Time Is Ripe For Phased Capital Account Convertibility

S S Tarapore, author of the seminal report on capital account convertibility, reckons that the tough pre-conditions are achieveable over a three-year period. In a free-wheeling interview, Tarapore tries to allay the fears that a regime of free capital transfers will make the economy vulnerable to massive aftershocks.

Q: Can you identify briefly the underlying macro-economic assumptions that prompted you to recommend full convertibility of the rupee in three years?

A: While the committee has set out certain pre-conditions for introducing CAC, it must be emphasised that the establishment of pre-conditions need to be viewed as processes rather than as one-time indicators. Contemporaneous with the attainment of these milestones are a cluster of measures and the timing and sequencing of measures would need to be modulated. The Committee is of the view that the initial conditions are favourable at the present time - real growth of the economy averaging seven per cent for the past three years, inflation rate down to six per cent, the gross fiscal deficit/GDP ratio appears on the trajectory of 4.5 per cent for 1997-98, the current account deficit is around one per cent of GDP, reserves are at an all time high of $ 28 billion, the debt service ratio has declined to 25 per cent (from over 35 per cent in the crisis period) and the cash reserve ratio (CRR) and the non-performing assets (NPAs) of banks are trending downwards. All this points to the conclusion that the time is

 

apposite to undertake a phased introduction of CAC. In fact, the pre-conditions in a sense merely emphasise the need to adhere to the present macro policy objectives.

Q: There is a criticism that you have been ultra cautious while recommending full convertibility. Critics have pointed out that the various pre-conditions that you have stipulated are nearly unachievable within the given timetable. How do you react to such criticism? Were these pre-conditions really necessary?

A: There are two strands of criticism of the Report. First, that the Committee has been too cautious and that we should have recommended that CAC be introduced day before yesterday and, secondly, that the pre-conditions are too exacting and that there should be a longer phasing in of measures. Now, if we were to skip the pre-conditions, we would be inviting chaos. As such the preconditions and the measures have to move together.

Q: Do you think that the pre-conditions set out by you can be fulfilled in three years? And if they are not, would you prefer the timetable for achieving full convertibility to be changed or prolonged a little?

A: The Committees considered view is that the pre-conditions are attainable in a three-year period. The move to CAC would need to be speeded up or delayed depending on the success or failure in the attainment of pre-conditions.

Q: All the measures suggested by you pre-suppose a strong political commitment. Have you or the Committee taken this key factor into consideration before making the recommendations?

A: I would invite attention to the terms of reference of the Committee. We believe that we have fulfilled our mandate. The Committee has taken into account the overall ground realities in India and we do believe that the pre-conditions and the timing and sequencing of measures can be achieved in a three-year timeframe.

Q: One suggestion of yours has raised quite a few eyebrows. You have recommended that there should be a Parliament-mandated inflation target of three-to-five per cent and RBI should take all necessary steps to keep inflation within that band. Several questions on this. Why did you envisage the need for any such mandate? Isnt the central banks primary role to contain inflation within a stipulated range? What did you really mean by that recommendation? Or, did the Committee indeed feel that Parliament should decide on the inflation rate? If so, why?

A: What the committee recommends is that it is Parliament which approves the government budget and it should be Parliament which should give a mandate to the central bank as to the inflation rate. This would avoid policies working at cross purposes. Once a mandate is given, the central bank should have unfettered freedom to use the instruments of monetary policy to achieve the mandated inflation rate. For a mandated-inflation to be really effective, it should have Parliaments approval. If Parliament feels that the fallout of the inflation rate as mandated by Parliament is not acceptable, it would no doubt wish to alter the mandate. There should, however, be clear and transparent guidelines on the circumstances under which the mandate could be changed.

Q: Among the various pre-requisites that the Committee set out prior to CAC, can some of these be ignored and which ones are more easily achievable?

A: As I have reiterated, the pre-conditions and the measures are to move simultaneously in each phase, albeit, the pace of the measures would need to be modulated depending on the degree of success achieved vis-a-vis the pre-conditions.

Q: With the threat of rising inflation looming on the horizon because of the petroleum product price hike, do you think RBI has any elbow room for further CRR cuts?

A: We need to draw a clear distinction between a generalised inflation and a sectoral increase in prices. I do not think a rise in petroleum prices would jeopardise the overall progress on attaining the pre-conditions. The CRR reduction envisaged in the Report for 1997-98 is modest and could be implemented.

Q: You have wanted the fiscal deficit to be reduced to 3.5 per cent of GDP. At the same time you want RBIs dividend payout to the Centre and PSU disinvestment proceeds to be diverted to setting up a Consolidated Sinking Fund. Wouldnt that make the task of reducing fiscal deficit even more difficult, since the RBI dividend payout and PSU disinvestment proceeds are two significant components of the central governments present receipts and these also help bring down its fiscal deficit?

