Brouhaha Over Capital Account Convertibility

Even before the committee on capital account convertibility submitted its report, people in India had come to believe in the possibility of its coming in the same way as a gentleman figuring in Disraelis anecdote. Asked by a lady whether he believed in platonic friendship, the gentleman replied after but not before. This scepticism about capital account convertibility is partly because it fits well into the past obsessive preoccupation with micromanagement of the economy and partly because of the committee mania, which more often than not results in adding small print to any new policy announcement that nullifies its overt intent. This time, however, a march towards capital account convertibility is clearly inexorable in view of the radical change in the internal structure of the economy and the dynamics of globalisation. The question is not whether the capital account will be made convertible so much as when and how.

 

In academic literature, the issue of capital account convertibility has evoked serious debate, mostly related to its timing. Admittedly, capital account liberalisation is an integral part of the overall reform process, but its sequencing assumes importance when certain fundamental preconditions do not exist. The most important of these are a reasonable control of fiscal deficit and maintenance of sound and efficient banking. The former is crucial as it determines whether capital account liberalisation can be sustained without repercussions on the domestic economy. A loose fiscal policy often leads to adverse expectations among the holders of financial assets as to their risk/reward characteristics. Absent this condition, foreign capital, far from flowing in will flow out and domestic capital will follow suit. If the financial system is fragile, a gyration in capital flow will weaken it further. If capital flows in, the banking system, which often plays a large role in intermediating these flows, will expand its balance sheet to such an extent that the quality of assets will tend to deteriorate, apart from generating excessive monetary expansion. In a reverse situation, particularly if capital outflows are as sudden and massive as in the Mexico case in early 1995, the unsound banking system will get out of whack, jeopardising not only the financial system but also the real economy. Judging by these two criteria, it may seem that full capital account convertibility is not yet round the corner as the fiscal deficit is still high and the banking system is fragile.

Even if one tries to seek truth in facts as the late Chinese leader Deng would have us do, it is futile because the facts are incapable of providing guidance. The international experience is diverse, conflicting and puts out confusing signals. No consensus has emerged on issues of speed and sequencing of capital account convertibility in industrial countries. Typically, capital account convertibility has followed relatively broad trade and domestic financial reforms. Some countries experienced serious macro-economic imbalances with rapid liberalisation of their capital accounts. However, one common thread that runs through their experiences is that they could cope with the consequences of capital account convertibility when they had the correct policy instruments such as flexible monetary and exchange rate policies, and used them in combination with properly co-ordinated structural policies. In the case of the developing countries too, no uniform pattern is discernible. While countries like Malaysia, Singapore and Indonesia initiated capital account convertibility when they had a strong balance of payments, they are counter-balanced by others like Mauritius and Trinidad & Tobago which had a weak balance of payments. Besides, these countries had financial systems which were incapable of dealing with the effects of capital account convertibility. Therefore, in Indias case, capital account convertibility has to be determined in the light of its own situation.

It is little realised that India has had a fairly liberal capital account since 1993. Inflows are now permitted with minimal controls and their repatriation is automatic without any prior approval of the authorities. What is missing, however, is that no resident can legally take capital out. Too much attention is being focused on the mechanism of formal convertibility of the capital account rather than on the policies necessary to manage a liberal economy. Much of what passes off as non-resident deposits is really illegal capital that has flowed out and has officially come in only because of the incentives provided by the appropriate monetary and exchange policies. If tomorrow, the foreign capital that has streamed in during the last four years bolts out and it will if the policies get wonky it will have the same effect on the economy as the flushing out of domestic capital. A real desideratum, therefore, is a design of policies in response to capital inflows and outflows. India has so far done well in its policy in response to capital inflows but it has not yet had to confront the problems of unanticipated and sudden capital outflows, foreign and domestic. Management of large capital flows, especially of swings in such flows, has posed a challenge for macro-economic policy makers and bank supervisors in many countries. The dual relationship between macro-economic policies and banking system vulnerability has become more transparent with a liberal capital account. Banks are exposed to credit and interest and market risks including off-balance sheet risks on account of their links with international financial market. This warrants that the soundness of banks as an objective has to be placed on the frontburner as a fore-runner of the objective of balancing the usual array of policies monetary, exchange rate and fiscal in an open capital account situation.

It is high time Indian policy makers recognise that the Indian economy has situated itself in a world of virtual capital account convertibility except that residents are not allowed to freely move their capital across the national boundaries in a legal way and turn their attention to how best to improve the banking system. Indias solipsistic finance minister gloated that his budget landed India in an embarrassment of riches. He would not know unless he puts his financial system in order when the embarrassment of riches will turn into an embrace of the rags. No one is sure for whom the Mexican bell may toll.