Capital Account Convertibility

This article appeared in Economic Times in June 1997.

There are three benefits to India from CAC :

  1. Rates of return on debt and equity in India are high by world standards. With convertibility, foreign money will come into India to arbitrage this differential away and reduce these rates of return: i.e., the cost of capital faced by the companies of India in equity and debt financing will drop. At a lower cost of capital, more investment projects would be viable, which would generate a faster pace of investment and growth in the economy.
  2. With convertibility, Indians would be able to diversify their portfolios internationally. Instead of being constrained to only hold Indian real estate, equity and debt, we will reduce our risk by diversifying internationally. This means that in a bad year in India, when Indian financial assets generate a poor return, foreign assets owned by Indians would continue to generate good returns. This reduction in the variability of returns would make Indians happier since they face less risk, and help stabilise India's macroeconomy.
  3. Convertibility means that the households and firms of India are not forced to meet each other through India's financial system. The GDR market is one example of the alternative: here Indian firms chose to meet with foreign investors through the markets outside India. This market arose in response to weaknesses of existing markets in India. With convertibility, it will be possible for Indian firms to interact with Indian households in (say) the markets of Singapore. This would provide alternatives for India's households and firms, generate competition for India's financial industry, and elevate the urgency of reforms in the financial sector. For example, if derivatives on the dollar--rupee start trading in Singapore or Chicago, convertibility means that we in India would be able to use them.

Convertibility would generate massive flows of funds into and out of India, as Indians and foreigners modify their portfolios to reflect new investment possibilities. Even if all policies in terms of financial regulation are correctly orchestrated, volatility in the dollar-rupee will innately increase. But given the tradition of government controls in India, we are all used to expecting low volatility of the rupee-dollar. This raises the urgency of developing futures and options on the dollar-rupee, which would give people a method for managing these risks.

The foreign exchange market will especially be in the spotlight, since all these increased flows of funds will have to go through the dollar-rupee market. An illiquid dollar-rupee market will display spurious volatility under such pressures. Hence, institutional development of India's foreign exchange market should precede convertibility. The two key approaches for this are (a) transition of the spot market away from the inter-bank market to modern screen-based trading that is widely accessible all over the country, and (b) transition away from the inter-bank dollar-rupee forward market to a modern dollar-rupee futures market without entry barriers. These approaches would transform the quality of the foreign exchange market.

CAC also has important ramifications for taxation. Convertibility opens up new avenues for a narrowing of the tax base, and hence upgrades the priority of a harmonisation of taxation in India with international standards.

Finally, CAC puts new pressures upon macroeconomic management of the economy, in the sense that poor macroeconomic policies will swiftly generate large outflows of funds, and price volatility. Financial markets will constantly monitor economic policy; this will constrain the behaviour of policymakers, and diminish the likelihood of irresponsible policy choices. CAC also brings up the spectre of a significant macroeconomic crisis if irresponsible policies are adopted.

Back up to Ajay Shah's media page (1997)