What is capital account convertibility?

There is no formal definition of capital account convertibility (CAC). The Tarapore committee set up by the Reserve Bank of India (RBI) in 1997 to go into the issue of CAC defined it as the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange.
In simple language what this means is that CAC allows anyone to freely move from local currency into foreign currency and back.

How is CAC different from current account convertibility?

Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. In other words, it allows residents to make and receive trade-related payments — receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts etc. In India, current account convertibility was established with the acceptance of the obligations under Article VIII of the IMF’s Articles of Agreement in August 1994.

Can CAC coexist with restrictions?

Contrary to general belief, CAC can coexist with restrictions other than on external payments. It does not preclude the imposition of any monetary/fiscal measures relating to forex transactions that may be warranted from a prudential point of view.

Why is CAC such an emotive issue?

CAC is widely regarded as one of the hallmarks of a developed economy. It is also seen as a major comfort factor for overseas investors since they know that anytime they change their mind they will be able to re-convert local currency back into foreign currency and take out their money.
In a bid to attract foreign investment, many developing countries went in for CAC in the 80s not realising that free mobility of capital leaves countries open to both sudden and huge inflows as well as outflows, both of which can be potentially destabilising. More important, that unless you have the institutions, particularly financial institutions, capable of dealing with such huge flows countries may just not be able to cope as was demonstrated by the East Asian crisis of the late nineties.

Following the East Asian crisis, even the most ardent votaries of CAC in the World Bank and the IMF realised that the dangers of going in for CAC without adequate preparation could be catastrophic. Since then the received wisdom has been to move slowly but cautiously towards CAC with priority being accorded to fiscal consolidation and financial sector reform above all else.

In India, the Tarapore committee had laid down a three-year road-map ending 1999-2000 for CAC. It also cautioned that this time-frame could be speeded up or delayed depending on the success achieved in establishing certain pre-conditions — primarily fiscal consolidation, strengthening of the financial system and a low rate of inflation. With the exception of the last, the other two pre-conditions have not yet been achieved.

What is the position in India today?

Convertibility of capital for non-residents has been a basic tenet of India’s foreign investment policy all along, subject of course to fairly cumbersome administrative procedures. It is only residents — both individuals as well as corporates — who continue to be subject to capital controls. However, as part of the liberalisation process the government has over the years been relaxing these controls. Thus, a few years ago, residents were allowed to invest through the mutual fund route and corporates to invest in companies abroad but within fairly conservative limits.

Buoyed by the very comfortable build-up of forex reserves, the strong GDP growth figures for the last two quarters and the fact that progressive relaxations on current account transactions have not lead to any flight of capital, on Friday the government announced further relaxations on the kind and quantum of investments that can be made by residents abroad. These relaxations are to be reviewed after six months and if the experience is not adverse, we may see further liberalisation and in the not-too-distant future full CAC.