The RBI Governor recently said that India will continue to approach capital account convertibility as a process rather than an event. He also pointed out that capital account transactions in the rupee are already convertible to a great extent.

What is it?

The balance of payments account, which a statement of all transactions made between a country and the outside world, consists of two accounts — current and capital account. While the current account deals mainly with import and export of goods and services, the capital account is made up of cross-border movement of capital by way of investments and loans.

Current account convertibility refers to the freedom to convert your rupees into other internationally accepted currencies and vice versa without any restrictions whenever you make payments.

Similarly, capital account convertibility means the freedom to conduct investment transactions without any constraints. Typically, it would mean no restrictions on the amount of rupees you can convert into foreign currency to enable you, an Indian resident, to acquire any foreign asset. Similarly, there should be no restraints on your NRI cousin bringing in any amount of dollars or dirhams to acquire an asset in India.

India has come a long way in liberating the capital account transactions in the last three decades and currently has partial capital account convertibility.

Some of the recent moves include increasing the foreign portfolio investment limits in the Indian debt markets, introducing the Fully Accessible Route (FAR) — through which non-residents can invest in specified government securities without any restrictions and the easing of the external commercial borrowing framework by relaxing end-user restrictions. Inward FDI is allowed in most sectors, and outbound FDI by Indian incorporated entities is allowed as a multiple of their net worth

Why is it important?

Developing are usually cautious in opening up their capital account. This is because inflows and outflows of the foreign and domestic capital, which are prone to volatility, can lead to excessive appreciation/depreciation of their currency and impact the monetary and financial stability.

India’s prudence in opening up its capital account was lauded after the currency crisis in East Asian countries in 1997 exposed the problems arising from the potent combination of high current account imbalances, dependence on short-term capital flows and the whimsical nature of these flows. The SS Tarapore committee’s report on fuller capital account convertibility released in 2006 argued that even countries that had apparently comfortable fiscal positions have experienced currency crises and rapid deterioration of the exchange rate, when the tide turns.

The report further points that most currency crises arise out of prolonged overvaluation in exchange rates leading to unsustainable current account deficits. An excessive appreciation of the exchange rate causes exporting industries to become unviable, and imports to become much more competitive, causing the current account deficit to worsen. Thus, it suggests transparent fiscal consolidation is necessary to reduce the chances of a currency crisis.

Why should I care?

If you are an investor looking to park money overseas or an NRI wanting to invest in Indian assets, full convertibility on capital account may give you a greater opportunity to diversify investments and reduce geographical risk. Note that cross-border investments are allowed even now under RBI’s Liberalised Remittance Scheme but within the overall limit of $250000.

The bottomline

It’s an alluring idea in theory but we’re not ready to put it into practise yet.