The Indian Prime Minister, Mr. Manmohan Singh, recently revived one of the early casualties of India’s bumpy road towards a more efficient economy – full convertibility of the Rupee on the capital account. India’s original roadmap for convertibility, drawn up by Mr. S. S Tarapore, then the Deputy Governor of the Reserve Bank of India (RBI), is believed to be one of the most comprehensive, and most ill-timed, reports on the subject - Mr. Tarapore’s ambitious plans for India’s currency laws were prematurely swept away by the currency typhoon that hit Asian Markets in July 1997, less than a month after his recommendations were made public.
Mr. Singh, himself a former Governor of the RBI, hinted at the possibility of capital account convertibility while releasing a voluminous historical account of his ex-employer. The occasion could not have been more appropriate given that the Prime Minister’s musings could well mark a new chapter in the bank’s history.
Capitalizing on convertibility
The posited arguments for capital account liberalization, primarily greater efficiency of capital allocation and the imposition of macroeconomic discipline, are well documented although the lack of supporting empirical evidence provides ample grist for the skeptic’s mill. However, the validity of theoretical arguments would not concern the RBI as much the very real, and rapidly increasing, stock of foreign exchange it is confronted with. The mounting pile of currency, largely attributable to the RBI-managed “dirty float” of the Rupee, is now beginning to raise a stink among policy mavens who feel that the central bank’s continual interventions to suppress the currency’s upward mobility severely limits the bank’s monetary policy options. The renewed enthusiasm for convertibility is also partly the result of the growing global ambitions of corporate India, which is no longer satisfied with the meager, and often discretionary, concessions offered by what is seen as a restrictive currency regime. Things seem to have come a full circle from the early days of liberalization when the Bombay Club, an informal interest group of leading Indian business houses, lobbied hard, but without success, to stall the fledgling reforms process.
While the Asian Currency Crisis put paid to hopes of an early transition to a liberalized capital account, the government has been slowly steering the economy towards greater openness ever since. Current account restrictions were among the first to go - most transactions on the trade account no longer require government approval. Foreign Direct Investments (FDI) have been liberalized in all but a few “sensitive” sectors, as have the more volatile portfolio investments, now a force to reckon with on Indian bourses. However, while the capital account transactions of external entities are largely free from control, the RBI has been somewhat reluctant to accommodate the desire of Indian residents and corporates to access global markets. The government’s cautious dismantling of investment and borrowing restrictions on corporates has prodded the External Commercial Borrowings (ECB) limit upwards to 500 Million USD and that of foreign investments to 100% of net worth. Individuals must, however, remain content with a rather modest allowance of 25000 US Dollars per annum. Although exemptions from these norms are possible on a “case to case basis”, the numbers would seem to be out-of-sync with the rising wealth, and ambition, of Indians and their business interests.
The key outstanding items of the currency liberalization agenda include enabling a free float of the Rupee, addressing the short term overseas borrowing and investment requirements of Indian corporates and substantially increasing, if not completely eliminating, the overall limits governing access to foreign capital. Mutual Funds, meanwhile, expect that reforms will allow them to look beyond the country’s shores in their search for better investor returns.
Mr. Singh, himself a former Governor of the RBI, hinted at the possibility of capital account convertibility while releasing a voluminous historical account of his ex-employer. The occasion could not have been more appropriate given that the Prime Minister’s musings could well mark a new chapter in the bank’s history.
Capitalizing on convertibility
The posited arguments for capital account liberalization, primarily greater efficiency of capital allocation and the imposition of macroeconomic discipline, are well documented although the lack of supporting empirical evidence provides ample grist for the skeptic’s mill. However, the validity of theoretical arguments would not concern the RBI as much the very real, and rapidly increasing, stock of foreign exchange it is confronted with. The mounting pile of currency, largely attributable to the RBI-managed “dirty float” of the Rupee, is now beginning to raise a stink among policy mavens who feel that the central bank’s continual interventions to suppress the currency’s upward mobility severely limits the bank’s monetary policy options. The renewed enthusiasm for convertibility is also partly the result of the growing global ambitions of corporate India, which is no longer satisfied with the meager, and often discretionary, concessions offered by what is seen as a restrictive currency regime. Things seem to have come a full circle from the early days of liberalization when the Bombay Club, an informal interest group of leading Indian business houses, lobbied hard, but without success, to stall the fledgling reforms process.
