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N. A. Mujumdar

India moved towards capital account convertibility not so much because of the intellectual support provided by the Tarapore Committee as by the compulsions of the foreign reserves affluence. The basic approach to liberalise further the capital account convertibility is outdated, flawed and premature, says N. A. Mujumdar.

THERE was a time when moving towards capital account convertibility was regarded as a mark of a developing country graduating into a developed country. This conviction also formed part of the IMF/World Bank theology. All this has changed now, with the 1990s experience challenging the underlying philosophy. Massive volumes of capital moved into East Asia and Latin America and then abruptly the flow reversed. At a moment's notice, hitherto successful economies plunged into deep recession. The London Economist sums up the contemporary wisdom on the subject: "For many developing countries, unrestricted inflows of capital are an avoidable danger.''

It goes on to add: Untidy as it may be, economic liberals should acknowledge that capital controls — of a certain restricted sort, and in certain cases — have a role." Even the IMF, which once advocated, with a missionary zeal, movement towards total convertibility on capital account, now cautions developing countries to hasten slowly.

These are some of the random thoughts which occur to us while ruminating on the book by Dr S. S. Tarapore entitled Capital Account Convertibility, Monetary Policy and Reforms, published recently (UBS Publishers' Distributors, New Delhi, 2003). The volume brings together 31 lectures delivered by Dr Tarapore on capital account convertibility, monetary policy, financial sector reforms and fiscal policy. The book makes a major contribution to the current thinking on the broad area of financial sector reforms and provides useful inputs for future policy-making.

The Committee on Capital Account Convertibility, which was appointed in 1997 with Dr Tarapore as chairman, had provided a road map for the economy to move towards full convertibility, step by step, and the time-frame was 1997-2000. The Committee had also laid down certain pre-conditions for implementing the reforms. But nothing much happened during this phase. Then, came the phase subsequent to 1999-2000 when there was a phenomenal increase in foreign exchange reserves of more than $41 billion cumulatively. In 2002-03 alone, there was a quantum jump in reserves by $21.3 billion. This significant improvement in the external position is, to quote the Reserve Bank of India (RBI), "unprecedented in India's history".

The total reserves soared to $73.5 billion towards the end of April 2003 and it is anticipated that the level may touch $100 billion in the not-too-distant future. Perhaps, it is this embarrassingly high level of reserves which swept the policy-makers off their feet and the soft option they chose was to liberalise both the current and capital account exchange control regime. Thus, we moved towards capital account convertibility not so much because of the intellectual support provided by the Tarapore Committee as by the compulsions of the foreign reserves affluence.

This conclusion is further corroborated by the fact that the pre-conditions stipulated by the Tarapore Committee for moving towards full convertibility were not fulfilled. What were the pre-conditions?

A look at three of them. First, in terms of fiscal consolidation, the Committee had stipulated that gross fiscal deficit, as a percentage of GDP, should be reduced from the budgeted level of 4.5 per cent in 1997-98 to 4 in 1998-99 and further to 3.5 in 1999-2000. In reality, the gross fiscal deficit, as a percentage of GDP, stood at 5.9 in 2002-03 and even in 2003-04 the percentage would go down to only 5.6.

Second, the mandated rate of inflation for the three-year period 1997-98 to 1999-2000 should be an average of 3 to 5 per cent. The annual inflation rate, based on the wholesale price index (WPI, Base 1993-94), averaged at 4.7 per cent during the three-year period 1999-2000 to 2001-02.

Third, the gross non-performing assets (NPAs) of banks, as percentage of total advances, should be brought down in phases to 12 per cent in 1997-98, to 9 per cent in 1998-99, and to 5 per cent in 1999-2000.

In reality, the gross NPAs of public sector banks, as a percentage of total advances, declined from 16 per cent at end-March 1998 to 11.1 per cent at end-March 2002, that is nowhere near the stipulated levels. Thus, going by the pre-conditions laid down by the Tarapore Committee, the economy was not mature enough to move towards capital account convertibility.

