Is it time to make the rupee fully convertible?

DEBATE

With huge forex reserves, the government is aiming for full capital account convertibility yet again. Are we ready?

Kalpana Morparia,
Deputy Managing Director, ICICI Bank Limited

"We must empower the domestic financial sector to enable competition on an equal footing with global players"

Globally integrated financial markets are considered to be a significant milestone in a developing country's march towards prosperity. India's earlier attempt to open up the capital account was partly thwarted by the onset of the south-east Asian crisis and the ensuing need of averting the contagion effect. Subsequently, gradual changes in regulation achieved through successive reforms under the Foreign Exchange Management Act have resulted in a fair degree of freedom for capital flows to and from India. FII investment into the equity market has been liberalised and FDI for several sectors been put on automatic route, while only certain sectors are subject to foreign holding restrictions. Initial steps have also been taken to allow domestic residents to channelise small amount of funds in markets and products abroad. Restrictions on corporate borrowing from the international financial market have been liberalised. Overall, we can conclude that we are more than halfway through the process of opening up the capital account.

International experiences with capital account liberalisation suggest a strong macro-economic backdrop and establishment of prudential norms of supervision and regulation as essential preconditions for capital account liberalisation. With India's growth engine in full throttle, stable inflation, moderating fiscal deficit, low risk of an external debt crisis and orderly conditions in all financial markets, with prudential regulatory framework and improving risk management capabilities among financial intermediaries and the corporate sector, the situation seems just right for an acceleration in the pace of opening up the boundaries for cross-border flows. The step to re-examine the issue of capital account convertibility is a move in the right direction.

Certain important restrictions continue to constrain the flow of global capital into Indian markets. Most important are restrictions on foreign investment in Indian debt markets, as well as restrictions on banks from intermediating foreign debt capital flows to Indian borrowers. These restrictions increase the reliance on domestic savings to fund India's growth. Given the vast need for investment from urban infrastructure to power and roads to the rural sector, from housing to industry to agriculture, domestic savings need to be supplemented to sustain India's growth at the desired pace. At the same time, there is a large pool of capital in the global markets that is seeking ways to participate in India's growth. The logical next step in the capital account convertibility process is freeing up debt capital inflows. But while liberalising capital inflows, we must also empower and liberalise the domestic financial sector to enable competition on an equal footing with global players.

Since 1991, India has adopted a gradual approach towards opening up the economy to global capital inflows. It would be appropriate to move forward on this path in a calibrated manner towards the goal of full capital account convertibility.

K C Chakrabarty,
Chairman & Managing Director, Indian Bank

"CAC is the logical culmination of India's journey towards globalisation. The authorities now need to spell out the standards"

Embracing capital account convertibility (CAC) is inevitable. It's only a question of time, rather than that of choice. Setting eyes on full convertibility is quite natural after maintaining an average growth rate in the vicinity of 8 per cent for the past few years in a row, and amassing forex reserves worth $145 billion "" equal to 13 months import requirements. We have been convertible in current account for the past 12 years and a good degree of convertibility already exists with resident Indians for travel, education, medicine and other designated purposes. Today, any citizen of the country can convert and invest up to $25,000, no questions asked. Corporations, too, enjoy this in terms of funding options and investment avenues.

CAC would encourage capital inflows and supplement domestic resources for stimulating growth. At the same time, CAC exposes the domestic sector to all the ups and downs of the global economy, specifically to volatile global capital flows. If the domestic economy is not resilient enough, it could find itself caught in a situation that it has not created, which it does not like and over which it has no control.

Many of the roadmaps posted by the earlier Tarapore Committee in 1997 has been achieved, with containment of fiscal deficit to 3.5 per cent and reduction in banks' cash reserve ratio to 3 per cent remaining as major residual issues. There had been improvement in containing the fiscal deficit that is at 4.1 per cent for 2005-06, and expected to be 3.8 per cent for 2006-07. The Fiscal Responsibility and Budget Management Act sets its sight on eliminating the revenue deficit by March 2009 and restrict borrowings within prescribed limits.

Adopting CAC would require domestic banks to be stronger and bigger to compete with international banks. They have to build skills to handle multi-currency balance sheet operations and the dollarisation of domestic assets. Further, there would be compulsions for equipping themselves with heightened risk management practices to deal with high volumes of currency flows at a global level.

Volatility of financial markets is more pronounced under full convertibility environment and interest rate arbitrages like non-deliverable forwards arising out of market imperfections would disappear totally. One cannot rule out the distinct possibility of rupee appreciating against other major currencies to align closer with the purchasing power parity of the domestic currency.

We need to be aware that we will be headed for a scenario where violent swings in interest and exchange rates are possible. Some countries such as Singapore have "non- internationalisation" policies in place to prevent their currency being subjected to speculative attacks, which may be emulated at a macro level. CAC is the logical culmination of India's journey towards globalisation. The authorities now need to draw up of a time-bound action plan and spell out the benchmarks and standards.