Nothing calibrated about CAC

Business Standard, 3 October 2007

RBI has long resisted capital account convertibility, for convertibility demands reform of monetary policy and banking regulation. It is claimed that we are on a meticulously calibrated trajectory towards convertibility. However, India's evolution into de facto convertibility is anything but calibrated, and is taking place at a pace that is not controlled by the government. When each individual can take Rs.80 lakh out of the country per year, we no longer have the luxury of thinking that convertibility is a future decision. The need of the hour is to set our house right with RBI reforms and a fresh focus on fiscal stability.

Over the last ten years, cross-border flows have gone from 50% to 110% of GDP. This dramatic growth has come through reforms of the current account, and from opening up inbound and outbound FDI, FII flows, ECB, etc. Multinational firms -both Indian and global - are able to effect capital flows through the current account by transfer pricing.

It is important to separate out two aspects of these changes:

  1. The first step is a decision by the government to (say) open up to FII flows.
  2. The second stage is the response by the private sector to the new opportunities. The timing and size of this response is not something which can be anticipated or controlled.

When outbound FDI opened up, nobody could have anticipated the timing and scale at which Indian firms turned themselves into multinationals. In similar fashion, when customs duties are reduced, and infrastructure is improved, it makes possible a new breed of globalised business opportunities. But it is not possible to predict either the timing or the scale of the response of the current account to these reforms.

Now, the difficulties of currency policy have inspired RBI to permit each citizen of India to take $200,000 a year out of the country. In the short run, this will have no effect, because of the restrictions imposed on the financial services required to translate this window of flexibility into genuine portfolio choices for individuals. But gradually, people will learn how to get around these constraints. As we have seen with the reforms of the past, going back to controls is damaging for the credibility of any government. In addition, the people who benefit from an element of opening up are a constituency that gets offended when controls are brought back. Hence, it is unlikely that these changes will be rolled back.

The key point to see is that a great deal of convertibility is here with us. In an opportunistic and bumbling manner, we will keep moving forward on convertibility. Most importantly, the response of the private sector to changes in rules takes place at a timing and scale that is both unpredictable and not controlled by the government. In short, there is nothing calibrated about India's movement towards convertibility.

Where does that leave us? The calibration rhetoric implies that RBI is in control and can be trusted to think about the evolution of policy in a thoughtful way. It involves an illusion of control - a level of control that RBI might have had in the 1970s and the 1980s, but is not found today.

It is possible to rationalise these changes as a good compromise, as a way of making progress in an imperfect way. As an example, RBI has been beaten back from the erstwhile extent of exchange rate pegging, thanks to the size of cross-border flows, which have been caused by deepening convertibility. While this may not be as nice as a well thought out monetary reform, a certain retreat from exchange rate pegging and a greater seriousness about inflation has come about, albeit in a disruptive way.

Yet, moving forward into convertibility while lacking a consistent monetary policy framework is fraught with danger. Our faulty monetary policy is destabilising capital flows, giving sharp inflows and outflows in response to one-way bets on the currency. As Bimal Jalan has emphasised, opening up to outflows induces new risks. The ideal time to open up to individual outflows would have been after putting a proper monetary policy framework and a system of financial markets into place.

With an uncalibrated movement towards convertibility, it is the rest of the policy framework that has to urgently play catch-up to the consequences of convertibility. New work is required on four fronts: banking, monetary policy framework, financial markets and fiscal stability.

At present, India's banks are unsafe, owing to poor banking regulation and supervision. Superior knowledge of financial economics needs to be brought into banking regulation.

It is increasingly clear that the pegged exchange rate is an inappropriate and infeasible monetary regime for India. The greater the convertibility, the greater the loss of monetary policy autonomy owing to exchange rate policy. In a continential economy, there is a genuine need for domestic monetary policy autonomy. Our politicians will - rightly - not accept CPI-IW inflation above 3%. RBI reform is required, in order to achieve transparency, predictability, autonomy and accountability of monetary policy.

A critical feature of countries that have properly graduated to convertibility lies in the development of sophisticated markets as shock absorbers and as sources of information. There are five key markets - equities, commodities, bonds, currencies and credit risk. In all five cases, there is trading on exchange and on the telephone. All these markets must have liquidity and market efficiency based on speculative price discovery, have tight interlinkages through arbitrage, with unified regulation and supervision.

Finally, there is the fiscal question. On one hand, genuine fiscal reforms have taken place in the form of legislative activism (the FRBM Act), the 12th finance commission, and the computerisation of income tax. This has yielded results in terms of a sharp drop in the fiscal deficit. However, much more needs to be done in bringing down the fiscal deficit to a point where the debt/GDP ratio will not balloon even in a recession.

In summary, India is inevitably moving forward with convertibility, in a manner which is anything but calibrated. A deep engagement with globalisation is a fundamental ingredient for achieving high GDP growth. However, in order to avoid a macroeconomic crisis, this calls for a commensurate change in the policy framework on banking, monetary reform, the Bond-Currency-Derivatives Nexus and fiscal stability. Urgent efforts need to be undertaken on these four fronts.

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