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Capital Account Convertibility: Don't Bell the Cat!

Ashish Goel - 11/8/2007

While there is no formal definition of CAC, the Tarapore committee (1997) defined it as “the freedom to convert local financial assets into foreign assets and vise-versa at market determined rate of exchange. It is associated with changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by, the rest of the world”. At present there is partial CAC in India . As a part of India ’s external economic policy, Capital Account Convertibility has remained a controversial issue for quite sometime. The committee[1] on Capital Account Convertibility which submitted its report in 1997 highlighted the benefits of a more open capital account but at the same time cautioned that Capital Account Convertibility could pose tremendous pressures on the financial system.

Conversion of Indian rupees into foreign currency even for the purposes of trading on capital assets as opposed to conversion only for payment of trading debts is known to be Capital Account Convertibility (CAC). Basically CAC implies freedom to convert local currency into foreign currency and vice versa, for any purpose whatsoever, without needing any permission from the government. This means that one can import or export goods or receive or make payments for services rendered. However, investments and borrowings are restricted. CAC allows freedom to make investment in foreign equity, extend loans to foreigners, buy real estate in foreign lands and vice-versa. Broadly speaking, CAC allows anyone to move freely from local currency into foreign currency and back. It refers to the freedom to convert local financial assets and vice versa at market determined rates of exchange. As of now, we all are probably aware that the convertibility of Indian rupee into foreign currencies and vice versa is almost wholly free for current account transactions like trade, tourism, travel, education abroad and in India, and remittances into and out of India for purchasing health-care products. In contrast, the principal focus of capital account convertibility is on assets, both financial and real. Today, we have limited capital account convertibility. An Indian individual or institution is allowed, subject to certain conditions, to invest in foreign assets. Foreigners too are similarly allowed to invest in India . The current limitation to capital account convertibility includes limits on investments by foreign financial institutions in government papers, ceiling of 74 per cent for foreign shares in domestic equity, and specific sectors being off limits for foreign investments e.g. retail trade. Complete capital account convertibility of the rupee would mean almost no restrictions and no questions for free flow of foreign currencies and rupee in and out of India[2]. The question is whether India should go for full capital account convertibility or not. John Williamson, the father of the Washington Consensus says; “I therefore see a series of reasons for India to take a go-slow approach in moving to liberalize one day I do not doubt. That there are some liberalizing measures that should be made early- of FDI, of portfolio investment, of small private transactions- I find compelling. But there are many other liberalizing reforms- from electricity pricing to making the courts work expeditiously to pruning the fiscal deficit- that deserve to be priorities over complete capital account liberalization for the next ten years (at least). At this stage full capital account liberalization promises no larger benefits, while it increases the risks of things going badly wrong[3].”

But at the end of the day, CAC might well turn out to be an overblown issue: a tale full of sound and fury, signifying much less than the strong views of proponents and opponents alike might suggest. The question is raised whether these gains and risks are symmetrically moderate if the competitiveness and growth consequences from an early move to CAC are fully taken into account. Echoing St. Augustine , if Indian policymakers were to say, “let us have CAC but not yet,” then it would be a case of undesirable procrastination or of wisely heeding the precautionary principle. The answer to that may be well former, but it would be a whole lot reassuring if it were arrived at after factoring in the exchange rate and growth consequences of CAC[4].

This paper discusses whether CAC should be a means towards achieving more fundamental goals or not. It presents an overview of the risks involved in CAC. Further it also states that going towards fuller capital account convertibility would be a disaster and would end in destabilizing the economic growth. The researcher for the project relied on the theories propounded by people considered to authority in this field. He also referred to various internet articles and got a better perspective on the subject. Journals such as Economic and Political Weekly were looked into. A V Rajwade, in his article ‘Risks and Rewards of Capital Account Convertibility’, discusses the risks and the rewards associated with CAC. According to him, it is not the right time for India for fuller convertibility on capital account because of the sudden and huge inflows as well as outflows of foreign capital. Again the statement is corroborated by Mr. Sury, when he writes in his book ‘Indian Economy in the 21st Century’, that these outflows and inflows of capital will be capable enough to destabilize the economy. Mr. Gurumurthi also agrees with the fact that India should not step forward for fuller convertibility of capital account. In his article, ‘Capital Account Convertibility of the Rupee’, he laid downs three preconditions which are need to be met before the rupee is made convertible in the capital account. The most recent contribution of Arvind Subramanium has been looked into which is represented by his article in the Economic and Political Weekly of June, 2007 on ‘Capital Account Convertibility (CAC): the neglected considerations’. The article focuses on an aspect of first order importance for longer term growth, the level of real exchange rate and also focuses on the objective of avoiding overvaluation. It could be very well understood that almost everyone is disagreeing with the fact that India is economically matured enough to go for fuller capital account convertibility.

