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Capital Account Convertibility of the Rupee

Three important preconditions need to be met before the rupee is made convertible on the capital account. Investment in real estate should be confined to persons of Indian origin, gold stocks should be used to provide a buffer against exchange crises and the combined deficits of the centre and states should be brought down to 3 per cent of GDP.

Capital AccountConvertibility of the Rupee

Issues for Prior Action

Three important preconditions need to be met before the rupee is made convertible on the capital account. Investment in real estate should be confined to persons of Indian origin, gold stocks should be used to provide a buffer against exchange crises and the combined deficits of the centre and states should be brought down to 3 per cent of GDP.


hough the rupee had become fully convertible on current account as early as 1991, the RBI has been adopting a cautious approach towards full float of the rupee, particularly after the 1997 south-east Asian currency crisis. While there has been a substantial relaxation of foreign exchange controls during the last 10 years, the current account convertibility since 1994 means that both resident Indians and corporates have easy access to foreign exchange for a variety of reasons like education, health and travel. They are allowed to receive and make payments in foreign currencies on trade account. The next logical step in the same direction would be full convertibility, which would remove restrictions on capital account. This will mean that domestic assets like real estate and shares could be sold to foreigners and payments received without prior regular clearance. Similarly foreigners, namely, not merely nonresident Indians, will be allowed to invest in Indian assets. Since 1997, the Reserve Bank of India has implemented various measures listed in the first Tarapore Committee (1997) report, which have helped in instilling certain degree of confidence in the Indian corporate world. While full convertibility will open the avenues for investments in real estate, one should note that the RBI has already permitted individuals to invest up to US $ 25,000 per annum in foreign currency assets. The fact, however, remains that very little investment has taken place through this route.

It should, however, be appreciated that when one talks in terms of autonomy in monetary policy, one has to recognise the fact that in the Indian context, monetary policy cannot have the same macroeconomic impact as fiscal policy. On fiscal policy itself we have to travel a long way to achieve fiscal consolidation. In this connection it needs to be mentioned that the earlier Tarapore Committee had confined itself only to the central deficit (this was the major weakness of that report) while in the Indian situation, one has to pay equal attention to the combined fiscal deficit of the states and the centre, which was around 8 per cent of GDP till recently and it has come down to 7.7 per cent of GDP according to the revised estimates for 2005-06. One should hope that the Tarapore Committee of 2006 has not repeated the same mistake and has looked at the fiscal deficit in its entirety and not just the fiscal deficit of the centre alone.

A Suggested Approach

Apart from keeping the experiences of other countries which have opened the capital accounts in view, we have to address ourselves to three major issues in the Indian context. They are the high level of the combined fiscal deficit of the centre and the states, implications of investment in real estate by foreigners in India, and the desirability of bringing the huge stock of domestic gold holdings in India into the banking system in general and the composition of the country’s reserves in particular. This requires certain measures both in the short term and the medium term. Investment in real estate: Full convertibility means that restrictions on capital account too will be withdrawn. This basically implies that domestic assets – real estate and shares – could be sold to foreigners and payments received without previous regulatory clearance. There will also be a corresponding right for foreigners – not just nonresident Indians – to invest in Indian assets.

There have already been substantial moves in the direction of full convertibility in India. The stock markets have been fuelled by foreign money, which comes in through registered institutional investors. Many categories of resident Indians have been allowed to open foreign currency accounts abroad. Indian companies have been making overseas acquisitions for which they have given generous access to foreign currency resources.

In practice there could never be a situation where capital moves across national borders, totally unhindered by controls. Full convertibility implies fewer but not a complete dismantling of controls. Even developed countries like the US restrict investments in specific sectors. In India too, it has never been easy even for non-resident Indians, who have enjoyed substantial capital account convertibility for long, to acquire property and real estate. Further, there are caps on foreign direct investment (FDI) in India. It is fanciful to think that all these will be scrapped to permit unrestricted capital flows only to prove that a full convertibility regime has arrived.

Once capital convertibility of the rupee is in place, domestic assets, real estates and shares could be sold to foreigners and payment received without previous regularity clearance. There will also be a corresponding right for foreigners – not just for non-resident Indians – to invest in assets abroad. It is a well known fact that real estate in India would be a highly attractive option for several foreigners. Prices have reached astronomical levels in the metros. It is but obvious that an asset price bubble is building up in real estate. As in the stock market, this may be music to the ears of those who have been holding on to their assets for some time, but it spells danger to those who enter the market as buyers at the last stages of the boom. While high prices for stocks make capital less expensive for companies and thereby facilitate fresh investment, high real estate prices have mostly negative consequences for a broad cross-section of the economy. We have now reached a stage where a premium flat in Mumbai commands a higher price than an average flat in Manhattan, notwithstanding the fact that construction costs in New York are five times as high as in Mumbai.

