Reality check over India's
currency By Kunal Kumar Kundu
BANGALORE - Recently, the Reserve Bank of
India (RBI)released a report from a special
committee chaired by deputy governor S S Tarapore
which was constituted to re-examine various issues
with the aim of making the rupee convertible for
capital account transactions. Shorn of any frills,
this amounts to removing restrictions on the
ability of resident firms and individuals to
monetize their rupee wealth, freely convert that
into foreign exchange and acquire assets abroad.
This, however, is not the first time that
the RBI has embarked on
a path to capital account
convertibility (CAC). An earlier
committee, chaired by the same
Tarapore, submitted a report in May 1997 laying
out a road map to full convertibility over a
period of three years. But the onset of the
financial crises in Southeast Asia barely two
months down the line resulted in the idea going
into prolonged hibernation.
In fact,
during the 1990s there was a widespread belief
that free international capital movements were as
much a part of a liberal economy as free product
markets, a liberalized domestic financial system
or free trade. So strongly was this belief held
that in 1997 the International Monetary Fund (IMF)
was on the verge of extending its remit to include
supervision of controls on international capital
flows, with the objective of helping its member
countries move progressively to a situation where
they had no such controls.
The IMF's
Interim Committee (now renamed the International
Monetary and Financial Committee) affirmed its
intention of having the IMF amend its articles to
that effect during an annual meeting in Hong Kong
in September 1997, after the Asian crisis had
already swept through Southeast Asia but before it
had engulfed Hong Kong and Korea.
The
principal lesson of this crisis appeared to be
that excessive inflows of financial capital were
more of a problem than a benefit. When this became
clear, the project to extend the IMF's remit to
cover capital flows, with its presumption that
freeing capital movements was a priority on the
reform agenda, was abandoned.
The moot
point now is whether India should change tack
again and allow free flows of capital, including
short-term loans, by all and sundry. The first
Tarapore Committee specified three preconditions
that needed to be satisfied before it would be
sensible to move to capital account
convertibility. First, the country needed to have
established fiscal discipline to make sure that
capital inflows did not provide an easy way of
perpetuating what is ultimately unsustainable.
A failure to do this would eventually lead
to a crisis when the market finally decided to
cease financing the deficit. Second, the country
needed to reduce the rate of inflation to the
range of 3% to 5% per year, and to make the
pursuit of an inflation target the central mandate
of the RBI. Third, India needed to have cleaned up
its banking system, so that one could be confident
that capital inflows would be efficiently
intermediated to where they would be profitably
invested, rather than used by banks to borrow more
with the object of postponing bankruptcy.
Since then, India has made important
progress in two of the three areas specified.
Inflation has fallen from more than 7% in 1997 to
under 5% now, and the RBI has been told to pursue
an inflation target. The percentage of advances
classified as non-performing - which is the best
single measure of the health of the banking system
- has fallen from 13.7% in March 1997 to 3.9% in
March 2006. And while Indian trade is still far
from completely free, it is now far less
restricted than it then was: in particular, the
quotas on imports of consumer goods have now been
phased out.
However, one important area in
which India has not made progress (as was pointed
out by John Williamson of the Institute for
International Economics), is the one that is
concerned with fiscal discipline: the total size
of the public sector deficit has actually risen
from 7.3% of gross domestic product (GDP)in
1997-98 to an estimated 7.7% of GDP in 2005-06,
while the ratio of public debt to GDP has
increased from under 65% to over 83%.
In
fact, not surprisingly, with the government being
unable to manage its expenses prudently (more
often than not giving in to the populist demands
of coalition politics) they have decided to go
slow on their much-touted Fiscal Responsibility
and Budget Management (FRBM) Act. Under the FRBM,
the government was committed to reducing the
fiscal deficit by 0.3% and revenue by 0.5% of GDP
annually in a bid to wipe out revenue deficit and
bring down the fiscal deficit to 3% of GDP by
2009.
The inability of the government to
adhere to strict fiscal discipline bodes ill for
the country if it is to push for full CAC. Low
fiscal deficit enables a lower interest rate
environment, encourages savings and enables the
government to undertake investments in necessary
sectors. Reduced fiscal deficit also makes the
debt more sustainable as the present ratio of
public debt to GDP is quite high.
Dilution
of these goals may not be conducive to growth in
the long run. In fact, lack of fiscal discipline
is one important factor why the sovereign rating
of India is unable to touch the investment grade.
And, this lack of discipline is a reason why full
CAC bears ominous portents.
It is worth
noting also that the first Tarapore Committee
rightly argued that acceptance of CAC presupposed
a pretty flexible exchange rate policy, so that a
change in capital flows could be absorbed by a
change in the exchange rate rather than a surfeit
of reserves or their possible exhaustion.
But this in turn is something that is
easier for an advanced industrial country to fully
accept than it is for an emerging market,
especially those in which growth has to be largely
export-led. The idea, however, is not to argue
that emerging markets benefit themselves by
running undervalued exchange rates and continuous
export surpluses; real resources are best used for
real investment at home, not for buying lots of US
Treasury bills.
But it is a mistake,
especially critical for an emerging market, to
allow its exchange rate to be pushed up to an
uncompetitive level. In fact, this becomes quite
clear if one looks at how the euro has been moving
vis-a-vis the dollar. Even when Europe was not
doing well, the euro was rising. This was because,
being the only true freely floating currency, the
euro was bearing the brunt of dollar depreciation
while other currencies were being managed. As a
result, Europe's competitiveness was impacted.
