What Is Convertibility All About?

The book, entitled Private Capital Flows to Developing Countries: The Road to Financial Integration, has clearly resulted from the experience of the Mexican crisis and also the successful restraints on capital flows exercised by countries as far apart as Chile and Malaysia. How do the fresh reservations of the World Bank, also endorsed by the IMF in a 1995 report, add up with the views of some sections that India is not ready for capital account convertibility and exchange controls should continue?

Not only do the new concerns of the World Bank and the general mindset of Indians opposed to convertibility put them on the same side of the fence, the CRB crash has, in the eyes of the latter, made the entire issue of capital account convertibility somewhat unreal. Their case is that when sharp practices are so rampant in the Indian financial sector, capital account convertibility is quite unsuited. It is thus necessary to understand what full convertibility really means, what is the World Bank actually saying , what the CRB scam means in systemic terms and what is the agenda of those who are opposed to full convertibility and a lot else.

 

First, full or capital account convertibility is not a policy prescription but more a description of the state of affairs at the stage where a country has put its economic house in order. If economic management and reform have proceeded well and an economy is more mature than emerging, it will be able to go in for capital account convertibility with little pain and without fear of adverse consequences. Convertibility is really a grand organising principle that brings together all the different strands of individual sectoral reform in a climax. As an economy progresses along this journey and sets its house in order, the restrictions on capital account transactions can be taken away one by one. So it is necessary not to confuse the destination with the road.

Before full convertibility is achieved, inflation and the fiscal deficit will have to be drastically lowered, a system of reducing the public debt initiated and monetary policy formulated without having to make sure that the governments borrowing programme is not derailed. The change in the banking and financial sectors will have to be even more drastic. Interest rates will have to be totally deregulated, banks non-performing asset levels drastically brought down and the weak banks made more into deposit takers. The Tarapore committees report even argues that autonomy to public sector banks and extensive computerisation are important for achieving full convertibility.

The World Bank, on the other hand, is making a somewhat narrow and limited point. At times certain dynamic economies become the flavour of the month and start attracting huge short term capital flows. Such flows can trigger inflation, put money into the hands of banks unable to handle them and lead to an overvalued exchange rate which harms exports. Once such signs of overheating become apparent, there can be an outflow as sharp as the inflow, leaving the system on the brink of financial collapse and necessitating policies which administer a deeply recessionary shock and fall in income levels. This is really a problem of plenty which the more successful ones among the emerging economies, like Chile and Malaysia , have had to face. The World Bank remains in favour of global financial integration but has called for careful sequencing . Some policy makers could indeed use its advice to retains the wrong controls for the wrong reasons but that has nothing to do with the correctness of the advice.

The CRB crisis, on the other hand, is a clear case of depositors putting their money in a highly speculative and unregulated sector and one set of financial operators simply running away after leveraging their operations to an untenable level and in the wake of a property market crash that saw their assets vanish into thin air. The stock market reforms after 1992 should not allow this to happen there again and the newly initiated registration of finance companies with the Reserve Bank of India should give fewer excuses to depositors for not knowing what is risky and what is not. The CRB crash has nothing to do with, say, free flow of foreign investment (a feature of capital account convertibility) which some businessmen and politicians do not want.

The section of the intelligentsia that opposes capital account convertibility is also opposed to total trade liberalisation, sharp lowering of the fiscal deficit, low personal taxes and most recently the raising of domestic oil process. If they were for strong fiscal discipline and financial sector reform but against capital account convertibility then there could have been scope for some discussion and argument. As far as the committee is concerned, it was courageous enough to come out clearly in favour of journeying to full convertibility. And it will require more courage on the part of the finance ministry and the government to lay the groundwork for it.