Some amount of control on the flows of capital is indispensable to redeem an economy from the global upheavals. The journey to fuller capital account convertibility is not going to be debonair.

The success of the RBI in managing exchange rates without any great volatility in the recent period may itself have had an unintended effect — that of proliferating self-righteousness amongst policy-makers. Whether this will also continue with an open capital account is somewhat debatable. India needs to review the issue of fuller convertibility itself, considering the risks of overvaluation and effects on growth, especially growth on manufacturing.

Dr Subramaniam[5] is apparently not too wholehearted about CAC as such. He points out that, at the end of the day, fuller convertibility itself may be a puffed up issue, an anecdote full of sound and fury than the strong views of proponents and opponents may suggest. There always remain a few factors that totally drive out the cheerfulness surrounding the endorsement of CAC in a developing country such as India at the moment. ‘One is the possibility of opening the floodgates of legalized capital transfers abroad by domestic residents, with the goal of availing of the lower tax rates abroad or even parking funds in tax havens such as Mauritius’[6]. The process may turn out to be a windfall for the rich.

Monetary and fiscal shadowing of the economy, guided by national exigencies hitherto, rather successfully, would have to face additional hurdles in terms of the newly achieved mobility of domestic capital. ‘This would entail the much talked about "trilemma" faced by countries in managing exchange rates while following an autonomous monetary policy under full capital account convertibility[7]’. The question arises is whether the RBI will be able to shun a run on the exchange rate, if all the equipments of national monetary management are portrayed fruitless. As more money flows in and out of the country it becomes screamingly thorny to control the price due to the simple reason that large amounts are involved in these flows. This could also garner intricacies for the RBI which has to buy or sell huge amounts of dollars if it wished to manipulate the rupee dollar rate. This too gathers difficulties in setting the interest rates according to the needs of the Indian economy. This happens because the rupee has to be allowed to become more flexible. Then if this is the sad scenario then India should take a prudent decision in opting for full convertibility of capital account. The major reason why India has to think twice before moving towards fuller convertibility is because of the experience faced by the Asian countries. The weakest link tends to be banking, when we talk of the international experience garnered with convertibility. Banks have a debt-equity ration of 20[8]. This extreme leverage goes with extreme risk. Just a slight mistake made by the CEO can lead to bankruptcy.

Again, the proponents of CAC have been continuously arguing that full capital account convertibility is very useful. It will force the government to behave more responsibly on fiscal balances. So to counter-argue, it is very well known to everyone of us that there is no empirical evidence for that whatsoever. To add further, ours is a democratic country. It is for us, the citizens, to bring our political leaders and the policy makers to discipline. ‘We should not be depending on a hundred odd currency and bond dealers, focused on short-term trading profits, to do so at an enormous cost to the real economy[9].’

While some others also argue that since effective performance of capital controls becomes more difficult in the arena of globalization, this de facto situation should be recognized de jure by lifting controls on capital account transactions[10]. This argument is debunked by Rajwade, when he wisely gives an exemplary analogy by analyzing corruption. He says that despite all the laws that India presently has which deals with corruption, it is practiced all over India . So this can never force us to make corruption legal. He says that the answer to this is very obvious. So not having a fully effective capital controls, however, is not the best argument that can be put forward for CAC.

Basically, a move towards fuller capital account convertibility will have to be justified in the terms as stated very explicitly below[11]:

a) The extent to which it can achieve the macroeconomic goals
b) The risk-reward ratio in relation to convertibility of capital account.

