Capital Account Convertibility

(column by Asif Ahmed & Deepak Patra)

The real test of an economy is whether it is capable to meet emergencies; as only those economies sustain over a long period, which were built by conflicts and defined by crises. Opening up of domestic markets fully to foreign participation is viewed as an important indicator of economic development of a country. One of the most important aspects of such opening up is the liberalization of capital account. But yes, it is the same 'cross ventilation' that actually broke the backs of East Asian nations in the late 1990s, and also led to the earlier Latin American financial crunch. Clearly, what was previously thought to be an undisguised blessing actually spelt doom for many developing economies and raised questions over the efficacy of Capital Account Convertibility (CAC) in contributing to a nation's development.

There lies the biggest problem facing Indian policy makers, who, applauding the progress made on the domestic and external sector, have decided to move towards fuller CAC, within a transparent framework. CAC might rightly look attractive, but comes loaded with hidden mines that can not only negate India's economic progress, but also completely destroy the economic structure!

In CAC, not only companies, but Indian individuals too can enjoy the freedom to have bank accounts denominated in a foreign currency. At the same time, it also gives independence to foreign nationals to hold their investment in local currency. As per Amit Saxena, CEO, Planman Financials, "This shift of the government is not just a move that is aimed at propagating the freedom to keep dollar accounts, it is also about the powerful message that India is sending to investors and strategists across the world that India has finally arrived!" Perhaps it's time one replaces those images of snake charmers & rope tricks with concepts that are more contemporary.

But what happened to East Asian nations like Malaysia, Indonesia, Phillipines, Singapore et al in 1997 cannot be marginalised, where a majority of people enjoying healthy per capita incomes went below the poverty line overnight, just because of unwarranted panic by foreign investors and their subsequent immediate withdrawal of "hot money," making these countries economically devastated. In fact, the crisis even forced the IMF & World Bank to grudgingly accept in their policy papers that they had made clear mistakes in forcing such economies to lower capital controls.

To summarise the legacy of the catastrophe suffered in these economies: An open capital account, with quasi-IMF-forced higher interest rates, attracted a flurry of borrowings (on an average, almost 50% of total capital in- flows) from abroad, generating the lending boom and immediate asset price bubbles. For many banks in the East Asian economies, the growth rate of foreign exchange liabilities started outpacing their foreign asset increase rate by about 5% per annum. And to utter surprise, these foreign liabilities, instead of being backed by cash flows, were backed by collaterals like real estate and equity, which were already standing tall on top of a bubble. The absolutely unprepared banking systems of these economies soon faced the growing mismatch of borrowing short and lending long. Interestingly, it was the Mexican Peso crisis in 1995-96 that was the tipping point for panic among foreign investors in East Asia as the flow of capital reversed from these countries in the period around 1996-97, giving rise to a fear of massive devaluation.

Overnight, stock markets across East Asian countries crashed, real asset prices slumped and banks found themselves saddled with staggering amount of NPAs (Non Performing Assets). Thanks to the underdeveloped institutional capacity and regulatory structures, the East Asian economies tumbled iniquitously, giving rise to the moniker, "Asian Financial Crisis." Recovery, for these countries, was painful, as aspects like restructuring of the banking system forced these nations to bear a cost amounting to a whopping 20-30% of GDP; a cost that pushed them back decades. Notably, the repercussions burnt Russia, Mexico & Brazil later on.

Two oft quoted straightforward reasons for the success of such massive devastation were firstly, the independence allowed to FIIs in these countries to withdraw their money; secondly, and more importantly, the extent of dependence of these economies on FII short term capital, rather than on long term FDI investments. Whereas an emerging economy like India needs both short term capital flow (ostensibly for stock market health) and long term FDI, as a fuel for its overall growth, it still is quite clear that extremely strong fundamentals & failsafe nets against crisis situation are imperatively required before going ahead for full convertibility. If one were to simply go by facts and figures, it is very obvious that a fair amount of work still needs to be done. Any hurried steps towards CAC, without correcting economic fundamentals will open India to the clear and present dangers of what happened in East Asia. Short-term capital inflows like FIIs are relatively more volatile than longterm inflows. Excessive inflows as well as outflows can have serious macroeconomic implications.