A: It must be appreciated that the profit transfer by RBI to government is an accounting procedure, but it tantamounts to creation of reserve money and such transfers should be used with caution. What the Committee has recommended is that any increase in profit transfers from RBI to government should go towards building a Consolidated Sinking Fund. The Disinvestment Commission has rightly argued that the proceeds of disinvestment should be used to retire the public debt. When one is selling the family silver, the proceeds should be used to reduce liabilities.

Q: Your recommendations seek to impart greater autonomy to the RBI as also to the entire financial system. Given the Indian financial sectors well-known lethargy to respond positively to such freedom, do you think the banks are sufficiently equipped to take on the new challenges that are natural concomitants of the proposed opening up? What do you think could be downside risks of such an opening up?

A: The public sector banks can no longer function as a monolith and the more efficient units will need to break away from the pack. In some ways autonomy is never given. It is always earned. The risks in the financial sector is the problem of the weak banks and these banks should early on be required to minimise the adverse impact by adopting the narrow bank concept. If credit management is weak in a bank, it just cannot afford to take on increased lending as there would be an inevitable increase in NPAs.

Q: In the current legal system, it is difficult for banks to recover NPAs. How important is NPA reduction for CAC and can this pre-requisite be diluted ?

A: The reduction in NPAs is crucial to the financial system and the important thing is that fresh NPAs should not be allowed to emerge. We should not dilute the desired NPA target but make a Herculean effort to attain it.

Q: What exactly will be the role of narrow banks?

A: The weak banks need to slow down their lending activity and invest largely in Government paper. It is sometimes argued, erroneously, that this is not remunerative. Let us assume that a bank has a 25 per cent NPA. If the bank earns 16 per cent on advances, its actual return would only be 12 per cent - the same as on securities - but in the process it may lose the principal amount. Thus, it makes eminent sense for a weak bank to refrain from lending. I am aware that issues are raised about social sector lending; what such banks need to do is to restrict lending to recoveries. In the case of extreme weakness, it is desirable that there should be a stringent liability control. It is essential to have an element of damage containment so that weak banks do not pervade over the banking system.

Q: How will you rule out disastrous consequences of full capital account convertibility in the form of a sudden inflow of capital attracted by relatively high interest rates in India and subsequent flight following panic reaction? What are the checks and balances against such a possible flight of capital out of the country?

A: The single most important safeguard against destabilising large outflows as a result of a panic reaction would be to ensure a sound macro-economic framework. In India, the initial conditions at the time of the move to CAC are relatively favourable - a lower fiscal deficit, a lower inflation rate, sustained real growth for the past three years, a low current account deficit and an unprecedented build up of foreign exchange reserves. The instruments for dealing with sudden large capital outflows are sterilisation (as also indirectly a reduction in the ex-ante monetisation of the fiscal deficit) monetary policy measures including reserve requirements on non-resident inflows. If interest rate and exchange rate policies are properly modulated the problem of sudden and large destabilising outflows would be avoided.

Q: Why is the committee in favour of investment in financial assets overseas and not in other areas like say real estate?

A: It is a question of a cautious opening up. Real estate would need much larger sums and also entail much larger risks and there can be a greater degree of locking up of investments.

Q: It is argued that you have not identified the starting point of the process towards capital account convertibility. One gets the impression that the economy would get into a self-driven virtuous cycle. But what is the point where it should begin and how?

A: It is important to recognise that the pre-conditions need to be viewed as processes rather than one time indicators. The Report sets out a set of pre-conditions and a cluster of measures for each phase. The Committees assessment is that the time is apposite to launch the first phase of measures. While the authorities can no doubt choose their inter se sequencing of the measures in phase one, the move to CAC would gain substantial credibility if, early on, certain measures are taken on the side of capital outflows.

Q: Can you elaborate on some of these measures ?

A: For instance, measures like allowing Indian joint ventures to invest up to $50 million, removal of impossible conditions on repatriation within a stipulated period of time and permitting Sebi-registered Indian investors to invest abroad are some of the steps which could build the confidence.

Q: Do you think there is merit in the argument and world experience that before embarking on full rupee convertibility, India should ensure that it has some degree of comfort by way of support of a strong economic power?

A: Indias move to CAC should be suo motu and not on the strength of an underwriting by a rich and generous Uncle.

Q: The timeframe for achieving CAC seems to have been finalised only in the Indian context. Have you taken the global scenario into account while making the recommendations: Would it have been better for the Committee to have taken note of the present global economic scenario and the outlook for the next three years?

A: We have to take the global economic situation as given. India has to take the plunge into CAC and broadly speaking there is nothing unusual about the global situation, which should refrain us from proceeding with CAC.

Q: It is argued that the committees report is not a workable document and is only a statement of good intentions. Your comments.

A: The Report is a public document and readers can form their own views.

The Committee has taken into account the overall ground realities in India and we do believe that the preconditions and the timing and sequencing of measures can be achieved in a three-year timeframe.

Parliament should give a mandate to the central bank as to the inflation rate. This would avoid policies working at cross purposes. Once a mandate is given, the central bank should have unfettered freedom to use the instruments of monetary policy to achieve the mandated inflation rate.