CAPITAL ACCOUNT CONVERTIBILITY - PRESPECTIVE 2000

Capital Account Convertibility(CAC) has been avidly discussed in India ever since the country embarked upon the path of liberalization in 1991. Though the inevitability of CAC was never in question, the actual decision continued to languish between the boundaries of economic caution and political expediency. The Peso crisis of 1994 served as a convenient justification for this procastination. But with the Tarapore Committee charting the road map to CAC by the year 2000 all this speculation, scepticism and pessimism has been laid to rest. CAC is a complex issue that spans fiscal and monetary policy, interest rates, inflation, exchange rates, derivatives, the financial sector, capital markets and also productivity, growth and competitiveness of the real sectors of the economy. What CAC means:CAC refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates. It implies freedom to citizens to buy and sell foreign exchange and utilise it for defined purposes. The need to opt for CAC stems from the realisation that it is futile to build sand walls to reign in escalating capital inflows and outflows, largely of hidden nature. This has its concomitant costs and distortions. By creating distortions in the resource allocation and consequent errors in decisions, both by the market and at the level of the authorities, ineffective capital controls compound the cost of inefficiency. Benefits of CAC: Availability of larger capital stock to supplement domestic resources leading to higher growth in the economy. Allowing residents to hold an internationally diversified portfolio, thereby reducing the vulnerability of their income streams to domestic shocks. Reduction in the real interest rate / cost of capital. Encouraging India entrepreneurs to seek global presence without interference from Government or regulatory agencies. Providing impetus for domestic tax regimes to rationalise and converge into a international tax structure. Most significant long term gain is that CAC is a ruthlessly efficient task master of domestic fiscal and monetary policy. With full convertibility, no country can afford to run up large fiscal deficits, raise money supply with impunity, administratively control interest rates, protect inefficient banks or rigidly adhere to a nominal or real exchange rate when they are out of line with economic fundamentals. PITFALLS OF AN UNPREPARED CAC This very aspect of efficiency CAC exposes our insulated economy to the full blast of economic discipline. International experience of CAC has notable examples of failure which emphasis the importance of getting some things right before plunging into full convertibility. There are five types of hazards. 1. Inflation driven appreciation of the real exchange rate :- When dollars are exchanged for rupees, they raise money supply which leads to inflation. Increasing supply of dollars raise the nominal exchange rate (rupee gets stronger). Inflation makes it worse and raises the real exchange rate. Exports get hit and the current account deficit increases. Uncontrolled, it leads to unsustainable, current account deficits and severe macroeconomic imbalances which severely erode the confidence of the investors resulting in currency flight, depletion of reserves and sudden collapse of exchange rate. This happened in Argentina and Chile in 197881. 2. Nominal exchange rate peg: Countries that have a high share of imports in GDP often try to maintain an artificially high nominal exchange rate even under CAC on the assumption that it would control inflation. It is an absurd thing to do because, like any market determined price, exchange rates reflect fluid supply and demand condition for foreign funds. Fixing a nominal exchange rate in the face of large foreign fund inflows has damaging consequences. It forces the economy to import even more and simultaneously chokes off exports. This widens the current account deficit to unacceptably high levels. When investors realise this and start taking funds out, the central bank makes things worse by intervening to maintain the exchange rate