At this point, although it is a diversion, one must record the appreciation of the transparency of the RBI. The data and information quoted above to compare the stipulated targets with the actuals are provided by the RBI itself in its Report on Currency and Finance, 2002-03 (page VII-22).

The ineptness of policy-makers and the RBI in making productive use of the bounty of foreign exchange reserves during this phase of 2000-03 is writ large on the liberalisation of the exchange control regime. The liberalisation went beyond the recommendations of the Tarapore Committee, which had advocated a gradualist approach.

For instance, in terms of permitting resident Indians to invest abroad, the Tarapore Committee had recommended that this should be gradually liberalised. In contrast, today, resident Indians are permitted to invest abroad, without any financial ceilings; the only irritant is that exchange control specifies permissible avenues of investment such as multinational corporations which are listed an the stock market and so on.

The new regime is particularly generous to non-resident Indians (NRIs), who can now merrily repatriate proceeds of their assets sold in India. The ceilings on Indian corporates' investment abroad or in joint ventures are quite high and such liberalisation is not confined to capital account. Even in respect of current account, the permitted allowances for travel, business travel, education, and soon, are so liberal that one would have never thought that India would usher in such an over-generous regime. The gay abandon with which the RBI has gone on liberalising outflow of foreign reserves gives an impression that the central bank is embarrassed by the surge in reserves.

The RBI is almost apologetic about the unusually high level of reserves, as is reflected in the following statement in a recent publication: "The sharp increase in the reserves in the recent period have raised issues about the costs and benefits of reserves, the financial cost of additional reserve accretion is estimated to be low. These costs are likely to be more than offset by the return on additional reserves. Furthermore, high reserves have provided important benefits in the form of precautionary lines of defence against under seen external shocks, the welfare gains from smoothing domestic consumption and investment, and the more visible benefits of ensuring financial stability despite an unsatisfactory international environment.''

Although the RBI has pontificated extensively on the adequate level of reserves, it does not seem to have evolved quantitative guidelines about the desired level of reserves. If, say, $30 billion of reserves are adequate — roughly equivalent to six months imports — could the economy use the `surplus' reserves of, say, $40 billion for productive purposes?

For instance, power is acting as a major constraint on industrial growth and can we import some power plants straightaway? This is the kind of issue which the RBI should address in the present context. It would then be able to draw up the modalities by which utilisation of part of reserves for productive purposes would be rendered feasible. Instead, the present panicky reaction of the RBI to somehow reduce the size of reserves would fritter away the valuable reserves. One is reminded of the frittering away by India of the huge sterling balances in the post-War period. Is history repeating itself?

In a capital-scarce economy like that of India, it is difficult to understand the rationale behind prodding resident Indians to invest abroad. The collapse of the UTI, the moribund capital market, the so-called the soft interest rate regime, are acting as a depressant on the household sector's savings. What purpose are these measures, to promote investment abroad, supposed to serve?

As it is, the bulk of the country's foreign exchange reserves are invested in developed countries such as the US, the UK and Germany. Do we want to reinforce this feature of public investment by promoting resident Indians also to invest abroad? Such efforts would be counter-productive. Thus, the basic approach to liberalise further the capital account convertibility is out-dated, flawed and premature.

Out-dated because the policy-makers who are adept in mimicking IMF/World Bank theology are yet to realise that the theology itself has changed. The IMF now sings a different tune.

Flawed because even empirical experience does not provide enough evidence to show that capital account openness does not necessarily result in large increases in capital inflows in developing countries.

On the other hand, the dangers to which it exposes developing countries are real, as emphasised by the Economist. Premature because the sort of pre-conditions set out by the Tarapore Committee are not fulfilled even today. The profligacy in the use of reserves, which is reflected in the current liberalisation of the exchange control regime, is unwarranted. The real challenge would be to facilitate the absorption of `surplus' forex reserves by the economy, so that it leads to higher growth. Policy-makers would do well to address this question, rather than imitating outdated IMF prescriptions.

(The author is a former Principal Adviser to the RBI.)

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