Issues India needs to address in Capital account convertibility

The finance minister in his various confabulations with the media has been indicating on the need to press on with full capital account convertibility for the Indian rupee. This isn’t the first time that the country is talking about CAC (Capital Account Convertibility). The chapter is being revisited by the incumbent bureaucrats of the country after none other than the PM Mr.Manmohan Singh’s clarion call on this issue. Therefore the objective of this article is to examine the relevance of this topic for our country per se, in light of the developments in the International economy.

Let’s start with “What is Full Capital Account Convertibility”:
Ø India already has current account convertibility (though partial in a few cases), meaning resident Indians and companies can import or export goods, receive consideration and make payments in foreign currency for travel, trade, education etc., though the extent of transactions are decided by RBI specified limits.

Now think of buying properties in US, shares of Microsoft in the NYSE (New
York Stock Exchange). Yes we are nearing the D Day -full CAC could turn out
to be a reality pretty soon.

Ø The PM in early 2006 constituted the second Tarapore Committee to prepare the road map for full CAC. The first Tarapore Committee was constituted in 1997 to look into this nebulous issue but post the East Asian crisis (discussed later in this article) CAC was put on the backburner.
Ø The 1997 Tarapore Committee has defined Full CAC as the freedom to convert local financial assets into foreign financial assets at market determined rates. It involves change in ownership and free, unconditional exchange of financial assets and liabilities across the globe without any restrictions whatsoever.
Ø Going forward, full CAC will also mean that a domestic individual can pay in foreign currency for purchases made within the country itself, thereby giving him the advantage of holding a strong hard currency say US $ or Yen.
Ø However care needs to be taken by the enforcing authorities to ensure that legitimate flow of money takes place. Dubious inflow/ outflow of money and money laundering activities can be curbed through proper KYC (Know Your Customer) guidelines being put into effect.
Ø One of the significant advantages of full CAC is that a fully convertible currency can be convertible even in a non-convertible country i.e. for e.g. US$, Euro is convertible in India whereas Indian rupee is not convertible in UK or US.

Whether the stage is set right for India to embrace full CAC:
One aspect on which all economic pundits agree is that implementation of Full CAC is axiomatic to steady economic growth and development. Full CAC will result in major influx of foreign direct investment, spur industrial growth, job creation and an overall improvement in the macro economic parameters.

Nobody can predict or gauge as to what is the most opportune moment for ushering in an era of Full CAC. All this resurfaced talk on CAC almost after a decade has mainly arisen due to the following factors:

Ø The forex reserves have already crossed the $100 billion mark and are poised to touch the double.
Ø Economic growth engines are in full steam
Ø Great amount of confidence that the global investors and various investment gurus are placing upon India
Ø A steady rise in the Business Confidence Index of the country (Refer NCAER reports)
Ø The sound macro and micro economic levers, increase in the Tax- GDP ratio (an increasing ratio indicates robust corporate earnings which augurs well for the future of an emerging market)
Deducing logic from the above factors, Full CAC is obviously considered to be the ultimate panacea for economic backwardness. Even a plethora of government agencies, international organizations have advocated and glorified the concept of Full CAC (A point that would be well appreciated here is that most international organizations thrive on the support from western powers and it would do well for countries across the globe to hold hard currencies once CAC comes into play).
The table below indicates the recommendations made by Tarapore Committee in 1997 for preparing a roadmap for Full CAC and also the current position of the economy vis a vis the recommendations – Source: Business line
We have complied with most of the parameters indicated by the committee, but are we ready for the final plunge?
In this regard let us examine the East Asian Crisis of 1997 in detail. The East Asian countries like Thailand, Indonesia and Malaysia (also referred to as Asian Tigers) opened up their economies way back in early 1990’s. These countries embraced liberalization, globalization and as a result full CAC with such fervor and vigor that rapid economic development was witnessed in the region. A major shift in manufacturing activity of products like Cars, textiles and ancillary goods took place from regions in the US to East Asia. Even companies like General Motors shut down their plants in North America and set up shop in South East Asia. This outsourcing led economic development (similar to what is being witnessed in our country now) resulted in a lot of influx of dollar forex reserves. The problem with huge inflows of forex reserves is that it results in a direct appreciation of the domestic currency, imports become cheaper and exports become uncompetitive over a period of time. For forex inflow to sustain, export competitiveness is a very important factor and it is the function of the Central bank of any country to regulate its monetary policy to maintain the exchange rate stability (for e.g., both RBI and Bank of China follow a policy of buying dollars to maintain exchange rate stability and export competitiveness). The policy makers of East Asian countries failed to regulate their currency fluctuations and had to pay a heavy price. The demand for their goods ebbed a little with their exports becoming costlier over a period due to continuous surge in their domestic currency vis a vis the dollar. This led to the sudden slowdown in dollar inflow; foreign investors and FII’s became bearish on the economy and there began a huge exodus of forex reserves to alternative investment destinations. Even the citizens of these countries followed suit and parked their money elsewhere. The Malaysian Ringgits, South Korean Won, Indonesian Rupiah, faced steep devaluation. The Asian tigers, ten yrs down the line, have still not recovered from the dead cat onslaught. The problem with these economies was that there was growth happening in all sectors except the real sector i.e.: Infrastructure, Engineering and Capital Goods. The growth in other sectors like banking and finance was fuelled by free capital mobility and arbitrage opportunities and such capital carries the risk of being pulled out any time in a fully convertible environment. The real growth of the economy is reflected only through investments in the form of FDI in capital goods and infrastructure.
Since early 1970’s there have been several crises triggered by speculative capital movements like the Southern Cone financial crisis of 1970, Mexican crisis of 1994 and Tequila Effect, East Asian crisis of 1997, Brazil’s flop show in late 90’s and the ensuing Latin American collapse, Russian crisis of 1999 and in the recent past, Argentina in 2001.
The damning experience of these countries show the dangers of making our rupee fully convertible based on short-term increase in forex reserves. RBI would do well to study the factors that led to the misadventures of the East Asian economies in detail while drafting the policy framework for Full CAC.