"With full CAC, there may also be heavy inflow of capital, leading to appreciation of the Indian rupee. This, in turn, would affect the competitiveness of the Indian industry and increase the trade deficit, requiring an intervention by the RBI," asserts Danish Hashim, Deputy Director, CII. Even though in the case of India, there is no significant evidence of such volatility, the kind of inflows India is witnessing has been questioned, and the Ashok Lahiri Committee report, submitted in November 2005, expresses the same concern. The first concern that the committee has expressed is of a pathetic domestic institutional framework; followed by the involvement of controversial Participatory Notes and Hedge Funds - points on which even the RBI and the government themselves differ. To strengthen the debt market, the Committee also calls for a greater flexibility to be provided to these FIIs, in terms of switching from equity to debt market investments in India.

As far as the question of access to foreign currency is concerned, the fact is that Indian corporates have been raising money by way of external commercial borrowings, foreign currency convertible bonds, medium term notes and other modes. Currently, under the Foreign Exchange Management Act, all they have to do is to state the purpose for which they are raising funds. But once CAC is in place, corporates need not even mention such reasons. At the same time, one must appreciate the fact that the RBI has been already periodically allowing and increasing the limit of funds transfer for companies accessing overseas market. Recently, even the government raised the ceiling of domestic companies borrowing from abroad under the ECB route from $15 billion to $18 billion for 2006-07. And as far as individuals are concerned, they are anyway permitted to invest up to $25,000 abroad on financial assets.

Though it does not require a nuclear scientist to understand that with massive returns in domestic markets, Indians, almost en masse, would be least interested currently in such foreign investments. But truly, the leap from the current state of semi-openness, to comprehensive capital account convertibility is gargantuan, and requires safety mechanisms that can withstand the test of both process and structure faults. But then, what exactly are these failsafe requirements? A sound banking infrastructure, a healthy fiscal situation, a subdued inflation and a proactive monetary policy are a must before taking any steps towards CAC.

In fact, these were the key points outlined by the S. S. Tarapore Committee, appointed by the government way back in May 1997. At that time, Tarapore, the former Deputy Governor of RBI, had suggested a 3 year timeframe for moving towards opening-up of capital account by the year 2000. But the recommendations of the committee were deferred as - fortunately for India - East Asia got smashed up by the CAC imbroglio. The three most important parameters identified, which India needs to secure before moving to CAC are fiscal prudence, inflation control and improvement of lending capacities of banks. Not only from CAC's viewpoint, but also from a strong economic perspective, these factors are of utmost importance. Ironically, India's progress on many of these fronts ranges from dismal to pathetic:

• According to the Tarapore report, fiscal deficit as percentage of GDP was ought to be reduced to 3.5% by the year 2000, as against 4.5% in 1997-98. As per the 2005-06 figures presented in Union Budget 2006-07, fi scal defi cit stands at 4.1% of GDP. But it doesn't stop here. The horrible part of it is that India's combined deficit of the state and the centre as percentage of GDP is a humongous 7.7% of GDP, among the highest in world.
• The banking sector in India, still dominated by public players, is dented by mounting NPAs. The figures have shown improvement, but till today the lending efficiencies of our banks are questionable. The report emphasised the need to trim gross NPAs of public sector banks from 13.7% to 5% by the year 2000. Unfortunately, even in the year 2004-05, gross NPAs of public sector banks stood at 5.7% of gross advances. Continuing with banking sector reforms, the committee had also stressed upon the need to bring down Cash Reserve Ratio (CRR) from 9.3% in 1996-97 to 3% by the year 2000, which is an indication of greater freedom given to domestic banks. The effective CRR currently is 5%.
• On the contrary, inflation situation is one area that has creditably remained more or less in the bracket of 3-5%. On the external front, situations have shown significant improvement and are much better than what it was in 1996-97. The committee had also asked the government to undertake policies so as to increase current receipts to GDP ratio and to nail down debt servicing ratio from 25% to 20%. While the debt servicing has improved phenomenally from 17.1% in 1999-2000 to 6.2% in 2004-05, which reflects India's ability to meet its liabilities comfortably, current receipts to GDP has also improved over the years. India has additionally added phenomenally to its foreign exchange kitty, as the reserves exceeded external debt by almost $30 billion, and presently stand at $148 billion, which means India can meet the import bills for 13 to 14 months. Without doubt, in the march to CAC, the government should necessarily keep in mind that barriers should be lowered gradually. But pitiably, as far as execution of capital account convertibility is concerned, the government has to necessarily and firstly consolidate its accounts and credibilty. As B&E has repeatedly reported, in the race to achieve targets mentioned in the Fiscal Responsibility and Budget Management Act of 2003, the government has pathetically continued practising "creative accounting" (refer Finance section, B&E current issue). How can the world believe in India, when the government has been accused by its own central bank (RBI Currency & Finances Report, March 2006) of window dressing?