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Egged
on by the Prime Minister, the Reserve Bank of India
has, in surprisingly good time, released a report from
a special committee (chaired by S.S. Tarapore) constituted
to revisit the issue of making the rupee convertible
for capital account transactions. Shorn of any frills,
this amounts to removing restrictions on the ability
of resident firms and individuals to monetise their
rupee wealth, freely convert that into foreign exchange
and acquire assets abroad.
This is not the first time that the RBI has traversed
this road. An earlier committee, chaired by the same
Tarapore, had submitted a report in May 1997 laying
out a road map to full convertibility over a period
of three years. But the onset of the financial crises
in Southeast Asia barely two months later aborted the
project. Faced with the facts that countries with strong
''macroeconomic fundamentals'', such as robust budgets
and surpluses on the current account of the balance
of payments had fallen victim to the crisis, there were
few left in the world willing to back an open capital
account.
There were, in particular, three lessons from the crisis
that challenged advocates of convertibility on the capital
account: (i) in the case of many countries, mere ''contagion''
or the spread of fear among financial investors, leading
to their exit as a herd, was the trigger for the crisis;
(ii) once contagion effects came into play, a speculative
onslaught on the currency made possible by an open capital
account converted a problem into a crisis; and (iii)
countries with strong capital controls, like India and
China, were relatively unaffected by these developments
and others that quickly opted for such controls, like
Malaysia, were affected less. Since then, crises in
countries such as Brazil, Mexico, Turkey, Russia and
Argentina have only strengthened these perceptions.
The principal lesson appeared to be that excessive inflows
of financial capital were more of a problem than a benefit.
While these developments put paid to the Indian government's
ambitions to move towards full convertibility of the
rupee, almost a decade later the project has been revived.
But, in the interim, there has been a gradual process
of liberalisation of transactions on the capital account,
as the committee's report itself notes. Resident corporates
are now permitted to make financial capital transfers
abroad to the extent of 25 per cent of their net worth.
Investment overseas by Indian companies of upto 200
per cent of their networth is permitted. Resident banks
are allowed to borrow from overseas banks and correspondents
up to 25 per cent of their capital. Resident individuals
are permitted to remit up to $25,000 per year to foreign
currency accounts for any purpose. And Non-resident
Indians (NRIs) are permitted to repatriate up to $1
million per calendar year out of balances held in ''non-repatriable''
Non-resident Ordinary (NRO) Accounts or out of sales
proceeds of assets acquired by way of inheritance. These
are all major relaxations that are already increasing
India's vulnerability. Interestingly, even the committee
could obtain only partial data on outflows under these
heads in recent years, pointing to the fact that liberalisation
has proceeded to a degree where even monitoring of permitted
capital outflows is lax. The task before the central
bank and the government is, therefore, to improve monitoring
and tighten regulation where capital outflow is seen
in excess of that expected.
However, rather than do that, the intention of the committee
is clearly to enhance the degree of liberalisation by
advancing new grounds for greater convertibility, contesting
arguments against increased liberalisation and focusing
on ways of dealing with the dangers associated with
liberalisation of capital account transactions. This
feature of the report is captured by the fact that the
new committee is distinguished from its 1997 predecessor
by being titled the Committee on Fuller Capital Account
Convertibility (FCAC). The recommendations, to be implemented
over a period of five years, suggest that ''fuller'' means
a lot. For example: The limit on corporate investment
abroad is to be raised in phases from 200 per cent of
net worth to 400 per cent of net worth over a five year
period. The facility under which individuals can freely
remit $25,000 per calendar year is to be successively
raised to $50,000, $100,000 and $200,000. Limits on
overseas borrowing by banks are to be linked to a larger
base (paid-up capital and free reserves, and not to
unimpaired Tier I capital), and raised substantially
to 50 per cent, 75 per cent and 100 per cent. Non-residents
other than NRIs are to be allowed to invest in foreign
currency deposit schemes in the country. And all financial
firms operating SEBI registered portfolio management
schemes are to be permitted to invest overseas with
the overall ceilings raised from the present level of
$2 billion to $3, 4 and 5 billion by the end of five
years.
This raises the question as to what accounts for this
desire to push ahead with the liberalisation agenda,
despite global developments during the last nine years?
It should be clear that attracting greater capital inflows
into the country can hardly provide a justification
for greater liberalisation. Capital inflows into India
are far in excess of that needed to finance the current
account of the balance of payments. As the report notes:
''During 2005-06, the current account deficit has been
comfortably financed by net capital flows with over
US$ 15 billion added to the foreign exchange reserves.''
What should have worried the committee is that an overwhelming
share of these inflows is in the form of portfolio flows
that are known to be volatile. However, the fact that
Foreign Institutional Investor (FII) and not Foreign
Direct Investment (FDI) flows dominate capital inflows
into the country is advanced as a reason for greater
convertibility. This is a strange twist, since it is
accepted even by the committee that convertibility on
the capital account for foreign investors has been far
more liberal than for residents, especially with conditions
for foreign direct investment inflow and repatriation
of capital by foreign direct investors having been eased
over time. The restrictions that apply have been determined
by sectoral policies with regard to the appropriateness
of inviting investment in particular sectors, the caps
on equity that should apply when such investment is
permitted and the conditions that should apply to such
investment. These are issues that fall in the domain
of industrial and commercial policy and not convertibility
per se. However, going beyond its brief, the committee
has decided that since ''China has had remarkable success
in attracting large FDI because of enabling policies
like no sectoral limits, decentralised decision making
at the levels of provisional and local governments and
flexible labour laws in special economic zones'', the
anomaly that ''policies for portfolio or Foreign Institutional
Investor (FII) flows are much more liberal'' than for
FDI in India needs to be corrected. The policy on convertibility
has been expanded to include that on FDI.
