds with other
international commitments, such as in trade and investment
treaties that restrict the ability to regulate cross-border
finance. The World Bank has also advocated the use of
capital control measures as a last resort to help mitigate a
financial crisis and stabilize macroeconomic developments.
It may be contextual to recall that when the Asian crisis
broke out, some economists advocated imposition of
temporary capital controls as a policy tool to steer the
affected economies out of the crisis. In fact Malaysia did
precisely this to check deepening of the crisis with success.
However at that time it was considered an unorthodox and
anti-market policy prescription. But in September 2008,
when Iceland faced a similar crisis, capital controls
implemented through stringent exchange control regulations
were a key component of the policy package. As pointed
out, the use of capital controls in times of currency and

~ 27 ~
banking crisis is now part of the accepted wisdom. It may
also be noted that India has been using capital controls to
effectively manage the flows. While on the subject, let me
point out that imposition of capital controls by one country
can have significant negative externality; it can generate a 9
flight of capital from other similarly situated countries for
fear of capital controls there too.
Though the debate on capital account convertibility has
moderated and its advocacy qualified, it is generally
accepted that sooner or later all countries have to be there
and the question is when, how and at what pace. Are there
preconditions to be created so that the benefits of capital
account convertibility outweigh the costs, as Tarapore
Committee advocated or should we rush to it in anticipation
of the Promised Land and leave it to the financial markets to
discipline economic management into good behavior? Is the
slow progress to capital account convertibility a case of
undesirable procrastination or wisely heeding the
precautionary principle as Arvind Subramanian puts it? This
leads me to examine the Indian situation

CAPITAL ACCOUNT CONVERTIBILITY VS.

CURRENT ACCOUNT CONVERTIBILITY

International trade by which we shall mean trade amongst

nations in goods, services, and assets (or in popular
parlance, capital) has perhaps been as old as human
civilisation itself, as would be evident from archaeological
finds of Indus valley coins in the Middle East. This trade and
interaction down the centuries till industrial revolution was
dictated by the compulsions of geography and geology:
certain commodities-coveted items of consumption
everywhere-were available only in some parts of the world.
The idea of trade in goods (and services) across borders
even when the commodities concerned could be produced in
the economies of both the trading partners as an efficiency
and welfare increasing engagement for both, dates back to
Adam Smith (the principle of absolute advantage, 1776) and
to David Ricardo (the theory of comparative advantage,
1821). There has been extensive research on the theory of
international trade during most of the last century and there
is now a general consensus among economist that free
trade amongst nations improves global welfare. As Gregory

~ 28 ~
Mankiw observes, Economists are famous for disagreeing
with one another, and indeed, seminars in economics
departments are known for their vociferous debate. But
economists reach near unanimity on some topics, including
international trade. Promoting free trade has been a stated
global policy priority during the post second world war
period. Article VIII; sub-section 2 of the Articles of
Agreement of the IMF states that ......no member shall,
without the approval of the Fund, impose restrictions on the
making of payments and transfers for current international
transaction. Similarly, the objectives of WTO include,
providing a forum for negotiating and monitoring further
trade liberalisation. Though, every now and then, we come
across modern mercantilism in objections to imports, these
are often driven by political considerations and not based on
economic logic. Be that as it may, India accepted the Article
VIII obligation as early as in 1994 and has been an active
member of the WTO. So the public policy view on free trade
in goods and services or current account convertibility is
settled.
What about capital account convertibility? Capital account of
the balance of payments comprises a summary of cross
border transactions in assets. Assets in the context of
international transactions mean investment assets: equity,
debt, immovable property or any combination or hybrid of
these. Thus capital account convertibility would mean that
there is no restriction on conversion of the domestic
currency into a foreign currency to enable a resident to
acquire any foreign asset or on conversion of a foreign
currency to the domestic currency to enable a non-resident
to acquire a domestic asset. Assets are diverse. If a foreign
company sets up an Indian subsidiary, say, to manufacture
automobiles or aircrafts that is also capital account
transaction and so is if a hedge fund buys treasury bills to
book a profit out of expected movement in interest rates.
Similarly capital flows may finance a metro project or fuel a
real estate boom. Therefore, capital flows cannot be viewed
as a homogeneous phenomenon with identical economic
consequences. Capital flows can be conceptually classified
into two broad categories. Those that imply long term
engagement without any incentive to exit at every
provocation and those that are motivated by disinterested
profit those that buy at every low and sell at every high, as

~ 29 ~
it were. Full capital account convertibility will open the door
to both without any discrimination. In this backdrop, is
capital account convertibility as much a public policy priority
as current account convertibility?