instead of letting it depreciate. The outcome is an even more acute depletion of foreign currency reserves, as was the case with the Mexican crash of 1994. 3. Dutch Disease:- This first happened in Holland in 1960s and hence the name. This is the outcome if the central bank is hypersensitive about inflation. Faced with a surge in foreign exchange inflow, it will sterilize some of the additional money supply i.e. sell government securities to mop up liquidity. This will first harden interest rates and then force them to rise beyond competitive levels. High interest rates will raise cost of production and will also suck in more short term foreign funds. This will force further sterilization, leading to a further increase in exchange rate thereby hurting exports. Sterilization is a high cost and ultimately futile game, yet anti-inflationary central bankers are prone to sterilize and sometimes it goes beyond their control. 4. Inefficient and imprudent banking:- Banking is the crux of CAC. It can either sustain and strengthen a convertible regime, or bring it down. CAC exposed serious defects in the banking sector and created crisis in Argentina(1980-81), Chile(1981-82), Indonesia (1992-93), Korea(1984-86), Malaysia(1985-86), Mexico(198288, 1994), Philippines(1984-87), Thailand(1986-87 and at present). 5. Fiscal extravagance:- Fiscal indiscipline is an invitation to disaster under CAC. If India liberalises its capital account despite having a high fiscal deficit it will lead to sustained government borrowing and will keep interest rates higher than international levels. The differential will suck in foreign funds and steadily raise the exchange rate to uncompetitive level. If these funds are used to finance more wasteful govt. expenditure, the difference in interest rates will persist, prompting further inflow to take advantage of sustained arbitrage opportunities. Eventually investors will get wiser. The response :- Capital outflows. Tarapore Committee Report :It is in the context of Indias imperfect fiscal, monetary and exchange rate regime that one must evaluate the recent report on CAC submitted by the Tarapore Committee. The Committee has recommended that the process of achieving full convertibility by the year 2000 sequenced over a 3 year timetable and subject to a number of strict conditions. The preconditions to be achieved by the year 2000 set by Tarapore Committee for CAC are: Gross fiscal deficit must be brought down from 4.5 per cent of gross domestic product (GDP) to 3.5 per cent. The average effective cash reserve ratio (CRR) must be reduced from 9.3 per cent to 3 per cent. Gross non-performing assets (NPAs) of public sector banks must be reduced from 13.7 per cent to 5 per cent of total bank advances. Parliament must give the RBI a mandate of managing inflation (measured presumably by the wholesale price index) at level of between 3 to 5 per cent. The debt service ratio (expressed as a percentage of current account receipts) must be brought down to 20 per cent. RBI must withdraw from primary government borrowing programs and the government must set up its own public debt office. Interest rates must be completely deregulated. There should be a consolidated sinking fund and disinvestment proceeds and the RBI dividends will go into this sinking fund. There must be moratorium on the creation of weak banks. There must be transparent and globally comparable procedures for fiscal accounting. There must be an adequate level of foreign exchange reserves which is essential to withstand cyclical changes in the balance of payments. Real Effective exchange rate management ( REER) :- The committee calls for managing REER which is a trade weighted real exchange rate. The committee has suggested that REER be evolved as a prime indicator of the market and the exchange rates be aligned to it. The committee argues that managing REER is certainly better than supporting a nominal exchange rate. The Committee has also recommended a 5% monitoring bad around a neutral REER beyond which RBI may intervene. With the use of REER as the basis for intervention, the degree of uncertainty will gradually vanish and enable the market to predict the value of the rupee reasonably accurately. Before discussing the specific recommendations of the Tarapore Committee there is an issue that does not quite mesh with the rest of the recommendations and needs a separate mention. This is the policy regime on gold and the Committee feels that a liberalization of this policy regime is required for convertibility to work.

In the first phase, banks and financial institutions will be allowed to sell gold freely to residents. In the second phase, gold derivatives and forward trading will be introduced. Indian entities will also be allowed to function in international commodity markets. The committee argues that convertibility requires a market determined exchange rate, therefore the hawala market must disappear. The reform in gold policy are desirable, but if the objective is to eliminate hawala market, one wonders if a liberal gold import policy alone will suffice. While gold smuggling does bear a correlation with hawala transactions, gold smuggling does not determine hawala rates completely. Therefore one ought to be arguing for an elimination of all quantitative restrictions on imports and placing everything barring a very small prohibited list on the OGL. And these imports should be at reasonable rates of duty. Let us now examine some of the conditions set out by the committee:Level of Reserves:- Most of the people who oppose the idea of CAC argue that foreign exchange reserves of around 30 billion dollars can be wiped out at the punch of a key once CAC is introduced. Such arguments assume that one is going to have CAC overnight. Hypothetically however such volatility and sudden capital outflows can indeed take place. But usually such capital outflows are symptomatic of various other things that are wrong with the macro fundamentals of the economy. In other words the sudden capital outflow is a symptom and not the disease itself. Hence the importance of macro fundamentals which the Tarapore Committee refers to as perquisites for complete CAC. Let us evaluate if forex reserves of close to 30 billion dollars are enough. The committee lays down the following criterion to determine the level of reserves. (i) Reserves should not be less than six months of imports . Imports in 1996-97 were around 44 billion dollars. That means reserves of 30 billion are enough to sustain over 8 months of imports. (ii) Reserves must not be less than 3 months of imports plus 50% of annual debt service obligations plus one months exports and imports . Three months of imports would amount to 11 billion dollars. Annual debt service obligations in 1996-97 would have been around 14 billion dollars, 50% of this means 7 billions dollars and one months exports and imports would amount to 7 billion dollars. If we add all this up we get 25 billion dollars. Incidentally Tarapores committee calculation on this works to 24 billion dollars. The level of current reserves therefore satisfies the second criterion as well.

