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Capital account convertibility, a mirage?

With many signposts that are difficult to reach, it is hardly likely that India will move towards free float of the rupee

THE ISSUE of convertibility of the rupee is back centrestage with the Reserve Bank of India releasing the Tarapore Committee's report. In March this year, following Prime Minister Manmohan Singh's suggestion to revisit the issue of convertibility, the RBI constituted the expert group.

Nine years earlier, in 1997, another expert group, also headed by Mr.Tarapore, had prescribed a road map for the introduction of full convertibility, also known as capital account convertibility. Then, as now, the launch of capital account convertibility was made conditional on the attainment of specific macroeconomic goals.

The details vary but both reports lay stress on fiscal consolidation and financial sector reform as crucial preliminaries to full convertibility of the rupee. The time-tables drawn up by the expert groups — just three years beginning 1997 (by the first committee) and now five years — are meant to underline the importance of economic consolidation and provide a sequence for the proposed liberalisation.

Three-phased approach

The more recent report advocates a three-phased approach, the first phase beginning this year (2006-07), the second during 2007-09 and the last ending 2011. Even before the rather lengthy report of the Tarapore II Committee has been assimilated, there have been strong reactions to it.

Capital account convertibility has always been a much-hyped subject, often without much understanding of what it entails. Specifically, the benefits it is supposed to confer on the economy are exaggerated while its pitfalls are blithely ignored.

In fact, there may be a fundamental misconception of what it denotes. In India, most current account transactions have been freed from controls over the years. Resident individuals now have the freedom to remit as well as receive foreign exchange on a variety of transactions. Thus, unlike a decade ago, anyone can finance his overseas education with practically no limit. Foreign exchange is freely available for travel abroad as well as for medical expenses.

No precise definition

Neither current account convertibility nor capital account convertibility admits of a concise definition. While there are internationally understood norms for indicating a country's "convertibility" status, these are not precise. All they connote is that the authorities will stipulate fewer controls on money transfers into and out of a country. However, whether on current or capital account, even developed countries have some kind of negative lists. Incidentally, these lists have expanded what with tough anti-money laundering laws and the all-pervasive need to fight terrorism.

It follows that there is no such thing as full convertibility of the domestic currency in absolute terms. Capital account convertibility in the sense of residents freely investing in property or financial assets abroad and foreigners in India still remains a distant, impractical dream. In any case, even if the monetary authorities in India allow residents to invest anywhere in the world, it does not automatically make such investments possible. This is because many countries restrain investments in specific sectors of their economies. That is easily understood in the light of the debate on sectoral caps for foreign direct investments in India. It is often forgotten that even developed countries have such restrictions.

The title of the Tarapore Committee report is "Towards fuller convertibility'' and not "Full convertibility". The distinction is crucial to an understanding of convertibility, its status as also the various safeguards suggested.

Hence the clamour for capital account convertibility is really for relaxations on capital transfers rather than for a withdrawal of all types of control. Critics of the report say its time-table is too long. They ignore the fact that substantial liberalisation has already occurred in India even on capital account transfers.

It is difficult to see what other benefits will accrue to the economy from liberalisation, especially when it is carried out quickly ignoring the commonsense safeguards.

On the other hand, many developing countries, from Southeast Asia to Latin America, that have had a more liberal exchange control regime including "fuller capital account convertibility" have suffered grievously. At the first sign of a loss of confidence in the economy, non-residents and domestic investors alike in those countries shifted their capital abroad.

In fact, since 1998, following the debacle in many East Asian and Southeast Asian countries, capital account convertibility has ceased to be fashionable among policy makers.

Exhaustive studies conducted by international rating agencies prove the point that a full convertibility status does not by itself make a country a more attractive investment destination. More important are traits such as fiscal rectitude and a strong financial sector. These are exactly the signposts the Tarapore Committee has advocated.

The fact that these are difficult to reach in the current Indian context is an entirely different matter.

For instance, in the area of banking sector reform, while everyone agrees that greater autonomy is good for the public sector banks and that there should be equal treatment for banks irrespective of ownership, it is difficult to visualise a reduction in government stake in PSBs to 33.33 per cent as suggested by the committee. Even fiscal consolidation as enshrined in the FRBM legislation is now being called into question insofar as it is seen as hindering resource mobilisation for the Eleventh Plan.

Participatory notes

The recommendation to phase out participatory notes (PNs) — instruments issued by foreign financial institutions that are backed by shares in India — through which unidentified overseas investors can access Indian markets — is unlikely to be accepted by the Government. However the course suggested is a prudent one as PNs are widely believed to be conduits for unaccounted money in India flowing back.

With many signposts that are difficult to reach, it is hardly likely that India will move towards fuller convertibility by adhering to the path set out. In that sense the value of the Tarapore Committee's report might well lie in its focus on crucial macroeconomic and procedural issues of the day.

C. R. L. NARASIMHAN

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