Chapter 4
CAPITAL ACCOUNT CONVERTIBILITY IN INDIA

JOURNEY SO FAR

The national freedom of India was lost to the foreign traders

who were licensed to trade by the rulers of that era, so
general opinion about the foreign trading interests or foreign
capital has been very guarded and suspicious since
independence. It was also felt that the domestic economy is
endowed with a reasonable base of human skills,
institutional, social and physical infrastructure and
diversified industrial base that the country could
productively commence on the path of self reliance with
relatively low level of economic reliance on rest of the world.
Therefore, for the first four decades after sovereignty in
1947, all economic policies were centered on regulation and
capital controls. Although there were intervallic reforms in
areas of foreign procurement, technology, travel, education,
exchange rate depreciation and easing of restrictions on
inflows. As these measures were narrow in scope so they
had little impact on inflows and outflows of foreign
exchange. Real liberalization was initiated in 1991 aftermath
balance of payment crises. On the basis of
recommendations made by Rangrajan Committee the
reforms in the external sector were initiated.
Recommendations included dismantling of trade restrictions,
transition to market determined exchange rates and gradual
opening of capital account. In 1997 a committee under
stewardship of S.S. Tarapore submitted its report on capital
Account Convertibility which provided the initial roadmap for
the liberalization of capital account transactions.

Taking the lessons from international experience, committee

recommended a set of preconditions to be achieved prior to
liberalization of capital account. It was the time when
banking sector reforms were also instigated on the

~ 30 ~
proposition of Narasimham committee. Finally in year 2000
Foreign Exchange Regulation Act (FERA) was scrapped and a
new act Foreign Exchange Management Act (FEMA) came
into existence. Till now, all the rules pertaining to foreign
exchange are governed by FEMA. All the current account
transactions are permitted under FEMA and no prior
permission of RBI is required for any such transactions, while
there remain restrictions on capital account. Under FEMA
some capital account transactions are completely permitted,
some are totally prohibited while some are allowed within a
fixed ceiling. Sectoral rules have also been shaped and
enforced with FEMA rules. On the success of the measures
adopted, the issue of capital account liberalization was re-
examined by Tarapore committee II. Setup in year 2006 it
was an extension of the previous committee. It also did not
recommended unlimited openings of capital account but
preferred a phased liberalization of controls on outflows and
inflows with a comprehensive review of the actions taken.

PRESENT STATUS OF CAPITAL ACCOUNT

CONVERTIBILITY

Government of India (GoI) has revised rules pertaining to

FEMA and capital account transactions during different
periods of time. In context of large capital flows and the
upshots of previous modifications during the last few years,
GoI and RBI have recently done some additional
amendments. The revisions related to capital account are
listed below. Component of Capital
Authorized Dealers (AD) RBI has provided license to the
entities for dealing in foreign exchange. They have 3
categories: a) Authorized Dealers Category-I (Public, Private
and Foreign Banks). b) Authorized Dealers Category-II
(Authorized on the city basis. They include cooperative
banks, private forex dealers and travel agents etc.). c)
Authorized Dealers Category-III (Non Banking Finance
Corporations) The authority vested in the hands of AD-I is
largest (ranging from stock market transactions to NRI
accounts, ECBs, ADRs etc.) while other categories of ADs
have a limited role to play.

Foreign Direct
FDI is restricted in the following sectors:

~ 31 ~
a) Multi brand retailing.
b) Lottery (public, private, online), gambling, betting and
casino.
c) Chit funds and Nidhi Company.
d) Trading in Transferable Development Rights in real estate
business or construction of farm houses.
e) Manufacturing of Cigars, cheroots, cigarillos and
cigarettes, of tobacco or of tobacco substitutes
f) Atomic energy and Railway transport In rest other sectors
such as agriculture, mining, manufacturing, broadcasting,
print media, aviation, courier services, construction,
telecom, banking, insurance etc.; the limits of FDI range
from 26% to 100%. All the foreign operators have to abide
by the sectoral restrictions of the statutory regulators in
addition to FDI rules.

