The Hindu Business Line : F-16s on radar, let's re-count dollars

RENU Kohli's "Liberalizing Capital Flows," from Oxford (www.oup.com) couldn't have come at a better time. With an overflowing forex kitty, and a Guv in control, we're debating full capital account convertibility, which one can liken to turning what was once a high-security fortress into a son et lumiere tourist centre.

"With current account transactions being freed, leakages in capital restrictions through under-invoicing of exports and over-invoicing of imports as well as transfer pricing have also become easier for economic agents," writes Kohli, hinting at the blots in the system that are making capital controls ineffective and redundant. Also to be considered are factors such as progress in IT and communication that make it "increasingly difficult to insulate domestic capital markets". In the process, are we getting pushed into capital account liberalisation?

The author says yes, because countries are finding no other option available to stay attractive to FDI players, and retain world market share. But there are horror stories that history books have chronicled about Mexico, East Asia, Russia and Brazil! "Doubts have been expressed as to whether the costs of liberalising capital flows might not altogether exceed the benefits that can be reaped from it," notes Kohli. One solution that is touted is to deal with different types of international flows differently. "Several economists have thus argued that welfare gains from direct foreign investment can be more meaningfully extracted without exposing an economy to volatile short-term flows by restricting the latter altogether," explains the author.

As if to balance the many proponents of liberalisation, there are economists like Joseph E. Stiglitz and Dani Rodrik who have reminded us that `information asymmetries and market failures' set apart financial markets from other markets. "As a result of these failures, financial markets are prone to herding, panics, contagion and boom-bust cycles; in short, enhanced volatility," is a comment that can't be dismissed as volatile.

Chapter 2 of the book deals with the `evolution, pace, and sequencing' of India's capital account liberalisation. You may chuckle if told that less than 15 years ago, we had wartime controls over forex. "With all private capital account transactions prohibited, the capital account consisted mainly of official transactions, leaving the government as the only effective borrower abroad," recounts the author. Apt thing then, considering the status of country's development, tax base, size of the government and so on.

Then came the BOP crisis in 1991 — "a breakpoint in Indian economic policy". For those interested in the history of external sector policy, there's the 1993 Report of the High-Level Committee on Balance of Payments. Key elements in it were: "A policy preference for foreign equity over foreign debt, reduction in recourse to commercial sources of borrowing, and NRI deposits."

In retrospect, it seems we made the right moves; FDI-freeing was "combined with real sector reforms like trade and industrial liberalisation", though it may be debatable whether "opening up the financial markets to foreign portfolio capital" was too hasty. The author discusses main elements of capital account, and also compiles in an elaborate table various liberalisation measures. "In general, deregulation of practically every control has progressed from outright prohibition to an intermediate status (prior approval on individual case or automatic basis) to total freeing of the related transaction," she writes. "Many deregulation measures have also relied upon gradual increases in the size of the transaction or purpose, activity or parties concerned."

The author devotes a chapter to `domestic financial sector,' the one that will eventually get married to the global financial markets after capital account liberalisation achieves integration. Wait! Is our financial sector "strong enough to absorb the shock of sudden changes in the direction of capital flows"? Are our financial markets "sufficiently developed to disperse the shock and contain the ensuing volatility"? Do the authorities have "the necessary instruments to put into action effective monetary and exchange rate policies"? For, if you rushed in without ensuring `yes' to these queries, there can major reversal of flows that can send BOP into a tizzy. Thus, for example, it is critical for banks to "adequately monitor un-hedged positions of their borrowers", and also keep a tab on end use of funds through prudential norms. Recommended for quick perusal is the useful appendix at the end of chapter 3, listing reforms spanning more than a decade.

Next comes the important discussion on `exchange rate and fiscal policies'. On the first, what Kohli sees as happening in India is `intermediate' — that is "between the two extreme textbook versions of fixed and free exchange rate regimes, and where the exchange rate is managed."

What's the result of such an approach? "So far, exchange rate management has successfully worked to contain a real appreciation while monetary policy has been able to insulate the domestic sector from the inflationary impact of these flows." Yet, there's a limit to what sterilisation by the central bank can do. An era of `exchange rate flexibility' is, therefore, not ruled out.

It is only when you get `fiscal' that you come face to face with the conflict between economics and politics. Was it not only a few weeks ago that the Finance Minister showed a B minus in his report card of fiscal management, even while exhorting us to be positive. A source of worry, this is, to economists because you can't have the two horses, viz. exchange rate policy and fiscal policy, trotting divergently, and still run an economy on course.

Though behind by two years, the author's analysis throws light on the `impact of capital account liberalisation', focussing not only on macroeconomic variables but also the domestic financial system. There're similarities with other economies that launched into liberalisation, though "the magnitude of capital inflows has not been very large in India."

The last chapter looks at `the road ahead'. The guiding force ought to be "the country's domestic economic considerations rather than an orthodox pursuit of liberalisation," counsels Kohli. A heterodox path that she suggests advocates the use of "short-term capital controls" that are market based — such as "raising revenue requirements on bank deposits by non-residents, imposing withholding taxes on short-term investments by non-residents," and so on.

On reserves, her view is that "the heightened risk of a crisis and the role of reserves in providing immediate liquidity is arguably an intangible benefit that lowers to cost of maintaining high levels of reserves."

After Condi ran the F-16 vending machine recently in a neighbouring country, one wonders if anybody here is looking at our reserves as being very high. Who knows, we may have to re-count the dollars on hand for some hurried purchases with belligerent jets blipping on our radar screens.

Economics@TheHindu.co.in

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