India & Capital Account Convertibility: Some Facts

Whatever the apparent theoretical benefits of capital account convertibility, they have not yet been vindicated by the actual empirical evidence; rather, the experience of the countries in the developing world that have experimented with capital account convertibility has been that of increased market volatility and financial crises.

Moreover, at least a part of the large inflows of capital into India are a consequence of the recessionary conditions elsewhere. The country’s macroeconomic fundamentals, though better than before, are not good enough to warrant long-lasting confidence from foreign investors. The reform process is not proceeding with adequate speed, banks are saddled with large volumes of non-performing assets, the financial system is not deep or liquid enough and the country ranks high in the list of corrupt nations.

Once the conditions in the rest of the world improve, and the interest rate differentials between India and the rest of the world narrow further, this capital may move on to greener pastures. Hence, one cannot bank on the continuous supply of foreign capital to finance whatever outflows occur from the country.

Therefore, we believe that India should be extremely cautious in liberalising capital outflows any further.

While it should leave no stone unturned to promote inward FDI, which, because of its very nature, is less susceptible to sudden withdrawals and also tends to promote productive use of capital and economic growth, it should be wary of short-term capital flows that have the potential to destabilise financial markets

The `slow and steady’ stance that the RBI has taken towards capital account convertibility is to be appreciated.

It must be emphasised that only over time will the Indian economy be mature enough to be comfortable with full capital account convertibility — financial markets will deepen, macroeconomic and regulatory institutions grow more robust and the government will learn from past mistakes.

The Government would do well to focus at present on the fundamental processes of institutional development and policy reform because, in the long run, these would serve the country better than an early move towards full capital account convertibility.

Economists realize that directly jumping into fuller capital account convertibility without taking into consideration the downside or the disadvantages of the steps could harm the economy.

The East Asian economic crisis can be a classic example to cite for those who are opposed to fuller capital convertibility. The further question that should be raised is that why is India so desperate in pushing ahead with the liberalization agenda. So what if there have been enormous global developments and developments in the last few years. It should be bore in mind at the very outset that attracting greater capital inflow into the country can barely provide a reason for greater or full convertibility. Capital inflows in India are far in excess of what is needed to finance the current account of the balance of payments. According to the report,

‘During the 2005-2006, the current account deficit has been comfortably financed by the net capital flows with over U.S. $15 billion added to the foreign exchange reserves.’

World Bank has said that embracing CAC without necessary precautions could be absolutely disastrous. At this stage of the country’s economic growth, fuller convertibility on capital account cannot be an objective per se, although it can be a step towards creating opportunities in achieving more goals of economic policies. The major hindrance to fuller convertibility of the rupee is the fiscal deficit of the centre and the states, which is around 10 percent of GDP, which is grossly high when we talk of opening a capital account. ‘Opening a country’s capital account when it has unsustainably high fiscal deficit can be likened to administering polio drops to a child suffering from high fever; it can prove fatal. It should be clearly bore in mind that until India reaches with a figure of 3 percent of GDP, it would be imprudent to give a sudden move to fuller convertibility of capital account and which is not insurmountable, so to say. Though the committee has emphasized on reducing fiscal deficit, as a necessary condition for fuller convertibility, it has not set a time-map for the same hitherto. Capital account convertibility should be treated as a process and not an event. The plan for further convertibility on capital account will depend, however on several factors, as well as on international developments. The most native but at the same time most fundamental argument put forward for CAC was that free markets are inherently better than restricted markets. Just as the government should eliminate barriers to trade, they should also eliminate barriers to the free flow of capital because doing so leads to better economic performance measured in growth, efficiency and stability. A second argument was that CAC enhances stability as countries trap into a diversified source of funds. CAC increases the welfare of domestic investors by allowing them to invest abroad and diversify risk. CAC is widely regarded as a prestige characteristic of an economy. It gives confidence to the foreign investors who are assured that anytime they change their mind, they can reconvert local currency back into foreign currency and take it out. Lots of people assume that a liberal capital account is, by itself, a desirable objective of economic policy.

