People's Democracy

(Weekly Organ of the Communist Party of India (Marxist)

Vol. XXX

No. 45

November 05, 2006

Fuller Capital Account Convertibility: A Euphemism For Disaster


Rana Mitra


IN their zeal to move forward down the path of economic reforms at a break-neck speed, bulldozing the speed breakers being put up by the Left and democratic forces, the prime minister announced on March 18, 2006 his government’s resolve to move towards full capital account convertibility of Indian rupee ignoring even the advice of his pro-liberal friends. In order to operationalise this, a committee named as Tarapore II under the leadership of S S Tarapore, ex-deputy governor, RBI was constituted by the RBI which commenced its work from May 1, 2006 and has since submitted its report on August 31, 2006 to RBI. 


This new report has generated a fresh debate on the fuller capital account convertibility (FCAC) and its real implications, particularly for countries like India. This is more so as the new Tarapore Committee II, have themselves admitted in their report that various countries including European Union still continue with several restrictions on FCAC. Even IMF, which has mooted the idea of changing its Charter to include FCAC in its mandate, has shelved the idea in view of its possible dangers. Moreover, the link between FCAC and growth is yet to be firmly established by any stretch of empirical evidence. 


First of all, we should try to gather the meaning of full capital account convertibility, as distinct from partial capital account convertibility or convertibility of current account. As of now, we all are probably aware that the convertibility of Indian rupee into foreign currencies and vice versa is almost wholly free for current account transactions like trade, tourism, travel, education abroad and in India, and remittances into and out of India for purchasing health-care products. In contrast, the principal focus of capital account convertibility is on assets, both financial and real. Today, we have limited capital account convertibility. An Indian individual or institution is allowed, subject to certain conditions, to invest in foreign assets. Foreigners too are similarly allowed to invest in India. The current limitation to capital account convertibility includes limits on investments by foreign financial institutions in government papers, ceiling of 74 per cent for foreign shares in domestic equity, and specific sectors being off limits for foreign investments e.g. retail trade. Complete capital account convertibility of the rupee would mean almost no restrictions and no questions for free flow of foreign currencies and rupee in and out of India.




It is to be noted that earlier in 1997, the central government had constituted a committee under S S Tarapore, the then deputy governor, RBI to indicate a possible road map for full capital account convertibility. It recommended a three-year time frame for complete convertibility by 1999-2000, subject to following conditions:

  1. The Gross fiscal deficit to GDP ratio should come down to 3.5 per cent

  2. A consolidated sinking fund has to be created to meet the government’s debt repayment needs to be financed by increases in the RBI profit transfer to the government and disinvestment proceeds

  3. The inflation rate should remain between an average of 3 per cent to 5 per cent

  4. Gross NPAs of the public sector banking system should be brought down to 5 per cent, along with bringing down the average effective Cash Reserve Ratio (CRR) to 3 per cent

  5. The RBI should have a monitoring exchange rate band of plus minus 5 per cent around a Real Effective Exchange Rate, about changes in which RBI should be transparent 

  6. The external sector policies should be designed to increase current receipts to GDP ratio and bring down the debt-servicing ratio from 25 per cent to 20 per cent


As of now, various above parameters remain unfulfilled even according to Tarapore II committee report. For example, the fiscal deficit, thanks to the government’s reluctance to mop up fresh resources through increased taxations on the rich (incidentally, India is one of the lowest taxed countries in the world with tax to GDP ratio remaining in the band of 10-10.5 per cent), remains in the domain of 4 per cent, not 3.5 per cent as desired by the Tarapore I committee. The inflation rate of late is also quite high, thanks to repeated bouts of increase in prices of petroleum products ignoring the productive suggestions made by the Left and democratic forces. So, even on the conditions suggested by the Tarapore I and II committees, a quick move to full capital account convertibility would be highly premature. 


In fact, IMF, the main proponent of full capital convertibility, has changed its tune a bit after the disaster of East Asian economies who suffered a setback due to their over enthusiasm to introduce pre-mature capital account convertibility. IMF research (Prasad Eswar, Kenneth Rogoff, Shang Jin Wei and M Ayhan Kose titled “Effects of Financial Globalisation on Developing Countries: Some Empirical Evidences”, 2003) concluded that there is at best mixed evidence of net benefits from free capital flows. Interestingly, after IMF partially abandoned its enthusiasm about immediate introduction of capital account convertibility for the developing countries, the main pressure for liberalising capital flows is coming from US treasury through arm-twisting of bilateral trade regimes. The US trade negotiators are vociferously demanding that the partner country commit itself to never reemploying effective capital controls for any length of time. The victims in question are, for example, Singapore and Chile, who were forced to choose between abandoning their aim of securing free trade agreements with the US and abandoning their ability to control capital movements with the object of bypassing a crisis a la East Asian type. 