So what is necessary to usher in Full CAC, what should be done and what needs to be done?
Making the rupee convertible would bring forth demand for dollars from private investors and would largely relieve RBI of the pressure to buy dollars endlessly to maintain stability in exchange rates. But the long term consequences of this policy needs to be examined:
Ø Once our citizens are allowed to start buying dollars for investments abroad, the possibility of capital flight cannot be ignored in the event of any short term financial crisis in the country as the country is getting more and more integrated with the global economy.
Ø RBI can continue to buy dollars and build our foreign exchange reserves similar to the policy being followed by China. But this policy can only exacerbate our woes in future. The dollar as such is a currency waiting on the hinges to take a heavy beating; the value of the dollar is bound to fall with mounting trade deficits and failure of the US to convince Chinese authorities to allow the remninbi (yuan) to appreciate. The value of our forex reserves will definitely fall in line with the depreciation of the dollar. Though China will also be partially affected by the fall in dollar, she has not made the yuan convertible and more so acts as the credit card for the US economy. China constitutes 40 % of US imports and also parks all its money in US treasury bills and money market instruments. Therefore to preserve Chinese interests, the Bank of China will continue to mop up excess dollar from the market to the extent it protects the yuan rates. However how long this process can be durable is anybody’s guess, as the Asian Superpower cannot tide against reality for times immemorial!!!
Ø China and India were the only exceptions to the Asian Crisis. This was because both the countries did not open up their economies and embrace CAC too fast and too soon. Therefore neither did they witness rapid economic development in the 1990’s nor did they suffer the huge exodus of foreign capital and the resultant economic meltdown towards the close of the decade. Rapid economic development should not be solely based on inflow of foreign capital is a lesson India needs to imbibe before ushering CAC.
Ø Full CAC can either be benign or malignant to any country based on the inherent strengths and weaknesses in the economy. India is experiencing a deluge of foreign funds, the stock markets reached a historic high and are trading at a premium valuation, we even edged out the Dow Jones index before falling back to realistic levels, but the moot point is whether the Indian economy is as strong as the US economy? The votaries of convertibility, apart from the PM and FM consist of external forces like IMF and World Bank, hedge funds and FII’s who seek to capitalize on the growth stories of the emerging markets to profit from arbitrage opportunities and money market operations. Both the PM and FM (Both men of reputed pedigree – atleast the former’s words can be taken seriously) are confident that even after a full and free float of the currency the economy is resilient enough to withstand pressures and fissures in the international fiscal and monetary markets.
Ø India still needs to travel a long distance as far as infrastructure growth is concerned. The basic concerns of Bijli, sadak and pani have still not been addressed for a vast majority of the population. Many areas of the country are facing acute power shortage and we have our own RBI sitting on a pile of US$ 100 billion forex reserves. The basic idea of holding forex reserves is to address the import needs of the country and to provide cover for current account deficits. Even RBI has openly acknowledged that around $40 billion would be enough to provide a 6-month import cover. Apart from this, RBI may need to provide for fluctuation in international exchange rates and maintaining monetary stability. Even discounting the above factors, the central bank will still be left with a huge surplus of forex reserves. A few questions may arise in the readers mind which have not yet been addresses by RBI:
§ Why hasn’t the surplus reserves been used for domestic growth and development? What’s the purpose in keeping the reserves idle?
§ Has RBI undertaken an incremental cost – benefit analysis on the additional forex reserves it keeps accumulating? What is the rate of return being earned on these reserves considering the fact that interest rates in US are pretty low? Will we better off holding reserves in some other hard currency, which would earn a higher return?

