What Are The Fundamentals?
The basic objective of capital account convertibility (CAC) is to deepen and integrate financial markets, raise access to global savings, discipline domestic policy makers, and allow greater freedom for individual decision making. In order to understand why CAC is necessary, it is helpful to take a historical perspective. Relative to world output, global capital flows were much larger before the First World War, and they, along with the gold standard, limited the independence of domestic macro-policy, but facilitated trade. But during the wars, and the Great Depression, as destabilising movements in capital occurred, more and more countries put controls on capital movements in order to gain freedom to stimulate domestic economies. In many countries, the stimulus turned inflationary as income groups fought to raise or maintain their shares, and governments accommodated these demands. Moreover, as world trade and capital movements expanded again, these controls became porous and sometimes counter-productive.
But the problem with capital flows is that they can be destabilising especially short-term capital movements. If a country is not doing well, a cumulative flight of capital can confirm the fears that provoked it. Still, there has been experimentation with different international mechanisms to minimise fluctuations and the consensus is that nations with sound fundamentals have been able to benefit from capital flows. It is possible to tame the tiger. But the trouble is that the committee on CAC defines fundamentals very narrowly.
The theoretical framework underlying the report is not spelt out. It seems to be a monetarist one in which it is presumed that restraining the fiscal deficit and the money supply, will be sufficient to keep inflation low, and absorb foreign inflows at a real effective exchange rate that stays within a narrow band. The statistics in the report show unambiguously that the countries that have absorbed foreign inflows with the greatest success have been those with high investment and growth. Such countries have also prevented their real exchange rates from appreciating, in order to stimulate exports. Yet these aspects are not emphasised. The presumption seems to be that deeper markets and the allocative efficiency they induce will automatically stimulate growth.
A major lacunae in the country statistics is that China is missing. Although its currency is not convertible, this is the country that has been able to attract and absorb the highest volume of foreign inflows at the fastest rate of growth. Since it is a labour surplus country and 42% of its post-1978 growth has come from a rise in labour productivity, it has a lot to teach India. Our brief historical analysis suggests that populous countries have the most to gain from the new mobility of global capital; they can use it to raise labour productivity. The World Economic Forum reported recently, on the basis of a survey of global executives, that India is the third most preferred destination for capital, after the United States and China.
The strongest fundamental to attract and safely absorb capital flows is high growth, not low inflation or a low fiscal deficit. The irony is that high growth does lower inflation, and improve other parameters; but targeting slow inflation and cutting public capital expenditure to lower a fiscal deficit can harm growth, and eventually worsen the fiscal balance. Public debt would become unsustainable only if the real rate of interest on old debt is higher than the rate of growth of the economy and new debt is raised at a cost higher than the returns from its investment. The experience of England and America after the Second World War bears this out. In the Indian context, a better way to contain inflationary expectations is to institute supply side policies that result in a 3-5% rise in agricultural prices. Rather than target the fiscal deficit, the revenue deficit should be targeted to raise government savings.
Low interest rates and easy credit availability are necessary to stimulate investment and ease the public debt burden. Even though the new credit policy of the RBI recognises the need to pay attention to real interest rates, it is strange that the committee neglects this aspect in its pre-conditions. It is a major way in which the Indian entrepreneur will gain from CAC since our interest rates are higher than world rates. But in transition, it is a major responsibility of the monetary authority to keep Indian interest rates linked to global ones. Low interest rates are also essential to prevent high short-term debt creating inflows.
The committee suggests that allowing outflows is one way to absorb high inflows without an appreciation of the exchange rate. This seems wasteful when India needs capital. Holding excess reserves is a similar waste. Moreover, as long as risk-adjusted returns in India remain higher than those abroad, allowing outflows will only stimulate greater inflows. But if growth falls then the outflows will take place. Foreign inflows can be used, in a transition period, to prevent crowding out of domestic borrowers by government borrowing. As long as exports are growing, and excess imports financed predominantly by remittances, foreign direct investment and long-term debt, a widening current account deficit is not a problem. Indeed, if net imports allow a rise in investment over saving, the real exchange rate determined by equating the current to the capital account of the balance of payments will be relatively constant.
The committee seems to be revelling in a techno-nirvana, where derivatives, futures, capital adequacy and hedging smooth all obstacles. There is no alternative to globalisation, the adoption of new techniques, and the development of markets, but it is necessary to be aware of potential problems. It is known that program trading strategies of portfolio fund managers, that use index futures, can enhance volatility of financial variables. Developing cheap avenues for risk diversification offers the greatest benefits. If risks are well diversified, cumulative infections in financial markets can be minimised. Imposing higher capital adequacy on weak banks can force them to take even greater risks to maintain profits. If they are to be restricted to government securities a good suggestion there is no need to impose higher capital adequacy as well.
It makes sense to excuse the large Indian corporate, exporter and banker from capital controls; such flexibility is desirable for efficient operation; anyway it is now difficult to police them; most of them already enjoy de facto convertibility. But it needs much learning and greater deepening of the retail mechanisms before the Laxmans common Indian will be able to securely play in dollars. Let us indulge our national proclivity for mathematical games: undoubtedly, we will quickly become skilled at diversifying risk. But the pragmatic Chinese realise that the priority is attracting foreign inflows by high growth, not capital account convertibility. It is dangerous to neglect non-financial fundamentals.