The Telegraph
Since 1st March, 1999
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- Full scale convertibility without restrictions can be dangerous

The latest battleground between the pro-reformers and the left parties is the issue of convertibility of the rupee on the capital account. Some time ago, the prime minister raised the topic of capital account convertibility in one of his innumerable public meetings. More recently, the Tarapore committee, appointed by the Reserve Bank to advise it on various aspects relating to capital account convertibility, has submitted its report. The issue of capital account convertibility of the rupee has now become a matter of intense public debate. The Communist Party of India (Marxist) has already labelled it the “worst form of financial liberalization”, while individuals on the other side of the fence would like us to believe that the Indian economy simply cannot travel along a sustained high-growth path unless the rupee is made fully convertible.

A popular argument in favour of convertibility runs along the following lines. The scarcity of capital is amongst the most important constraints preventing developing countries from growing at reasonably fast rates. The “obvious” solution is to attract capital flows from the developed countries in the form of foreign direct investment. Convertibility of the local currency is supposed to facilitate this process. Convertibility provides a guarantee that foreign investors can withdraw their investments whenever they want to, and this assurance will increase their willingness to invest in countries offering this kind of guarantee. Equally importantly, convertibility signals the host country’s own confidence in the strength of the local currency and in the fundamentals of the economy. This, in turn, will induce greater inflows of FDI since a strong economy is more likely to yield high returns on their investment.

How compelling is this argument for a country like India' Will there be a significant increase in FDI in the near future if the government decides to make the rupee fully convertible' It does not take much thought and even less time to come to the conclusion that convertibility is not really the factor constraining inflows of FDI into India. It is highly improbable that any foreign company apprehends that it will not be able to withdraw from India even under the rules currently prevailing in India. Lack of infrastructure, bureaucratic delays, labour laws (or their absence) — these are the factors that are taken more seriously by foreign companies. So, the route to higher inflows of foreign capital must involve changes in the structural features of the domestic economy. Convertibility by itself can at best have a marginal effect on increased flows of FDI.

In fact, capital account convertibility can be beneficial for reasons that are almost completely orthogonal to the “increasing FDI” argument. Several developing countries including India have been experiencing very large foreign exchange inflows in the form of investments in the domestic stock exchanges. These inflows are so large that the foreign exchange reserves of the recipient countries are several times larger than the reserves required for precautionary purposes. The excess reserves constitute an embarrassment of riches. A central bank then has essentially two choices. Either it can do nothing and let the market determine the external value of the domestic currency or it can intervene and maintain the current value of the currency.

Neither option is costless. The first option would result in an appreciation of the local currency. This, in turn, will result in an increase in the prices of domestic goods in global markets, so that exporters will find it hard to compete in these markets. The second option involves the central bank buying foreign currency, and investing it in buying bonds issued by foreign governments. Of course, it has to issue domestic currency to buy the foreign currency and this increases domestic money supply. In order to contain inflationary pressures, the central bank has to “sterilize” the excess money supply so created by issuing government bonds. At least in India, the rate of interest on these bonds is much higher than the returns earned by the Reserve Bank on its holdings of foreign government bonds because inte- rest rates are typically higher in India than in the developed countries. So, the sterilization exercise is costly.

At any rate, public appetite for government bonds is limited, and there is an upper bound to the extent of sterilization that is possible. Capital account convertibility opens up the possibility that domestic residents can invest abroad and so contribute towards some capital outflow. Of course, such capital outflows reduce the amount of sterilization that has to be performed by the central bank.

Equally strong views have been expressed against the easing of any kind of restrictions governing transactions in financial assets in foreign exchange. In particular, the opponents of convertibility on the capital account point to the 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. Opponents of convertibility claim with some justification that it was no coincidence that these were the two Asian countries with several foreign exchange controls.

Of course, integration with the world economy or globalization carries the risk that shocks in one country can be transmitted to another more easily. This is true of all kinds of markets, and particularly so for financial markets. In fact, financial markets are more volatile than other markets. In the absence of controls on financial transactions, huge sums of money can move across international borders at the flick of a mouse. So, full-scale convertibility without any restrictions or unless some prerequisites are satisfied by the domestic country can be quite dangerous.

The recommendations of the Tarapore committee constitute a set of such prerequisites and restrictions for the Indian economy. Of course, these recommendations represent an amalgamation of the individual views of the experts on the committee, and cannot be the last words on this topic. So, it is imperative that there be discussion and debate on whether the recommendations specify adequate safeguards to protect the Indian economy from the ravages that can be caused by excessive volatility in international financial markets. It is foolish to let preconceived notions dictate one’s thoughts and shoot down the idea of capital account convertibility simply because the economies of some countries at some points of time have been severely affected.

It also makes sense to consider alternatives to full-scale capital account convertibility. Two IMF economists, Eshwar Prasad and Raghuram Rajan, have recently floated one interesting proposal. They suggest that governments of developing countries that experience large capital inflows for speculative purposes can establish private close-end mutual funds. These funds would issue shares to domestic residents in the local currency, utilize the proceeds to buy foreign exchange from the central bank and then use the foreign exchange to invest abroad. The amounts invested abroad would reduce the extent of sterilization that has to be performed by the central bank. The attractiveness of such a scheme is that the government or central bank can, by specifying the total size of the fund, control the amount of capital outflows, and so limit the extent to which the domestic economy is affected by volatility in international markets. Similar examples of ‘out of the box’ thinking are very likely to produce some of the benefits of capital account convertibility without its attendant costs.

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