Two issues need attention. First, it is but natural for real estate prices to climb when the economy is doing well, incomes are rising and interest rates are low. All these factors encourage investment in housing,

Economic and Political Weekly September 2, 2006

and therefore demand increases. It might seem logical that there should be land scarcity in India’s crowded cities, but it has been pointed out that the scarcity is mostly the result of defective land use policy. All the land occupied by dead textile mills in central Mumbai, similarly, has been locked out of the market for decades, and is being unlocked only now, though at a snail’s pace.

The second issue is the negative impact of high real estate prices. They lock the majority out of the housing market and make the dream of owning a home more distant in a country where the majority in our cities are not homeowners, and the majority of homeowners crowd their families into one or two-room apartments/tenements. The second negative consequence of high real estate costs is that they push up wages because it has become more expensive to live in a big city. As a result, the competitiveness of Indian companies suffers. One reason why Mumbai now has competition from Delhi/Gurgaon and Bangalore is precisely because real estate costs in Mumbai have gone far too much high, and companies had to look for cheaper alternatives. But if the disease of high house prices were to spread to all of India’s 35 million-plus cities (as seems to have started happening) there is trouble brewing.

In view of the soaring real estate prices in metro cities like Mumbai and Delhi as well as suburbs of Delhi, investments in real estate will become a highly attractive option for not just persons of Indian origin settled abroad but wealthy foreigners who have nothing much to do with India. This will not merely push up the real estate prices to such an extent that the houses and flats in India may become out of reach for Indian residents.

In fact it may be worth studying the position prevailing in Singapore where people are not allowed to make money on real estate, as they have to resell their flats or houses only to a government agency. Keeping in view the large population in general and longevity of the ageing population in particular and the need to provide shelter to all Indians irrespective of the fact whether they are rich or poor, it is felt that investments in real estate should be restricted to persons of Indian origin only in the first instance. Throwing open the flood gates of investment in real estate to everybody living across the globe could very well result in a situation where the future generations of Indians would be paying rent in hard currency to some overseas investor who has no connections with India at all – “a sight to dream of, not to tell”. It is recommended that as and when capital convertibility of the Indian rupee is in place, investment in real estate and properties in India is restricted to persons of Indian origin only and that this avenue will not be open to any other foreigner.

Monetary and fiscal surveillance of the economy, till now guided by national exigencies, and rather successfully at that, would have to face additional hurdles in terms of the newly achieved mobility of domestic capital. This would entail the much talked about “trilemma” faced by countries in managing exchange rates while following an autonomous monetary policy under full capital account convertibility. One is tempted to ask if the country’s central bank will be able to avoid a run on the exchange rate, upward or downwards, if the tools of national monetary management like the Market Stabilisation Scheme and the Liquidity Adjustment Facility are rendered ineffective?

Possibilities of money transfers by residents on a legal basis would also make it obligatory, if not mandatory, on the part of the monetary authorities to maintain parity between the risk/uncertaintyadjusted domestic and foreign interest rates. The added responsibility would erode further the social priorities for credit disbursements in the economy, which are being steadily dismantled in terms of financial deregulation.

The market-oriented priorities of credit today are evident in the flows of loans towards housing and real estate moving up by 44.6 per cent and 90.3 per cent during 2004-05, in contrast to the rather moderate increases of around 35 per cent and 15 per cent respectively for agriculture and small industry during the year, though the last two sectors provide a major share of employment in the country.

Stock exchanges have been experiencing a bull run for a while now. These are well funded both with domestic credit and net inflows of Foreign Institutional Investor (FII) funds. The latter speak for closer integration with major international capital markets. New FII inflows at $ 8.2 billion during 2004-05 were more than two-thirds of the aggregate net inflow of foreign capital at $12.1 billion in the same year. Will the government be able to manage the exchange rate and avoid a financial disaster if resident Indians too join the FIIs in moving out in times of crises? The country can ill afford to falter. This takes us to the next section.