Capital account liberalization leads to the availability of a larger capital stock to supplement domestic resources and thereby higher growth. To add, CAC allows residents to hold an internationally diversified portfolio, which reduces the vulnerability of income and wealth to domestic shocks. It is also argued that CAC has a disciplinary influence on domestic policies. It does not allow monetary policy to take on an excessive burden of the adjustments. At the same time CAC enhances the effectiveness of fiscal policy by:

a) Reducing real interest rate applicable to public sector borrowing

b) Bringing about an optimal combination of taxes through a reduction of the inflation tax and in the rate of other taxes to international levels with beneficial effect for tax revenues

c) Reducing crowding out effect in the access to funds.

On the face of it, CAC seems to be a panacea to all financial problems and bottlenecks. But there is hardly any empirical evidence and studies to support and substantiate the free flow of capital. Free mobility of capital exposes a country to both sudden and huge inflows as well as outflows of foreign capital, which can be potentially destabilizing the economic growth of a country. Thus, it is necessary for a country to have experienced institutions to deal with such huge flows.

“It may be recalled that in 1980s, many developing countries introduced CAC in a bid to attract foreign investments. After the disastrous experience of some East Asian Countries, developing countries ( India in particular) have become very cautious in adopting CAC”. It is an undisputable fact that in the arena of globalization, we have financial integration in the markets all over the world. But it should be bore in mind that before taking any quick decision about fuller CAC, one must properly understand the volatilities of these inflows. India has successfully avoided the trap so far and policy makers must remain cautious as regards to CAC. Jagdish Bhagwati’s interesting take on the risks of CAC becomes relevant when he says “cease and desist from moving rapidly to full convertibility until you have gained political stability, economic prosperity and substantial macroeconomic expertise- and not just transparency and better banking supervision..” Countries are exposed to great risk when they liberalize. But the people of the countries—–especially workers, small businesses, and the poor—-have no way of protecting themselves against these risks. The argument that CAC allows residents to diversify risk by investing abroad focuses on the benefits for a small group of residents while it ignores the larger affects ion society as a whole. In late 1990s, Chile relaxed restrictions on domestic pension funds investing abroad. The pension funds then speculated against the national currency and deepened the BOP problems in the aftermath of the Asian crisis. Domestic pension funds and domestic investors were the main agents behind the massive capital flows. What is perhaps the most important argument against CAC can be stated in three words: it increases instability. CAC allows speculative capital to flood into a country. While the money flows in, the currency appreciates. The capital inflows may support short term growth, but they can also lead to an unsustainable expansion of consumption, and to changes in the structure of production. The most compelling case against CAC is that it leads to instability. Nonetheless CAC could be desirable if it led to a faster economic growth.

There is no doubt that economic indicators of Indian economy have improved quite a bit since 1997. But so far as fuller CAC is concerned India has yet to go a long way ahead. International experience shows that India should be very careful and calibrated while deciding towards fuller CAC.

In general, at this stage of the country’s development, CAC cannot be an objective per se but should be considered as a means to achieving more fundamental objectives of economic policy.

From what was a nebulous concept a decade ago, could become a reality soon. If satisfied the above cited problems, CAC could be the logical culmination of India ‘s journey towards globalization. It should be carefully determined about whether the risks involved in fuller convertibility of capital account seems to be greater than the rewards we get from it. To the mind of the researcher at this stage of the country’s economic development, capital account convertibility cannot be a desired means per se, but India can step forward by the means of it to maximize more economic goals.

The fact that fuller convertibility has been a subject of fierce debate from past five years and the reasons in being so has been addressed throughout the course of this paper.

It has been also elaborated that the risks involved in fuller capital account convertibility are much more that the fruits we get from it.

For India is it not the right time to go for full convertibility. Taking into consideration of the Asian crisis, we need not touch the fire and set an example just like. It must be remembered that the move towards capital account convertibility calls for a conformist and cautious approach.

The Asian financial crisis sealed the fate of  that recommendation but the FM has once again revived the issue.

There are five reasons why India should not rush into convertibility. First, as Prof Jagdish Bhagwati forcefully argued in his celebrated 1998 article:  The Capital Myth: The Difference between Trade in Widgets and Dollars, persuasive empirical evidence on the benefits of full convertibility is lacking. Recent research shows that for countries with well-developed financial markets and stable macroeconomic environment, convertibility offers small positive growth effects.

