During the last six months, there has been a heavy inflow
of foreign exchange (forex) into India that has led to
forex reserves swelling to about $70 billion equivalent
to about 14 months of the countrys import requirements.
rupee too, during this period, appreciated dramatically
against the dollar from about Rs 48.60 to Rs 47.90.
This has reopened a debate on whether India should go
in for capital account convertibility.
exchange transactions are broadly classified into two
types: current account transactions and capital account
transactions. If a citizen needs foreign exchange of smaller
amounts, say $3,000, for travelling abroad or for educational
purposes, s/he can obtain the same from a bank or a moneychanger.
This is a current account transaction.
if someone wants to import plant and machinery and needs
a large amount of foreign exchange, say $1 million, the
importer will have to first obtain the permission of the
Reserve Bank of India (RBI). If approved, this becomes
a transaction on the capital account.
recent history teaches us
In 1994, transactions on the current account were made
fully convertible and foreign exchange was made freely
available for such transactions. But capital account transactions
are still not fully convertible. The rationale behind
this is clear. India wants to conserve precious foreign
exchange and protect the rupee from volatile fluctuations.
the early nineties, Indias foreign exchange reserves
had dipped to such abysmally low levels that there was
just enough forex to pay for a few weeks of imports. To
overcome the crisis the then government had to pledge
a part of its gold reserves to the Bank of England to
obtain foreign exchange.
situation improved in the mid-nineties and a committee
headed by Dr S S Tarapore, the then deputy governor of
the RBI, was formed to look into the issue of capital
account convertibility. The committee recommended that
full capital account convertibility be brought in only
after certain preconditions were satisfied. These included
low inflation, financial sector reforms, a flexible exchange
rate policy and a stringent fiscal policy.
assumption of the committee was that these preconditions
would take care of possible problems created by unseen
flight of capital. Given a sound fiscal and financial
set-up, the flight of capital was unlikely to be large,
particularly in the short run, as capital would be invested
and not all of it would be in a liquid form.
inflation is fairly under control but the financial sector
continues to be in a mess and the fiscal deficit is still
high. It will, therefore, be imprudent for the government
to go in for full convertibility on the capital account
unless both the financial sector and the fiscal deficit
In the RBIs latest Credit and Monetary Policy, RBI
Governor Dr Bimal Jalan had asserted that the central
bank would continue its approach of watchfulness,
caution and flexibility in the management of foreign
exchange-rate policy of focussing on managing volatility
(that includes preventing the flight of capital on the
capital account) with no fixed rate target while underlying
demand and supply conditions to determine the exchange
rate in an orderly way has stood the test of time,
Dr Jalan had noted.
experience of certain Southeast Asian nations, which went
in for full convertibility, also needs to be kept in mind.
Foreign speculators bet huge amounts in these currencies,
indulged in price speculation and withdrew money after
booking huge profits, and in the process left the economies
of these countries in a shambles.
President Dr Mahathir Mohammed has even gone on record
blaming George Soros, the legendary financier and punter,
for Malaysias currency woes after it went in for
full capital account convertibility.
for the reasons for the recent spurt in forex reserves
is that many Indian businessmen, who had parked their
funds abroad, are now bringing their money back to India.
The ongoing international war on terrorism has made them
do so. Financial transactions and accounts are being tracked
and scrutinised very closely, making it difficult to park
funds abroad. This money, however, is hot money
and can leave the country at any time.
we cannot ignore the tensions in the Gulf, where a warlike
situation exists. This can have a severe impact on the
oil supply and prices, and oil accounts for nearly 70
per cent of Indias imports. Remittances from non-resident
Indians working in the Gulf have always been regular and
steady. Nevertheless, if a war breaks out in the region
these remittances could be affected.
conclusion it can be said that all economies will ultimately
have to go for capital account convertibility, keeping
globalisation and the changing world trade scenario in
mind. The governments aim in going in for capital
account convertibility is to further increase forex inflows
into the country.
given the present state of the economy and the tensions
in the Gulf, capital account convertibility will have
to wait. For now, at least.