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India's case for capital account
convertibility
By Dinkar Ayilavarapu
KOLKATA - It is tough being Bimal Jalan,
Governor of the Reserve Bank of India. He is sitting on
billions of dollars of foreign exchange reserves. The
increased flow of dollars into India has caused the
rupee to appreciate, leading Bimal Jalan to go on a
dollar buying binge, and in the process build up
impressive, if expensive, reserves of dollars. These
reserves have led for calls to open up the capital
account completely, permitting both Indians to buy
dollars and invest abroad. Uneasy lies the head that
sits on billions of dollars.
Last week Finance
Minister Jaswant Singh seemed to have been listening
when he liberalized rules for domestic entities to
invest abroad. But despite that, India continues to be
one of the most insular places in the world. The flows
of capital into the nation and those out of it (not as
much into it, but out of it) are restricted and
regulated by the state. This was the reason why India
escaped the economic contagion in 1997, which affected
so many Southeast Asian economies.
Before
proceeding further, once needs to analyze exactly what
capital account convertibility is. This entails that
there be free international trade in money and financial
assets. This means that people in India should be
allowed to buy financial assets abroad, and those from
abroad be allowed to do so in India, without
restrictions and hindrances. In simple terms, foreign
money flows in and out of India, while Indian capital
does the same abroad.
Capital flows are of two
kinds - official and private. Official capital flows
again can be multilateral, ie lending by agencies such
as the World Bank and the International Monetary Fund
(IMF), or bilateral, ie when some other country either
lends money or gives aid (as in 1991 when India borrowed
dollars from the Bank of England by shipping gold as
security). The official flows are usually not volatile,
and Bimal Jalan doesn't lose sleep over them. Moreover,
these flows are usually insignificant when compared to
the total flows of capital around the world.
The
private flows are the interesting ones. Not just Bimal
Jalan, but Britain in 1992, Mexico in 1994, the Asian
Tigers in 1997, Russia in 1998 and Brazil in 1999 all
lost sleep over them. They can be of four types -
foreign direct investment, portfolio investment, bonds
and bank lending.
In addition, there is
significant activity in the currency trading area as
well. Direct investment is usually with a long term view
and rarely leaves a country in a hurry. Portfolio
investment is in stock markets. Although this is
volatile, it is less so in the case of very large
players, as their leaving causes the market to drop and
thus reduces their investment.
Bonds
are usually those issued by sovereigns (like
Resurgent India Bonds) or corporations through American Depository
Receipts (ADRs) or Global Depository Receipts (GDRs) with fixed coupons
and maturity and are usually not very volatile.
It is bank lending and currency transactions
which are volatile, due to their very short period of
maturity. Bank lending is when a foreign bank lends to
locals (banks or private entities), and this is what
caused disaster in Southeast Asia in 1997. Currency
deposits are when foreigners hold foreign currency with
the primary purpose of exploiting interest rate
differentials or just to benefit from exchange rate
fluctuations.
As things stand, India allows
partial convertibility. This means that while FDI and
portfolio investment are welcome, bank lending is
strictly regulated by the Reserve Bank of India (RBI).
Also, until their partial relaxation last week,
investment abroad by Indian companies was closely
monitored and regulated by the government. So was the
use of the proceeds of investment from abroad. Thus the
RBI kept a watch on who raised money abroad and for what
purposes it was used. It would be unfair not to say that
this system has served India well. After all, India did
come out of 1997 without damage.
Benefits of
capital account liberalization
The proponents of
relaxation of regulations on the capital account contend
that it is good for business. The government of India
would be making it easy for people in India to invest
abroad. This would enable large Indian companies to be
able to invest abroad and emerge as truly international
giants.
It would make it easier for companies to
raise money to acquire companies abroad. According to
some experts, lack of this option to invest abroad is a
key reason for the absence of Indian multinationals.
Also, the capital raised abroad can be used according to
the wishes of the company raising it, rather than the
Reserve Bank of India. For example, until last week,
ADRs and GDRs could be raised by companies with good
financial records and the receipts of such issues could
only be used for capital expenditure. With complete
liberalization, it would the company's prerogative of
what to do with the money.
Another school of
thought says that the ease of exit determines the amount
of capital entering a nation. So the easier it is for
outsiders to exit India, the more will they invest in
India. They contend that if India opens up the capital
account, more capital will flow into India, which can
then be put to use to generate more employment and GDP
growth.
Texts of economics and finance talk of
capital account mobility in terms of efficiency of use
of capital. According to them, if the capital account is
open, the capital will flow to the deserving economies
and thus reward good behavior. Since capital chases the
best investment opportunities available, strong
economies (like India now) will get capital.
