The Hindu Business Line : Convertibility — conditions and consequences

Instead of devoting more attention to dollarisation, the Second Tarapore Committee has gone into detail on the possibility of internationalisation of the rupee, which is not likely to happen in the near future.

The need for Fuller Capital Account Convertibility is not strong at India's current stage of development. Illegal remittances and recycling of money may get legal cover if FCAC is introduced without any controls whatsoever.

The Second Tarapore Committee (STC) on Fuller Capital Account Convertibility (FCAC) should be congratulated for bringing out a business-like report on time. Whether one agrees with its recommendations or not, it is rich in information on banking and foreign exchange, particularly prudential aspects. One criticism of the report is on its length. But much of the material pertains to background details which should be of use to researchers .

Pre-conditions

The second report has referred to the preconditions of the First Tarapore Committee (FTC) report and dropped the latter's recommendation of a formal inflation mandate of 3-5 per cent. This is, perhaps, the result of the criticism that the Reserve Bank of India (RBI) was set up to ensure price, and not inflation; stability and any mandate of the proposed type would require an amendment of the Preamble to the RBI Act.

In fact, there is already an informal inflation target of 5 per cent, as indicated by both the Finance Minister and the RBI. The RBI also provides for it in its target for money supply. The STC has said: "The Committee recommends that, consistent with overall economic policy, the RBI and Government should jointly set out the objectives of monetary policy for a specific period and this should be put in the public domain." The objectives of the Monetary Policy are set out in every review and they cannot be any different because they are unexceptionable.

The target of fiscal deficit of 3.5 per cent of GDP is not likely to be realised in the near future, certainly not within the five-year time-frame for the adoption of the FCAC. The main problem is the heavy burden of interest payments on outstanding debt, which makes it necessary for the government to borrow for the purpose. There is no effective solution to this problem in the report. A sinking fund will not help because the Government may have to borrow for building it!

While the target for gross non-performing assets of banks has more or less been achieved, much remains to be done on lowering the Cash Reserve Ratio (CRR) to 3 per cent. The STC has itself now found that there may be occasions to raise the ratio to deal with extraordinary situations of liquidity.

One is not able to see the connection between FCAC and CRR. They can exist independently of each other. The US has a high CRR on transaction deposits and is none the worse for it in maintaining the convertibility of the dollar.

Consequences: Dollarisation

One of the criticisms of the FTC was that it did not take cognisance of the dollarisation of the economy. This time, the Terms of Reference (ToR) included it. However, the contribution of the panel is patchy and gives the impression that a short para, in general terms, has been incorporated just to show that the subject has been covered.

Implication of the dollar being used by citizens as a unit of account, a medium of exchange and a store of value in domestic transactions and the consequent difficulties for monetary management could have been examined and suggestions made to deal with them.

Further, the modalities of capital account convertibility already obtaining in Offshore Banking Centres (OBCs) set up in the country could have been examined. Problems, if any, especially with regard to money laundering, could have been discussed with the banks operating in the OBCs and lessons drawn from them. It was certainly within the area of analysis of the Committee, even though not specifically mentioned in the ToR.

There is a demand from the Commerce Ministry and other interested parties that OBCs should be set up in all Special Economic Zones. Such a proliferation would tantamount to the establishment of capital account convertibility in the country as a whole with all its attendant complications. It is in this context that the panel fails to analyse the trends in OBCs and come out with an assessment of their working.

Instead of devoting more attention to dollarisation, the Committee has gone into detail on the possibility of internationalisation of the rupee. This is not likely to happen in the foreseeable future. The report says: "Although export of Indian rupee currency notes beyond a very modest sum is not permitted, the fact is that a significant amount of rupees in currency form is held outside the country, particularly where there is sizeable expatriate Indian population. This is, perhaps, some indication of the growing acceptability of the rupee outside the shores of the country." The circulation of the rupee outside India is due to the favourable rate that NRIs get there which they use for meeting expenditure in India during their visits.

Impossible trinity

The report refers to the impossibility of the simultaneous achievement of an independent monetary policy, an open capital account, and a managed exchange rate. Still it has recommended the adoption of a target zone for the exchange rate in relation to the Real Effective Exchange Rate (REER) of the rupee while, at the same time, indicating the modalities of Monetary policy. Despite the considerable work done on REER, there are many problems in the construction of an index based on it.

The export sector has done well in the recent years despite the periodical complaints about the rupee being overvalued. In terms of purchasing power, the rupee is really undervalued as anyone who has travelled in the US or Europe would confirm. The ranking of India in the GDP league of countries based on purchasing power parity by the World Bank is high. REER is anchored on the Purchasing Power Parity Theory, which had little empirical support even when the current account decided the exchange rates. Now, it is all the more so in view of the predominant role of capital account transactions in determining the rates.

The RBI used the REER at the time of the Gulf Crisis to support the downward adjustment of the rupee. Subsequently, the concept fell into disuse. The central bank would do well to continue with its current policy of benign neglect of the exchange rate and concentrate on domestic Monetary Policy.

Case for Adoption in India

The need for adoption of FCAC in India is not strong at the current stage of development. There is enough freedom for the conversion of a foreign currency into rupee and vice-versa for all except the resident Indian. Even for the latter, there is an allowance of $25,000 per year for remittance abroad for investment purposes. This facility has not been used to any great extent. So raising the limit or even abolishing it may not lead to any capital flight under normal circumstances. But what may happen is that illegal remittances and recycling of money that is obviously going on will get a legal cover if FCAC is introduced in any unabridged form. The RBI should continue its incremental approach of relaxing controls on the external sector.

(The author is a former Officer-in-Charge of the Department of Economic Analysis and Policy, Reserve Bank of India.)