While the Asian Currency Crisis put paid to hopes of an early transition to a liberalized capital account, the government has been slowly steering the economy towards greater openness ever since. Current account restrictions were among the first to go - most transactions on the trade account no longer require government approval. Foreign Direct Investments (FDI) have been liberalized in all but a few “sensitive” sectors, as have the more volatile portfolio investments, now a force to reckon with on Indian bourses. However, while the capital account transactions of external entities are largely free from control, the RBI has been somewhat reluctant to accommodate the desire of Indian residents and corporates to access global markets. The government’s cautious dismantling of investment and borrowing restrictions on corporates has prodded the External Commercial Borrowings (ECB) limit upwards to 500 Million USD and that of foreign investments to 100% of net worth. Individuals must, however, remain content with a rather modest allowance of 25000 US Dollars per annum. Although exemptions from these norms are possible on a “case to case basis”, the numbers would seem to be out-of-sync with the rising wealth, and ambition, of Indians and their business interests.
The key outstanding items of the currency liberalization agenda include enabling a free float of the Rupee, addressing the short term overseas borrowing and investment requirements of Indian corporates and substantially increasing, if not completely eliminating, the overall limits governing access to foreign capital. Mutual Funds, meanwhile, expect that reforms will allow them to look beyond the country’s shores in their search for better investor returns.
Beyond dilemmasEconomic reforms in India, even eminently sensible ones, have struggled to cope with the country’s chaotic, agenda-ridden, and often ill-informed, political process. Seeing through a proposal with as contentious a claim to promoting economic welfare as capital account convertibility would require a satisfactory explanation of concerns on several fronts. The standard argument against currency liberalization is, of course, the experience of South East Asian countries in 1997. Empirical evidence against permitting free capital flows is further bolstered by a World Bank survey of 27 instances of capital inflow surges between 1976 and 1996 in 21 emerging markets – the study found that, in close to two-thirds of the cases, the inflows were followed by a banking crisis, a currency crisis or both. This apparent lack of compatibility between economic stability and freedom of capital movement is believed to result as much from the intrinsic inadequacies of emerging economies (in particular, shallow and non-transparent capital markets, unhealthy banking systems and fiscal laxity) as from sequencing issues such as, for example, the order in which the capital and current accounts are liberalized.
Of more relevance to India, which is largely free of the sort of crony capitalism that plagues South East Asian economies, is the impact of the proposed measures on monetary policy, the exchange rate and exports. A theoretical framework for analyzing the issue is provided by the so-called “Macroeconomic Trilemma” which contends that, of the three objectives of capital account convertibility, a fixed exchange rate and an effective monetary policy, no more than two can be achieved simultaneously. With controls on foreign investment already dismantled, the RBI’s attempt to pin down the Rupee, therefore, comes at the expense of a huge, unproductive reserve of foreign currency which, in turn, is believed to constrain monetary policy. On the other hand, letting go of the Rupee could result in impairing the competitiveness of exports including, in particular, the critical IT Services industry. This cautionary implication for liberalization is compounded by other limiting factors such as the questionable ability of India’s NPL-afflicted banks to cope with the rigors of the international financial system, the potentially inflationary effects of development spending under a free float scenario and finally, the widely feared, yet rather distant, prospect of a South East Asia style currency shock.
With many risks and few obvious benefits, argue some observers, capital account convertibility is neither essential nor desirable. The Indian Left parties, on whose support, the survival of the present government depends, lost no time in expressing their disagreement with the Prime Minister’s opinion which, they felt, was “dictated by (the) World Bank and corporates” and therefore “disastrous”.
Better luck next time
Doomsday prophecies notwithstanding, the ever-increasing stock of foreign currency is a real problem as is the need of Indian corporates for greater access to capital. With investor confidence continuing to soar on the back of rapid economic growth and improving government finances, chances of a large-scale capital flight in the foreseeable future appear remote. In any event, it is hard to see how convertibility would significantly add to the possibility of an investment exodus given that the usual suspect for such events – portfolio investment – is already a well-entrenched feature of the economy.
Free float of the Rupee would, however, pose a more immediate problem. An appreciation of the Rupee, as is widely expected to result from such an action, has the potential to pull the plug on India’s booming exports. The impact would be particularly severe on sectors such as IT services which, thanks to their negligible import requirements, have little use for a cheaper Rupee. Further, with inflation well under control, the need for an interventionist monetary policy in the short to medium term is not very evident. In short, while full convertibility is clearly in the interest of the economy, free float of the Rupee is a bit of a mixed bag. To complicate matters further, although free convertibility in the absence of a market determined exchange rate is theoretically possible, such a move has historically proven to be the perfect recipe for economic disaster.
As with most reforms initiatives in India, it is unlikely that anything will happen in a hurry. The RBI, for its part, was quick to set up a committee to revisit the issue under the stewardship of the same gentleman responsible for the production of the original report. Mr. Tarapore plans to come out with his findings by the end of July and would no doubt be hoping for a better hand from fate this time.
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