The Hindu Business Line : Capital account liberalisation

The crux of liberalising capital account controls lies in liberalising access to capital flows, especially of the short-term type. It is in this segment that economist John Williamson sees danger ahead.

The Economic and Political Weekly issue of May 13-19, 2006 presents a symposium on capital account convertibility with the views of a number of economists. I was particularly impressed by the essay of Mr John Williamson on the subject. His definitive conclusion is that capital account convertibility in India is premature.

We must remember that Mr Williamson is no ordinary economist. He is almost a cult figure, associated with the evolution of the famous Washington Consensus. He is a friend of India, deeply concerned about its progress and the evolution of the reforms process.

His views are, therefore, worth serious consideration, especially as they are informed by a critical appraisal of the experience in many emerging market economies. Mr Williamson ranks as a "guru" of Indian economics and economists. His views are, therefore, "guruspeak" by all standards.

As part of an introduction to the piece, Mr Williamson points out how during the 1990s, there was a rather widespread belief that free international capital movements were as much a part of a liberal economy as free product markets, a liberalised domestic financial system on free trade.

So strongly held was this view that in 1997, the IMF was on the verge of amending its remit to include supervision of controls on international capital flows, with an objective of helping its member-countries move progressively to abolition of such controls.

The IMF's then Interim Committee had affirmed its intention of having the Fund amend its Articles to that effect during the annual meeting in Hong Kong in September 1997 — after the Asian crisis had swept through South-East Asia, but before it hit Hong Kong and Korea. Fortunately, the crisis led to the IMF leadership reversing its views.

Perhaps, it is appropriate in this context to refer to the opinions of Lord Keynes, one of the progenitors of the IMF. He was clearly in favour of encouraging a move to current account convertibility, but not on capital account transactions, where his position was much more guarded.

The IMF's Articles of Association did not specifically include any provision regarding surveillance of capital account transactions and restrictions on them. While the spirit of the age was in favour of freeing all transactions, the motive of prevention of speculative outflows played an important role in Keynes' excluding capital account liberalisation as a specific objective of setting up the IMF.

US trade conditions

Let us now return to Mr Williamson. He points out that the US used to require a condition regarding "non-imposition" of capital account controls on all prospective free trade partners.

If a country wanted to enter into a free trade area agreement with US, it had to forswear capital controls for any length of time.

The US Treasury got its way, although countries involved were faced with a difficult choice. Thankfully, India is not in such a position, at least on this issue.

The crux of liberalising capital account controls lies in liberalising access to capital flows, especially of the short-term type. It is in this segment that Mr Williamson sees danger ahead. Liberalising short-term loans may bring costs that far outweigh its benefits.

All the evidence is that bank flows that fall in the short-term category are highly volatile. As soon as a developing country hits a difficult patch, whether because of low prices of the commodities it produces or political uncertainties or contagion from neighbours, bank loans are liquidated. Unlike equity investments, where liquidation may be costly, loans can be liquidated without cost to the lender unless the borrower defaults.

Mr Williamson cites studies by IMF experts on whether countries without capital controls fare better than countries with them. The researchers failed to find evidence in support of the conjecture that a complete absence of controls brings about greater growth or other economic benefits. This makes it all the more necessary to listen to Williamson's compelling arguments for caution.

Progress in India

Mr Williamson, reviewing the progress made by India in regard to the conditions laid down by the first Tarapore Committee, notes that, except in regard to fiscal deficit, the conditions are more or less satisfied. Particularly, in view of the situation on fiscal deficit, Williamson believes that a quick move to capital convertibility would be premature.

It is worth noting that the first Tarapore Committee had argued that acceptance of capital account convertibility pre-supposed a flexible exchange rate policy so that a change in capital flows should be absorbed by a change in exchange rate rather than a surfeit of reserves or their possible erosion. But Mr Williamson admits that it is easier for an industrial country to fully accept that than for an emerging market in which growth is largely export-oriented.

He points out that it is a critical mistake for an emerging market economy to allow its exchange rate to be pushed up to an uncompetitive level.

Williamson's view is that the current exchange rate policy is sensibly balanced, whereas any rapid move to liberalised capital flows could create problems in maintaining such a balance. Mr Williamson paints a grim picture of capital markets on a global scale turning their back on countries in the emerging part of the world.

To quote him, "When a mature industrial country gets into trouble or wishes to borrow more, in order to tide over bad times, it can always do so because lenders do not doubt that it will be able and willing to continue servicing debt. It can be charged more interest, but it can always find a willing lender. But emerging markets cannot, notwithstanding their "perfect" records of non-default, as happened in the case of India in 1991".

Cautionary note

To sum up, Mr John Williamson's essay is a warning to India not to enter prematurely the uncharted waters of capital account liberalisation.

True, the economic agents of the country, especially the corporate world, like the idea of capital account convertibility for the freedom it gives to them to access global markets for lower cost capital. But that brings with it the temptation for governments also to access the same global pool for meeting fiscal deficits. This is a danger that one has to avoid.

Mr Williamson concedes, of course, that capital account convertibility does confer some benefits. Especially, he favours FDI because of the technological transfers it enables. But his overall note of caution is timely.

The Tarapore Committee (II) will surely consider what precautions one should take to diminish the high volatility that can characterise global flows, particularly of the portfolio variety. This is all the more timely as we are currently in the grip of a stock market crisis, due in part to the reversal of global capital flows.

With the increased dominance of hedge funds in international portfolio flows, the future is extremely unpredictable as they are apt to play a high leveraged game in the markets.

While it is good to have the goal of free capital movements, we must note that with freedom come risks. Risk mitigation measures, including strong regulatory systems, must be firmly in place.

The onward march to full capital account convertibility must surely be taken only with measured steps. After the mayhem of the latest Black Monday, Williamson's warnings will surely fall on receptive ears.