The Hindu Business Line : Stop, look and go slow

Convertibility will not quite ensure massive flows of foreign direct investment, the key requirement for the country's No 1 problem: Growing unemployment. Instead it could trigger hot money flows with destabilising consequences for the real economy. BHANOJI RAO says the Tarapore panel could suggest ways to attract higher levels of FDI, and recommend a regulatory system that tempers hot money flows.

"I have requested the Finance Minister and the Reserve Bank of India to revisit the subject and come out with a road map on capital account convertibility based on current realities," the Prime Minister, Dr Manmohan Singh, said in Mumbai on March 18. Promptly a committee was constituted under the chairmanship of a former RBI Deputy Governor, Dr S. S. Tarapore, to revisit the issue. It is a revisit because, a decade ago, another Committee headed by Dr Tarapore had studied the issue of Capital Account Convertibility and came up with a road map.

MEANING OF FULL CONVERTIBILITY

As of now, convertibility of the rupee into foreign currencies and vice versa is almost wholly free for current account transactions such as trade, tourism and travel, education abroad and in India, and remittances into and out of India for purchasing health-care. In contrast to the current transactions, the focus of capital account convertibility is on assets, both financial and real. If capital account convertibility is allowed, that along with convertibility on current account would imply full convertibility.

Today, we have limited capital account convertibility. An Indian individual or institution is allowed, subject to certain conditions and limitations, to invest in foreign assets. Foreigners too are similarly allowed to invest in India. The current limitations on capital account convertibility include limits on investments by foreign financial institutions in government paper, ceiling of 74 per cent for foreign share in domestic equity, and specified sectors being off limits for foreign investment (retail trade, for instance).

Complete convertibility of the rupee would mean no restrictions and no questions. It would then be possible for a foreigner to buy property or other assets in India and for an Indian to sell her home or small industry to a fellow Indian or a foreigner and invest the proceeds abroad. Domestic industry could shop abroad for credit and take it from where the price is right. Even in the case of full convertibility, there can be restrictions in specific areas, but these are to be minimal and temporary, giving a strong signal to the rest of the world that they can hold and trade in rupees just as locals can hold and trade in foreign currencies.

TARAPORE I

According to an RBI press release of June 3, 1997, the Committee on Capital Account Convertibility (Taraproe I) recommended a three-year time-frame for complete convertibility by 1999-2000, subject to the fulfillment of the following pre-conditions. First, the gross fiscal deficit to GDP ratio has to come down to 3.5 per cent.

Second, a consolidated sinking fund has to be set up to meet the government's debt repayment needs; to be financed by increases in the RBI's profit transfer to the government and disinvestment proceeds. Third, the inflation rate should remain between an average 3-5 per cent.

Fourth, gross NPAs of the public sector banking system should be brought down to 5 per cent, along with bringing down the average effective CRR to 3 per cent. Fifth, the RBI should have a Monitoring Exchange Rate Band of plus minus 5 per cent around a neutral Real Effective Exchange Rate, about changes in which RBI should be transparent.

Finally, the external sector policies should be designed to increase current receipts to GDP ratio and bring down the debt-servicing ratio from 25 per cent to 20 per cent.

In addition to the road map for capital account convertibility, the Committee also suggested phased liberalisation of capital controls. Several of the suggested measures are already in place, thanks in part to those recommendations and (to a greater extent) due to the phenomenal growth in foreign currency reserves from around $25 billion then to $140 billion now.

TARAPORE II

The present Committee (Tarapore II) is also (once again) to prepare a roadmap for full capital account convertibility. The terms of reference of the committee include reviewing the measures of capital account liberalisation in India so far; to examine implications of fuller capital account convertibility on monetary and exchange rate management, financial markets and financial system; and to provide a comprehensive medium-term operational framework, with sequencing and timing, for fuller capital account convertibility.

Tarapore II will commence work from May 1 and submit its report by July 31, indicating that the Government is in some hurry. As for the pre-conditions set by Taraproe I, the data assembled by Business Line (March 22) indicate that the fiscal deficit is not quite near 3.5 per cent (close to 4 now), inflation is closer to the upper bound of 5 per cent, and the CRR is still relatively high (and lowering could have consequences for NPAs). The most comfortable parameter is the level of foreign exchange reserves and it should drive some further liberalisation measures.

That a central bank will not be able to fix both monetary parameters and also the exchange rate is the introductory lesson in open economy macro economics. Thus, if the RBI allows the free float of the rupee, it will have freedom in terms of monetary policy. It could, in fact, fine-tune money supply and interest rates to ensure price stability (read, 2 to 3 per cent inflation), which is both an anti-poverty measure as well as a force to propel growth.

In contrast, it could determine the exchange rate and lose the freedom on the monetary policy front, which never works well in a free country, where the entrepreneurial capabilities will find innovative outlets in smuggling and black marketing in currencies. It is important to recognise, however, that free capital mobility would not allow full freedom on the interest rate front. All these considerations should shape policy and prompt the Indian policy maker to move on, but carefully and slowly on capital account liberalisation.

Tarapore II should help in shaping not only a road map but also setting a revised set of pre-conditions consistent with the present increasingly globalising economy combined with its enormous problems on the governance and labour fronts.

HOT MONEY FLOWS

Capital account convertibility will not quite ensure a massive flow of foreign direct investment, the key requirement for the present Indian economy's number one problem: Growing unemployment. Instead it could trigger hot money flows in and out with destabilising consequences for the real economy. This has been the spirit of the arguments advanced recently by a large group of Indian economists and their point of view should not be taken lightly in the formulation of policy.

What has been done since Tarapore I is impressive. In many ways we now enjoy a liberal foreign exchange regime. For instance, Indian nationals can now have dollar accounts as long as they have legal dollar earnings; foreign investors can freely repatriate earnings; domestic firms can borrow abroad within prudential limits, etc. Tarapore II could suggest ways to build on what has already been done, with the key purpose of attracting relatively higher levels of FDI. It should also recommend the key elements of a regulatory system that would help deter hot money flows in and out. Full convertibility is neither a fashion nor fad. It is more a complementary attribute of a strong economy rather than a critical input for building economic strength.

(The author, formerly with the National University of Singapore and the World Bank, is Professor Emeritus, GITAM Institute of Foreign Trade, Visakhapatnam. He can be reached at bhanoji@gmail.com)

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