The Hindu Business Line : Not the road to Shangri-la

In recent years there has been no instance of a country opting for capital account convertibility on its own or at the instance of the IMF. There is the larger perception that not every country lifting controls attracts capital by that mere fact. Other conditions are necessary and much is subjective. It is no paradise, says K. SUBRAMANIAN.

A few economists advocate the virtues of capital account convertibility (CAC) and see it as the road to Shangri-La: The paradise of reforms. The majority, however, do not share that view. Most of the latter doubt the theoretical validity and the impact on growth, productivity and welfare. Studies of over 80 countries do not lend credence to the claimed benefits of CAC. Shangri-La never ceases to allure.

The Prime Minister's recent request to the Finance Ministry and the Reserve Bank of India (RBI) to study the framework for CAC is surprising. Any jubilation among the "reform lobby" that the country is marching towards CAC is doused by the suggestion for a comparative study, along side, of the Chinese experience. Several studies suggest that China has decided not to put the cart before the horse.

The Prime Minister's request is surprising for other reasons too. The country is under no compulsion either from the International Monetary Fund (IMF) or other financial institutions to move towards CAC in a time-bound manner.

Foreign institutional investors (FIIs) have come to terms with our capital repatriation policies, sectoral caps on investment and related options, which have been calibrated over the past decade. Yet FII flows have touched dizzy heights as reflected in the current buoyancy in the stock market.

Why jump the gun

For the IMF and other donors, `shock therapy' is passé. Though confused and contradictory in its approach towards CAC over the years, the IMF has come to accept "gradualism" as the mantra. It was a lesson from the Asian financial crisis and driven harder home by later crises in Latin America, Russia, Turkey, etc.

In recent years there has been no instance of a country opting for capital convertibility on its own or at the instance of the IMF. Furthermore, the IMF, in its current wisdom, does not advocate CAC unless it is preceded by conditions such as diversified economic structure, financial deepening, regulatory capability, legal institutions and other socio-political support structures. It may be flattering, but true, that the IMF looks upon India as a model for other countries. Why then are we jumping the gun?

Gradualism pays off

There is the larger perception that not every country lifting control attracts capital by that mere fact. On the contrary, large inflows take place in countries known for `financial repression.' Other conditions are necessary and much is subjective; and the attraction, as with beauty, is in the eyes of the beholder. For reasons known and unknown, India is a favoured destination. Partly, it is due to external factors and the comparatively higher returns offered. However, it may not be assumed to last forever. Partly, it is due to the credibility of our policies rooted in gradualism.

Curiously, Western academic opinion, which reviled the Hindu rate of growth, seems to have changed. As John Williamson and Roberto Zagha describe, "... Gradualism has yielded two enormous benefits to India. First, the avoidance of premature liberalisation of the capital account prevented India from being exposed to contagion in the Asian crisis. Second, the Hindu rate of reform has allowed time for the magnificent but somewhat cumbersome Indian democratic polity to buy into the reform programme" (From the Hindu Rate of Growth to the Hindu Rate of Reform, Working Paper No. 144, July 2002, Stanford University). Many others acknowledge the credibility and sustainability of our policies and compare them with others.

By and large, academics who have studied the impact of CAC on developing countries have turned pessimistic or cautious in suggesting policy prescriptions. Dr Padma Desai's conclusion is illuminating: "Financial globalisation is a complex process in which animal spirits of risk-prone, return-savvy investors from the developed market economies with global electronic reach collide with the weak financial institutions, traditional corporate practices, and vulnerable political arrangements of emerging economies with disastrous consequences for the latter" (Financial Crisis, Contagion and Containment: From Asia to Argentina, Princeton University Press, 2003).

She pleads for sensible alternative arrangements. So do many economists who have analysed the implications. The IMF itself was caught in a logjam in the early 1990s when it tried to enlarge its writ to include "capital account" by an amendment to its Articles. During 1994-97, the move met with strong resistance from its Executive Directors, and the Board could not even muster 85 per cent of the weighted vote to carry it. The G-7, representing developed countries and generally disposed towards CAC, was also against it. Not surprisingly, a number of developing country Executive Directors opposed the amendment fearing ceding of policy autonomy to the IMF. The proposal was shelved but did not die after the Asian crisis.

IMF indicted

Notwithstanding this history, the IMF continued its efforts to push CAC among some emerging countries. The Independent Evaluation Office's (IEO) report on the Fund's approach to capital account liberalisation submitted in May 2005, indicts the Fund for its controversial role in promoting CAC. The IEO faults the Fund for directing its policy advice more toward emerging market recipients of capital inflows and on how to manage the inflows and boom-and-bust cycles. As the IEO puts it, "Little policy advice was offered on how source countries might help to reduce the volatility of capital flows on the supply side."

Large capital inflows threaten the financial stability of recipient countries. In recent years, hedge funds, private capital and derivatives amounting to trillions of dollars have entered the fray. Black-money exits and flows back into the country (round tripping) through overseas corporate bodies (OCBs) and P.N. accounts of FIIs. In China they become foreign direct investments (FDI)!

Greater concerns

India is a victim of large inflows, especially via the portfolio windows. The cumulative flows are estimated at $25.3 million for the period ending December 2005. The deft management of the rupee rate and the sterilisation of inflows by the RBI were the levers. The tax exemption on capital gains is estimated at Rs 7,857 crore by C.P. Chandrasekhar and Parthapratim Pal (Economic and Political Weekly, p.978, March 18, 2006). It is unlikely that increasing inflows would have taken place if the RBI had not maintained the exchange rate. The Government held out hopes of further relaxation facilitating direct or indirect takeover of Indian companies.

It is evident that the RBI has turned uneasy over the increasing inflows and feels that it has reached the tether and there are limits to its management capability without causing adverse consequences to the economy.

Even as the RBI is desirous of corrective steps, serious differences seem to have crept in between the Government and the RBI on the future course of action. These are reflected in the Lahiri Committee Report.

It is rather disconcerting that without trying to resolve those differences, the Government should commence a debate on CAC. Adoption of CAC would maim the RBI's ability to manage the exchange rate and the inflows.

If the rupee takes a southern dive, capital would flee in minutes and not all the reserves built assiduously over the years can save the rupee or the economy. The road to Shangri-La could well prove to be the road to disaster.

(The author, a former Finance Ministry official, has extensive experience in international, financial and trade issues.)

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