Now, if we look at the trend of capital flows in and out of the developing countries in the recent past in the wake of introduction of full capital account convertibility in a number of them, we get an interesting emerging trend. The IMF estimates quoted in Global Development Finance 2006 shows such capital outflows by private entities from developing countries galloping from less than $60 billion in 1995 to as much as $260 billion in 2005. The opening of capital accounts in such countries enabled the rich and the nouveau rich to park their funds abroad through diversification of financial assets at their disposal at the cost of irreparable loss for the starved-off investment sectors of these countries. This has become another tool for the developed countries to enchain the capital starved economy through systematic siphoning off capital from the poor developing countries. 


Paradoxically, the Economic Survey, Government of India, 2005-06, has adopted a cautionary approach as far as introduction of capital account liberalisation is concerned. Hailing the conservative approach followed by India, which apart from China had escaped the crisis faced by East and South East Asian economies, it says: “ … the potential disruptive consequences of the sharp expansion in the capital account appear limited in case of India because of the calibrated policy followed in liberalizing the capital account …” Pointing at the negative current account balance of (-) 1.8 per cent of GDP for India compared to (+) 6.1 per cent of the GDP for China (the latter is still hesitant to introduce such full convertibility), the Economic Survey points out: “…. Nevertheless given the marked difference in the current account performance between India and most other economies in the region, there may be a continuing need to maintain a close watch on the quality of the capital flows financing the current account deficit.” 


Even, the United Nations “World Commission on Social Dimension of Globalisation” in its recent report says that on capital account convertibility there is an emerging agreement that the growth benefits to be derived from it are small. A basic structural flaw of this system of full convertibility is the prominence of short-term speculative flows within the system. This has led to surges in capital flows when the capital accounts are opened, only to be swiftly reversed after a brief span. This has been largely driven by a quest for short term speculative gains that has not only failed to contribute to an increase in productive investment but has spawned new bottlenecks and crisis to design development policy. It is needless to say that like East, South East Asian and Latin American experience, the burden of this crisis, in the form of closure of banks, factories, severe unemployment, unbridled price rise, upswing in poverty ratio et al, in case of any eventuality, will have to be borne by the common people for no fault of their own. Interestingly, the Tarapore II committee too, in their latest report, could not rule out the possibility of sudden outflow of capital as a result of FCAC. It says: “…. The issue of liberalisation of capital outflows for individuals is a strong confidence building measure, but such opening up has to be well calibrated as there are fears of waves of outflows…”. 




In Indian context this and other possibilities of outflow of capital as a result of FCAC has assumed special significance as the relevant RBI report on the subject says that the short term foreign loans as a percentage of foreign exchange reserves has increased from 4.2 per cent as at March end 2004 to 7 per cent as at March end 2006. Similarly, the percentage of volatile foreign investment to total foreign exchange reserve has galloped from 35.2 per cent to 43.2 per cent during the same time span. However, surprisingly, in spite of making all these observations about endangering financial stability in India in wake of possible introduction of FCAC, the Tarapore II has finally recommended for gradual introduction of FCAC in a three-staged phased manner ending in 2010-11. 


Moreover, in the name of consolidation of PSU banks in India in order to face up to the challenges posed by the post-FCAC period, the committee has digressed from its main agenda and mandate, to recommend bringing down the government stake in these banks from the minimum stipulated 51 per cent to 33 per cent. In this connection, the committee failed to answer one simple but important question. This is: if at all the pattern of private ownership in banks is a factor for consolidation to avoid currency crises that have been well-documented by the committee itself in its report, why countries like Thailand, Malaysia, Indonesia, South Korea, Brazil etc. suffered inspite of having private sector domination in bank ownership? In the Indian context, can we afford to forget easily the bitter experience of winding up of private banks like the Global Trust Bank, Nedungadi Bank, Centurion Bank and, of late, the United Western Bank, who all were and are proposed to be rescued by their mergers with some of the Public Sector Banks? This shows that the committee may be acting under some external pressures to hurry up introduction of FCAC – if not fully then at least fulfilment of some amount of road map suggested by it, even if it means a compromise on its intellectual honesty. 


So, ordinary citizens of the developing countries like India – not the cash-rich privileged few, who can take advantage of liberal capital account regime to park their funds abroad to maximise their wealth – should stand firm against any attempt to further liberalise the capital account transactions, which is a recipe for sure disaster. (Incidentally, Tarapore I & II committee reports made no secret of its core purpose to help the resident individuals to find legal avenues to park their overflowing funds abroad, as the facilities available to corporates, according to the committee, are already fairly liberal). It may not be out of place to mention here that it was the movement of the Left and democratic forces, especially of the financial sector trade unions through series of action programmes including no less than ten all India strike actions following the introduction of disastrous recipe of Liberalisation, Privatisation and Globalisation (LPG) policies in India in 1991, that have saved the country, albeit partially, from the machinations of international financial sharks. Through this, these trade unions have, in effect, shouldered a nationalist duty of saving the economy of our country from being totally ingested by the international finance capitalists. Narratives of Indian democratic and patriotic movement in this period should include proper appreciation of this historic role played by the trade unions and other mass organisations at a critical juncture of our national existence.