Themes > Current Issues
14.09.2006
Convertibility: Road Map for Whom?
C.P. Chandrasekhar
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.
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.
© MACROSCAN 2006