Capital Account Convertibility in India

Capital account convertibility (CAC) means the freedom to change local currency into foreign currency, and back, for buying assets abroad or bringing in foreign money as investment or loans. For example, if an Indian can freely change rupees into dollars to buy a flat in Dubai or shares in a US company, without any limit, the rupee is "fully convertible on the capital account". India allows this only partly. It follows a careful, step-by-step approach and keeps some controls in its hands.

What does "convertibility" mean?

A currency is convertible when you can exchange it for another currency freely at the market rate. There are two kinds of deals with the outside world:

• Current account deals: buying and selling goods and services, paying for travel, education or medical treatment abroad, and sending or receiving gifts and family remittances. These do not create any asset or loan.
• Capital account deals: buying or selling assets or taking on debts across borders, like foreign investment in Indian shares, an Indian company buying a firm abroad, or an Indian company taking a loan from a foreign bank.

The rupee has been fully convertible on the current account since August 1994. On the capital account, it is only partly convertible.

Why does it matter?

Full freedom to move capital has benefits. Foreign money can flow into Indian businesses and markets, Indians can spread their savings across countries, and the financial system becomes more efficient. But it has a big risk too. Money that comes in quickly can also leave quickly. If foreign investors pull out suddenly, the demand for dollars jumps, the currency crashes, and banks and companies with foreign loans get into trouble.

Think of it like opening all the doors and windows of a house: you get fresh air, but a storm can also blow everything away. So a country needs strong "walls" first: low deficits, low inflation and healthy banks.

Where did it come from?

India's journey has moved slowly, one step at a time:

• 1991 crisis: India had very low foreign exchange reserves and faced a balance of payments crisis. This started wide economic reforms.
• 1992: India introduced LERMS, a dual exchange rate. Part of foreign exchange was converted at the market rate and the rest at the official rate.
• March 1993: India moved to a single, market-determined exchange rate.
• August 1994: India accepted Article VIII of the IMF's Articles of Agreement. This made the rupee fully convertible on the current account.
• 1997, First Tarapore Committee: The RBI set up a committee under S.S. Tarapore (a former RBI Deputy Governor) on 28 February 1997. It submitted its report on 3 June 1997. It suggested moving to CAC in three stages up to 1999-2000, but only after meeting some preconditions.
• 1997-98, Asian Financial Crisis: Countries like Thailand, Indonesia and South Korea, which had opened up to short-term foreign money, saw huge outflows and currency crashes. India, with its controls, was much less affected. This made India even more careful.
• 2006, Second Tarapore Committee (Committee on Fuller Capital Account Convertibility): It began work on 1 May 2006 and submitted its report on 31 July 2006. It drew up a roadmap in phases up to 2011.
• After 2008: The global financial crisis again showed the dangers of fast-moving capital, so India continued its gradual approach.

What preconditions did the first Tarapore Committee set?

It said a country should first make its economy strong enough to handle sudden money flows. Its main signposts were:

• Bring the Centre's gross fiscal deficit down to about 3.5% of GDP by 1999-2000. (Fiscal deficit is how much more the government spends than it earns, so it must borrow.)
• Keep inflation low and stable, in a range of 3% to 5% per year.
• Strengthen the banking system, mainly by cutting non-performing assets (NPAs), the bad loans that are not being repaid.

These preconditions were not fully met on time, so full CAC was never brought in.

How does India manage its capital account today?

The legal base is the Foreign Exchange Management Act (FEMA), 1999. It treats the two kinds of deals differently:

• Current account (Section 5): "Allowed unless banned." Most deals are free, and only a few are restricted or banned by the government.
• Capital account (Section 6): "Banned unless allowed." Only the classes of deals that the RBI permits (in consultation with the central government) can take place.

Under this system, India has opened up many routes, each with its own limits:

• Foreign Direct Investment (FDI): Allowed in most sectors, some fully automatic and some needing government approval.
• Foreign Portfolio Investment (FPI): Foreign investors can buy Indian shares and bonds, within set limits. Since 1 April 2020, the Fully Accessible Route (FAR) lets non-residents buy specified government bonds without any limit.
• External Commercial Borrowings (ECB): Indian companies can borrow from abroad, with rules on amount, cost and use.
• Liberalised Remittance Scheme (LRS): A resident individual can send up to $2,50,000 per financial year abroad for allowed current or capital account deals. The scheme began in February 2004 with a limit of $25,000. It was cut to $75,000 in August 2013 when the rupee was under pressure, and it reached $2,50,000 in May 2015.

