Financial Developments in India: Should India Introduce Capital Account Convertibility?

By Gupta, Desh; Sathye, Milind | Indian Journal of Economics and Business, June 2005 | Go to article overview

Financial Developments in India: Should India Introduce Capital Account Convertibility?


Gupta, Desh, Sathye, Milind, Indian Journal of Economics and Business


Abstract

The objective of this paper is to examine whether India has reached a stage of financial development when full capital account convertibility could be introduced. The issue is important because in the aftermath of the Asian and other developing countries crises, there has been some rethink and recognition that financial deregulation can't run ahead of prudence. We answer the question posed above within the framework provided by McKinnon on financial repression and thereafter use the relevant financial development indicators developed by Goldsmith to assess whether India has reached a stage of financial development when full convertibility of rupee could be introduced. The study concludes that India has not yet reached a stage where full capital account convertibility could be possible.

Key Words: Currency convertibility, Indian economy, capital movements, economic integration.

JEL Classification: F 21, 32, 36.

Introduction

The objective of this paper is to examine whether India has reached a stage of financial development when full capital account convertibility could be introduced. 'Capital account convertibility is the freedom to convert local financial assets into foreign financial assets and vice-versa at market determined rates of exchange' (Tarapore Committee, 1997). It is associated with changes of ownership on foreign/ domestic financial assets and liabilities and embodies the creation and liquidation of claims on or by the rest of the world. Capital account convertibility can be, and is, coexistent with restrictions other than on external payments. It also does not preclude the imposition of monetary/fiscal measures relating to foreign exchange transactions, which are of a prudential nature (Reserve Bank of India, 2000).

The issue is important, first, because until the Asian crises of 1997-98, there was a growing consensus that free global financial flows were positive for all and more so for the developing countries. This was based on the proposition that it would help improve global allocation of financial resources. As the returns on capital were higher in developing countries, finance would flow, in general, from the developed countries to developing countries. In the aftermath of the Asian and other developing country crises, however, there has been some rethink and recognition that financial deregulation can't run ahead of prudence (Stiglitz, 2002). Second, there is also the issue of the sequencing of financial liberalisation. Even the leading proponent of financial repression and its associated costs, McKinnon (1973, 1991) has argued that capital account convertibility should come at the end of this process. Though there was support for financial liberalization, opinions differed about the pace at which it could proceed. Some countries like Thailand abolished the controls quickly and opened up their economies while countries like India continued to proceed at slow pace. Until 1991, the Indian economy was subject to a high degree of financial repression and national and international controls. These controls were being lifted slowly when the Asian economic crisis struck. Though, India didn't experience the shock and contagion as some South East Asian countries did, rethinking began whether or not controls should continue to be lifted and the pace at which this should be done. It was feared that lifting of all controls and thus making rupee fully convertible could expose India to shocks and contagion such as those experienced by Asian countries. At the same time, lack of full convertibility on capital account was acting as an impediment for free flow of capital resources. Third, India is now in race with China to attract foreign direct investment and hence has to weigh the pros and the cons in taking a decision about full convertibility of its currency. Thus, India provides a good case to analyze.

We answer the question posed above within the framework provided by McKinnon (1973) on financial repression and thereafter use the relevant financial development indicators developed by Goldsmith (1969) to assess whether India has reached a stage of financial development when full convertibility of rupee could be introduced. …

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