Roadblocks To Convertibility
The Committee on capital account convertibility headed by S S Tarapore, the former deputy governor of the Reserve Bank of India (RBI), has submitted wide ranging recommendations. It has chalked out a time-based programme which runs up to three years (1997-2000) at the end of which the rupee would be truly convertible on capital account. As a run up to the grand finale, the Committee has prescribed certain pre-conditions in terms of fiscal consolidation, a mandated inflation target and strengthening of the financial system. Additionally, the conduct of exchange rate policy, balance of payments, adequacy of foreign exchange reserves are macro economic indicators that should be continuously monitored, says the Committee. Both pre-conditions and capital account convertibility should be treated as ongoing process.
For now, the Committee has adopted a simple definition of the concept, cutting across all technical jargon: capital account convertibility refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market-determined exchange rates. In other words, it implies freedom to citizens to buy and sell foreign exchange and utilise it for defined purposes.
How far-reaching are the Commitees recommendations? And what impact will they have on Indias financial sector, in the short-term and the long- term? Is it feasible to achieve the pre-conditions within the given time- frame?
The reactions of the financial sector circles - bankers, money market players and forex dealers - range from ecstasy to apprehension. While some bankers are bullish about the recommendations and feel that they will improve the financial market, others are not so sure and fear that they will expose the banks to unnecessarily high risk. They also question the recommendations on grounds of consistency, practicality of pre-conditions prescribed by the Committee and relevance of the international experiences in this regard.
Companies will now be able to access foreign funds more readily. The rupee borrowing costs will continue to be lower and the economy will continue to increase competitiveness, says Jamal Mecklai, managing director of Mecklai Financial and Commercial Services. On the other hand, P S Subramanyam, executive director, IDBI, is more cautious. While the goal is clear, the milestones to be crossed are far too many. The road being bumpy, one is not sure whether the timeframe of three years is reasonable, he has gone on record as saying.
The CAC rationale
What is the logic behind the Committees recommendations? It has identified several benefits of a more open capital account : the av-ailability of a larger capital stock to supplement domestic resources and thereby higher growth, reduction in the cost of capital and improved access to international financial markets. Capital account convertibility (CAC) allows residents to hold an internationally diversified portfolio which reduces the vulnerability of income streams and wealth to domestic real and financial stocks, lowers funding costs for borrowers and creates prospects of higher yields for savers. An associated gain, as pointed out by the Committee, would be the dynamic gains from financial integration. Allocative efficiency improves as a result and this can stimulate innovation and improve productivity. CAC provides the impetus for domestic tax regimes to rationalise and converge into international tax structures. This removes inducements for domestic agents towards evasion and capital flight.
In the process of doing its homework, the Committee has found that after the rupee became convertible on current account in August 1994, the capital account has become porous, leading to large-scale leakages. It has thus recognised that capital controls turn progressively ineffective, costly and even distortive, causing more damage than benefit to the economy, and in particular to the financial sector.
According to the Committee, the institution of financial sector reforms in India brought into the open weaknesses which had been in the system for a long time. The introduction of CAC would require more proactive policy action as an open capital account could bring these weaknesses under sharper focus. CAC would impose a strong discipline upon the financial system and would expedite the early rectification of infirmities in the system and lead to widening/deepening of markets to enable the spreading/distribution of risks.
The Committees survey of the international experience with CAC revealed that countries which initiated the move to CAC on the basis of strong fundamentals were able to modulate the pace of instituting CAC without undertaking large and dramatic shifts in the stance of macro economic policies. Furthermore, these countries were less vulnerable to backtracking and the re-imposition of controls. Countries with weak initial conditions were constrained to adopt drastic macro economic policies to facilitate the move to CAC. Some of these countries had to re-introduce capital controls in the evolution of CAC .
The international experience
A major concern with capital account convertibility has been the prospect of flight of capital. International experience, however, shows that the initial reaction to convertibility would be a strong inflow of capital. When that happens, the authorities are compelled to defend the local currency, which otherwise would appreciate and harm export efforts. In some countries, the authorities had to give up the defence of the local currency as the flow was too strong. The local currency then appreciated, and exports started declining rapidly. As this continues for some time, the local currency becomes unstable. It is around this time that capital flight begins, and the government has to think about re-imposing the controls. The interregnum of three years that the Committee has suggested should be utilised to strengthen the external sector to prevent such a scenario.
Concerns..........
The pre-conditions suggested by the Committee are likely to be controversial. The Committees survey of the country experiences shows that strengthening of the financial system emerged as the most important pre-condition. Fiscal consolidation is another important precondition for CAC among all countries. An important concomitant in the process of CAC is the conduct of an appropriate exchange rate policy.