What are capital flow management measures?

Even countries that allow capital to move freely sometimes use temporary tools to slow down sudden flows. These are called capital flow management measures (CFMs). Some of them are also macroprudential measures, which means rules that protect the whole financial system, not just one bank. In 2012, the IMF adopted its "Institutional View" on capital flows.

It accepted that capital flows bring benefits, but said CFMs can be useful in certain situations, as long as they are temporary and are not used in place of proper economic policies.

A well-known type of CFM is the unremunerated reserve requirement (URR). Here, a part of the money involved in a deal must be kept as a deposit with the central bank, and this deposit earns no interest. This makes the deal costlier, so people do it less. Two famous examples:

• Chile (1991): In June 1991, Chile asked that 20% of many kinds of foreign inflows be kept as an interest-free deposit with its central bank. It raised this to 30% in July 1992, with a one-year holding period. The aim was to discourage short-term "hot money". The rate was cut to zero in 1998.
• China (2015): On 31 August 2015, China's central bank asked banks to keep a 20% foreign exchange risk reserve, earning no interest, on forward contracts in which clients bought foreign currency and sold yuan. It took effect on 15 October 2015 and aimed to curb bets on a falling yuan. China suspended it in September 2017 and brought it back at 20% in August 2018.

India's position and examples

India calls its approach calibrated or gradual: it opens the capital account step by step, gives priority to stable flows (like FDI) over short-term debt, and keeps the power to tighten rules when the rupee is under stress. For example, in 2013, when the rupee fell sharply, the LRS limit was cut from $2,00,000 to $75,000. Such steps show that capital account opening in India is not a one-way street.

Commonly confused concepts

• Current account convertibility vs capital account convertibility: The first covers trade, services and remittances, and the rupee is fully convertible here since 1994. The second covers buying assets and taking loans across borders, and the rupee is only partly convertible here.
• Convertibility vs internationalisation of the rupee: Convertibility is about the freedom to exchange the rupee. Internationalisation is about the rupee being used by foreigners for trade, investment and reserves. A currency usually needs a high degree of convertibility before it can be widely used abroad.
• Section 5 vs Section 6 of FEMA: Section 5 (current account) is "allowed unless banned". Section 6 (capital account) is "banned unless allowed".
• Capital controls vs macroprudential measures: Capital controls treat residents and non-residents differently based on where they live. Macroprudential measures apply to the whole financial system to reduce overall risk. Some tools, like a reserve on forex deals, can be both.
• Cash Reserve Ratio (CRR) vs an unremunerated forex reserve: CRR is a share of a bank's deposits kept with the RBI. A forex risk reserve is linked to the value of particular foreign exchange contracts, and is meant to make those contracts costlier.

Issues, criticism and the way forward

• For fuller CAC: Supporters say it would bring more foreign capital, cut the cost of borrowing for Indian companies, give Indian savers more choice, and help the rupee become an international currency.
• Against hasty CAC: Critics point to the Asian crisis of 1997-98 and the 2008 global crisis. They argue that fully open capital accounts expose countries to sudden stops and outflows, especially when the current account is in deficit and fiscal deficits are high.
• Effectiveness of controls: Research on Chile's URR suggests it changed the mix of inflows towards longer-term money, but its effect on the total amount of flows and on the exchange rate is debated. Controls can also be dodged, for example by splitting deals into smaller pieces.
• Cost to genuine users: Tighter rules can raise hedging costs and paperwork for honest importers and exporters, not just speculators.
• Way forward: Both Tarapore committees stressed that strong fundamentals (low fiscal deficit, low inflation, healthy banks, good reserves) must come first. Most experts favour continued gradual opening, with the RBI keeping temporary tools ready for times of stress.

Concepts to Know

• Hot money: Short-term foreign money that moves quickly between countries to chase higher returns. It can leave as fast as it comes.
• Balance of payments (BoP): The record of all money flows between a country and the rest of the world. It has two main parts: the current account and the capital account.
• Current account deficit (CAD): When a country pays more to the world for goods, services and other current items than it earns. It must be filled by capital inflows or by using reserves.
• Sudden stop: When foreign money suddenly stops coming in, or rushes out, often causing a currency crash.
• Speculation: Buying or selling something not because you need it, but to profit from a change in its price.
• Forward contract: An agreement made today to buy or sell foreign currency on a future date at a rate fixed today.