This implies that the current Indian
exchange rate policy is sensibly balanced, whereas
any rapid move to liberalize capital flows could
create problems for maintaining that balance. In
fact, the inflows that are currently occurring
have created immense difficulties in managing the
exchange rate. Unusually large capital flows
trigger an appreciation of the rupee and undermine
India's export competitiveness.
This
forces the RBI to acquire foreign exchange and
increase its reserves to prevent rupee
appreciation. To balance the resulting increase in
its assets and control money supply, the RBI needs
to reduce its holding of government securities, at
considerable cost to itself and the government.
And as it runs out of government securities to
retrench, it loses control over money supply.
Even IMF research [1] - which one may
assume was inclined to find support for capital
account liberalization if a serious case could be
made for it - concluded that there is at best
mixed evidence of net benefits from free capital
flows. The idea of their paper was not to argue
that there are no benefits from certain types of
capital flows.
The question the authors
sought to find an answer for was "does financial
globalization promote economic growth in
developing countries?" In fact, they find that
"financial globalization can be beneficial under
the right circumstances. Empirically, good
institutions and quality of governance are crucial
in helping developing countries derive the
benefits of globalization. Similarly,
macroeconomic stability appears to be an important
prerequisite for ensuring that financial
globalization is beneficial for developing
countries."
However, after a detailed
empirical analysis they could not establish a
robust causal relationship between financial
integration and economic growth. Furthermore, they
found little evidence that developing countries
have been consistently successful in using
financial integration to stabilize fluctuations in
consumption growth.
What is also
noteworthy is that in a 2003 paper they embarked
on a question as to whether countries without
capital controls do better than countries with
them, and they failed to find evidence to support
the conjecture that a complete absence of controls
brings faster growth or other economic benefits.
What this surely suggests is that what is
usually the last step in liberalizing the capital
account, namely, the liberalization of short-term
loans, may bring costs that outweigh the benefits.
It is not difficult to believe this. All the
evidence is that bank flows - which are the part
of the capital account that is separately recorded
and that falls most clearly in the short-term loan
category - are highly volatile. As soon as a
developing country hits a difficult patch, bank
loans and equity investments would be liquidated.
A higher share of financial and
non-durable components would imply lower real
sector absorption of liquidity and higher
spillover impact on domestic asset prices. Trade
(be it merchandise or service) and foreign direct
investment inflows go directly to the real sector
as does part of commercial borrowing and
transfers. Clearly a majority of inflow is
attributable to financial sector, which brooks no
exit barrier.
When the world is awash with
liquidity, flows tend to follow perceived higher
returns and, at the peak, it tends to ignore the
risk. But, as the global liquidity gets tightened
through an increase in global interest rates or if
domestic inflation rises due to the lagged effect
of excess liquidity (mainly arising out of the
inability of the real sector to absorb the capital
flows) there is every possibility that the trend
will reverse.
What is also important to
note is that currently capital movement in and out
of India is mostly free, and the move toward full
convertibility would free up most of the
constraints to short-term flows. And, short-term
flows hardly contributes to welfare. They cannot
safely be used to expand investment, since they
may be withdrawn before the investment project
matures. They tend to disappear just when they
could play a useful role in helping to smooth
consumption. And inherently they do not provide an
instrument for portfolio diversification. Yet it
is primarily variations in the flow of short-term
capital, like bank loans, that give rise to the
variability of the capital account, which provides
the main mechanism by which free capital flows
create problems.
While the committee
should have been more worried about the volatile
(namely foreign institutional investor ) nature of
the inflow, they use this as the reason to go for
greater convertibility. Strangely, even the
committee accepts the fact that convertibility on
the capital account for foreign investors has been
far more liberal than for residents, especially
with conditions for foreign direct investment
inflow and repatriation of capital by foreign
direct investors having been eased over time.
The restrictions that apply have been
determined by sectoral policies with regard to the
appropriateness of inviting investment in
particular sectors, the caps on equity that should
apply when such investment is permitted and the
conditions that should apply to such investment.
These are issues that fall in the domain of
industrial and commercial policy and not
convertibility per se.
The argument seems
to be that given the level of India's forex
reserves (more than US$150 billion), India should
move toward full convertibility. While this seems
to be valid, the question is would India be in
similar position to maintain its growth if in the
interim it has taken on a load of short-term debt
and given investment banks the right to play games
with its money.
For example if, at a later
stage, the unsustainably high current account
deficit of the US leads to a crisis caused by a
collapse of the dollar, the consequence for the
rest of the world is likely to be even more
traumatic. Recession in the US will be tempered in
the medium run by the shift in expenditures toward
American-made goods caused by the dollar
depreciation, but in other countries
expenditure-switching and expenditure-reduction
will reinforce each other in making for recession.
Countries whose exchange rates float
uncontrollably upwards will suffer the most. And
India, which is far from being a developed
country, will suffer substantially if the currency
floats freely.
This is, however, is not to
argue that India should never have CAC. As the
economy grows and the per capita income increases,
it is to be expected both that market trust will
increase and the efficacy of capital controls will
fall. That, however, is still a long way off.
