The Telegraph
Since 1st March, 1999
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- The steps to full convertibility are being taken slowly but decisively

The author is an economist at the Indian Statistical Institute, New Delhi

Reports from different sources indicate that the Indian economy is poised to enter a higher growth path. Despite a stagnant agricultural sector, the overall rate of growth during the last year has been reasonably satisfactory, mainly because the manufacturing sector has performed quite creditably. Not surprisingly, this has given rise to a large degree of optimism about the future performance of the economy. However, this optimism has been tempered by the feeling that the government has somehow lost its way in so far as economic policy-making is concerned.

Perhaps the need to counter this pessimism about the government’s lack of initiative forced the finance minister to announce a couple of weeks ago that the government would soon announce a flurry of policy measures to accelerate the growth process. The recent meeting of non-resident Indians provided a perfect forum for him to announce the first of these policy initiatives. As a business daily declared in bold headlines, the government has now opened up the world to Indian investors.

During his speech at the NRI meeting, Jaswant Singh declared that resident individuals, companies and mutual funds could now invest in the equities of listed foreign companies which have at least a ten per cent stake in any listed Indian company. Of course, mutual funds were already allowed to invest abroad subject to a ceiling of 500 million dollars. The current announcement increases this ceiling to one billion dollars. Companies will now also be permitted to acquire land and property abroad, and retain their American depository receipt and global depository receipt proceeds abroad for future expenditure in foreign exchange. Several other relaxations in foreign exchange controls for Indian companies have also been permitted.

These measures represent an important step forward towards making the rupee fully convertible on the capital account. The rupee was made “almost” convertible on the current account in August 1994. This was when the P.V. Narasimha Rao government removed foreign exchange restrictions on a large number of transactions in goods and services. Since then, authorized dealers have been allowed to release foreign exchange without prior approval of the Reserve Bank of India for an increasingly large number of current account transactions. Of course, despite the gradual easing of controls, there remains an important sense in which the rupee is not fully convertible even on the current account. After all, there are still quantitative restrictions on the amount of foreign exchange which an Indian can spend on most current account transactions. For instance, there are ceilings on the amount of foreign exchange that an Indian tourist can take out of the country.

The move towards current account convertibility, at least in a phased manner, was spurred by the anticipation of a surge in capital inflows from abroad. Indeed, the spectacular rise in India’s foreign exchange reserves has been one of the most visible success stories of the reform process. In June 1991, the RBI hardly had sufficient foreign exchange reserves to pay for a few weeks’ imports. Since then, foreign exchange inflows have increased dramatically, causing the dramatic turnaround in India’s stock of foreign exchange — the current figure exceeds seventy billion dollars. Indeed, there has been a tendency for the rupee to appreciate against foreign currencies, forcing the RBI to intervene in order to protect the interests of Indian exporters.

Despite the comfortable foreign exchange reserves position during the last five or six years, successive steps have proceeded very slowly towards the goal of full convertibility. Of course, this slow progress should not have come as a surprise to observers of the reform process in India since gradualism has characterized economic decision making in India throughout the Nineties. However, the reluctance of policy-makers to make the rupee fully convertible has made this a hotly debated topic in policy discussions throughout the latter half of the Nineties.

Most of the economists who believe in the “market is almost always right” hypothesis have been advocating full convertibility of the rupee for a long time. This school of thought believes that the Indian economy must completely integrate with the world economy. And how can full integration take place unless the Indian currency itself is allowed to be freely exchanged in international currency markets' To others, full convertibility is more of an “emotional” issue — they equate convertibility with national prestige since a convertible rupee is viewed as a symbol of the strength of the Indian economy.

Equally strong views have been expressed against the easing of restrictions governing transactions in financial assets in foreign exchange. In particular, the opponents of convertibility on the capital account point to the recent east Asian meltdown, where countries such as Thailand and Hong Kong, whose currencies are convertible, experienced large scale volatility in financial markets. Only large doses of devaluation restored some semblance of order. In contrast, China and India came out of the crisis relatively unscathed. And it was no coincidence that these were the two Asian countries with several foreign exchange controls.

Of course, integration with the world economy carries the risk that shocks in one country can be transmitted to another more easily. This is true of all kinds of markets, including financial markets. Presumably, the removal of restrictions in foreign transactions of various kinds is worthwhile if the benefits of integration exceed the costs. The potential cost associated with the current set of relaxations is the possibility that there will be a large outflow of foreign exchange because of higher returns abroad on foreign portfolio investment. However, this is extremely unlikely, at least in the foreseeable future. Real rates of interest are actually higher in India than abroad. Moreover, the comfortable foreign exchange reserves position actually means that the rupee has been more than holding its own against major currencies. So, Indians are much better off investing here than abroad.

What about the potential benefits' The relaxation of controls represents a declaration of confidence by the government — it is an assertion that the government does not foresee any major problems in so far as the stability of the rupee is concerned. This has at least one important consequence. Foreign investors will be more willing to invest in India if they believe that the risks associated with their investment are minimal. This in turn means that Indian companies can borrow abroad at lower rates of interest since creditors will ask for a smaller “risk premium”. Just for this reason alone, the move towards a greater degree of convertibility represents a step in the right direction.

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