Gold Holdings

The second issue, which the RBI panel has to address, would be with regard to gold holdings in India. According to the latest estimates, gold holdings in India are almost a third of its GDP and 10 per cent of worldwide stock. The value of gold held by Indian households is more than double the market value of the equity stock they own. At the beginning of 2004-05, gold holdings in India exceeded $ 200 billion, which is almost a third of India’s gross domestic product (GDP). Significantly, this is 2.5 times the current estimated equity holding of $ 80 billion. While the share of gold in household savings declined between 2000 and 2002 to 5 per cent, it has been on the rise once again during the past two years and stood at around 10 per cent in the quarter ended March 2005. It has been estimated that instead of investing their annual savings predominantly in gold, if Indians were to invest them in productive business assets, India’s annual GDP growth would be higher by about 0.3-0.4 percentage points.

Traditionally, gold has been a good safety net for Indian households. However, the sharp rise in gold imports over the past three years is surprising when the rupee started appreciating, inflation was

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Economic and Political Weekly September 2, 2006 relatively low, banking facilities improving, and economic confidence picking up. India’s share of global gold demand is about one and a half times that of the US, though its GDP is only 1/20th that of the US. With its high rate of gold consumption, India accounts for 18 per cent of annual global gold demand, while its share of global GDP on nominal dollar GDP is only 1.6 per cent.

At current market values, gold accounts for 10-15 per cent of the Indian household balance sheet. The real question is why don’t financial assets impress the average Indian household? Analysts say it points towards gaps in the broader policy framework, including the government’s expenditure mix.

After rising by 63 per cent during the fiscal year ended March 2004, India’s gold consumption excluding gold used for jewellery exports rose by 57 per cent in the fiscal year ended March 2005. In fact, during the quarter ended March 2005, gold consumption shot up by as much as 88 per cent. What is a matter of concern is the fact that with no domestic gold mining, the purchase of gold also means spending precious foreign exchange earnings. It would not be exaggerating to claim that gold holdings in India are comparable to oil reserves of a country like US, if only they could be brought into the banking system instead of either remaining hoarded or lying idle in bank lockers. There is a school of thought that includes M Narasimham, a former governor of the RBI, which holds that the Reserve Bank of India should keep 10 per cent of its reserves in the form of refined gold by buying such gold in the open market. In fact during the last decade the composition of the reserves itself has undergone major changes. For example SDR holdings, which did not form part of the reserves till the early 1990s are part of the country’s reserves today. This will be a good hedge against inflation. The sale of gold to Reserve Bank of India could be considered for exemption from capital gains tax at the hands of the seller. Further, the source of acquisition would not be subject to investigation and possession of gold would not be subject to wealth tax. Unless such incentives are provided many may not come forward to sell gold to the RBI.

Besides purchase of refined gold to the tune of 10 to 25 per cent of its reserves, the RBI, in close coordination with the ministry of finance, could also encourage individuals and institutions like temples to bring their respective gold holdings into the banking system by extending the following fiscal policy incentives: (1) the source of acquisition of gold will not be questioned, (2) the gold assets will be exempt from wealth tax, and (3) the gold thus brought into the banking system would be eligible for being pledged as collateral for availing loans from banks.

Maintaining gold in the region of 10 to 25 per cent of reserves and bringing gold holdings into the banking system will go a long way in providing adequate buffer against exogenous shocks to the Indian currency besides providing adequate manoeuverability in official foreign exchange intervention.

Reduction of the Combined Fiscal Deficit

The major roadblock to full convertibility appears to be the unsustainable level of the combined fiscal deficit of the centre and the states, which currently stands at around 8 per cent of GDP, is too high if one were to consider opening the capital account. In this connection it should be remembered that admission of new members to the European Union was strictly guided by the norms enshrined in the Maastricht Treaty, which stipulated a fiscal deficit of not more than 3 per cent of GDP. India should adopt the same 3 per cent of GDP as a medium-term objective to open the capital account and until such time this figure is reached it would not be prudent to make the rupee convertible on the capital account. It will not be exaggerating if one were to say that capital account convertibility is one, which “angels fear to tread” where we should never rush in. However, it should be mentioned that it is not as if the figure of 3 per cent of GDP is something which is a pipedream.

As the reduction relates to the states’ component of fiscal deficit it would be absolutely necessary to take certain strong, nay, drastic measures to accomplish this hard task within a span of three to five years. They have been dealt with below.

