A Maginot Line of controls

Business Standard, 4 July 2007

In India, it is often felt that capital account convertibility is an exotic cocktail. Further, it is felt that India has a highly closed capital account, and we now face a policy decision about whether to move on to convertibility or atleast about how this movement can be done at a "calibrated pace" set by RBI. Both these propositions are substantially incorrect.

A pair of economists, Menzie Chinn and Hiro Ito have developed a measure of capital account openness. Their measure is a stringent one, where a need to obtain permission constitutes a restriction, even if the permission is `usually' or even `always' given. Their focus is on measuring the extent to which governments are trying to be involved in the capital account.

Comparisons for India are most interesting against large countries. We focus on the biggest 25 countries of the world by nominal GDP, the smallest of which is Austria. Amongst these countries, the Chinn-Ito measure takes values from -1.1 to 2.6. Countries at 2.6 have complete unquestioned capital account convertibility, where governments absolutely do not get involved in any private decisions about movement of capital.

There are three countries at the bottom of the table - the last holdouts of nonconvertibility - with a score of -1.1: Turkey, India and China. Given the poor capabilities of the Indian State, it should worry us when India has a high degree of control, by world standards, of the government in any part of the economy.

Amongst these top-25 countries, the average score is 1.467 and half of them are above 2.33. Key peers to India are ahead of us. Brazil is at 0.21, Russia is at -0.06, Mexico is at 1.23, Indonesia is at 1.23. Even if we go beyond these 25 countries to the full database of 180 countries, the median score is 0.18: much better than India's -1.1.

In India, there is a widespread belief that convertibility causes crises. If this belief were true, the countries which faced the East Asian crisis should have been circumspect about convertibility. However, barring Malaysia, none of these countries suspended convertibility either during or after the crisis.

Central banks of lots of little countries that lack Indian-style intellectual firepower are plodding along in their everyday business under convertibility. Their ways of doing everyday business are different, to be sure, when compared with the present lifestyle of RBI. But the fact is that they were able to learn the tricks of the trade, and operate monetary policy with convertibility in a routine manner year after year.

If anything is exotic by world standards, it is the remarkable system of capital controls that is in place in India, that is out of line with international practice. Convertibility is not exotic: Indian-style nonconvertibility is.

With an exotic Maginot Line of capital controls, manned round the clock by vigilant RBI staff, what does India achieve in terms of closing off the world? The remarkable fact is: not much.

The Chinn-Ito measure focuses on de jure capital controls, the system of rules through which governments seek to interfere in the movement of capital that households and firms want to achieve. The moment a government sets up such rules, individuals set about doing their business in ways which gets their job done despite the rules.

Participatory notes are a classic example of rent-seeking based on a license-permit raj. The government has set up a licensing system whereby only "foreign institutional investors" can buy shares in India. Hence, the privileged licensees earn a rent on this preferential access by selling participatory notes to those who are barred. The bottom line is that any `barred' entity has access to the Indian market - so there is de facto openness. All that is achieved is a layer of rents and government interface when there should be none.

Inbound and outbound FDI is giving a proliferation of multinational firms with operations in India. These firms can easily achieve capital flows through transfer pricing between subsidiaries located across various countries. Even without FDI in the picture, all Indian entrepreneurs have friends or family who are NRIs, who can cooperate in setting up firms in other countries and then doing transfer pricing to move capital across the boundary.

The recent BOP data shows gross flows on the current account of roughly $70 billion into and out of the country in one quarter. Scaling up to a full year, this translates to gross flows on the current account of $560 billion a year. If misinvoicing of a modest 10% is done on average, this translates to a capital flow of $56 billion or roughly 5.6% of GDP. It is not possible to setup an inspector raj which can monitor the staggering $560 billion of activities on the current account and stop misinvoicing.

With misinvoicing and multinationals in the picture, an open current account inevitably implies that the capital account is de facto open.

In 2006-07, gross flows on the current account and capital account added up to over $900 billion. Looking forward, the size of these flows is likely to grow sharply. Even if no further capital account liberalisation takes place, flows on the capital account will grow faster than GDP. Flows on the current account will grow faster than GDP, fueled by improvements in infrastructure and the growing sophistication of Indian firms. The rate of growth of these flows - and thus the speed of India's progression in de facto convertibility - is anything but the `calibrated pace of opening' that RBI talks about. India is opening up at its own pace; it is RBI that has to run to catch up with the facts on the ground.

In summary, convertibility is not an exotic idea on an international scale even amongst emerging markets. Current account convertibility and capital account convertibility go together in the `package deal' of harnessing globalisation. There is a baroque Maginot Line of capital controls manned by RBI staff, but enough holes have been punched in it so that there is substantial, and increasing, de facto convertibility. "Should India go for convertibility" is no longer a meaningful question. The question that India faces is about how the intellectual framework and institutional capacity of monetary policy and financial regulation can be rapidly overhauled to match the needs of a trillion dollar rapidly globalising economy.

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