But for countries with weak financial sectors and macroeconomic vulnerabilities, convertibility leads to greater instability in growth without dividend in terms of higher average rates. But even this and related research does not distinguish between limited convertibility in terms of openness to trade and foreign direct and portfolio investment and full-fledged convertibility. Therefore, we have no evidence showing positive benefits from a move from the limited to full convertibility, which is the  question facing India today.

Second, on the fiscal front, India remains far from ideal conditions for convertibility. The average growth rate of almost 8% during 2003-04 to  2005-06 has led to increased tax revenues and some reduction in the deficit  but not nearly enough. Moreover, we can scarcely be sure that the deficit will not return to the higher level if the GDP growth rate and therefore tax revenue growth revert to the previous trend as happened after 1996-97.

With interest payments on the debt amounting to more than 6% of the GDP,  gross fiscal deficit of 8% and debt-to-GDP ratio of more than 90%,  convertibility is bound to leave India vulnerable to a crisis. One hazard is that the government itself would be tempted to turn to lower-interest short-term external debt to finance its deficits and debt.  Third, the financial sector is still insufficiently developed in India.  Banks are predominantly in the public sector and credit markets relatively shallow. Insurance has barely been opened to the private sector with the foreign investment in it capped at 26%.

The debt and equity markets are thin and dominated by public sector FIs and FIIs. Because the Indian debt and equity markets are tiny in relation to the worldwide stakes of the FIIs, any time the latter begin to exit the Indian market, the financial markets go into turmoil. Because few FIIs have the incentive to carefully gather detailed information on the future profitability of various firms, such exits are characterised by herd behaviour.

Fourth, India is still far from fully integrated on the trade front. For this reason, ensuring a competitive exchange rate is a high priority. A move to the capital-account convertibility is bound to bring more capital inflows initially and force an appreciation of the rupee.

If the appreciation ends up being large and persistent, it could put trade integration into jeopardy. Furthermore, even if the appreciation is only temporary, convertibility could hurt export growth by making the real exchange rate more volatile.

Finally, the embrace of Full Capital Account Convertibility can place the ongoing reforms in other areas at grave risk. In the Indian political environment, building a consensus for even most straightforward reforms such as privatisation and trade liberalisation is an uphill task. Therefore, if capital account convertibility were to culminate in a crisis or even create greater volatility in growth, the cause of reforms would be set back.

The advocates of speedy convertibility sometimes make two counter arguments.  First, the adoption of convertibility will speed up the reform, especially in the financial sector. For instance, giving individuals and firms access to the global markets may bring pressure on the domestic banks to become more competitive. Likewise, the possibility of a crisis may force the government to act more urgently on fiscal deficits and debt.

While these outcomes can indeed follow the embrace of convertibility, the opposite can also happen. Both the government and the firms will be tempted to quickly proceed to accumulate short-term external debt and rapidly move the economy towards a crisis.

The question is largely empirical. On balance, the weight of the empirical evidence favours erring on the side of caution: whereas the countries that ended up in a crisis following the premature adoption of convertibility are many, those that reformed more speedily and smoothly on account of the premature embrace of convertibility are few.

The second argument in favour of moving rapidly to convertibility is that this will help India turn into a major financial centre in Asia. Given its vast pool of skilled labour force and rapidly developing information technology industry, India certainly has the potential to become such a centre. It is also true that full convertibility is a necessary condition for becoming a hub of financial activity. Yet, the argument is misleading.

Currently, the financial sector in India is heavily dominated by the public sector, which account for 70% of its assets. It is implausible that India would turn into a major financial centre in Asia without the reforms that give primacy to private sector in the financial markets. It is even more implausible that the government will relinquish its control of the financial markets overnight – just calculate the prospects of bank privatisation!

Though India must eventually adopt Full Capital Account Convertibility, which is a defining characteristic of all mature modern economies, our arguments lean against the kind of approach the Tarapore Committee I recommended. We should instead stay the course on reforms including increasing the role of the private sector in financial markets without committing to a specific timetable for  convertibility.

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