Convertibility is also in line with the libertarian
belief that an individual should be allowed to invest
and divest from places he desires. The state has no
business deciding for him. With capital account
mobility, any Indian would have the option of parking
his funds anywhere in the world where he gets the best
return. The babu (bureaucrats) bashers talk of
the infeasibility of controls and also the scope of
reducing corruption by removing the discretion given to
bureaucrats under the controlled regime.
The
more recent calls for allowing for greater capital
account convertibility are based on the US$70 billion
reserves with the RBI. The argument is at two levels.
One, the number of dollars India has puts it in a much
better position to handle crises if it is hit. Thus it
offers the country protection from international crises
of confidence which may lead to capital flight.
The second argument is a little more subtle. It
says that by opening the capital account, many Indians
would like to invest abroad, and thus in the process
take dollars from the RBI coffers and hence ease the
upward pressure on the rupee. According to this
argument, liberalizing outflows would allow dollars to
flow out and thus reduce Bimal Jalan's rupee headaches
mentioned earlier. Benefits of liberalization seem to be
many.
The flip side
There are no free
lunches, and capital account convertibility also doesn't
promise any. Ever since crisis hit Southeast Asia in
1997, free movement of capital is widely considered to
be a dirty term. Of the four most severely hit economies
- South Korea, Thailand, Malaysia and Indonesia - the
ones to come out quickly were the ones that introduced
some sort of capital controls.
Malaysia defied
the standard IMF prescription and imposed capital
controls, and was the second best performing economy of
the region. Even South Korea, the best performer,
negotiated a debt rollover in 1998 which helped it tide
over the crisis and which is argued by economist Paul
Krugman (in his book Return of Depression
Economics) as being in effect capital controls.
The crisis hit the region in the first place due
to the maturity mismatch between the lending of the
foreign banks to the local banks and the further lending
by the local banks. So when the crisis in confidence in
the Thai baht happened, foreigners decided against
rolling over their loans and the local economies
virtually collapsed. The argument goes that if foreign
capital's exit was prevented, then there would have been
no crisis.
On a more theoretical basis, it is
argued that by freeing capital flows, the sovereign
government loses control over the monetary policy (and
pegged exchange rates). After all, the RBI is a puny
player, despite its $70 billion when compared to the
might of the international capital markets.
Not
just the RBI, but all international central banks put
together, don't have enough dollars to match the muscle
of international private investors. The central banks'
abilities to set interest rates are severely constrained
in mobile capital situations. In the Asian region in
1997, and more recently in Argentina, the central banks
had to set high interest rates to attract capital when
the economies needed much lower interest rates to battle
recession. Moreover, the financial puritans' belief that
economies get what they deserve complicates bids for
fiscally unbalanced economies to allow free capital
mobility. To know what fiscal irresponsibility can do to
economies that permit free flows, just look at
Argentina.
Capital question
In 1997,
the government of India set up a panel under the then
RBI deputy governor S S Tarapore to look into the
mechanics of when, if and how the government of India
should permit capital mobility. After deliberations, the
committee came up with its recommendations.
These basically set three broad criteria which
needed to be met for India to open up the capital
account. The first was the adequacy of reserves, which
they said should be above 70 percent of the money supply
and not below 40 percent. As things stand, the reserves
are over 100 percent of the money supply.
The
second was to do with the financial sector. The
committee stipulated that the cash reserve ratio (the
cash the banks park with the RBI) should be 3 percent by
1999-00. This is yet to be met, but India is moving in
the correct direction. Among other things that the panel
pointed out was that the non-performing assets of the
banks should be less than 5 percent of the total loans.
With the securitization bill, it can be hoped that even
these start moving in the correct direction. The
committee also called for a fundamental overhaul of
financial sector risk management practices. The third
criteria dealt with macro economic indicators.
Inflation, they contended, needed to be kept between 3
percent to 5 percent and the fiscal deficit should be
below 3.5 percent of GDP. Let's not even start talking
deficit.
With this data in mind, what can or
should the government of India do? The answer varies
depending on who answers the question. Those against
convertibility will point to the fate of the Asian
tigers, and then to the fate of Malaysia. They rightly
say that convertibility is a two-way street and freer
mobility might bring in new capital and add to the
headaches of Bimal Jalan.
But as of last week,
the government has apparently made up its mind about
which way the wind is blowing. Capital account
convertibility may well be the logical successor of the
current account convertibility allowed years ago, but
the decision to further ease the restrictions (complete
free mobility of capital is still some way off) puts an
enormous responsibility on the government.
That,
in the final analysis, may well be the clincher in the
argument. Forces of international capital will show no
mercy, while making India pay for the irresponsibility
of the government (with deficits or handling of the
economy). With a functioning democracy, a bad economy
may well force the politicians to face up to their sins
at the hustings. And which politician would want that?
Good economics might yet make good politics.
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