The Hindu Business Line : Is `capital flight' a whopper?

Though full convertibility and full float are independent policy issues, many economists have urged policymakers to keep away from both. Capital flight, in their view, will be the inevitable result. Through four scenarios, G. RAMACHANDRAN demonstrates why capital flight is a bogeyman.

What is a whopper? It is something extraordinary. It is out of the world. It is unusually large. Burger King distinguishes its burger from other burgers by calling it a whopper. It sells billions of whoppers each year.

Whopper has another meaning. It is a monstrous and fantastic lie. It would be unjust to use this meaning to describe any burger made by Burger King or its peers. Their burgers are all nice and real. But whopper may be used to describe a phenomenon called capital flight. Capital flight is a whopper.

Financial and physical assets do not flee. These assets are deeply rooted in sovereign economies. A nation's savings and wealth do not flee when it moves towards capital account convertibility. Money and assets stay rooted. This is good news for India. It could be bad news for those who assert that full convertibility leads to capital flight.

BRUTAL BOGEYMAN

Capital flight supposedly means the flight of financial and capital assets, and savings and wealth from a country. It is entrenched in the vocabulary of the World Bank and the International Monetary Fund. Economists refer to capital flight when they describe the financial crises in Brazil, Indonesia, Malaysia, Russia, South Korea and Thailand in the 1990s.

Capital flight is now a bogeyman in India. Over 160 economists have expressed their total disapproval of full convertibility (see The Hindu, March 29). They have also expressed shock over the unstated plan to fully float the rupee.

Though full convertibility and full float are independent policy issues, they have urged policymakers to keep away from both. Capital flight, in their view, will be the inevitable result. It can be inferred that they want the controls on convertibility and exchange rates to remain.

LEVELS OF CONTROLS

Currency convertibility is a matter of necessity. How else will countries buy crude oil and ships? The apt question is who gets the freedom to convert. Can individuals, businesses and companies convert from and to the domestic currency?

If they all can, their currency is fully convertible. They may change it into any currency they want for all legal purposes. If some or all cannot convert, convertibility is controlled. Governments and their affiliated institutions alone can convert a domestic currency back and forth.

There are other stages in between. With current account convertibility, citizens and businesses can freely exchange currencies to buy and sell goods and services. But they cannot buy physical and financial assets abroad. They cannot borrow or extinguish liabilities abroad.

Limited capital account convertibility allows full current account convertibility and partial capital account convertibility.

With partial capital account convertibility, some controls on capital inflows and outflows are relaxed. India allows limited capital account convertibility. So, capital account convertibility is not new. What nettles many is full convertibility.

FUNDS AND ASSETS STAY

Those afraid of capital flight may argue that full convertibility has two threatening components.

First, it allows resident citizens to invest their wealth abroad. They may withdraw their wealth and then make bank deposits, buy physical assets and invest in financial assets abroad.

Second, it allows foreign investors to withdraw their investments rapidly from India. Capital may flee on two more wings derived through over-invoicing of imports and under-invoicing of exports. But imports and exports belong to the current account. Hence, this analysis is restricted to the capital account.

First, consider a bank deposit in India. When the deposit is closed, rupee funds are withdrawn. A resident depositor will have to sell rupees to buy, say, US dollars. A foreign depositor too will sell rupees to buy dollars. In both cases, rupee funds stay within India. The rupee economy is unaffected. There is no disturbance when other depositors and borrowers step in to sustain the chain of deposits and loans.

Second, consider an investment in Government of India securities. When a resident or a foreign investor sells the securities, the seller receives rupee funds. Rupee funds will then be sold to buy dollars. But securities and rupee funds stay in India. The rupee economy is unaffected. There is no disturbance when other investors step in to sustain investments.

Third, consider a mall in Gurgaon. When a resident or a foreign investor sells the mall, the seller receives rupee funds. Rupee funds will then be sold to buy dollars. The mall and rupee funds stay in India. The rupee economy is unaffected. There is no disturbance when other investors step in to buy the mall.

Fourth, consider an investment in the equity of State Bank of India. When a resident or a foreign investor sells the shares, the seller receives rupee funds. Rupee funds will then be sold to buy dollars. But the shares and rupee funds stay in India. The rupee economy is unaffected. There is no disturbance when other investors step in to buy the shares.

SAVINGS AND WEALTH STAY

Exiting investors leave rupee funds and assets behind in all four cases. They take away US dollars. US dollars are not India's currency. Exiting investors take away dollars sold by exporters and foreign investors.

Exporters and foreign investors will in any case have to sell dollars. How else will they make payments and buy capital assets in India? Therefore, no exiting investor takes away any savings and wealth from India. There is no flight of capital when holdings are liquidated.

DIFFIDENCE AND ELITISM

Confidence in the Indian economy may leave along with exiting investors. There should be no problem if new depositors and investors step in. If there are not enough new depositors and investors bubbling with confidence, asset prices could fall. That is a serious problem. But the cause is not full convertibility.

Yet, economies that do little to infuse widespread confidence will impose controls on convertibility. Economies that do little to spread opportunities fairly and evenly will want controls on convertibility. And, economists with proof that an economy has spawned diffidence and elitism will recommend strict controls on currency convertibility.

(The author is a financial analyst. Feedback may be sent to indiagrow@yahoo.com and pari@thehindu.co.in)