ADRs/ GDRs by Indian companies

Indian companies can raise additional finances abroad
through the issue companies of ADRs/ GDRs, in accordance
with guidelines issued by the Government of India. Unlisted
companies, which have not so far accessed the ADR/GDR
route for raising funds in the global market, would require
prior listing in the domestic market. Unlisted companies,
which have already issued ADRs/GDRs in the international
market, have to list in the domestic market on making profit
or within three years of such issue of ADRs/GDRs, whichever
is earlier. A Limited two way fungibility scheme is also
operationalised through the custodians of securities and
stock brokers under SEBI.
External Commercial the ECB limit under the
automatic route is enhanced to USD 750 million
Borrowings (ECBs)/ Foreign (Circular No. 27 dated
September 23, 2011).
The maturity guidelines have also Currency Convertible
Bonds been revised (Circular No.64 January 05, 2012).
(FCCBs)
a) ECBs up to $20 million in a financial year should have a
minimum average maturity of three years.
b) ECBs of more than $20 million and up to $750 million or
equivalent should have a minimum average maturity of 5

~ 32 ~
years. c) Eligible borrowers under the automatic route can
raise Foreign Currency Convertible Bonds (FCCBs) up to USD
750 million or equivalent per financial year for permissible
end-uses.
d) Corporate in services like hotel, hospital and software,
can raise FCCBs up to USD 200 million or equivalent for
permissible end-uses during a financial but the proceeds of
the ECB should not be used for acquisition of land.
e) ECB / FCCB availed of for the purpose of refinancing the
existing outstanding FCCB should be viewed as part of the
limit of USD 750 million available under the automatic route.
Government Securities
NRIs and SEBI registered FIIs are permitted to purchase
Government Securities/ Treasury bills and corporate debt.
The details are as under:
1. On repatriation basis a Non-resident Indian can purchase
without limit,
a) Dated Government securities (other than bearer
securities) or treasury bills or units of domestic mutual
funds.
b) Bonds issued by a public sector undertaking (PSU) in
India. MANAGEMENT INSIGHT Vol. VIII, No. 2; December
2012 54
c) Shares in Public Sector Enterprises being disinvested by
GoI.
2. on non-repatriation basis
a) Dated Government securities (other than bearer
securities) or treasury bills or units of domestic mutual
funds.
b) Units of Money Market Mutual Funds in India.
c) National Plan/Savings Certificates. A SEBI registered FII
may purchase, on repatriation basis, dated Government
securities/ treasury bills, listed non-convertible debentures/
bonds issued by an Indian company and units of domestic
mutual funds either directly from the issuer of such
securities or through a registered stock broker on a
recognized stock exchange in India. The FII investment in
Government securities and corporate debt is subject to the
Investment limit. For the FIIs in Government securities
currently is USD 10 billion and limit in Corporate debt is USD
20 billion.

Rupee and Foreign Currency denominated Bonds

~ 33 ~
 Rupee and Foreign currency denominated bonds issued by
the Infrastructure Denominated Bonds Debt Funds (IDFs) set
up as an Indian company and registered as Nonbanking
Financial Companies (NBFCs) with the Reserve Bank of India
have been allowed (circular number 49, dated 22.11.2011)
Eligible non- resident investors: Sovereign Wealth Funds,
Multilateral Agencies, Pension Funds, Insurance Funds,
Endowment Funds, FII, NRI, HNIs registered with SEBI are
allowed to invest in these bonds.
Maturity and lock-in period: The maturity period for
these bonds is five years. They are subject to a lock in
period of three years. However, all non-resident investors
can trade amongst themselves within this lock in period of
three years.
Quantitative limits: All non-resident investment in IDFs
would be within an overall cap of USD 10 billion. This limit
would be within the overall cap of USD 25 billion for FII
investment in bonds / non convertible debentures issued by
Indian companies in the infrastructure sector.

