The Telegraph
Since 1st March, 1999
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- Why is the government anxious to make the rupee convertible'

The Reserve Bank of India has recently set up a committee, headed by S.S. Tarapore, to put together a roadmap for steering the country towards full capital account convertibility. The committee is supposed to commence its work from the first day of May this year and is expected to submit its report in three months time. It seems difficult to doubt the government's commitment about implementing this move, prescribed by the International Monetary Fund, towards freer international trade and balance of payments. Indeed, capital account convertibility is viewed as the removal of the last obstacle to a fully globalized and liberalized economy. So it is pertinent to ask: what is capital account convertibility anyway' What good is it supposed to do to the common man' Is it going to bring unmixed goodies for the people or are there darker sides to the deal as well'

Full capital account convertibility, if implemented, would allow unrestricted conversion of the rupee into dollar or any other foreign currency at the going exchange rate. It would empower the common man to convert, if he so desires, all his pecuniary assets into the currency of his choice. More important, foreign investors would be able to withdraw their investments in the country, convert them into dollars without bar, delay or financial cost, and leave with their money, if the need arises. It is this last option which is thought to be the most attractive for overseas investors and advantageous for the economy as a whole.

It is argued that transparent and painless exit options always encourage entry, and foreign investment is no exception to this general rule. As long as the investors know that their funds will not be stuck in case the going gets bad, they would not hesitate to bring them in. This, in turn, would stimulate production, employment and income within the economy, starting off a virtuous cycle of growth and development. Again, at a global level, full convertibility of currencies across the world is expected to increase efficiency by removing distortions in international capital movements. This would lead to a global boom from which individual countries must also benefit. In short, advocates of full convertibility believe that free exchange of currencies, which guarantees free capital movements across countries, is a natural extension of free trade and therefore should be implemented without procrastination, provided macroeconomic fundamentals are right.

At present, macroeconomic fundamentals in India are indeed believed to be right. The overall growth rate for the economy has touched a dizzy height of eight per cent. Inflation is low and very much under control. Foreign exchange reserves are overflowing the chest. Stock markets are vibrant at a level previously unheard of. Investment, both domestic and foreign, is increasing at a comfortable rate. What could be a better time of implementing full convertibility of the rupee' What could be a better opportunity of making the rupee a truly international currency' Yet the issue of convertibility rings a not-so-distant warning bell.

Ten years ago, Asian countries like South Korea, Thailand, Malaysia, Indonesia and the Philippines were having pretty strong macroeconomic fundamentals. The economies were booming, inflation rates were low, foreign exchange reserves were piling up, and inflow of foreign capital into these economies was steady. In 1996, these five Asian economies, taken together, received a net capital inflow of 93 billion dollars. Yet one year later, there was a net outflow of 12 billion dollars from these economies, a turnaround of 105 billion in a single year amounting to more than 10 per cent of the combined gross domestic product of these economies. And this sparked off the infamous East Asian Crisis. The story of the crisis is well known and need not be repeated here. For the present, we wish to recall just a few facts related to the crisis.

First, a crisis of that scale could have been avoided if in those economies there were partial restrictions on convertibility. India was protected from the contagion and emerged completely unharmed from the crisis mainly because the rupee was not a freely exchangeable currency.

Second, though economists, armed with hindsight, point to the lack of financial prudence, high interest rates and an unusually large short-term liability in relation to foreign exchange reserves or exports as the main culprits behind the crisis, no one could actually perceive the impending danger. Neither could the general debt crisis of 1982 or the Mexican crisis of 1994-95 be predicted by financial pundits. Therefore, the crux of the matter is that financial crises, characterized by boom and bust cycles, although happening at regular intervals, have always taken the world by surprise.

Third, and most important, the causes of financial crises are still little known. Sometimes they are attributed to financial imprudence, sometimes to expansionary monetary and fiscal policies and sometimes to high interest and overvalued exchange rates. But these explanations are invariably offered for a crisis, not before one actually takes place. The lack of knowledge about the real cause of crises is the only reason why they could not be anticipated.

The moral is simple. However much macroeconomic fundamentals seem to be improving and however much prudential norms are imposed on the domestic financial market, if the rupee is made fully convertible, there will always remain a chance of a fresh crisis triggered off by an outflow of foreign and domestic funds. More so, because Western investors do not fully trust emerging markets as yet and get jittery at the slightest provocation spreading panic and catastrophe. It is therefore ridiculous at this stage to dream of making the rupee a truly international currency.

Most important, it is not at all necessary to have full convertibility for a smooth economic development. Indeed we are having enough capital inflows and growth without full convertibility and so are the Chinese. Why risk introducing convertibility then' In a cross-country study, Dani Rodrik of Harvard has found little correlation between per capita GDP growth, investment and inflation on the one hand and capital account convertibility on the other. In fact, it is only the footloose, hot money that would require full convertibility and clear exit options as a precondition for entry. But for the long-run health of the economy it is desirable to keep them away. On the other hand, foreign direct investment, which flows into the country on a more permanent basis and which is likely to create income and employment within the country, does not seem to be guided by convertibility.

Why is the government so anxious to introduce full convertibility then' Some would like to explain the eagerness in terms of pressures from the IMF and the World Bank. While there is certainly a grain of truth in this point of view, it is often overlooked that the pressure is now more from within than from outside. No one can deny that with globalization the rich in our country are getting richer. The crux of the matter is that this privileged few would like to have the option of keeping their rapidly swelling assets in some internationally liquid form. They would, in particular, like to enjoy the alternative of converting their resources to some stable currency in case there is a crisis. The internal demand for full convertibility is basically coming from them.

While the middle class remains happy with current account convertibility, which allows them to consume foreign goodies of their choice, the rich are really concerned with the mobility of their assets, which can be guaranteed only by capital account convertibility. It is thoroughly disturbing to see that the government is anxious to protect the interest of the chosen few at the cost of making the masses vulnerable to a big financial misadventure.

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