Among the major issues here are a reduction in the non performing assets (NPAs) of the banking sector from 13.7 per cent in 1986-97 to 5 per cent by the end of the century. It has been recommended that the cash reserve ratio (CRR) be reduced from 9.3 per cent to 3 per cent during the period. There are numerous other pre-conditions listed by the Committee. These pre- conditions are so fundamental that a Committee on any matter - say on population control - also could have prescribed them, says P V Maiya, chairman, ICICI Bank.
These pre-conditions have raised a spectre of doubt in banking circles. Take for example the proposal that fiscal deficit should be reduced from 4.5 per cent to 3 per cent. This pre-condition is difficult to achieve. As it is, the deficit is higher than 4.5 per cent if you take into account the amounts in the petrol pool. So, to reduce this level to 3 per cent is a Herculean task, says Ashish Sen, managing director, Centurion Bank.
Others too agree. In fact, A K Dam, executive director, UTI Bank, puts the current level of fiscal deficit at 6.2 per cent, taking into account the oil pool deficit and states fiscal deficits. From 8 per cent earlier, it has now come down, but it is at the cost of infrastructure investment, where the government has cut its expenditure. This is not good for the economy, he says. Further, reduction in deficit will depend on revenue projections coming true, based on tax, PSU disinvestment and voluntary disclosure scheme proposals. Since these projections are not likely to materialise, the whole scheme and the timeframe may go off the track, he adds.
Almost every one connected with the financial sector seems to believe that the pre-conditions are too tough to achieve. Deepak Rao, associate director at Coopers & Lybrand, for example, says that the Committee has virtually recommended a move towards inflation-targetting. This model is based on the Bank of New Zealand experience where the inflation target is decided by the Parliament and then the central bank is free to pursue it. Only the Parliament can change the parameter and then the central bank is relieved of responsibility to achieve it. But this autonomy will require consensus in the political arena which seems difficult in the present scenario, says Deepak Rao.
In support of his argument, Rao cites the example of the Narasimhan Committee report, some of the recommendations of which have not been implemented even till now. Consolidation of the financial sector is one of them. So there is no guarantee that the Tarapore Committees recommendations will be implemented within the recommended time- frame, he points out.
A major change concerning the financial sector that may come through these recommendations will be its integration. As we move towards inflation targetting, other controls will get diluted and the compartmentalisation of the finance sector will tend to disappear, says Rao. Instead, we will find uniform CRR and prudential norms for banks, financial institutions and NBFCs, he adds.
Tackling NPAs
As for the recommendations on NPAs, a high degree of scepticism prevails. If NPAs have to be brought down to 5 per cent in the third year of the programme, many banks, including the strong ones, will have to undertake write-offs on a large scale. That will erode their profitability, says Sen. He is doubtful if the NPAs can be reduced to the desired level in a three-year time frame.
The Tarapore Committee seems to have realised this fear, and has therefore recommended that weak banks should confine themselves only to business activities such as government securities. Is this feasible? No, say senior bankers. No bank can survive by only investing in government securities and it is a sure prescription for closing down these banks, feels Sen. It is a political Utopia which is obviously impossible to achieve, seconds Dam.
Another concern expressed is the lack of adequate checks and balances in the system after capital convertibility actually materialises. Dam, for example, is critical of the 5 per cent band recommended by the Committee on the exc-hange rate. No central bank can ensure such a thing. It is best left to the market, he says. He also feels that end use guidelines are a must for companies raising resources abroad. Else, the freedom is bound to get misused, he warns.
The Tarapore Committee has recommended that capital inflow should be opened up for all non-residents, not mere non-resident Indians. Bankers are worried about this proposal. Sen, for example, is worried that the interest rates are still too high by international standards. This will attract hot money from abroad, and impart a large degree of instability to the economy, he feels. The required adjustment will be quite painful, he says.
And will the economy be able to absorb the large capital inflows? Absorption of such resources should be attempted in major sectors like infrastructure, and by and large, public sector companies. One hopes that these corporations would have the freedom and the choice to shape their destiny free from government regulations and influence, says Maiya.
While the proposal of capital convertibilty has been welcomed by all segments of the financial sector, scepticism is widespread about just how practical the pre-conditions suggested by the Committee are. More than being the road map they are intended to be, they constitute road blocks, says UTI Banks Dam. One wonders if that sums up the markets feeling on Tarapores prescription.
Abhijit Doshi
Market apprehensions
Pre-conditions too tough to achieve lDifficult fiscal deficit target; will result in cut-down in infrastructure investment
Autonomy for RBI requires political consensus
Three-year time frame too short
Drastic reduction in NPAs will result in write off; will cause losses for banks
The concept of narrow banks is impractical; will lead to closure of weak banks
Checks and balances needed, to prevent freedom from being misused
Interest rates too high; will attract hot money, lead to instability
The deficit is higher than 4.5 per cent
if you take into account the amounts in the petrol pool and state deficits,feel some bankers