Joint Venture/ wholly owned Subsidiaries

Overseas Investment can be made fewer than two routes
(i) Automatic Route and subsidiary
(ii) Approval Route
Under Automatic Route, an Indian party has been permitted
to make investment in overseas Joint Ventures (JV) / Wholly
Owned Subsidiaries (WOS), not exceeding 400% of the net
worth as on the date of last audited balance sheet.
Investment in an overseas JV / WOS may be funded out of
one or more of the following sources:
A) Drawal of foreign exchange from an AD bank in India
b) Capitalization of exports
c) Swap of shares
d) Proceeds of ECBs / FCCBs
e) Balances held in EEFC account of the Indian party
f) Proceeds of foreign currency funds rose through ADR /
GDR issues.
In respect of (e) and (f) above, the ceiling of 400% of the net
worth will not apply.
Approval of the Reserve Bank: Sectors have been currently
reserved for RBI approval. Investments in energy and
natural resources sector, overseas investments by
Proprietorship concerns and Registered Trust / Society

~ 34 ~
 require prior approval of the Reserve Bank for direct
investment abroad.

PROGRESS THROUGH CAPITAL ACCOUNT

CONVERTIBILITY

A hybrid between control and liberalization of the capital

account, has served country well for nearly a decade. India
has witnessed a significant surge in cross border capital
flows through CAC. The strong capital movements to India in
the recent period reflect the momentum in following:
Progress at country level
(1) End of Balance of Payment (BoP) crisis: In 1991 India was
struggling with the crisis in its balance of payments.
Importing was essential for the country while the
governments conservative approach towards exports
pushed country into severe balance of payment deficit.
Capital account liberalization has been the strongest
medium in curbing such crisis. Depicted in the graph there is
an ongoing trade deficit from the year 1990-91, but a
positive capital account has provided cushion against all
odds and overall balance of payments are in surplus.
(2) Plenty of Foreign Currency Reserves: India has envisaged
a plentiful surge in its reserves. The liberalization of capital
account has helped country in recovering from reserve
shortage. The doting supply of dollars to Reserve Bank
exchequer is a healthy sign for economy, as reserves can be
utilized during the times of adversity.
(3) Efficiency in Financial System: Capital Account
Convertibility is incomplete without fiscal consolidation,
sound policies and financial prudence. RBI and Government
of India have been very conservative and watchful during
whole process of liberalization. This has improved total
financial performance of economy. Banks today have greater
access to additional capital (foreign borrowing), autonomy in
operations (easement of control by RBI) and intensive
competition (opening of private and foreign banks and Non
Banking Finance Corporations). There is larger room for
financial efficacy, specialization and innovation in financial
system.
(4) Development of Securities Market: Gush of Foreign
Institutional Investment (FII) has helped in multifold
enlargement of security market. The market capitalization of

~ 35 ~
 BSE and NSE has significantly risen. Derivates, bonds,
commodities now constitute the major trading instruments
besides equity shares. Sensex (above 20,000) and Nifty
(above 6,000) touched new heights due to huge investment
in the listed stocks.
(5) Worldwide Presence and Friendly Relations with Trading
Counterparts: Flow of investment is a distinctive medium of
developing global relationships. Indian MNCs and service
organizations are conducting business operations in almost
140 countries across the globe. India is 19th largest
exporting country in the world according to 2011 estimates.
Indian IT services, handicrafts, cuisine and jewelry are world
famous and contribute to major chunk of revenue from
international operations. It all has become reality with the
financial liberalization. India is the founder member of WTO,
IMF and World Bank. It is a member of BRICS and G-20 at
WTO trade negotiations. Government has entered into
multilateral trade agreements and tax avoidance treaties
with the trading counterparts. Immigration norms have also
been untangled. All this has given a global presence to the
country and friendly relations too are in progress.

Challenges of capital account convertibility and

their management
In the process of capital account liberalization, Indian
economy has been able to attract reasonable foreign
investment without any major shocks. The benefits that
have been derived with an open capital account have
induced the growth and development of Indias financial
markets and external sector. Due to some or other reasons
from inside and outside macroeconomic instability has
lingered in the economy and things are not going well.
Inflation rate is high from the year 2009onwards. The
average yearly inflation was 10.9% in 2009 and 11.7% in
2010. In 2011 the rate of inflation stood at 9.6%. Between
the periods it rose to double digits too. RBI has revised
monetary policy during the different time periods. Cash
Reserve Ratio (CRR) was revised 13 times in the time frame
of 2 years which is a benchmark in itself. Despite continuous
efforts RBI is not able to tame inflation and it is still modest
at the level of 8% according to latest estimates. The
depreciation in the value of rupee to the level of 1
USD=57.33 INR has also raised serious questions and

