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Capital account convertibility concerns

Sunanda Sen

Can the Government avoid disaster if resident Indians join others in moving funds out in times of crises?

RECENT ANNOUNCEMENTS that India will very soon be in the club of nations with full capital account convertibility (CAC) fulfils a long-awaited promise endorsed in the Tarapore Committee's recommendations of 1997. The crisis in South-East Asia came up within a few months during that year. There was unprecedented volatility in exchange rates and capital flows, along with sharp downturns in the economies of the region. These events reversed the direction of policy-making in India with caution ruling out the prospects of an early introduction of CAC.

What will CAC mean? It will permit the resident Indian to convert the rupee into any foreign currency and to take it to any country without any restrictions. The restrictions on capital flows for foreigners and non-resident Indians had been scrapped earlier.

The official stance relies on the "strong fundamentals" in the economy to justify CAC. These include stable prices, GDP growth exceeding 8 per cent, the trade surpluses over the last few years, and official foreign exchange reserves of nearly $140 billion.

The time has thus come to celebrate India Inc., not only by the moneyed elite who had been waiting to reorganise their portfolios but also by the ruling elite to project India as a major developing economy, which can even seek membership, like Mexico or Turkey, in rich country clubs such as the Organisation for Economic Cooperation and Development (OECD).

Grounds for caution

There remain, however, a few factors that should dispel the optimism surrounding the endorsement of CAC in a developing country such as India at the moment. One is the possibility of opening the floodgates of legalised capital transfers abroad by domestic residents, with the goal of availing of the lower tax rates abroad or even parking funds in tax havens such as Mauritius. The process may turn out to be a bonanza for the rich.

Monetary and fiscal surveillance of the economy, till now guided by national exigencies, and rather successfully at that, would have to face additional hurdles in terms of the newly achieved mobility of domestic capital. This would entail the much talked about "trilemma" faced by countries in managing exchange rates while following an autonomous monetary policy under full capital account convertibility.

Will the country's central bank be able to avoid a run on the exchange rate, upward or downwards, if the tools of national monetary management (say the Market Stabilisation Scheme and the Liquidity Adjustment Facility) are rendered ineffective?

Possibilities of money transfers by residents on a legal basis would also make it obligatory if not mandatory on the part of the monetary authorities to maintain a parity between the risk/uncertainty-adjusted domestic and foreign interest rates. The added responsibility would erode further the social priorities for credit disbursements in the economy, which are being steadily dismantled in terms of financial de-regulation.

The market-oriented priorities of credit today are evident in the flows of loans towards housing and real estate moving up by 44.6 per cent and 90.3 per cent during 2004-05, in contrast to the rather moderate increases of around 35 per cent and 15 per cent respectively for agriculture and small industry during the year. This though the last two sectors provide a major share of employment in the country.

Stock exchanges have been experiencing a bull run for a while now. These are well funded both with domestic credit and net inflows of Foreign Institutional Investor funds. The latter speaks for closer integration with major international capital markets. Net FII inflows at $8.2 billion during 2004-05 was more than two-thirds of the aggregate net inflow of foreign capital at $12.1 billion during 2004-05.

Will the Government be able to manage the exchange rate and avoid a financial disaster if resident Indians too join the FIIs in moving out in times of crises? Policy makers need to be alert to the possible pitfalls. The country can ill afford a mis-step.

(The writer is Visiting Professor, Academy of Third World Studies, Jamia Millia Islamia, New Delhi.)

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