Some weeks ago, the prime minister reopened the subject of the full convertibility of the rupee and announced the Tarapore committee to present a plan of action. Why bring it up now' Will it ever be necessary for India' Is it part of any 'deal' with the United States of America or a belated recollection to tick it off on the old reforms agenda' It could merely be a threat to Indian commercial banks to get them to become more efficient but that could have been achieved by opening the market more to new domestic and foreign entrants.
Full convertibility often came up for public debate in 1990 to 1997. Invariably, it was challenged as being dangerous in the then macroeconomic position of the economy. Those who stood to financially benefit from full convertibility ' like merchant-bankers, financial market operators, speculators and others ' argued for it.
Analysts are agreed that the principal reasons for the unraveling of the 'miracle' economies of southeast Asia in the second half of 1997 were the inherent weaknesses in their economic and financial systems. There was little regulation, lax supervision, little reporting of financial data that would allow outsiders to evaluate a business, poor management of risk, and continuous lending to politically well-connected firms, sometimes at the government's direct behest. There was often little due diligence regarding the credit-worthiness of the borrower or the economic merit of a project for politically favored enterprises.
India in 2006 has progressed well on all these issues. The Securities and Exchange Board of India and the Reserve Bank of India are stronger, faster and effective in their supervision and in imposing penalties although there continue to be hiccups. Thanks to Section 49 of the listing agreement with SEBI, at least listed companies are more transparent. Auditors are also imposing the discipline of fuller and more honest reporting on all companies. Risk has now to be systematically analyzed and reported. Crony lending especially under government direction is less than it used to be.
After 1997, convertibility has not been on top of the list of 'things to do' for foreigners and Indians as essential reform measures for India. The other old chestnut, labour reforms, is more heard of. It is recognized that the principal measures required are reduction in fiscal deficits, uniform sales taxation over the country as in VAT, better infrastructure, less red-tape, less paper and less inspections by government inspectors, cutting the time involved in starting a new industry, opening retail trade to foreign investment, higher foreign investment limits in telecom, lower interest rates, and so on.
The fiscal deficit has come down at the central level by hardly 1 per cent over five years while the state deficits continue as they were. But if economic growth stumbles, there is no doubt that the deficit targets will be the first to be sacrificed. Deficits squeeze liquidity, could raise interest rates, deprive governments of money for public investment, and must reach consistently lower levels before opening the economy to capital account convertibility.
Value-added tax was introduced last year but large and important states, Uttar Pradesh and Tamil Nadu, are not with it. India is only a semi-common market. Infrastructure continues to be a problem. Railways show better revenues and might have funds for investment. Metro rail in large cities and an express freight corridor are approved ambitious plans. Public private partnerships, or PPP, have begun with private ownership of railway rakes. Road construction has witnessed large investments in urban and rural roads and more is planned. Airport modernization and new airports are to come under PPP. But congestion at airports and in the skies will continue for many years. Port modernization has commenced and PPP in smaller ports has made great progress. Energy remains a huge bottleneck, with domestic crude and gas availability remaining static. Indian government-owned oil companies are losing huge sums since government is not letting them pass on the high prices of crude and gas to the consumer in finished product prices. Coal is a poor reformer under government ownership. The infrastructure remains a bottleneck and full convertibility will make our companies vulnerable.
State governments are losing huge sums in operating electricity systems, being unable to manage their electricity investments efficiently, effectively and commercially. Privatizing electricity distribution is the only option to proven inability of state governments to manage electricity. But even a 'reformer' prime minister has not publicly recognized that privatized electricity in Delhi has improved matters, and other states are unlikely to follow the Delhi example . Without improving distribution, electricity will not improve in availability and financially. Inefficiency and high cost for industry because of electricity will continue. A convertible rupee will expose the economy more strongly to external pressures and instabilities.
The rise in liquidity in the money market, and so-far-concealed inflationary pressures owing to making companies and not consumers pay for high crude and gas prices have already led to higher interest rates. This will adversely affect industry, which has shown substantially improved performance in recent years mainly due to low interest rates.
Current account deficits on balance of payments have been rising, but perhaps more because of 'one-off' imports (like defence equipment) and not as much because of economic activity. But it is another indicator to be watched. A managed currency somewhat insulates Indians from the ill effects of many of these poor indicators.
Why do we need convertibility at all' The unraveling of south-east Asian economies some years ago was attributed to their ties to the dollar and full convertibility. So was the case in Argentina. The lesson was that there should be a firm Central bank to manage exchange rates by intervention. We enjoy all features of convertibility and have abundant foreign exchange inflows. Not much is coming as direct investment because of difficulties in manufacturing and moving goods in India arising from poor infrastructure and red tape, and not from fears of denial of repatriation of funds. Indeed, as American interest-rates rise, we must fear that funds might flow out for better returns there. Full convertibility might cause outflow of Indian-owned funds and to a haemorrhage of outflows.
Rising oil and gas and other commodity prices provide another reason to retain interventionist weapons of the Central bank. The huge losses of oil and gas companies will have to be reimbursed soon from government funds and by consumers. That could trigger sharp inflation. Full convertibility will make foreign exchange freely flow out of the system and further aggravate the liquidity and inflationary crisis.
There is no sign of administrative reforms to reduce red tape and speed up the many approvals required for running factories and starting new ones. This is another bottleneck to efficiency and an argument against convertibility.
There is no merit in full rupee convertibility at any time. Instead, we need measures to make industries and agriculture more efficient, improve the quality and availability of power, better roads, faster and safer rail, better urban infrastructure, less red-tape and corruption, a reformed government that can deliver more and better health, education, sanitation, water supply, nutrition, social security, and so on. Rupee convertibility is for the good of merchant bankers and foreign- exchange dealers.