The Hindu Business Line : Report on Fuller Capital Account Convertibility

Though the latest CAC report reads like a travelogue of India's financial sector and government finances reforms to date, it is a valuable guide to the subject of convertibility. Changes will come organically, as a result of political expediency because coalition politics does not give policymaker the freedom to float the currency like a balloon, says ASHOAK UPADHYAY.

In 1997 when the first Tarapore Committee on Capital Account Convertibility (CAC) was released, it was complimented for being the most comprehensive guide to a country's journey to the free float of its currency. Not only were the prerequisites spelt out in succinct form, the timing and sequencing too were outlined for policymakers to refer to in the run up to the magical year of 2000, when the rupee would have reached that state of freedom enjoyed by the currencies of the developed world.

Nothing in this country works by the book. The CAC word was soon forgotten as successive governments took one step forward, sidestepped some critical issues, yet managed to pass some of the signposts on that road map. Nine years later, another committee chaired by the same former RBI Deputy Governor picks up the subject where it was left off and offers yet another "road map", this time towards Fuller Capital Account Convertibility (FCAC).

That adjective suggests an acknowledgement of the advances made in the CAC over the years; just how much is the subject of the first part of this dense and unduly long report. Since the CAC report of 1997 was as comprehensive as any body of advice on a policy as critical as currency free float can get, a shorter, crisper volume on the remaining tasks would have sufficed.

Verbose guide

As it stands, the FCAC report reads more like a verbose guide to India's banking system and public finances than a map to a specific destination. Long and turgid as it is, the FCAC report is probably the best travelogue of India's financial sector and government finances reforms to date. It is all the more so because it uses the 1997 report as its point of departure, thus contextualising subsequent changes up to the present. Despite the thicket that one has to wade through, it is a valuable guide to the subject it addresses.

The committee's critique of financial liberalisation since the 1997 report on CAC is majesterial in tone especially where the Reserve Bank of India is concerned. Despite a fair degree of liberalisation, "the basic framework of the control system remains unchanged... " The RBI has instituted changes in "an ad hoc" manner and the need is to rationalise/institutionalise those changes.

While the central bank has acted on a number of the 1997 recommendations, "the extent of implementation has been somewhat muted on some of the proposed measures (for example, outflows by resident individuals and overseas borrowing by banks), while for some other measures, the RBI has proceeded far beyond the Committee's recommendations (e.g. outflows by resident corporates)."

The charge

Persistence of control systems and ad hoc changes are the core of the committee's charge at the policymakers; therefore, the bulk of its initiatives are driven by these twin concerns especially when it comes to capital flows and systemic changes. Noting that restrictions still apply on outflows for resident individuals and banks, the Committee suggests an overall easing of controls in three phases for all user-categories. By the same token, it also recommends that the distinction between foreigners and Non-Resident Indians be narrowed for investment purposes while also allowing foreign corporates to invest in Indian equity.

This move should deepen the stock markets and loosen the stranglehold that any one block of investors can have on share price movements. At the same time its call for systemic changes are also noteworthy because it validates the charge of ad hoc changes with controls still in place.

Bank consolidation

One of the conditions for CAC that the earlier committee had suggested was the consolidation of the banking system. The present Committee reiterates that contention.

"In an FCAC context, the banks would be exposed to greater level of risks than at present and hence the capital requirement would go up even further."

The Committee asks government to reduce its holding in scheduled banks to 33 per cent from 51 per cent because "the government is unable or unwilling to provide large additional capital injection into the public sector banks... " that will need to strengthen their capital base to meet the exigencies of greater and perhaps more volatile capital flows.

At the same time, "greater focus may be needed on regulatory and supervisory issues in banking to strengthen the entire risk management framework. Preference should be given to control volatility in cross-border capital flows in prudential policy measures." In the Indian context, banks are, after all, the focal point for appropriate prudential policy measures. "In the absence of strong risk management policies and treasury management skills, banks may be prone to excessive risk taking."

Guns on Government

The Committee trains its guns on the government too; the fiscal deficit is a matter of concern; despite an "element of transparency in fiscal operation, quasi-fiscal deficits still remain". Inflation is under control and converging toward internationally acceptable lower levels, the Committee admits, but why has the 1997 committee's recommendation of a formal inflation mandate, "not been put in place," it wonders.

After its long "review of existing controls", the Committee issues a five-year time frame in three phases, 2006-07 (Phase I), 2007-08 and 2008-09 (Phase II) and 2009-10 and 2010-11 (Phase III) as an appropriate schema for the policymaker to take stock after each phase before moving on to the next one. For better or worse the Committee puts the onus of change and movement toward FCAC on the government.

The fact is that it has, rather surprisingly, given its general tenor of disapproval of unnecessary controls, given the control-minded policymaker something to cling on to; its call for a ban on Participatory Notes may at first glance seem justified because of the veil of secrecy that surrounds their identity.

But instead of a ban the Committee could have suggested measures to make them more transparent even while allowing investors that do not wish to register with the authorities, participate in Indian debt and equity. It would be fatal to base freedoms on the grounds that only the illegitimate would misuse them.

Organic changes

The Government's response to the panel recommendations is usually one of willful neglect or grudging acceptance.

In the case of CAC or versions thereof, changes will come organically, as a result of political expediency because coalition politics does not leave the policymaker a great deal of freedom to float the currency like a hot air balloon.

Already, the Left is readying to join battle over the report and the word FCAC may just disappear from the official lexicon.

In the meantime, the RBI will introduce those ad hoc changes, perhaps easing capital outflows by individuals and banks, while New Delhi frowns on easing its control over the latter. But that is India.