But, the committee is forced to admit that increased
flows are not without problems. Even the inflows that
are currently occurring have created immense difficulties
in managing the exchange rate. Unusually large capital
flows trigger an appreciation of the rupee and undermine
India's export competitiveness. This forces the RBI
to acquire foreign exchange and increase its reserves
to prevent rupee appreciation. To balance the resulting
increase in its assets and control money supply, the
RBI needs to reduce its holding of government securities,
at considerable cost to itself and the government. And
as it runs out of government securities to retrench,
it loses control over money supply. And all of this
happens because of a process that threatens to increase
India's external vulnerability.
In fact, the support for greater capital account liberalisation
partly comes because of these problems created by excess
capital flows induced by liberalisation over the last
decade. One response would be to reverse excessive liberalisation
of certain kinds of capital controls, as the Governor
of the Reserve Bank of India once suggested to his cost.
The other would be to encourage an outflow of foreign
exchange, by encouraging foreign exchange profligacy
on the part of domestic corporates and residents. The
fundamental difficulty with the latter position is that
while inflows of capital are associated with a commitment
to finance repatriation of profits and capital in foreign
exchange, liberalised outflows of foreign exchange are
not associated with any commitment to earn foreign exchange
to refurbish the pool from which future commitments
must be met. Hence, if residents are encouraged to use
up the foreign exchange that liberalised inflows deliver,
the danger of a crisis increases, if there is a sudden
call on the country to meet its commitments as happened
in India in 1991 or Southeast Asia in 1997.
The committee is therefore concerned with arguing that
such an eventuality is unlikely to arise in the Indian
context and that policies can be devised to foreclose
such an eventuality. The case that such an eventuality
is unlikely is built on the grounds that India's current
account deficit is much lower than warranted by its
reserves and that reserves are large enough to meet
any capital flight or surge in outflows that may follow
liberalisation. These are mere assertions made on arbitrary
grounds. What is of relevance is that (in the words
of the committee): ''Unlike some countries, which have
accumulated their foreign exchange reserves through
current account surpluses, the build up of the Indian
forex reserves has largely been the result of capital
inflows.'' This has meant that the ratio of volatile
capital flows (cumulative portfolio inflows and short-term
debt) to reserves increased from 35.2 per cent at end-March
2004 to 43.2 per cent at end-March 2006. This has serious
implications, since even many Southeast Asian countries
with current account surpluses were seen as safe, because
they were carrying excess reserves at the time of the
1997 crisis. Those reserves proved inadequate when the
flight of capital began.
The real issue then is whether there are policies which
can foreclose the eventuality of a crisis. The FCAC
committee believes there are. But many of these are
merely measures to appease financial investors and ensure
that ''as the capital account is liberalised for resident
outflows, the net inflows do not decrease''. These are
of three kinds. One set consists of so-called ''confidence-building''
measures, including the liberalisation of capital outflows
for individuals. The reasoning is circular here: measures
to deal with the dangers created by capital account
liberalisation, cannot involve more such liberalisation.
The second is a major reform of the banking system involving
strengthening of prudential regulation and coporatisation
of public sector banks as a prelude to their privatisation.
This is seen as necessary for facilitating injection
of capital and consolidation aimed at meeting the higher
capital requirements needed in the context of increased
risk. The main recommendations here are: (i) to reduce
the stipulated minimum shareholding of the Government/RBI
in the capital of public sector banks from 51 per cent
(55 per cent for SBI) to 33 per cent; (ii) allow industrial
houses to have a stake in Indian banks or promote new
banks; and (iii) allow foreign banks to enhance their
presence in the banking system. A cursory examination
of the experience of the Latin American banking system
would make clear that these are no guarantees against
bad decisions, malpractice and failure. In fact, they
promote such tendencies. And a study of the performance
of the Indian banking system prior to nationalisation
shows that such measures are bound to concentrate credit
with a few corporate borrowers, encourage overexposure
to a few clients and increase systemic risk.
The third set of measures is a return to fiscal conservatism
aimed at appeasing finance, made easy today by the passing
of the Fiscal Responsibility and Budget Management (FRBM)
Act in 2003. The consequences for growth, employment
and the alleviation of deprivation that adherence to
the irrational targets set by that Act has been recognised
even by the Planning Commission which has recommended
amending the Act. So it is unclear why such targets
should be sanctified on the grounds that they are needed
to appease financial investors and reduce the dangers
associated with capital account liberalisation, which
itself has little justification.
Seen in this light, the recommendation of the FCAC committee
to push ahead with capital account liberalisation, even
in phases and with some caution, seems as unwarranted
today as it was in 1997. Unless CAC is the ruse to implement
other measures of fiscal and banking reform that the
government finds difficult to directly defend. Or if
the interest of a miniscule elite wanting to hedge and
protect the value of its wealth by investing abroad
is seen as more crucial than that of the majority of
Indian citizens.
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