Capital account convertibility: an inescapable choice? (The Hindu,GSpaper 3 )

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Keeping any restriction for too long could prove self-defeating, says RBI Executive Director

G Padmanabhan, Executive Director of the Reserve Bank of India (RBI), has suggested that India should move towards making the rupee more convertible for capital transactions by foreign investors.
Addressing a meeting at MSNM Besant Institute of PG Management Studies in Mangaluru recently, he said that “ greater opening of capital account is inescapable as the Indian economy grows further and becomes global in dimension.’’
The text of his speech has since been put up on the website of the RBI.
Stating that India would become a truly globalised economy in the not-too-distant a future, he felt that the country could not afford to remain isolated for a very long period of time. “Sooner than later, it will need to get closely integrated with the rest of the world,’’ he pointed out.
Significantly enough, Mr. Padmanabhan’s observation comes in the wake of the RBI allowing Indian companies to raise rupee debt offshore. Also, this has to be read in the context of Governor Raghuram Rajan’s recent call for full convertibility of the rupee in a “short number of years.’’
Mr. Padmanabhan conceded that there were risks associated with full capital account convertibility. Yet, he felt that resisting liberalization over an extended period could prove futile and counter-productive. As the economy got more globalised, it would become harder to maintain closed capital accounts, Mr. Padmanabhan said. “Increasing openness to international trade may create opportunities for circumvention of capital account restrictions through under- and over-invoicing of trade transactions, and the increasing sophistication of investors and global financial markets makes it much easier to do so,’’ he conceded. Corporates could use transfer pricing to get around capital account restrictions, he said. However, keeping any restriction for too long could prove self-defeating as people ended up finding new methods of bypassing that restriction, he added. Ipso facto, he felt, India should move towards full capital account convertibility. “There is simply no escape from it,’’ Mr. Padmanabhan asserted.
How fast that movement should be would, however, depend on how fast the country could meet the pre-conditions such as fiscal consolidation, inflation control, low level of NPAs (non-performing assets), low and sustainable current account deficit, strengthening of financial markets, prudential supervision of financial institutions etc. “India has already made visible progress on these fronts. There are, of course, risks, but we need to accept these risks and move forward boldly while controlling the risks as far as practicable,’’ he said. Sound policies, robust regulatory framework promoting a strong and efficient financial sector, and effective systems and procedures for controlling capital flows greatly enhanced the chances of ensuring that such flows fostered sustainable growth and did not lead to disruption and crisis, he said. “India has all these in place, and we need to keep on strengthening them,’’ he pointed out.
What does capital account convertibility mean?
Essentially, it means freedom to convert local financial assets into foreign ones at market-determined exchange rates.
What can it do?
It can lead to free exchange of currency at lower rates. Also, it can result in unrestricted mobility of capital.
How does it benefit a nation?
It can trigger stepped up inflow of foreign investment. Transactions also can become much easier, and occur at a faster pace.
What are the negatives?
It could destabilise an economy especially if there is massive capital flows in and out of the country. Currency appreciation/depreciation could affect the balance of trade.
Where does India stand now
India currently has full convertibility of the rupee in current accounts such as for exports and imports. However, India’s capital account convertibility is not full. There are ceilings on government and corporate debt, external commercial borrowings and equity.
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