The road to full convertibility

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Full convertibility is a necessity that can inject high-octane fuel into the economy. It will secure the autonomy of the RBI in the management of monetary policy and interest rates. The RBI and the Government have an onerous task ahead but it will vouchsafe India the trinity of equity, enterprise and economic growth, says G. RAMACHANDRAN.

G. Ramachandran

Nobel Laureate Friederich Hayek wrote

The Road to Serfdom

in 1944. This classic is a must-read for those that have very big stakes in the equity, robustness and growth of the Indian economy. It explains how controls on foreign exchange convertibility are the decisive step to totalitarianism. Controls on convertibility suppress equity, enterprise and economic growth.

Hayek was awarded the world's top prize in economics in 1974. He taught at London and Chicago, and lived until 1992.

If Hayek were alive, he would compliment the Prime Minister for announcing that the Indian rupee is on the road to full convertibility. The announcement is a decisive step towards deriving the best from the enterprise of Indians living anywhere in the world.

But Hayek would be candid to say that circumstances have forced India's hand. Full convertibility has become a necessity. It is no longer negotiable. Managing the rupee's dirty float within a system of limited convertibility and full interest rate autonomy has become a nightmare. The Reserve Bank of India (RBI) has had a torrid time balancing capital inflows against the nation's policy on money supply, interest rates, inflation, price stability and growth.

Full convertibility and freely floating exchange rates are not joint policy issues.

But a combination of the two will restore India's full autonomy over money supply, interest rates and growth. It would not be surprising if the Finance Ministry and the RBI are soaked in joy.


They have onerous tasks ahead. First, full convertibility will require a system of monitoring and deterrence aimed at flows related to terrorism, crime and money laundering. Second, the roadmap to convertibility will have to address how India will integrate itself into the global currency markets. They will set the spot price of the rupee after reckoning with its supply and demand. They will also set the rupee's forward price after reckoning with rupee interest rates. The road map will have to address how the price of domestic credit will flow into the global currency markets.

Third, the road map to convertibility will have to address how India will put in place a fair and free market for domestic credit. India has come a long way since July 1991 when it deregulated interest rates on corporate debentures. But there is some more distance to go in the context of other borrowers.


Convertibility, interest rate autonomy and exchange rate systems are tightly related policy issues. Convertibility or capital mobility offers two courses of action. Interest rate policy offers two. And exchange rate policy three. There are in all a dozen theoretical combinations. Many are sustainable; at least one is impossible.

First, India can choose to control convertibility or have no control. Second, India can choose autonomous money supply and interest rates or slavishly allow these to be set by the central bank of a foreign country.

Third, India can choose to follow one of three types of exchange rate regimes for the rupee. They are freely floating, fixed and pegged rates. Fixed rates are not the same as pegged though many think they are. Though floating and fixed rates appear to be dissimilar, they are members of the same family. Pegged rates are the odd men out.


Floating and fixed rates are free-market mechanisms for international payments in the current and capital accounts. With a floating rate, the RBI chooses monetary policy, but cedes control over the exchange rate policy. The rupee is on autopilot. As a desirable result, the RBI wholly determines India's monetary base and interest rates.

With a fixed rate, the RBI sets the exchange rate but has no monetary policy. The monetary policy is on autopilot. The monetary base is determined by the balance of payments. When foreign exchange reserves increase, the monetary base expands. Interest rates could fall; inflation could rise. When reserves decrease, the monetary base contracts. Interest rates could rise. Growth could be undermined.

Growth is good for India. That is not negotiable. Price stability is good for India. That too is not negotiable. Therefore, it is wholly inadvisable to cede control over monetary policy and interest rates to the central bank of a foreign country. So, full interest rate autonomy and freely floating exchange rates are possible, compatible and desirable. Full interest rate autonomy and fixed exchange rates are impossible.


India's economy and governance style, unlike China's, does not make pegging the rupee a viable choice (see

Business Line

, June 4, 2005). India has to work with fully floating exchange rates. But they pose significant problems to exporters and importers.

Exporters may be very uncomfortable if the rupee strengthened from Rs 44 to 40 per US dollar in response to strong inflows of global capital. Importers may be wrecked if the rupee weakened from Rs 44 to 48 per dollar in response to strong capital outflows.

This explains why nations abhor capital mobility. They control convertibility in the capital account because capital mobility, freely floating exchange rates and full interest rate autonomy cannot coexist. Any two but not three can coexist.


India's current account deficit is the result of growth. Capital account surplus is necessary to fund this deficit. It would be disastrous to staunch capital inflows. It would be wholly foolish too because they bring technology and employment with them. Hence, India has a seemingly respectable mixture of partial capital account convertibility, managed or dirty float of the rupee and bulging foreign exchange reserves.

The RBI creates foreign exchange reserves when capital inflows threaten to strengthen the rupee, say, from Rs 44 to 40 per dollar. It involuntarily expands the domestic monetary base by injecting rupee funds to soak up capital inflows. Exporters may reap rich rewards but bulging reserves are a badge of dishonour. Bulging reserves suppress the purchasing power of ordinary Indians. They make the rupee prices of imported crude oil, petrol, diesel, edible oils, metals and fertilisers costly. They hurt growth (see

Business Line

, April 2, 2004). Hayek would have denounced this.

The RBI draws from the foreign exchange reserves when capital outflows threaten to weaken the rupee, say, from Rs 44 to 48 per dollar. It involuntarily contracts the domestic monetary base by sucking out rupee funds and raising interest rates. These hurt consumption, investments and growth. Hayek would have denounced this too.


India has been playing a dysfunctional game for long despite its earnest focus on growth. This game has its worshippers who consider foreign exchange reserves a badge of honour and a source of resources (see

Business Line

, January 21, 2005). What these worshippers have not disclosed is that reserves are iniquitous and detrimental to future growth.

Full convertibility is a necessity that injects high-octane fuel into the economy. It secures the autonomy of the RBI in monetary policy and interest rates but only when the rupee can float freely. It pushes India into the possible trinity of equity, enterprise and economic growth.

(The author is a financial analyst. Feedback may be sent to and

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`Full float must be done in phases'
Capital account convertibility - Carefully-calibrated approach needed
Capital account convertibility - Challenging the underlying philosophy
Capital account convertibility - Why it's better for India to go slow

(This article was published in the Business Line print edition dated March 22, 2006)
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