Should India move to full convertibility?

Debate in Business Standard, 2 August 2006

Ajay Shah
Independent Scholar

When India had trade restrictions, barges from Dubai could bring in some things such as gold or VCRs, but not most goods such as steel or sugar. In contrast, capital controls are much easier to evade. Over-invoicing and under-invoicing can achieve two-way flows, for what Reserve Bank of India (RBI) inspector can know the value of a pouch of diamonds? When a software company earns "export" revenues of $100 million, this could just be capital coming in. Large Indian firms are becoming multinationals, with operations all over the world. Through transfer pricing with their subsidiaries, capital can be moved in and out of the country. A great deal of the remittances coming into India are known to be capital account transactions.

We have now internalised the idea that a sound Indian company must buy the cheapest steel in the world, regardless of whether it is made in India or not. In similar fashion, if an Indian company can source cheaper equity or debt outside the country, it is inefficient to force it to use a domestic source. Such compulsion merely invites evasion.

The external sector is now big. In 2005-06, $403 billion moved up and down the current account (56 per cent of GDP), and $254 billion moved up and down the capital account (35 per cent of GDP). With gross flows across the boundary adding up to $657 billion -- 91 per cent of GDP -- it is easy for private agents to move $100 billion in or out of the country. This is de facto convertibility and, every year, it only deepens.

A wall of capital controls once held back the ocean of global capital from the Indian economy. Big holes have been punched in this wall, thanks to the reforms of the post-1990 period. Now, tinkering with one hole (like PNs) will merely move the flows to another hole. Hence, I believe the question Should India achieve convertibility is ill-posed. Convertibility is already upon us. Our choice is between doing it in a choreographed and graceful way, or doing it in a bumbling and incompetent way.

This story is hardly unique to India. Setting up effective capital controls requires a police state, and capital controls introduce enormous distortions and rent-seeking behaviour as was the case with trade barriers. Hence, most countries in the world have dismantled capital controls. Russia is a recent example.

A few plane crashes do take place, but thousands of planes fly soundly every day. In similar fashion, the fact that occasional currency crises take place does not change the fact that for most countries, convertibility is the unremarkable everyday reality. Most central banks world-wide do everyday business in a framework of convertibility. It is easy for the RBI to tap into this knowledge and mimic these ideas.

Bibek Debroy,
Secretary General, PHDCCI

Why has the RBI kept the report of the second Tarapore Committee temporarily under wraps? Surely, these six gentlemen couldn't have come up with anything that revolutionary, unless they advocated a slower transition to capital account convertibility (CAC) than the government wanted. The contrast with 1996 is striking. Back then, before the east-Asian currency crisis, votaries of CAC were external. Today, it is internal, with the prime minister, the finance minister and the deputy chairman of the Planning Commission pushing for CAC. True, in March, when the Second Tarapore Committee was appointed, 160 economists issued a statement against CAC. But that?s probably a strong argument in favour of CAC. However, consider the following. First, have the first Tarapore Committee's preconditions been met? Except for current account deficit (GDP ratio), the external sector is rosy. Lawrence Summers thinks 15 per cent of our foreign exchange reserves are excessive, Dani Rodrik estimates excess reserves cost developing countries 1 per cent of GDP. On deploying reserves, the RBI governor has talked about switching focus from safety to returns. CAC may even allow the rupee to appreciate.

But what about internal preconditions? We are okay on gross NPAs, middling on inflation and less than okay on gross fiscal deficit (GDP ratio), CRR and RBI autonomy. Does that mean Tarapore-II produces another roadmap? Second, why push for CAC? We might want it because it is a powerful signal for reforms and there is nothing on liberalisation to show otherwise. The proposition that it helps attract capital inflows is doubtful. We do want FDI and other forms of foreign savings. However, not only have other countries (China) attracted FDI without CAC, there are few restrictions on capital inflows, except not allowing global hedge funds to invest in Indian stocks. Third, there are valid arguments for integrating with global financial markets and benefits from greater competition. But is that constrained by absence of CAC or lack of domestic reforms? Fourth, regulatory approvals are required for Indian companies to access foreign capital (debt markets) and investing abroad. But these are being liberalised, without a song and a dance about CAC being necessary. Is there any evidence of these regulatory approvals being significant constraints?

Fifth, the Indian capital account is, therefore, effectively open, except for the Indian householder, who faces restrictions on international asset acquisition. Jack the threshold up from $25,000 to $50,000 or even $100,000. Big deal. How many takers have there been within the $25,000 cap? To paraphrase Victor Hugo, everyone's favourite since the PM quoted him when he was the FM, CAC is not an idea whose time has come : time is a continuum and CAC is not an overnight change, but a phased transition.

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