The Hindu Business Line : Convertibility: Go all the way

That there are risks to full convertibility should not deter India, for it sends a signal to the financial world that the country is confident of itself in the economic and financial arena.

RISKS TO full convertibility should not be a deterrent.

The Reserve Bank of India set up the Committee on Fuller Capital Account Convertibility under the former RBI Deputy Governor, Mr S. S. Tarapore. The committee recommended that the capital account convertibility (CAC) be done in a phased manner with an outer limit of financial year 2011. The six key recommendations of the committee are:

Raising the overall ceiling of $18 billion placed on external commercial borrowings (ECB) and removing end-use restrictions.

Raising the limit of resident outbound transfers from $25000 to $200000 per year.

Removing tax benefits on NRI deposit schemes.

Raising the limit of banks' overseas borrowings from 25 per cent of Tier 1 capital to 100 per cent of their net-worth.

Raising the ceiling of overseas investments by mutual funds from $2 billion to $5 billion.

As far as the FIIs are concerned, the committee was for:

Banning Participatory Notes (PN) and phasing out the existing PNs within a year.

Raising the ceiling on government debt from $2 billion to 10 per cent of issuances and $1.5 billion to 25 per cent of new issuances in a year on corporate debt.

As in 1997, this committee too has a set of pre-conditions before full CAC. They are:

Eliminating Central and State revenue deficits by FY-09 and building a revenue surplus of 1 per cent by FY-2011.

Building adequate reserves and limiting the current account deficit yo under 3 per cent of GDP.

Strengthening the banking system with all banks subject to a single legislation.

Why another panel?

But the question is: Was a new committee needed to set a framework for CAC, a subject already studied in 1997? If one considers the semantics, the word `fuller' would suggest that capital account convertibility already exists in some form, as in the case of the FIIs, ECBs and resident outward transfers, and that the committee is broadening the framework. By this logic, the need for this new committee is justified to an extent. The world has changed dramatically since 1997 and even more so in terms of financial flows. The lightening-fast money flow has made it necessary to take a cautious approach that is better safe than sorry.

Next come questions about the pre-conditions. Will they, especially the first, be met? If history is any guide, quite unlikely. This is because even in 1997, the first Tarapore Committee had set conditions for CAC, including reducing the fiscal deficit to below 3.5 per cent of GDP by 2000. But that is still yet to happen. While it is theoretically possible to reduce this deficit, it is unlikely to happen unless there is a massive jump in tax revenues. The main problem is that interest payments, Defence spending and subsidies are on the revenue expenditure side and all tend to grow every year.

Ghost of Asian crisis

One of the key oppositions to CAC is the constant harking back to the 1997 Asian financial crisis. While most of the affected countries have moved on, India is still haunted by the ghosts of that crisis. The popular misconception about the Asian meltdown is that the countries were hit only because they had CAC, and that India and China escaped because their capital accounts were closed. While it is true that the affected countries had open capital accounts, most also had problems with their economies, such as an over-appreciated real exchange rate, high `short-term debt to reserves' ratio, high current account deficits, low international reserves, a real-estate-centric credit boom, weak domestic financial sector, and, most important, inadequate oversight and poor governance.

China and India escaped for other reasons too. China's currency was not over-appreciated and it had enough reserves to beat back any speculative attack. India was still a relatively closed economy and not `fertile' enough for hedge funds to attack. But a myth got created that India having a closed capital account was brilliant policy foresight when it was merely the result of the economy being closed (in economic terms, autarkic).

Economic reforms are implemented, in the broad sense, mainly for two reasons: One, to improve the living standards of its citizens, and the other, to integrate the country more with the world economy. Many empirical studies on capital flows and free trade show that more of the latter often leads to the former. Economic reforms do not really work in the long-term if they are piece-meal; one usually has to go all the way for it to sustain. This is the case with India. The country must necessarily go to full capital account convertibility, albeit after ensuring that all the necessary pre-conditions are met.

Opponents to convertibility seem to suggest that the moment there is full CAC, there will be a rush to convert rupees into dollars or euros causing instability in the economy. However, that is not really true. Many countries have full CAC and there have been no binge buying of foreign currency. This is because they are confident about the country's economy as well as the future. Given the country's potential, there is no reason to believe that it will not be this way for India too.

Gains from convertibility

The benefits of being fully convertible on the capital account are immense. It paves the way for companies to access unhindered funds from abroad. It makes it much easier for foreign companies to invest in India. But, most important, it sends a signal to international investors as well as the financial world that India is confident of itself in the economic and financial arenas and has the capability to withstand anything that is thrown at it.

There is no doubt that there are risks to full CAC but, then, there were risks to economic reforms too. The country must exorcise the ghosts of the 1997 financial crisis because the countries that were hit have themselves done so, and progressed well.

Coming back to the issue of semantics, hopefully, `fuller' really means `full'.

(The author is Group Economist of the Murugappa Group, Chennai. The views are personal. He can be reached at sunilrongala@corp.murugappa.com)