~ 36 ~
concern on the conduct and policies of Reserve Bank and
Government of India. Global rating agencies Standard &
Poor (s & P) and Fitch have revised Indias rating from stable
to negative. S&P has released a report strongly criticizing
the Governments inability to move ahead with economic
reforms and referred to cracks in ruling coalition that they
were holding up progress. Fitch has censured and added the
general elections due in early 2014 could see politically
driven pressure to loosen fiscal policy, which could further
weaken Indias public finance related to peers. The ratings
and statement of S&P and Fitch raise the risk of Indian
bonds slipping into junk category, hurting the countrys
image as an investment destination. The cost of overseas
borrowing for Indian companies could also go up.
The story is not yet over. Equity market is plummeting week
after week because FII are on selling fling. Sensex is
currently trading lower than 17,000 and Nifty near 5,000.
Investor sentiments are down. Individual portfolios are
making losses. Volatility and panic are the latest buzz words
for the Dalal Street.
Food inflation is constantly maintaining its double digit
levels causing a decline in domestic savings with banks. IIP
has fallen to the level of 3.5% from 8.1% of the previous
year. GDP growth in 2012- 13 is estimated at the aching
level of 6.5% while fiscal deficit is at 5.9%. Reserve Banks
Governor D. Subbarao said fiscal deficit in 1991 was 7% and
it is ruling at 5.9% in 2012.Is it an alarming signal? Because,
India was going through its meager times in 1991 and latest
GDP estimates too are worrisome. There are additional
doubts about Governments ability to trim subsidy level to
cut fiscal deficit, which could further increase the prices of
essential commodities. A new retro tax GAAR (General Anti
Avoidance Rule) is also proposed to be enacted in budget for
fiscal 2013. GAAR aims to target tax evaders, partly by
stopping Indian companies and investors from routing
investments through Mauritius or other tax havens for the
sole purpose of avoiding taxes. It has sparked an outcry
among foreign investors.
Thus the recent global turmoil, volatile capital flows and
economic instability have considerably heightened the
uncertainty surrounding the outlook for India, complicating
the conduct of monetary policy and external management.
The intensified pressures have necessitated stepped up

~ 37 ~
 operations in terms of capital account management and
more active liquidity management with all instruments at
command of Reserve Bank. Therefore in this scenario, it is
suggested that India should adopt a go slow approach in
moves to liberalize capital account. Instead, it is important
for the country to be ready to deal with potentially large and
volatile outflows along with spillovers. In this context, there
is a need of maneuver for Reserve Bank to deal with present
serious matters by deployment of monetary policy
instruments, buying and selling operations of forex,
complemented by prudential restrictions and measures for
capital account management.

Advantages and Disadvantages of Capital

Account Convertibility
Advantages:
(1) Unrestricted mobility of Capital:
Capital account convertibility allows free mobility of Capital
into a country from the foreign investors. It allows to convert
the foreign exchange brought into as Capital to convert into
rupees at market determined rates , which makes the
investors encouraging. It allows the foreign investors to
easily move in and move out from an economy. This enables
the domestic companies to raise funds from abroad.
(2) Ability to invest in abroad easily:
Capital account convertibility allows the individuals of a
nation to invest in abroad by easily converting their rupees
into foreign exchange at the rates determined by the
Market. This enables those potential domestic investors to
acquire & own the assets in abroad.
(3) Improved access to global financial markets:
One can easily invest in the equity and debt markets of
another economy alongside a reduction in the cost of
capital.

Disadvantages:
(1) Easier access to Hawala money:
As it allows converting any foreign receipt into Indian
rupees at market determined rates there may be chance
that domestic economy will be flooded with foreign
exchange which in long run may damage the financial
health of an economy.

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(2) High volatility of markets:
During the times when the financial markets of an
economy are doing well, a country may receive huge
foreign investment. But during the adverse times the
reverse scenario may happen. For example when the
federal reserve Bank of America gave a sign that they are
going increase the interest rates the foreign Institutional
investors who invested their dollars in Indian stock market
had withdrawn their investment from India which
adversely impacted the rupee value.