Ø Another factor critics point out against Full CAC is that it permits Indian citizens to invest abroad and hold dollar denominated assets. What purpose does it serve to invest abroad when domestic savings are not being channelised into domestic investments? Retail participation in our own stock markets is still at an infancy level. Most individuals still consider small savings, LIC schemes and fixed deposits as safe avenues for investment. After the recent waterloo at the stock markets in May 2006, most retail investors close their ears when they hear the word “Sensex”. So even after a robust Q1 performance by corporate India, though the sensex has retraced to around 60 % of its old highs, volumes are still pathetic which only reflects the conservative outlook of our retail participants. When they cannot withstand a minor shakeout in our domestic markets, how can we expose them to the vagaries of the international financial markets by allowing them to hold assets abroad?
Ø India has still not addressed problems related to fiscal deficit with mounting government expenditure, transparency, accountability and financial prudence are words still considered Greek and Latin by the government agencies.
Ø Our country’s macro economic fundamentals though considered good by many, is yet to reach the stage to warrant a full CAC – Fiscal deficit at the end of Q1 has already reached 50% of the target deficit for the whole year, banks still have to address their NPA concerns (more so now in light of Basel II norms), reforms process has largely slowed down with the current coalition finding it difficult to push them through amidst a lot of cat calls from coalition partners, the country has not yet been able to address its energy concerns (with rising crude oil prices, the RBI covers up supply side shocks by raising interest rates which in the author’s humble opinion has no correlation). The alternative sources of energy like ethanol, bio gas have to be harnessed on a large scale and products like ethanol can be produced on a large scale only if sugar companies are allowed to function freely. Until Mr.Sharad Pawar stops deciding as to what quantum of sugar needs to be released in the market, generating fuel from ethanol will remain a distant dream. The country is still unsure as to when the benefits from The Indo –US civilian nuclear agreement will begin to accrue.
Ø Coming back to this debatable topic of CAC, there has been no empirical evidence in the past to suggest that Full CAC has benefited the economies that have implemented it. We only have stories of the downside floating around like the East Asian Crisis, Latin American Crisis etc due to unforeseen capital flight. The downside risk is indeed very high for any economy implementing full CAC as it wipes out years of economic development.
Ø Also another point which we would need to appreciate is that most of the inflow is happening in India due to recessional conditions elsewhere and this inflow would soon become the outflow once the arbitrage opportunity narrows down.

Should India then usher in full capital account convertibility:
Yes, India is an emerging market, a developing nation and a growing economy. Enforcing full CAC is a must, a necessity from which we cannot extricate ourselves with our ever-increasing presence in the global arena. A number of Indian companies are promoting joint ventures abroad and a lot of overseas companies are on Corporate India’s shopping list. Therefore with increased integration into the global economy the rupee should be made freely convertible but not before we set our house in order.

Lets welcome CAC without much fuss but after addressing the following issues

Ø Improve the fiscal prudence of the economy and deepen our financial system to withstand any shocks or meltdown in the global economy. Create institutions of growth and development.
Ø As an alternative to full CAC, the country can allow the rupee to appreciate and liberalize imports. The imports will prove to be cheap, the cost of production will come down and our exports will become competitive in the global arena. In the current scenario, even in spite of a devalued rupee our export competitiveness is less than 1, which does not augur well for a growing economy.
Ø Expedite the economic and policy reform process, and revamp the entire legal, judiciary system to ensure accelerated dispute settlement process.
Ø Increased infrastructure spending in the form of greater Public Private Partnerships (PPP)
Ø Ensuring more retail participation in the financial markets
Ø Allow the economy to be run by market-determined factors, without providing scope for subsidies (which can only hamper industrial growth and conceal reality)
Ø Allow the rupee to locate its real value against the dollar; a strong rupee is a sign of a strong economy.
Ø Open up different sectors of the economy, which act as engines of economic growth whereby FDI can be pumped in on a large scale, as FDI is the most rewarding form of investment for any economy, representing foreign funds that will stay invested within the country and lend stability to foreign inflows.

To conclude, what is required is a careful, cautious and calibrated approach by RBI buttressed by a full study of historical facts and clinical analysis of the current Indian and global scenario without drawing a blank as to the safeguards that must be put in place for free convertibility of the rupee.