In this article we will discuss about the parameters for capital account and rupee convertibility in the financial markets.
Capital Account Convertibility:
Capital account convertibility is one of the essential parameters, not only for an effective integration of the financial markets of the domestic economy, with the world economy but also for India’s maturing as a mega world economic power in the prevailing environment of competition, deregulation and proliferation of information technology.
The basic objectives of capital account convertibility are:
1. To deepen and integrate financial markets
2. To raise the access to global savings
3. To discipline domestic policy makers
4. To allow greater freedom to individual decision making.
In recent years, many emerging economies have gradually relaxed or removed capital controls and are now proceeding toward full capital account convertibility. Remaining restrictions are nevertheless significant, and are mostly asymmetric-placing more restrictions on capital flowing out than on capital flowing in.
More liberal rules in both directions would have the advantage of increasing economic efficiency (allowing more capital to flow to where it gets the best returns). Liberalization would also provide domestic investors with more opportunities to diversify their portfolios and reduce the concentration of exposure to domestic market risk.
A movement toward full capital account convertibility, however, can succeed only in the context of sound economic fundamentals, a sound banking sector, and an exchange rate policy that allows adequate flexibility.
The increasing number of developing countries adopting more flexible exchange rate regimes probably reflects, at least in part, a recognition that increased flexibility maybe helpful in making the transition to full convertibility. As developing countries become ever more integrated with global financial markets, they will likely experience more volatility in cross-border capital flows.
How to manage such volatility has thus become an important issue for policy makers. One obvious way to contain volatility is to try to reduce reliance on short-term capital flows. It would be undesirable to eliminate short-term flows entirely given that, among other things, they help provide liquidity to the currency market.
The advantages of capital account convertibility are the following:
1. To integrate national economy with the global economy.
2. To access the international financial markets to get foreign capital at low cost.
3. To increase the growth rate of the economy through pumping of foreign capital.
4. To facilitate resident Indians to invest their surplus funds in foreign markets for better investment portfolio, i.e. wide range of derivatives and management products, in order to reduce the investments ‘risk factor’.
5. To facilitate specialization in financial services offered by the financial sector in the economy.
6. To move capital from one country to another without hindrances.
7. To have a competitive tax system on par with the developed countries.
Full Convertibility of Rupee:
Full convertibility also known as ‘floating rupee’ which means the removal of all controls on the cross-border movement of capital, out of India to anywhere else or vice versa. There are two kinds of convertibility – current account convertibility and capital account convertibility.
Capital account convertibility (CAC) refers to the freedom to convert local financial assets into foreign financial assets or vice versa at market-determined rates of interest. 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. If CAC is introduced along with current account convertibility it would mean full convertibility.
Complete convertibility would mean no restrictions and no questions. It would also mean that a domestic individual can pay in foreign currency for purchases in India – rupee or US dollar or euro or yen will mean the same and hence, the ability to hold your cash in a currency which is strong.
Advantages of Full Convertibility:
The advantages of full convertibility of a rupee are as follows:
1. It would raise the comfort levels of investors and, thus, boost the inflow of FDIs and foreign capital into the country.
2. The expectation that the Indian currency will progressively strengthen would cause more dollar inflows.
3. The currency reflects the strength of an economy.
Hurdles for Full Convertibility:
In the course of full convertibility there are many hurdles:
1. Firstly, there is a risk of higher volatility of rupee. Short-term capital outflows which might occur as a result of CAC can worsen the risk.
2. Secondly, India’s fiscal conditions are far from ideal. The lesson for India is that, in the event of a domestic or external shock, full convertibility could prove to be a costly experiment.
3. There is also the danger of India getting swamped by an inflow of dollars, and the rupee appreciating beyond manageable limits. This would make the exports of the country suffer.
Capital account liberalization is a difficult thing. It is like fire. You can’t play around with it. If you want to heat your house, be careful that you don’t burn yourself.