In the 1990s, two committees—one known as Sodhani Committee (1994) and another the Tarapore Committee (1997)—were set up by the RBI to prepare further relaxation of exchange control.
The Committee on Capital account Convertibility, that is, the Tarapore Committee headed by S.S. Tarapore was asked to prepare a road map for capital account convertibility as this constitutes a great leap towards globalisation of our economy.
The Committee submitted its report on 3 June 1997 and recommended for its introduction after fulfilling certain conditions.
Meanwhile, the then Finance Minister said in June 1997, that the country’s foreign exchange reserves were embarrassingly high and that it had become necessary to liberalise the export of capital by allowing residents to invest abroad—a sentiment broadly along the lines of the recommendations of the Tarapore Committee.
The Committee defined the concept of capital account convertibility (henceforth CAC) as the freedom to convert local financial assets and vice versa at market-determined rates of exchange. The Committee laid down some preconditions for the introduction of CAC.
1. Fiscal consolidation implying reduction of fiscal deficit of the Central and State Governments to 3.5 p.c. of GDP;
2. A mandated inflation target of 3.5 p.c.;
3. Strengthening of financial system by bringing down banks’ bad debts and cash reserve ratio (CRR).
In addition to these three main preconditions, the CAC Committee also said that, for the purpose of introducing of CAC, country’s foreign exchange reserves should exceed (i) six months’ imports, (ii) three months’ import plus half of annual debt service payments plus a month’s commodity trade, etc.
Benefits of Capital Account Convertibility:
It has many protagonists and critics. First, we will present the arguments suggested by the supporters and then the counter-arguments of the CAC.
In the first place, advocates of CAC argue that it leads to higher investment and, hence, economic growth because of easier and cheaper availability of foreign exchange resources.
Secondly, countries like India need more foreign capital and investment in a liberalised regime as developing countries suffer from ‘savings gap’. CAC, thus, spurs foreign capital to move in the country that brings in foreign advanced technology, skills and many other related positive externals. Again, economic growth will then get a boost.
Thirdly, CAC helps to maintain macroeconomic discipline. As convertibility involves external monitoring by the global financial markets, governments tend to behave in a responsible manner so that fiscal imbalances do not creep in. Rising fiscal deficit is a damper to the foreign investors thereby defeating the purpose of convertibility. It has also the potentiality of improving efficiency in the country’s financial system.
Critics, however, do not think as we have suggested here.
First, one cannot conclusively argue that CAC leads to higher economic growth. In fact risks and uncertainties abound in liberalising capital account, if at least East Asian crises of 1997-98 were any guide. Thus, the gain in economic growth is ‘potential’ but the dangers involved in the scheme are ‘real’.
Secondly, CAC is not a magic wand that, in all probability, will minimise the savings gap by greater inflow of foreign resources. Actually, economic performance of a nation largely depends on the growth of industrial and other sectors of the economy and not on the CAC. Even without adopting CAC, China’s economic performance has attracted the attention of the Western powers and international organisations—the IMF, World Bank, etc.
Thirdly, conditions/signposts for CAC require reduction of fiscal deficit to GDP ratio to 3.5 p.c. This is the area where the Government of India as well as the State Governments are shy at reducing fiscal deficit. In other words, governments need to be more disciplined so that the fiscal deficit could be kept at the recommended level. Fiscal deficit rose from 4.7 p.c. of GDP in 1997-98 to 6.2 p.c. in 2001-02. Since then, however, we see a decelerating trend and it came down to 3.1 p.c. of GDP in 2007-08.
A battery of measures have been taken to liberalise the capital account so that convertibility on capital account transactions can be made. A proposal was made in 2006 for the introduction of full CAC, taking the ground realities into account. Accordingly another committee, named Fuller Capital Account Convertibility, was constituted under the chairmanship of S.S. Tarapore in July 2006. This Committee submitted its report in September 2006. Anyway, following the recommendations of the Committee, several measures have been taken by the Reserve Bank.
Thus, we are heading towards the last leg of full convertibility on capital account. It is expected to be accomplished within next two years, provided no serious disruption in the domestic front as well as in the external sector occurs consequent upon the economic turmoil that has engulfed the entire world. India is also in the know where the shoe pinches.