Mumbai: 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 country’s import requirements.

The 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.

Foreign 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.

But 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.

What 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.

In the early nineties, India’s 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.

The 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.

The 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.

Today 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 improve.

Time not ripe In the RBI’s 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.

“India’s 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.

The 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.

Malaysian President Dr Mahathir Mohammed has even gone on record blaming George Soros, the legendary financier and punter, for Malaysia’s currency woes after it went in for full capital account convertibility.

One 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.

Lastly, 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 India’s 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.

In 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 government’s aim in going in for capital account convertibility is to further increase forex inflows into the country.

Well, given the present state of the economy and the tensions in the Gulf, capital account convertibility will have to wait. For now, at least.