(iii) Short term debt and portfolio stock should be 60% of forex reserves . Short them debt is around 5 billion dollars now and portfolio stock is around 13 billion dollars. And 18 billion dollars is 60% of 30 billion dollars. Tarapore Committee gives us a figure of 31 billion dollars. The level of reserves is close to that required by the committee. (iv) The net forex assets to currency ratio should not be less than 40%. This is designed to ensure that an increase in currency does not take place without adequate backing of forex reserves. We have a current ratio of 70% and therefore reserves of 15 billion dollars would have satisfied this criterion. Although the Committee does not state it strongly, the level of Indias reserves are enough to sustain a push towards CAC. Only one of the four criteria is not fully satisfied and to satisfy that our reserves need to go up marginally to 31 billion dollars. The Mexican example is often quoted by the critics of economic reform as a pointer to the shape of things to come if India continued to open its markets and look outwards. The Mexican experience is relevant in that it tells us what not to do. However India is in a far better position as compared to Mexico at that time as the following table indicates: MACROECONOMIC INDICATOR GDP growth rate(1990-94) Savings rate Current a/c deficit(%of GDP) Debt Service to exports Short term debt to foreign debt MEXICO <3 % 16% 6-8% 34% 25% INDIA >4% 22% 1.4% 26% 5%

Inflation Rate :- Is an inflation rate of 3 - 5% necessary ? There is a trade off between low inflation and growth. Working towards a global inflation rate is fine if one has to settle for global as opposed to East Asian rates of growth. Would not it be a better proposition to settle for around 7% growth and 6% inflation as compared to 4% growth rate and 3% inflation rate? Fiscal Deficit :- There is an imperative need to work towards a reduction in gross Fiscal Deficit. But reduction in fiscal deficit by cutting down govt. expenditure in infrastructure & other developmental activities may have an adverse impact on economic growth. One needs to worry about how fiscal deficit is brought down. The committee is silent on this. There is also no mention of the revenue deficit at all. Efficient Banking, Reduction in CRR & NPAs :- No country has survived CAC with inefficient banks while few have failed with well functioning and carefully supervised banking system. This is where India faces its biggest hurdle. There are some serious drawbacks in the banking system. Directed priority sector lending at concessional rates has distorted the interest rate structure and put too much pressure on lending rates for commercial loans. And despite, greater flexibility interest rate structure remains regulated. Moreover, credit markets still remain segmented and competition among banks has been traditionally weak. But, the most serious barrier is government ownership of this engine of growth. In India public sector banks account for 87% of assets compared to 57% in Taiwan, 48 in Indonesia, 13 in Korea, 8 in Malaysia, 7 in Thailand and none in Hongkong and Singapore. Government ownership has led to over-manning and protection of the weakest. Over employment and its concomitant inefficiencies have resulted in high operating costs: 2.6% of total loan assets in India, compared to an average of 1.7% for ASEAN countries. Worst of all there is a pervasive signal that no bank, however poor its performance will be wound up. Indian Bank is a prime examples of marginalised player which have been put on life support system. Out of 27 nationalised banks 10 had NPAs in excess of 20 percent. If this mollycoddling continues the long term costs will far exceed those of propping up such institutions. The committee has rightly called for an effective supervision of the banking sector, more autonomy for the banks and FIs, called for a comprehensive review of all banking and finance related enactments and a general strengthening of the financial sector. But it has not been very forceful on the issue of closing down marginal and efficient players. Upgradation of Technology for Risk Management With an administered exchange rate and with restrictions on capital flows, one can successfully insulate the domestic economy from changes in the international economy. But as soon as one moves to market determined exchange rates, liberalizes imports and removes controls on capital inflows and outflows such insulation from exogenous shocks in no longer possible. Logically, there ought to be nothing wrong with exposure to volatility and shocks as long as one has in place instruments that permit risk aversion to take place. The Committee calls upon market participants to build strong risk management systems. The Tarapore Committee report while expressing its intention, however, has added several new dimensions to the debate. Is a three year road map for CAC feasible? Is our forex reserve position sufficient to insulate the shocks of capital flight ? Is the RBI in a position to profitably manage a glut of forex reserves? Are the pre-conditions like controlling inflation and banking NPAs practical? Most importantly, should the preconditions precede CAC or be synchronized with CAC? The contribution of the Committee on CAC to Indias reform does not lie in the milestones that it has so carefully erected on the road map to the complete convertibility of the rupee. Nor does it lie in its meticulous calibration of the transition process, which has unwittingly become the focus of debate. Instead the Committees singular achievement is the elevation of the concept of convertibility to the front and center of the liberalisation process. No longer is convertibility a radical, remote, rather fuzzy goal for the average Indian. It is now a tangible and not so distant reality. Not withstanding the grumbling about the unattainability of the targets, there is certainly nothing wrong with chalking out an agenda. If convertibility is pursued with the pre-conditions set out by the committee that in itself will send out the signal that the reforms are back on the nations agenda. Establishing that credibility is actually the sole ineluctable necessity for convertibility.