The Hindu Business Line : A curate's egg

The Tarapore Committee report has nothing really new or novel, but at places it offers rare insights into banking and finance. Tarapore-II recommends the need for stress-testing models to be adopted by banks in assessing risks and portfolio management.

There is a sea change between the approaches of the Tarapore Committee of 1997 (Tarapore-I) and the present Committee (Tarapore-II). Tarapore-I was an overly confident report, which had set the goal of capital convertibility over a three-year span (1997-2000). It recommended full capital account convertibility — both inflows and outflows — subject to preconditions. With the outbreak of Asian financial crises within weeks and global rethinking on the issue of capital convertibility, Tarapore-I was all but shelved.

Capital liberalisation after 2000 was necessitated more by the need to manage extraordinary foreign flows than by Tarapore-I. Surprisingly, Tarapore-II attempts to give new life to it by treating itself as a continuation of Tarapore-I.

On all accounts, Tarapore-II is not about `capital account convertibility' per se but about a framework for Fuller Capital Account Convertibility (FCAC). The view taken by Tarapore-II seems to be that there is already an ongoing process of capital account liberalisation and it should help deepen it. In fairness, Tarapore-II is circumscribed by the terms of reference set for it by the Reserve Bank of India. The panel has proposed a five-year time frame (2006-2011) to move towards convertibility in three phases. Thresholds begin with $50,000 in phase one from the current $25,000 and further raised to $100,000 in phase two and $200,000 in phase three. At the end, "there would be a comprehensive review to chalk out the future plan of action."

Limits on investment abroad

In line with the same rationale, it sets limits for investment abroad by individuals, companies, banks, mutual funds, etc. It also opens the window for foreign currency borrowing. All these operate within the framework already set by the RBI since 2000 and there is nothing new or novel about the scheme. This perhaps led to the dissenting note by Dr Surjit Bhalla, one of its members, that there is no "big picture." By and large, Tarapore-II may be said to have recalibrated the process of liberalisation. Notwithstanding the dissenting note of Dr Bhalla, one may question the wisdom behind the thresholds and the rationale attached to the phases and recalibration. Overall, Tarapore-II has not opted for capital convertibility in the sense monetary economists define it. It implies that the Committee wants more of capital liberalisation.

If there is no `big picture', it is more in the failure to provide a macro analysis matching estimated outflows with expected inflows during the phases of liberalisation. If there is a mismatch, the FCAC bus will hit roadblocks. Tarapore-II recommends the need for stress-testing models to be adopted by banks in assessing risks and portfolio management. Strangely, Tarapore-II does not attempt any stress-testing for the liberalisation schemes suggested, especially in the context of two of its own suggestions. The first is to treat all non-residents alike and do away with the differential status accorded to non-resident Indians (NRIs). And the second is to ban participatory notes (PNs) by foreign institutional investors (FIIs) and phase out current PN accounts. If these were given effect, there would be a steep reduction in inflows.

Financial markets

Tarapore-II devotes many pages covering areas on the need for strengthening various segments of the financial markets. Some of these display a rare insight, possible only for those with long and varied experience in banking and finance. However, it does not pay similar attention to inflows and how to manage them. For instance, while dealing with foreign reserves (page 35-36) it vaguely feels that the reserves are comfortable. However, it is unsure of the inflows of private equity capital as currently captured in the RBI data. It does not take into account two of its own important suggestions. Thus, one has reasons to feel uneasy about the roadworthiness of the liberalisation recommended. There are suggestions in the report for improvements in banks, markets, institutions, etc.

These are in the nature of obiter dicta or expression of wishes not backed by specific programmes for action. Institution building and strengthening is a long process and has to contend against past baggage and vested interests. Those plumbing for higher levels of liberalisation would need to be less ambitious in their expectations and should not pin their hopes on strengthening institutions in a span of five years.

Breaking new grounds

Tarapore-II has broken new grounds in the most unexpected areas. These may be the undoing of the report this time round. The first is on the treatment of non-residents; the second on the review of double taxation treaties with foreign countries; and the last is on investment by foreign institutional investors (FIIs).

It has recommended that all non-residents be treated alike and the special treatment including tax concessions given to non-resident Indians should be done away with. India perhaps is the only country, which has this hybrid category styled NRIs. For too long, since the early 1960s to be precise, governments and politicians have courted them for their own reasons. A medley of avenues was opened from time to time and these have lost their validity.

Whatever may have been the advantages of attracting funds from NRIs in the years of exchange stringency, this source has proved to be high cost in the context of global financial integration. From a regulatory angle, banking or tax, there is a strong case for abolishing this special status and treat all non-residents alike. Politically, this is an explosive suggestion and may not find favour with the Government.

Double taxation treaties

The second suggestion is on double taxation treaties and the need to harmonise them. Mauritius has been a gaping hole and most of the investments come through this route with inestimable loss of revenue, lack of control over dubious investments, money laundering, etc. It is not necessary to labour the obvious. This suggestion, again, is politically a mine and may be set aside.

The last is on investments by the FIIs. There are actually two subsets: One is the recommendation that all investors should be registered and make investments direct and thereby withdraw the participatory notes (PN) currently operated. Tarapore-II recommends abolition of PN route and past investments through PNs to be phased out. There has been a battle royal between the RBI and the Government on this. Sadly, the issue remains unresolved. Tarapore-II has rightly connected it with capital liberalisation as it impacts on the ability of the RBI to manage inflows and the rupee rate at the same time.

`Exceptional measure'

The other radical idea related to FIIs is that on page 41. It suggests that FIIs "would be required to retain a stipulated percentage of the inflows with the bank and the bank in turn would be required to transfer these balances to the RBI." The impounded balance would be released to FIIs after a stipulated period.

Of course, this is recommended as an exceptional measure to contain inflows especially when they turn extremely large and volatile. Tarapore-II is aware of the high cost of sterilisation and the problems, which the RBI has on its hands. While recommending it, Tarapore-II is not liberalising but playing the role of a regulator! Tarapore-II, like the curate's egg — good in parts. The RBI has already entrusted some of the suggestions relating to procedural improvements to a Task Force. Otherwise, the report will remain in a limbo and keep company with Tarapore-I.

(The author, a former Finance Ministry official, has extensive experience in international, financial and trade issues.)