A V Rajwade: Full convertibility-I
While there is little evidence to show it boosts growth, there are enough examples of the problems it can cause
While there is little evidence to show it boosts growth, there are enough examples of the problems it can cause
One part of the agenda for financial sector reforms is the question of full convertibility on capital account: In fact, both Percy Mistry and Raghuram Rajan committees stress/touch on it. (This columnist was a member of the two Tarapore committees on the subject.) There is also the question of the ‘impossible trinity’ — managed exchange rate, independent monetary policy and a liberal capital account, to which a reference was made in the RBI Governor’s JRD Tata Memorial speech. We need to revisit the issues in the light of what has happened in the global markets over the last couple of years.
The theoretical argument is that “allowing the free flow of capital across borders would lead to a more efficient allocation of resources and be welfare enhancing … in a fashion similar to the liberalisation of trade.” [CGFS Paper No 33, Capital Flows and Emerging Market Economies, Bank for International Settlements (BIS), January 2009]. However persuasive the argument may seem initially, there are major reservations.
To quote from a paper, Financial Globalisation: a Reappraisal by M Ayhan Kose, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei, (IMF, August 2006), “The majority of empirical studies are unable to find robust evidence in support of the growth benefits of capital account liberalisation”. Jagdish Bhagwati, in his recent book, In Defence of Globalisation, is highly sceptical of financial globalisation, as distinct from free trade in goods and services, arguing that, “the claims of enormous benefits from free capital mobility are not persuasive”. To quote once again from the BIS paper cited above, “Despite the numerous cross-country attempts to analyse the effects of capital account liberalisation, there appears to be only limited evidence that supports the notion that liberalisation enhances growth. This failure to find robust evidence has been interpreted by the critics of capital account liberalisation to mean that liberalisation does not promote growth, as the proponents of the alternative view would argue. For example, one of the earliest (and most widely cited) papers about the macroeconomic effects of capital account liberalisation is Rodrik (1998). He uses data for about 100 countries (both developed and developing) between 1975 and 1995 and regresses growth of income per capita on the IMF indicator-based binary variable mentioned above. He finds no correlation between liberalisation and per capita growth.”
The BIS paper summarises the hierarchy as follows: “There are good grounds — in a phased liberalisation of capital controls — for freeing foreign direct investment and portfolio equity flows before allowing non-residents to conduct debt-related transactions such as portfolio flows into domestic debt securities and international debt issuance by local firms. In addition, there are grounds for limiting short-term flow”;
In fact, full convertibility on capital account may well attract entirely the wrong type of capital flows. In a 2007 paper titled, Global imbalances and destabilising speculation, Heiner Flassbeck and Massimiliano La Marca, two UNCTAD economists, argue that “(Capital) Flows moving from low-yielding, low-inflation countries to high-yielding, high-inflation countries would cause the currencies of the latter to appreciate, and provoke the paradoxical and dangerous combination of surplus economies experiencing pressures to depreciate, and deficit countries facing a correspondent pressure to appreciate.”
“The examples… also show how much real appreciation (loss of overall competitiveness for a nation) can result from speculation that is driven by interest rate differentials. Pre-crisis Brazil was characterised by an overvalued real exchange rate, large interest rate differentials (aimed at maintaining capital inflows in a condition of financial fragility) and unsustainable costs for the real economy.”
“Floating currencies under various monetary policy regimes, rather than being immune to speculative operations actually stimulate them if the amounts available to investors are big enough to drive the market in a certain direction.”
“Unhedged borrowing by hedge funds and other speculators more than anything else raises questions about the wisdom of widespread acceptance of floating as the only feasible solution to the problem of the external balance.”
Under a liberal capital account, there clearly are risks resulting from a sudden reversal of capital flows. While risks have to be taken when economies undergo reforms, they also need to be justified by the expected rewards. The chain of events leading to BoP crises in the 1990s and later, in a somewhat oversimplified form, seems to be: Capital inflows leading to overvalued exchange rates, leading to unsustainable deficits on current account, loss of confidence in the sustainability of the exchange rate and the rush to exit — by both residents and non-residents. This was the sequence not only in South East Asia in 1997-98 but earlier in Mexico (1994) and later in Argentina (2001). But more on the risk/reward equation next week.