The Hindu Business Line : Is CAC need of the hour?

In 1997 following the roadmap suggested by the Tarapore Committee report, many thought that a fully convertible rupee would be a reality within a few years. Then, the Asian crisis put it on hold. No doubt, restrictions on borrowing and investment by both foreigners in India and by Indians abroad were being gradually relaxed. In effect, we were moving towards full CAC by small, measured steps. Now, the debate has been rekindled with the Prime Minister talking about the need for a re-look at the question in the light of the current economic realities. Since then, a second Tarapore Committee has been appointed to produce a new road map.

What are the major issues involved?

But before that it is important to remove some misconceptions about the concept.

TWO-STEP PROCESS

Convertibility is a two-step process. Full convertibility should imply that anybody can convert rupees into dollars and, in addition, buy whatever foreign goods, services, financial assets and property he wants with those dollars without any restriction. If Indians are allowed to buy only foreign goods and services but restrictions remain on the purchase of assets abroad, it is only current account convertibility, not full CAC. Remember, so long as goods can be freely imported by paying import duties and there are no quantitative restrictions, current account convertibility exists. In this sense, India achieved virtual current account convertibility from 1992.

The second misconception is that full convertibility requires free float of the currency. Note that both under the gold standard and the adjustable peg system (alternatively called the IMF System) major Western currencies were fully convertible but the exchange rate was kept fixed by government intervention. That means full convertibility exists so long as people are allowed to convert the local currency into foreign exchange without restrictions, at the prevailing exchange rate. What are the major restrictions currently in force on capital account transactions in India? We have virtual capital account convertibility for foreigners and NRIs for investing in India and taking out proceeds relating to FDI, portfolio investment and bank deposits in India. For Indian residents and corporates, fairly conservative limits still exist on how much they can invest abroad. Indian companies also need RBI permission to borrow funds from abroad.

WHY NOW?

The immediate trigger could be that some Indian policymakers want Mumbai to emerge as a major global financial centreThey feel that India has the manpower and expertise. What it lacks is the full freedom to bring money in and take it out. Other supporters of full CAC would point to many favourable economic factors for India at this time. According to them, India's GDP has been growing at 7-8 per centfor three consecutive years. The stock market is breaking one milestone after another due to massive inflow of foreign portfolio funds. So, it is highly likely that instead of a capital flight, post-CAC there will be more inflows into India. The forex reserves amount to $144 billion that covers 13 months of imports.

India's external debt is less than itsforex reserves by about $20 billion. Short-term debt accounts for 6.7 per centof the total external debt. This was 10.2 per centin 1991. Inflation is less than 5 per cent, despite the surge in crude oil prices. The share of bad bank loans in total loans has come down from 13 per cent a decade ago to 5.2 per cent now. The Centre's fiscal deficit is around 4.1 per cent, down from 5.9 per cent in 2003-04.

NOT-SO-ROSY

But detractors would highlight some other facts. The Centre plus States' combined fiscal deficit is still around 8 per cent of GDP, way above the earlier Tarapore Committee stipulation of 3.5 per cent. China has maintained an annual growth rate of 8-10 per cent over more than a decade without going in for CAC. Capital inflows into India have been primarily of portfolio funds that are inherently volatile. The more stable and economically more beneficial FDI flows into India amounted to around $6 billion in 2005. But this is only about 10 per cent of what China is receiving. All these imply that time is not yet ripe for full CAC. Irrespective of the timing, what are the possible benefits and costs of full CAC? The supposed benefits include the following.

First, India needs huge resources, especially to upgrade its infrastructure. Domestic savings alone are not enough. More (net) foreign funds would come in only if they are sure of free entry and exit. Second, Indian businesses (especially, the established companies) would be able to access cheaper foreign funds that would improve their international cost competitiveness. Third, unhindered access to foreign funds would facilitate Indian companies taking over firms abroad and developing more Indian MNCs in the process.

Fourth, Indian banks would be able to borrow foreign funds at lower rates which would, in turn, enable them to lend at a lesser rate to Indian small and medium enterprises which may not otherwise be able to borrow directly from the international capital market. Fifth, cutting delays in foreign exchange trading would reduce transaction costs and improve efficiency in Indian business. Finally, ordinary Indian investors would be able to further diversify their asset portfolios by investing abroad, thereby improving their risk-return profile.

NOT UNSTABLE EITHER

Many economists (including free traders like Dr Jagdish Bhagwati) would not agree. To them, financial markets adjust much faster than goods market. International financial flows are more unstable than flows of trade in goods and services. The direction and volume of capital flows depend on expected returns that are subjective to a large extent. Investors do suffer from herd mentality.

Capital flows suddenly change direction, even if the economic fundamentals of a country do not change overnight. Further, it depends on factors beyond the control of domestic policymakers (like changes in the US interest rate). So, one needs to be careful about allowing free entry and exit to international financial investors (unlike the more stable FDI flows).

When, in future, capital starts to flow out and rupee tends to depreciate, even ordinary Indian savers would be tempted to take their money abroad. Foreign exchange reserves would dwindle, rupee would fall and investors would gain at the expense of the government by reconverting their dollars into depreciated rupee.

Why should a country willingly accept this kind of instability to its economy by allowing full CAC, especially, for Indian residents? Indian residents do not need full CAC to invest their money in India. If attracting more foreign capital is the objective, then restrict full CAC to only foreign investors, at best. The so-called international asset diversification benefit from full CAC is not relevant for small Indian investors. Only a handful of rich investors would gain at the cost of subjecting the economy to greater instability.

The problems would be even more if Indian banks are allowed to borrow unlimited amounts from abroad. The East Asian crisis started that way. As things stand at the moment, it looks like the policymakers, in favour of a gradual movement to full CAC, would win over the supporters of the "big bang" approach.

(The author, a Professor of Economics at IIM Calcutta, is currently a Visiting Professor of Economics at the University of Rochester, US. He can be contacted at alokray15@yahoo.com)