Endorsing Augustine’s famous remarks, it can be well derived that Indian policy-makers may move to fuller convertibility on capital account, but just not yet, they should wait for the right time to knock the doors. “Better be safe than feel sorry” seems to be, in all likelihood the better recommendation. But it an illusion that the policy makers will at last pay heed to the well-argued note of caution.

For almost half a decade CAC raged as a key of battle in the debate of globalization-----and for good reason. CAC has been a subject of fierce remorseless debate since a decade. Though the rupee had become fully convertible on current account, it has been proposed by the RBI that now fuller convertibility should be an objective of economic policy. This will mean that domestic assets like shares could be sold to foreigners. And similarly foreigners will be allowed to invest in India . Fuller capital account convertibility would mean that restrictions on capital account will be fully withdrawn. Full convertibility implies that foreigners are free to convert domestic currency into foreign currency and vice-versa.

The new report submitted by the RBI in 2006, on fuller capital account convertibility has become a subject of fierce debate. Today we have limited capital account convertibility. An individual is allowed to invest in foreign assets but it is subject to certain limitations. So is the case of foreigners. Complete capital account convertibility of the rupee implies that there will be no restrictions and no questions for capital flows outside India .

The Tarapore committee set up a time frame within which fuller convertibility can be imposed. But it was subject to specific conditions which need to be fulfilled[12]. Such as,

· The Gross fiscal deficit to GDP ratio is to be 3.5percent
· Average inflation rate should be within 3-5percent
· Debt-servicing ratio should be brought down to 20percent

The conditions laid down by the Tarapore committee have not been fulfilled hitherto. Like in India the rate of inflation is so high. Another problem is of fiscal indiscipline. The total size of the public sector deficit has actually from 7.3 percent of GDP to an estimated 7.7 percent of GDP in 2006. So even on the conditions suggested by the committee a sudden move to fuller convertibility would be screamingly premature. So the lay men of India should stand firm against any attempt to further liberalize the capital account transactions, which is a complete disaster. Not the rich men because they can take the advantage of liberal capital account regime to park their funds abroad and earn a lot of money by maximizing their wealth[13].

Economists realize that directly jumping into fuller capital account convertibility without taking into consideration the downside or the disadvantages of the steps could harm the economy. The East Asian economic crisis can be a classis example to cite for those who are opposed to fuller capital convertibility[14]. The further question that should be raised is that why is India so desperate in pushing ahead with the liberalization agenda. So what if there have been enormous global developments and developments in the last few years. It should be bore in mine at the very outset that attracting greater capital inflow into the country can barely provide a reason for greater or full convertibility. Capital inflows in India are far in excess of what is needed to finance the current account of the balance of payments. According to the report,

‘During the 2005-2006, the current account deficit has been comfortably financed by the net capital flows with over U.S. $15 billion added to the foreign exchange reserves[15]’.

World Bank has said that embracing CAC without necessary precautions could be absolutely disastrous. At this stage of the country’s economic growth, fuller convertibility on capital account cannot be an objective per se, although it can be a step towards creating opportunities in achieving more goals of economic policies. The major hindrance to fuller convertibility of the rupee is the fiscal deficit of the centre and the states, which is around 8 percent of GDP, which is grossly high when we talk of opening a capital account[16]. ‘Opening a country’s capital account when it has unsustainably high fiscal deficit can be likened to administering polio drops to a child suffering from high fever; it can prove fatal[17]’. It should be clearly bore in mind that until India reaches with a figure of 3 percent of GDP, it would be imprudent to give a sudden move to fuller convertibility of capital account[18] and which is not insurmountable, so to say. Though the committee has emphasized on reducing fiscal deficit, as a necessary condition for fuller convertibility, it has not set a time-map for the same hitherto. Capital account convertibility should be treated as a process and not an event. The plan for further convertibility on capital account will depend, however on several factors, as well as on international developments. The most native but at the same time most fundamental argument put forward for CAC was that free markets are inherently better than restricted markets. Just as the government should eliminate barriers to trade, they should also eliminate barriers to the free flow of capital because doing so leads to better economic performance measured in growth, efficiency and stability. A second argument was that CAC enhances stability as countries trap into a diversified source of funds. CAC increases the welfare of domestic investors by allowing them to invest abroad and diversify risk[19]. CAC is widely regarded as a prestige characteristic of an economy. It gives confidence to the foreign investors who are assured that anytime they change their mind, they can reconvert local currency back into foreign currency and take it out. Lots of people assume that a liberal capital account is, by itself, a desirable objective of economic policy[20]. Capital account liberalization leads to the availability of a larger capital stock to supplement domestic resources and thereby higher growth. To add, CAC allows residents to hold an internationally diversified portfolio, which reduces the vulnerability of income and wealth to domestic shocks. It is also argued that CAC has a disciplinary influence on domestic policies. It does not allow monetary policy to take on an excessive burden of the adjustments. At the same time CAC enhances the effectiveness of fiscal policy by[21]:

