The Hindu Business Line : Further capital account convertibility

Successful growth is accompanied by the private sector undertaking new, varied and sophisticated activities.A recent article argues that greater capital account convertibility constrains the country’s ability to manage the exchange rate in view of the unrestricted capital flows. It further establishes that Asian countries with sustained economic growth and higher manufacturing exports did not have overvalued currencies.

S. Venkitaramanan

Dr Arvind Subramaniam has recently swung into prominence as a seminal contributor to debates on India’s economic growth and prospects. One of his most pertinent contributions, reviewed in this newspaper, concerned India’s growth record in the 1980s. He pointed out how the 1980s saw an impressive and effective liberalisation in India’s economic policies with consequent impact on GDP growth. The most recent contribution is represented by his article in the Economic and Political Weekly of June 23–29, 2007 on “Capital account convertibility (CAC): The neglected considerations”. The article focuses on an aspect of first order importance for longer term growth — the level of the real exchange rate, the objective of avoiding overvaluation.

The author sets the problem in proper perspective. He quotes with approbation the statement of Singapore’s Senior Minister, Mr Lee Kwan Yew, in his Jawaharlal Nehru Lecture of 2005, where he had stated succinctly and dramatically that since the industrial revolution, no country has become a major economy without becoming an industrial power. Given that manufacturing is the tradable sector par excellence, manufacturing growth is a sine qua non for overall gr owth.

Dr Arvind Subramaniam corroborates this by a set of graphs showing how most successful economies, including China, Thailand, Singapore, South Korea and Malaysia have had rising shares of manufactured exports to GDP. In contradiction to this is the case of Latin America and Sub-Saharan Africa. To this obvious proposition, Dr Subramaniam adds another consideration — that successful growth is accompanied by the private sector undertaking new, varied and sophisticated activities. The tendency of the private sector to engage in such activities is rooted in various factors, such as history, tradition, endowments and culture. But, the most important of these is the exchange rate policy.

Dr Subramaniam cites a research paper co-authored by him, which establishes that countries in Asia, which had sustained economic growth and growing manufacturing exports, did not have overvalued currencies, while Latin America and Africa have had bouts of overvaluation. This shows the importance of avoiding overvaluation from the point of view of sustained economic growth, including growth of manufactured production and exports. Interestingly, China has avoided overvaluation since its growth took off in 1978.

Role of CAC

What is the role of CAC in all this? Dr Subramaniam points out that this arises because capital account convertibility constrains the country’s ability to manage the exchange rate in view of the unrestricted capital flows. He cites the ‘trilemma’, or the impossible trinity of international economic theory, which states that a country cannot simultaneously attain the three objectives — of an open capital account, monetary independence and a fixed exchange rate — one or the other has to give.

The importance of avoiding overvaluation is conceded. But, given the move to greater CAC, is it feasible? Dr Subramaniam points out that the two Tarapore Committees devoted comparatively little attention to the issue of exchange rate overvaluation. The Tarapore Committees’ discussion centred more on the need to avoid volatility and refine measures of real effective exchange rate (REER). The professor may not be quite fair in describing the Tarapore Group as ignoring the possibility of costs of overvaluation. Although it is true that the Group had not discussed the possibility in detail, it had suggested a limit or band of REER, within which RBI may not intervene. True, this raises issues of when and how. But, the issue is not easily solved. The trilemma bites.

The problems of sterilisation have been adequately identified by various experts and Dr Subramaniam emphasises the same. Sterilisation means that the RBI sells debt paper to absorb the excess liquidity arising from its purchase of dollars. Sterilisation has its cost. The value of the debt paper the RBI sells to the banks decreases as its market supply increases. This means that the interest rate payable on sterilisation increases.

Sterilisation thus contributes to an increase in the rate of interest of debt paper, which encourages further capital flow, adding to the pressure of liquidity.

While all this may seem simple, the interest tool with which the Government and the RBI combat the excess inflow of dollars by sterilisation may be high, and the problems may not be easy to solve, because the inflow is likely to be increased as a result of higher interest rates.

Added to this are the quasi-fiscal costs of holding reserves which are invested in US or other Treasury securities, carrying a lower rate of interest than the rate at which it causes Government to raise money in the Indian market. In effect, therefore, sterilisation is not a painless solution. Liquidity tends to increase rather than decrease if the overall effect of the chain reaction is considered.

Added to these factors is a recent discussion among Indian policy-makers on higher inflation in India arising from excess liquidity introduced by the RBI’s purchase of dollars to weaken the currency. It seems obvious that fuller CAC may increase the problems, both of inflation and loss of competitiveness.

The flip side

All this reminds one of the Dutch disease, which the Netherlands experienced as a result of its discovery of oil and related fuels. The foreign exchange inflows led to the Guilder appreciating so much that the competitiveness of Dutch industry was affected adversely.

The Dutch disease is something similar to what the emerging market economies have experienced due to capital inflows, particularly of the portfolio variety. It is, indeed, a pity that this dilemma cannot be easily solved.

Freedom of capital movement has brought both advantages and disadvantages. Disadvantages may sometimes outweigh the temporary benefits.

Dr Arvind Subramaniam cautions that the journey to CAC will not be smooth. He points out that the success of the RBI in managing exchange rates without any great volatility or overvaluation in the recent period may itself have had an unintended effect — that of breeding complacency amongst policy-makers. Whether with an open capital account this will or can continue is debatable.

India needs to review the issue of CAC itself, considering the risks of overvaluation and effects on growth, especially growth on manufacturing.

Dr Subramaniam is obviously not too enthusiastic about CAC as such. He points out that, at the end of the day, CAC itself may be an overblown issue, a tale more full of sound and fury than the strong views of proponents and opponents may suggest. Are these pains and risks to growth and competitiveness from overvaluation resulting from fuller CAC symmetrically moderate? Endorsing Augustine’s famous remarks, Dr Subramaniam suggests that Indian policy-makers may move to CAC, “but just not yet”.

The growing confusion arising from the recent appreciation of the rupee and the loss of competitiveness of the export sector would add strength to Dr Subramaniam’s cautionary note. This is particularly necessary as there is another Committee, headed by Dr Percy Mistry, on making Mumbai an International Financial Centre that seems to call for even fuller capital account convertibility.

We have now the views of Dr Arvind Subramaniam on the issue. We have to counterbalance Percy Mistry’s views against the note of caution sounded by Dr Subramaniam. Obviously, both are weighty considerations. “Better be safe than feel sorry” seems to be the better advice. Will the policy-makers listen to the well-argued note of caution?