The source of the fiscal deficit of the states is two-fold. In the first place there is a tendency on the part of the states to go in for annual plans far in excess of their proven resources and states hardly keep up their word of raising additional resources assured to the Planning Commission at the annual exercise of plan approval. Therefore, spending in excess of its resource year after year is the major factor responsible for the growing fiscal deficit of the states apart from increasing their debt burden. The states should realise that what is important is not the size of the plan, but the rate of growth and human development index. Secondly, there is a tendency on the part of the states to create a large hierarchy of staff under the garb of externally funded projects, both bilateral and multilateral. It is not unusual to see that the positions created for a project with a life-term of three years are hardly ever abolished at the end of the life of the project and states continue these positions under some pretext or the other. Very often phase II of the project is formulated to justify these positions and such additional establishment cost is the other major factor contributing to the fiscal deficit of the states and it is necessary that the foreign exchange component of the externally assisted projects is confined to non-recurring items of expenditure and that the projects are executed only with the existing staff or staff funded out of the states’ budget and not from the foreign aid component.

As part of the drive to reduce the fiscal deficit to 3 per cent of GDP, it would be necessary to contemplate certain drastic

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Economic and Political Weekly September 2, 2006

measures to arrest the rising levels of debt and debt-servicing liabilities of the states. Even though the Planning Commission no longer extends loans to the states under the Gadgil formula and advises the states to go in for market borrowings, it would still be desirable if the Planning Commission, after a careful assessment of the states’ fiscal position, could fix an overall ceiling for market borrowings and a sub-ceiling up to which approval for market borrowings through the RBI would be given and for the balance amount the states may have to fend for themselves from the market. Further, it is also necessary that interest payments as a percentage of revenue receipts should be kept below 25 per cent. In the case of those states whose percentage is more than 25 per cent, they should be made ineligible for contacting any fresh loans with either external or domestic sources till such time their interest payments liability declines to around 20 per cent of their revenue receipts. In this connection the observations of the Twelfth Finance Commission (TFC) are relevant.

The TFC felt that states should take efforts to eliminate their revenue deficits so that borrowings are not used to finance revenue expenditure but are utilised for generating capital assets. The TFC recommended that as a measure of fiscal discipline, all states should enact fiscal responsibility legislation prescribing specific annual targets for reducing their revenue and fiscal deficits and providing a ceiling along with a path for reduction of borrowings and guarantees. The TFC had further recommended that the legislation should provide that the revenue deficit of states be brought down to zero by 2008-09, coinciding with similar targets prescribed for the central government. The TFC had recommended that enacting fiscal responsibility legislation would be a necessary precondition for availing debt-relief recommended by the Commission.1

Unless such concrete measures to eliminate the revenue deficit and reduce the fiscal deficit to 3 per cent of GSDP are taken by the states, it would be quite difficult to find a lasting solution to the burgeoning fiscal deficit of the states on the one hand and debt burden on the other in the foreseeable future, not to speak of the country going in for capital account convertibility. In this connection it should also be mentioned that the fiscal health of both the centre and the states would face another major threat in the medium term with the recent announcement by the central government to appoint a new pay commission for the central government employees. It should be recognised that the central pay scales are adopted by almost all the states since they have become the basis for the wage structure for the states in the absence of a national wage policy.

To summarise, before making any move towards opening its capital account, it is absolutely necessary that certain tough decisions have to be taken both in the short and medium term. While measures to contain the real estate prices and introduction of gold into the reserves coupled with the required fiscal policy incentives should be undertaken in the short term, revamping of the archaic labour laws and reduction of the combined fiscal deficit of the centre and the states to 3 per cent of GDP should be the medium-term objectives. It is reiterated that unless the combined fiscal deficit of the centre and the states is brought down to 3 per cent of GDP, it might be too dangerous to open India’s capital account. It must also be noted that no unforeseen event on the defence front has been included in these projections. Taking into account the time frame to implement the proposed Sixth Pay Commission’s recommendations, which would be adopted by the states, a minimum of six years may be necessary to open India’s capital account, if the above sequence of measures are put in place to achieve the short-term and medium-term objectives.




[The above paper reflects the personal views of the author, and do not represent in any way the views of the government of India on this subject. The author wishes to thank M Narasimham, Raja J Chelliah, Bimal Jalan and T V Somanathan for their comments on an earlier draft of the paper. The author also wishes to express his sense of gratitude to the meetings with the executive director for India at the IMF as well as the IMF staff at Washington DC in June 2006 and the office of the executive director for India at the IMF for making available copies of various IMF publications on capital account liberalisation.]

1 Report of the last Twelfth Finance Commission,

Government of India (2005-2010), New Delhi,

November 2004, pp 211-37.

Economic and Political Weekly September 2, 2006

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