a) Reducing real interest rate applicable to public sector borrowing
b) Bringing about an optimal combination of taxes through a reduction of the inflation tax and in the rate of other taxes to international levels with beneficial effect for tax revenues
c) Reducing crowding out effect in the access to funds.

On the face of it, CAC seems to be a panacea to all financial problems and bottlenecks. But there is hardly any empirical evidence and studies to support and substantiate the free flow of capital[22]. Free mobility of capital exposes a country to both sudden and huge inflows as well as outflows of foreign capital, which can be potentially destabilizing the economic growth of a country. Thus, it is necessary for a country to have experienced institutions to deal with such huge flows[23].

“It may be recalled that in 1980s, many developing countries introduced CAC in a bid to attract foreign investments. After the disastrous experience of some East Asian Countries, [5] developing countries ( India in particular) have become very cautious in adopting CAC[24]”. It is an undisputable fact that in the arena of globalization, we have financial integration in the markets all over the world. But it should be bore in mind that before taking any quick decision about fuller CAC, one must properly understand the volatilities of these inflows. India has successfully avoided the trap so far and policy makers must remain cautious as regards to CAC[25]. Jagdish Bhagwati’s interesting take on the risks of CAC becomes relevant when he says “cease and desist from moving rapidly to full convertibility until you have gained political stability, economic prosperity and substantial macroeconomic expertise- and not just transparency and better banking supervision[26].” Countries are exposed to great risk when they liberalize. But the people of the countries-----especially workers, small businesses, and the poor----have no way of protecting themselves against these risks. The argument that CAC allows residents to diversify risk by investing abroad focuses on the benefits for a small group of residents while it ignores the larger affects ion society as a whole. In late 1990s, Chile relaxed restrictions on domestic pension funds investing abroad. The pension funds then speculated against the national currency and deepened the BOP problems in the aftermath of the Asian crisis. Domestic pension funds and domestic investors were the main agents behind the massive capital flows. What is perhaps the most important argument against CAC can be stated in three words: it increases instability. CAC allows speculative capital to flood into a country. While the money flows in, the currency appreciates. The capital inflows may support short term growth, but they can also lead to an unsustainable expansion of consumption, and to changes in the structure of production. The most compelling case against CAC is that it leads to instability. Nonetheless CAC could be desirable if it led to a faster economic growth.

There is no doubt that economic indicators of Indian economy have improved quite a bit since 1997. But so far as fuller CAC is concerned India has yet to go a long way ahead. International experience shows that India should be very careful and calibrated while deciding towards fuller CAC.

In general, at this stage of the country’s development, CAC cannot be an objective per se but should be considered as a means to achieving more fundamental objectives of economic policy.

From what was a nebulous concept a decade ago, could become a reality soon. If satisfied the above cited problems, CAC could be the logical culmination of India 's journey towards globalization. It should be carefully determined about whether the risks involved in fuller convertibility of capital account seems to be greater than the rewards we get from it. To the mind of the researcher at this stage of the country’s economic development, capital account convertibility cannot be a desired means per se, but India can step forward by the means of it to maximize more economic goals.

The fact that fuller convertibility has been a subject of fierce debate from past five years and the reasons in being so has been addressed throughout the course of this paper.

It has been also elaborated that the risks involved in fuller capital account convertibility are much more that the fruits we get from it.

For India is it not the right time to go for full convertibility. Taking into consideration of the Asian crisis, we need not touch the fire and set an example just like. It must be remembered that the move towards capital account convertibility calls for a conformist and cautious approach.

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