With convertibility, it would be wise to have the legal framework for reimposing controls in times of necessity and keep the policy option open both for prudential and ad hoc controls.

B. S. Raghavan

Full convertibility is at best of times a delicate balancing act, with all the actors fine-tuned to the directions and dimensions of capital flows. Opening the doors should not be followed by throwing away the keys.

In the last 25 years many countries have, either voluntarily or under duress by the IMF, opened their doors facilitating full conversion of their currency and unconditional influx and efflux of capital. How have they fared? A survey of 27 capital inflow surges between 1976 and 1996 in 21 emerging market economies undertaken in 1999 by the World Bank showed that in about two-thirds of the cases, there was a banking crisis, currency crisis or both types following the surge.

In a study of sample covering 100 countries, developing and developed, undertaken in 1998, with reference to the period 1975-89, Prof Dani Rodrik of Harvard University found "no evidence... that countries without capital controls have grown faster, invested more, or experienced lower inflation. Controls are essentially uncorrelated with long-term economic performance" as measured by per capita GDP growth, investment (as a share of GDP), and inflation.


Pointing out that "financial markets... are prone to herding, panics, contagion, and boom-and-bust cycles," Prof Rodrik added: "Thanks to advances in technology and communications, international capital flows will likely continue to expand irrespective of government policy. The question is whether it makes sense to link up domestic financial markets tightly with international ones, and therefore speed up this process. There are two major risks in doing so: First, we increase the liquidity to which borrowers in an individual country have access, thereby greatly magnifying the effects of any turnaround in market sentiment.

"Second, we increase systemic risk through contagion from one market to another... it will leave economic policy in the typical `emerging market' hostage to the whims and fancies of two dozen or so country analysts in London, Frankfurt, and New York.

"A finance minister whose top priority is to keep foreign investors happy will be one who pays less attention to developmental goals. We would have to have blind faith in the efficiency and rationality of international capital markets to believe that these two sets of priorities will regularly coincide."

Full Capital Account Convertibility will induce unhindered capital flows in all directions. Is India's financial sector strong enough to stem the rising crescendo of speculative activity that is likely to follow? Here again, Prof Rodrik is worth listening to: "Putting in place an adequate set of prudential and regulatory controls to prevent moral hazard and excessive risk-taking in the domestic banking system is a lot easier said than done. Even the most advanced countries fall considerably short of the ideal...Only four of the 64 largest North American banks practise state-of-the-art portfolio risk management and loan standards are more lax than they ought to be."


It is said that one way of overcoming the Tequila Effect (economic crisis resulting from foreign investors pulling out of the country in droves for political, commercial or other reasons and leaving it high and dry) is by putting the premium on longer-term capital flows. How to distinguish between long- and short-term capital flows?

This is how Dr Y. V. Reddy described the problem when he was Deputy Governor of the Reserve Bank of India, in his speech to the Overseas Development Institute, London, in 2000: "... the cross border flows, with all the globalisation, are not subject to the same logic as domestic flows... the presumed differences between portfolio flows and FDI flows can be overdone as FDI flows can also be volatile.

"Longer maturity external liabilities may seem less vulnerable to volatility than short maturity ones but if there are active secondary markets, long maturities may be highly liquid. Similarly, there are also different points of view regarding the risks involved in debt and equity. Foreign owners of equity can choose to exit although a falling market or depreciating currency should provide a disincentive, but not if there is herding." In short, the situation bristles with uncertainties.

Will not dependence on foreign capital flows, especially to plug the current account deficit, make the country vulnerable to currency crisis? Here is Dr Reddy again: "Capital inflows to finance such deficits are welcome for their role in financing investment, and thereby sustaining long-term development. At the same time, it should be apparent that a large current account deficit implies correspondingly a large dependence on such capital inflows.

"The developing countries are vulnerable in many spheres and hence such large dependence has a potential for destability. The issue is not whether there are inflows or outflows at a point of time, since a fall in inflows is enough to cause a crisis when there is large dependence."

Many observers have noted that China is doing fine without loosening its grip on capital controls. As recently as March 3, a Deputy Governor of the People's Bank of China ruled out CAC in that country and gave out its current mission to be "to strengthen regulations governing the cross-border flow of capital and promote a more balanced international balance of payments." CAC would be introduced "step by step" as a "slow, methodical" exercise tailored to fit China's economic conditions, the `maturity' of its financial markets, and risk managing skills of market players.


The pith and substance of all that has been argued in this article is that CAC is by itself neither good and bad, but, as Dr Reddy himself put it at one time, has to be viewed in a country's specific context.

One should not entertain any exaggerated or exuberant expectations of its transforming the country into an economic Elysium. On the contrary, there will be much greater need for watchfulness to ensure that dollarisation of the economy does not end up in economic disruption and destabilisation and that a regulatory mechanism is in place to keep tabs on private sector debt and the positions taken by them as also the unhedged positions of corporates.

The entire effort at managing CAC will go awry unless bolstered by close and constant monitoring with the aid of accurate, up-to-the-minute and dependable information networks. It goes without saying that all these will require the sharpening and upgrading of the skills of those connected with, or watching over, transactions under the CAC regime.

Full CAC is at the best of times a delicate balancing act, with all the actors fine-tuned to the significance of the directions and dimensions of capital flows. Opening the doors should not be followed by throwing away the keys. It is wise, to quote Dr Reddy again, "to have the legal framework for reimposing controls in times of necessity and keep the policy option open both for prudential and ad hoc controls."

India's strength in working its economic reforms so far has been its wise handling of the various issues arising out of them. We can be sure that on CAC also, our genius for careful calibration will tide us over teething difficulties.


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(This article was published in the Business Line print edition dated March 31, 2006)
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