There is an interesting debate on whether or not the rupee should be made convertible on capital account. My unequivocal view is that in the course of the Budget for 1997-98, the government should announce a three-year time-frame within which full capital account convertibility (CAC) would be attained.
The danger of a premature and rapid introduction of CAC is not a real effective depreciation but an appreciation of the rupee. The immediate response to CAC would be a large inflow to take advantage of high real rates of interest but if the programme lacks credibility there could very quickly be a large capital flight.
There must be credibility in the intent of overall macro-economic policy towards a reduction in the inflation rate to levels prevailing in major industrial countries. This implies that monetary and fiscal policies would need to be tighter. If there is a slippage in either the monetary target or the fiscal deficit it would be necessary to undertake a more than proportionate tightening in the next year to maintain credibility of medium-term policies.
CAC would result in an increase in gross capital inflows and outflows but it is not possible to determine whether there would be a net capital inflow or an outflow. Again, if the authorities tighten monetary-fiscal policies, real rates of interest could rise. The move to CAC will require a major strengthening of the domestic financial system. The progress towards a consistent macro-economic framework, with mutually supporting monetary, fiscal and exchange rate policies, will be as important as the sequencing of CAC. The domestic financial system would need to be liberalised concurrently or prior to removal of capital controls and in this context it would be necessary to remove all interest rate controls and market segmentation between banks and non-bank financial institutions. While the endeavour would need to be to bring down the overall height of the reserve requirement to ensure that Indian financial entities are competitive in an international environment, it would be quite in order to impose higher
reserve requirements on foreign capital inflows lodged in the banking system. Indirect instruments of monetary control would need to become the primary tool of monetary policy.
At the same time, since CAC would increase the risks for the banking system with increased interface with international markets and increased exchange rate volatility, it could be necessary to adopt stricter prudential norms and disclosure standards for foreign currency exposure. It is not always possible to control the sequencing once a critical mass of opening up of the capital account is achieved. With a tightening of monetary-fiscal policy there would be beneficial effects of larger net foreign capital inflows and if the primary money creation is kept under check there would be a lower inflation rate. But if CAC is accompanied by a loose monetary-fiscal policy, there would be an acceleration of inflation, an overvalued effective exchange rate and as an exchange rate depreciation would be inevitable capital outflows would take place.
The issue of CAC is essentially an issue of internal convertibility defined as the right of residents to acquire domestic assets denominated in foreign currency. A broad outline of a feasible sequencing is set out below:
At the outset, the government should announce in the Budget of February 1997 that there would be full CAC by April 1, 2000. As part of the three-year programme, in 1997-98, there should be a package of measures including the following:
(i) The present red tape on foreign capital inflows and outflows should be drastically eliminated. There should be a virtual scrapping of how much and where foreign capital including NRI funds can be invested and procedural hassles for repatriation should be eliminated.
(ii) Domestic corporates should be allowed to raise funds abroad without having to go through an obstacle race and the eligibility criteria should be strictly limited to exacting rating requirements.
(iii) The restrictions on forward exchange markets should be reduced and banks non-banks, domestic corporates and all foreign investors including NRIs should be given greater freedom to operate in spot/forward exchange markets and hedging should be fostered.
(iv) The present low limits for Indian corporate investments abroad should undergo a quantum increase and the guide for such investments should be commercial profitability and not the enhancement of Indias diplomatic relationships.
(v) The limits for individuals to send donations or gifts abroad should be substantially raised and the exchange control should give up its superior wisdom which enables it to be the final arbiter of whether a son-in-law is legitimate. (vi) Indian residents should be allowed to hold foreign currency deposits up to a specified amount in banks in India.
(vii) The government should be resolute in keeping the inflation rate down and the gross fiscal deficit (GFD) should not exceed 4.5 per cent of GDP in 1997-98.
(viii) All interest rate controls should be abolished.(ix) The overall cash reserve requirement (CRR) should be brought down by 2 percentage points while CRR should be reimposed on non-resident deposits.(x) There should be a significant tightening of prudential norms for banks and non-banks with higher risk weights for foreign currency risks.
(xi) The exchange rate should be allowed to find it own level using a stable real effective exchange rate as a lodestar and there should be no attempt to prop up the nominal exchange rate.
In 1998-99 there should be further progress.
(i) All restrictions on banking capital flows should be abolished but subject to stringent CRR which should be distinctly higher than for domestic liabilities.
(ii) Corporates should be freed from all restrictions on borrowing abroad.(iii) Indian investments abroad should be further liberalised.(iv) The amount of foreign currency deposits allowed to be held by Indian residents should undergo a quantum jump.
(v) In 1998-99, the GFD should be reduced to 4 per cent.(vi) Overall CRR should be reduced by 2 percentage points.
The year 1999-2000 should be the final year of adjustment.
(i) The GFD should be reduced to 3.5 per cent.(ii) The overall CRR should be reduced to the statutory minimum of 3 per cent.(iii) All residual restrictions on capital inflows and outflows should be abolished and any influence on these flows should be through close co-ordination of fiscal, internal debt, and monetary policies, which would impinge on the exchange rate and the authorities should then bid good bye to exchange control. Thus, the Indian Rupa would be restored to its pristine beauty in the year 2000.
CAC is not like pouring milk over cornflakes to make an effortless breakfast; it is rather like a carefully prepared gourmet meal with the right ingredients and proper sequencing. It is an unfortunate aspect of life that not only are there no free lunches but there are no free breakfasts!
