Convertibility of Rupee on Capital Account

Summary

Dr. S.R.K. Rao’s pamphlet, based on a 30 September 1997 talk under the auspices of the Forum of Free Enterprise, is a primer on capital account convertibility (CAC) and a stocktaking of where India stood at that moment. Rao defines convertibility on capital account as the freedom to swap local for foreign financial assets and vice versa at market-determined exchange rates without government controls, then lists its advantages: deeper integration with the global economy, cheaper access to foreign capital, portfolio diversification, alignment of domestic with international interest and tax regimes, deterrence of capital flight, and the development of a derivatives and risk-management market.

The bulk of the pamphlet works through the preconditions and sequencing recommended by the Reserve Bank of India’s Committee on Capital Account Convertibility (the Tarapore Committee): fiscal consolidation, an inflation target of 3–5 per cent, financial-sector strengthening, reduction of bank non-performing assets from 13.7 per cent to 5 per cent by 2000 A.D., a cut in average effective CRR to 3 per cent, an REER monitoring band of ±5 per cent, a rise in the current-receipts-to-GDP ratio from 15 to 28 per cent, and a forex-reserve cushion of at least six months of imports. Rao tracks the liberalisation already undertaken since 1991 — devaluation, opening of FDI ceilings to 74/51 per cent, GDR and FCCB issues, FII access to debt markets, NRI deposit schemes shorn of exchange-rate guarantees, and current-account convertibility under IMF Article VIII in August 1994 — and notes that the RBI’s 1996-97 Annual Report broke with the Committee by favouring an “eclectic” approach that liberalises while preconditions are still being met.

A second half of the pamphlet examines sectoral consequences: stiff competition for banks with mergers, restructuring and pressure on small/regional banks; NPA reduction and risk-management upgrades; stock-market gains tempered by the need for international reporting norms, depositories, derivatives, T+1/T+3 settlement and end-to-end transparency; and a thin forward forex market that needs deepening if the rupee is to be insulated against volatility. Rao registers the perception that CAC will trigger capital flight, then cites Deputy Governor Y.V. Reddy’s empirical rebuttal and former Governor S. Venkitaramanan’s claim that the rupee is already three-fourths convertible.

The pamphlet closes with a cautionary glance at the 1997 Asian currency crisis — Malaysia’s Mahathir Mohammad blaming foreign fund managers such as George Soros, UNCTAD’s worry about short-term speculative inflows, and proposals for a Tobin tax, “Global Watch dogs” and ethics rules for fund managers. Rao reads the Tarapore sequencing pragmatically (25 of 40 recommendations are ready for 1997-98), welcomes the replacement of FERA by FEMA, and recommends India follow Japan/US/Chile-style central-bank legislation to track large flows even after CAC.

Key points

• Defines capital account convertibility as two-way market-rate convertibility of local and foreign financial assets without government controls — distinguishing it from already-achieved current account convertibility.

• Lays out the advantages of CAC: integration with global capital markets, cheaper foreign capital, portfolio diversification, alignment of domestic tax and interest rates with international levels, deterrence of capital flight, and growth of derivatives markets.

• Catalogues the Tarapore Committee’s preconditions — fiscal deficit to 3.5% by 2000 A.D., inflation 3–5%, bank NPAs from 13.7% to 5%, CRR to 3%, REER ±5% band, current-receipts/GDP from 15% to 28%, debt-service ratio to 20%, six-month forex reserve buffer.

• Traces India’s incremental liberalisation since July 1991 — devaluation, FDI ceilings raised to 74/51%, GDRs and FCCBs, FII access, NRI deposit reforms, Article VIII current-account convertibility from August 1994.

• Highlights the divergence between the RBI’s preferred “eclectic” approach and the Committee’s preference for fulfilling preconditions before moving further toward CAC.

• Sectoral impact: bank consolidation and pressure on small/regional banks, urgent NPA reduction, stock-exchange upgrades (depositories, derivatives, T+1/T+3 settlement, international reporting), and the need to deepen a thin forward forex market.

• Treats the 1997 Asian/Malaysian currency crisis as a cautionary tale on weak banking, unregulated short-term flows and speculative attacks — citing Mahathir’s clash with George Soros and UNCTAD’s findings, and listing Tobin-tax-style remedies.

• Recommends replacing FERA with FEMA, retaining central-bank monitoring of large inflows and outflows on the Japan/US/Chile model, and moving on the 25 of 40 Tarapore recommendations that are immediately actionable.