Chapter 5
Role of IMF in Capital Account Convertibility

Under the supervision of IMF other developing economies

had implemented CAC. They had fixed exchange rate
system pegged to the USD. When the Dollar rose,
consequently the ASEAN currencies grew too, resulting in
lower exports. This resulted in a decline in export earnings
of these countries and thus increasing their trade and
current account deficit. The crisis first emerged in Thailand
in 1997 when a loan repayment crisis led to fears of loan
defaults and foreign short-term creditors withdrew funds
from Thai financial institutions. This withdrawal of led to
pressure on forex reserves and the value of Baht. The
Bank of Thailand in its attempt to save the Baht lost all its
Reserves and had to request assistance from the IMF. This
eventually spread to Philippines, Malaysia and Indonesia
and thus led to the outbreak of the South East Asian crisis.
After taking important learning from the CAC crisis in
South East Asian countries, India has adopted a gradual
phased approach towards the implementation of CAC.
Tarapore committee which was set up for this purpose had
suggested certain pre-conditions for the implementation of
CAC. India has been consistent in its commitment towards
CAC and has shown marked improvements in some of the
factors mentioned in the Tarapore committee. But Indias

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march towards CAC needs to be dealt with caution as the
risks involved in capital inflows into the country are huge.
IMF has predicted the Indian economy to grow at a rate of
8.9% which puts India on the path of growth along with
other emerging economies. India stands to gain by
implementing CAC provided all the measures are in place
to effect a successful implementation and the
macroeconomic factors of the country are strong enough
to support the surge in capital inflows. To start with the
interest rates in India are higher compared to US and
other developed economies. This results in inflow of
foreign currency into India to arbitrage the differential
interest rates. This inflow of money will reduce the cost of
capital for the Indian companies and this in turn could be
utilized for growing the economy further. It would also
enable Indian investors to diversify their portfolios and
reduce their risk. It should be noted that the capital
inflows will put immense pressure on the foreign exchange
market and the volatility of the dollar and rupee is bound
to increase. In Indias ace, our floating exchange rate
system will stand to benefit India unlike the fixed
exchange rate that was adopted by the South East Asian
countries.
Thus a decision of implementing CAC in India is a complex
one and has to take into account the multiplicity of
constraints and objectives at hand. It is necessary to focus
on the macroeconomic constraints as well as the
development objectives of CAC. The implication of CAC on
exchange rate policies in India has not been touched upon
yet. Hence factoring in the exchange rate and growth
consequences of CAC would be important before the final
implementation of CAC in India.

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 CONCLUSION
As we say that every coin has its two sides, Fuller Capital
Account Convertibility is no exception it also has some pros and
cons. Having a closer look at the advantages and
disadvantages of CAC it can be inferred that it can be a boon to
our country if managed properly. India should not move into it
in hurry instead they should take their own time and first
consolidate their fiscal deficit and regulations. They should
learn from the mistakes that other Emerging Market Economies
did in 90's and what happened to them during the Asian Crisis.
In my view India can go ahead with Fuller Account Convertibility
but they should still keep some restriction or control over it i.e.
they should allow Capital Account Convertibility with
reasonable limits on some transactions. After saying this I
would also like to add that India and China survived the East
Asian Crisis only because they didn't had fuller capital account
convertibility and if we open up our economy by allowing CAC
we will increase the susceptibility to economic crisis. Thus any
decision taken by RBI and the government will be another
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wishful thinking that all would go right if some pre-conditions
are fulfilled and CAC will trigger the growth of the economy but
there still are some problems with CAC which will come roaring
if there is any global crisis and all the measures taken by
government will not be sufficient to avoid such crisis in India.
The topic Is Capital Account Convertibility - A Boon or a Bane is
a debatable one and has been debated in India for decades.
There are people who say that India should go for CAC and
other who are against it. So, Whatever happens in the next few
years as Tarapore Committee has already set a road map for
CAC let's hope that everything goes as per the plans of UPA
government and our economy gets that much needed boost
through CAC.

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 Bibliography

A) Books Referred:

1. Biswajit Chatterjee, Capital account convertibility in India,

2007, Kolkata.
2. Owen Evans, Capital Account Convertibility: Review of
Experience and Implications for IMF Policies (Occasional
Paper), international monetary fund, 1993.
3. V Subhulakshmi, Capital Account Convertibility: An
Introduction (Economy Series), 2004.

B) E Data

1. www.Investopedia.com
2. www.rbi.org.in
3. www.businessstandard.com
4. www.bse.com
5. www.sebi.com

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