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This paper is related to Capital account convertibility in India

To what extent the capital account convertibility is there in India and what is the best thing to have ?

Capital account can be divided into three categories .

1. Foreign Investment

Foreign investment can be categorized into FDI and FII

a. FDI India's policy is geared towards allowing 100% FDI except in following sectors like defense, Retail, insurance ,print and media, private sector banking etc. There are two routes Automatic and Government and in different sectors the lock-in period varies. The trend is more towards to opening up of more FDI.

b. FII - Limit in each company is 24% and instruments available are Securities in primary and secondary market, Units of mutual funds, Dated government securities, Derivatives traded on recognized stock exchange and commercial papers and they can issue Participatory notes a derivative of their holding subject to a limit of 40% of their holding but only a few are using them currently.

2. Loans :

a. ECB refers to commercial loans in the form of bank loans , buyer's credit, suppliers credit and securitized instruments. FCCB,FCEB. Financial intermediaries , banks, Housing Financial companies are allowed ECB. Maximum amount of ECB is $500 Million except for hotel, hospital and software services. For hotel, hospital and software the ECB is up to $100 Million. There are also guidelines for which the ECB should be put to use and mostly includes the infrastructure and capital building activities. It is not allowed for things like working capital management. Trade credits are allowed to the level of 20 million per import transaction with maturity period ranges from 1 year to 3 year( 1 year for non-capital and 3 year for capital goods). But there are no restrictions placed on the minimum debt-equity ratio like that. One restriction was that the proceeds from FCCB/ADR cannot be invested in stock market and real estate. Some relaxations have been made that the proceeds from ADR/FCCB can be used in the first stage to fund the acquisition of shares in disinvestment process.

b. Government Borrowings : Government external debt was around US$74.5 billion as of Dec 2010 which is 25% of India's external Debt

3. Banking Capital

a. NRI Deposits : There are different types of deposits. Accounts in Indian Rupees and Accounts in Foreign currency. In FCNR only term deposits are allowed. The rate of interest will be directed by RBI. The interest rate is linked to International LIBOR

The general logic is that the policies should prefer long term flows to short term flows and non-debt to debt flows. Other disadvantage of full capital account convertibility with floating exchange rate is that sometimes the monetary policy might become ineffective(Impossible Trinity).

What Data Shows : ( Jan-Jun 2010 Gross Balance of Payments)

In the Foreign investment 85% is in Institutional and 15% is FDI( Inflow), FII has the risk of outflow. FDI is considered long term

Suppliers and Buyers Credit contribute close to 65% in the Loans category and majority of rest is taken by external borrowings by Corporate and rest taken by External assistance to India and by India. Research shows that trade credit increases when there is tight monetary condition and if they use trade credit for funding their investment and this might increase the domestic demand. So this is another instance where the effect of monetary policy will get nullified to some extent.

Loans : Interest rate differential is seen as a major determinant of capital flow. Portfolio inflows into equity will not be affected by interest rate differential. ECB will be very sensitive to interest