The Hindu Business Line : Capital account convertibility: Is the economy ready?

Why is India revisiting the capital account convertibility doctrine and what is the relevance of the debate? The major votaries this time round are from within the country. The benefits of convertibility could percolate to the middle-class. The policymakers seem confident that even after full and free float of the currency, the economy is resilient enough to withstand the vagaries of international fiscal and monetary turbulence.

THE FINANCE Minister, Mr P. Chidambaram, and the Prime Minister, Dr Manmohan Singh, ... Capital account convertibility could soon become a reality.

The India of 2006 is not just a different country. It is a different world from the India of 1996. So, it is not surprising that the debate over capital account convertibility should re-visit us now.

Unlike earlier instances, the clarion call for this revisit has emanated from none other than the Prime Minister, Dr Manmohan Singh.

From what was a nebulous concept a decade ago, capital account convertibility could become a reality soon. In the last decade, India has crossed some last mile roadblocks.

However, the debate over capital account convertibility remains relevant. Is it a chimera, the lion-headed Greek monster that India is pursuing for the sake of pursuit?

A decade ago, it was widely believed that economic development was axiomatic to capital account convertibility.

That full free float of the domestic currency would result in a major influx of foreign investment, spur rapid industrialisation, leading to accelerated economic development.

Using this deductive logic, capital account convertibility was deemed to be the ultimate panacea for industrial stagnation and economic backwardness. It was the World Bank and the IMF, and a plethora of government, quasi-government and private bodies of the developed world that glorified the concept.

Benign or malignant?

The 1990s proved that capital account convertibility did stimulate rapid economic development. But also that the very same tools of convertibility could lead to huge exodus of capital, which eventually precipitated the East Asian meltdown.

Does this prove that capital account convertibility is bad and inimical to economic development? No, it just shows that it can be either benign or malignant, depending on the inherent strengths or weakness of the economy.

China and India were the exceptions to the Asian meltdown. Neither of these countries embraced liberalisation and globalisation with the same fervour as the East Asian countries. Nor did they pursue capital account convertibility with equal vigour.

Consequently, neither country witnessed the rapid influx of foreign capital and rapid pace of economic development, evident in other East Asian tiger economies. However, neither did they confront the same exodus of foreign capital and the resultant economic meltdown.

The new model

Is capital account convertibility a necessary pre-condition for rapid economic development? Again the answer seems to be no, as has been proved by the economic success stories of India and China during the last decade.

Both these economies kindled an economic tempo, generating handsome returns to capital and attracting huge foreign capital to its shores. This was contrary to the traditional paradigm of foreign capital stimulating rapid economic growth.

What China and India revealed to the world was that the votaries of capital account convertibility of the 1990s might have been wrong. That rapid economic development was not solely dependant on foreign capital inflows, nor was it an overriding necessity.

And going by present indications, the India-China model seems far more sustainable than the East Asian model.

Problem of plenty

India is today experiencing a deluge of foreign funds. The stock markets have been driven to historic highs, spurred by unabated flow of FII funds. So much so, the spate is creating anxiety among a section of the market. The price-earning multiple in India has reached comparable levels with that of the US. But is the economy as strong and stable as that of the US? Is India beginning to face a problem of plenty?

In this context, why is India revisiting the capital account convertibility doctrine and what is the relevance of the debate? The votaries of convertibility in the 1990s were mainly external forces, institutions and funds seeking to capitalise on the success stories of developing economies, to reap higher returns from interest rate arbitrage and money market operations.

The external sound-bytes and fervent demands for convertibility have virtually faded. Now the major votaries of convertibility are from within the country. And the benefits from convertibility could percolate to the middle-class. But is the economy ready?

Based on the inherent strengths, stability and solvency of the economy, sane and sober Indian voices, led by the Prime Minister, Dr Manmohan Singh and the Finance Minister, Mr P. Chidambaram, seem to think so. They seem confident that even after full and free float of Indian currency, the economy is resilient enough to withstand the vagaries of international fiscal and monetary turbulence.

That does not mean that we should forget the voice of the 160 economists who aired their concern over ushering in convertibility: That we should pursue capital account convertibility for the sake of pursuit, to add a final crowning glory to the Indian growth story. There can be no doubt that India of 2006 has come a long way from the India of 1996. But the moot question remains: Have we come long enough?