What is Capital Account liberalisation? What is Capital Account Convertibility (CAC)?

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June 8, 2024

What is Capital Account liberalisation? What is Capital Account Convertibility (CAC)?

Why in News:Gearing up to remain “future-ready for India’s fast-growing economy”, the Reserve Bank of India (RBI) has listed a series of aspirational goals, including capital account liberalisation and internationalisation of the Indian rupee (INR), universalising of digital payment system and globalisation of India’s financial sector in a multi-year timeframe.

Liberalizing Capital Account in the Indian Economy:

  • India has been following a gradual approach to liberalizing its capital account, which refers to the freedom of capital to flow in and out of the country. This approach balances potential benefits with managing risks.

Why Consider Liberalization?

Access to Foreign Capital: It can attract foreign direct investment (FDI) which brings in technology, expertise, and funds for infrastructure development. It can also attract portfolio investments that increase liquidity in the financial markets.

Improved Efficiency:  By integrating with global financial markets, Indian companies can access cheaper funds and investors can get better returns.

Signaling Effect: A more open capital account can be seen as a sign of a strong and stable economy, attracting more foreign investment.

Positive ImpactsEconomic Growth: Increased access to capital can lead to higher investment, job creation, and economic growth.

Exchange Rate Stability:  Foreign capital inflows can help stabilize the exchange rate by increasing the supply of foreign currency.

Financial Market Development:  Integration with global markets can lead to a wider range of financial products and services for Indian investors.

Negative Impacts:

Exchange Rate Volatility:  Large capital inflows or outflows can lead to sharp fluctuations in the exchange rate, impacting exporters and importers.

Financial Crises:  Sudden capital flight (investors pulling out money) can trigger financial crises.

Asset Price Bubbles:  Easy access to foreign capital can inflate asset prices (like stocks or real estate) creating bubbles that can burst later.

The Indian Approach:

  • India has taken a cautious approach, gradually relaxing restrictions on foreign investments while maintaining controls on short-term capital flows. This helps manage potential risks like exchange rate volatility and financial crises.
  • The Reserve Bank of India (RBI) constantly monitors and regulates capital flows to ensure financial stability.

What is Capital Account?

  • The capital account refers to the part of a country’s balance of payments that tracks non-trade related transactions. These transactions involve the movement of capital, such as:

Foreign direct investment (FDI) – Investments in businesses or assets with the intention of controlling or influencing them.

Portfolio investment – Buying and selling of stocks, bonds, and other financial instruments.

Loans – Borrowing or lending money between residents and non-residents.

What is Capital Account Convertibility (CAC)?

  • Capital account convertibility refers to the freedom to convert a country’s domestic currency into foreign currency, and vice versa, for capital account transactions. In simpler terms, it allows for the free flow of capital in and out of the country.

There are two main types of convertibility:

Full convertibility: Permits unrestricted conversion of domestic currency for both current and capital account transactions.

Partial convertibility: Allows conversion for some, but not all, types of capital account transactions.

The Tarapore Committee and CAC in India:

  • The Reserve Bank of India (RBI) set up the Tarapore Committee in 2006 to examine the feasibility of full capital account convertibility for India. The committee recommended a phased approach towards achieving this goal.

Key points from their report:

Preconditions for CAC: The committee identified certain economic preconditions for successful capital account convertibility, such as low and stable inflation, a strong financial system, and adequate foreign exchange reserves.

Phased Approach: They recommended a three-phase liberalization of capital account transactions, allowing for gradual relaxation of controls.

Benefits and Risks: The report acknowledged the potential benefits of CAC, such as attracting foreign investment and boosting economic growth. However, it also cautioned about the risks, like exchange rate volatility and potential for capital flight (sudden outflow of capital).

 Current Status:

India has been gradually liberalizing its capital account based on the Tarapore Committee’s recommendations. While significant progress has been made, full convertibility is still not achieved. The RBI continues to manage capital flows to maintain financial stability.

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What is Capital Account liberalisation? What is Capital Account Convertibility (CAC)? | Vaid ICS Institute