International Financial Markets and Full Convertibility of Rupee

Prakash G Apte


Definition

“Capital account convertibility is the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. It is associated with changes in ownership of foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on or by the rest of the world. Current account convertibility can be and is co-existent with restrictions other than external payments. It also does not preclude imposition of monetary/fiscal measures relating to foreign exchange transactions that are of a prudential nature (Tarapore Committee Report, RBI, 1997)

Every year we publish the Balance of Payments (BoP) position. Balance of payments is nothing but double entry record of transactions between residents of India and the rest of the world. There is one debit entry and corresponding credit entry.

Anatomy of BoP

BoP has three parts— I) Current Account Convertibility in which we record transactions such as exports and imports of goods and services. For eg. An Indian company exports software services to America. Any transaction in which a payment is made to us from abroad is recorded in credit. Any transaction that involves payment from us to them is recorded in debit. Any transaction that increases the availability of foreign exchange will be recorded as a credit. Any transaction that reduces the availability of forex is recorded as debt. For every credit there must be a debit.
Interest payments made to foreigners, received from foreigners, dividends either way, labor earnings made to foreigners, received from them.
II) Capital account requires changes in India’s foreign assets and liabilities. These are recorded in capital account. Eg. An Indian company takes a loan from a foreign bank. India government takes a loan from IMF or Indian government repays a loan from IMF. An FII buys stock from Indian stock market. That transaction appears in capital account.
III) Any debit or credit balance arising from both current and capital account has to be offset somewhere. Eg. There is a net credit balance in current account and net debit balance in capital account.
Forex assets held by Reserve Bank of India in the form of bank deposits abroad or foreign government securities. RBI holds these foreign currency asset as special drawing rights, foreign currency deposits, foreign government securities. RBI keeps buying and selling dollars in the forex market. Currently, we have a reserve of $ 100 bn.

Current account convertibility

In 1994, the Central Government accounced that rupee will become convertible on current account. So long as the transaction comes under the current account you don’t have to take advance permission from RBI. This does not mean you can export anything you want or import anything you want. So long as export or import does not violate any trade control law, you are free to indulge in it with out any RBI nod for converting rupee into dollars and dollars into rupee.
Even now rupee is not fully convertible on current account. There are limitations. There is a limit of say $10,000 for a tourist or visitor abroad. But in 1970’s it use dto be $8, when I first went abroad. There are some ceilings on obtaining forex for going abroad for education, treatment, tourism, business etc. So rupee is not fully convertible on current account also.

Capital account convertibility

Transactions on Capital Account is not convertible as of now. In 1997, RBI appointed a committee headed by Tarapore that submitted its report in July 1997. It said that in three years time we should move to full capital account convertibility in stages by July 2000.
In 1998, the famous Asian Currency Crisis in Thailand, Malaysia, Indonesia and Korea faced severe problems of capital outflow. In ten months time the currency depreciated 100 percent.So Indian government thought if capital account restrictions are lifted all these countries will be bringing in capital and if something goes wrong as happened in Thailand then they will flee. So that will lead to a big crisis as has happened in the East Asian countries in 1998. So the government thought it could keep the issue in the back burner.
If I export $ 50,000 worth of goods or services and put 50 percent of it in dollar denominated bank account, I could still use it only for a specific purpose. So as individuals we do not have the freedom to convert local financial assets into international financial assets. Under Capital account convertibility- companies, individuals and residents can freely convert from rupee assets to foreign currency assets.
Some companies seeks loans and sell bonds in foreign markets but they require prior approval from RBI. This king of external commercial borrowings requires submission of documents before the concerned department of Ministry of Finance.

In 1997, we started relaxing ECB guidelines regarding how frequently companies can seek funds abroad. The average maturity of loan, restrictions on how to use ECB- ie. import of raw material, capital equipment and not for investment in stock markets. Now there are restrictions on what you can do with your foreign exchange assets. We opened up our stock markets to foreign institutional investors in 1997 under certain restrictions. All FII’s together cannot hold more than 49 percent of a stock. No single FII can hold more than five or 10 percent of the share of a company except where special permission can be granted. For corporate sector acquiring foreign exchange assets and handing over assets have become much more easy.

Full capital account convertibility does not mean there will not be any restrictions. In times of currency crisis Central Bank can say, for three months you cannot pay transactions in that currency.
IMF member countries—60 of them have opened up their capital account. Most developed countries, ie. OECD countries—Canada, USA, most of Europe, Japan, Scandinavia, started opening up their capital account some time in 1970s. By the end of 1980’s virtually all restrictions were lifted.

By mid- nineties, South-east Asian countries followed – Indonesia, Malaysia, Thailand etc have opened up their capital account. Other developing countries like India, China continue to retain capital account control. In late 1980’s and early 1990’s, many emerging economies in South East Asia and Latin America began the process of achieving capital account convertibility. Why should we open up the current account? India’s economic growth is currently at nine percent. Where does the growth come from? Economic growth comes from making investments in agriculture, industry, services and infrastructure. Massive amounts of investment is required to build roads, power stations, ports, airports development and so on. In 10 years we want to double our per capita income.

Currrent Account convertibility –Pros and Cons

Current account convertibility opens up the domestic economy to foreign capital. Foreign capital augments investible resources of the home country and facilitates faster growth.
Cost of capital for domestic firms is lowered and access to global capital markets is enhanced. Just as there is gains from international trade in goods and services, there are gains from trade in financial assets. It allows residents to hold globally diversified portfolios improving their risk return trade off. It lowers the funding cost for resident borrowers.

Economists talk of capital output ratio. In order for the GDP to grow at 8-9 percent, 25 percent more investment is required. Twenty to 25 percent of the country’s gross icome should be invested in various infrastructural assets. India’s investment rate has not been more than 20-25 percent of GDP at best of times. The remaining five to six percent must come from foreign investments otherwise we will not be able to achieve a high growth rate. Our savings rate should be 32-34 percent but in actuality it is only 26 percent. The gap has to be filled by foreign investment.

Take the case of Japan, Scandinavia, Europe—there the opportunities for investment are limited. They are looking for more attractive investments abroad which will give say, eight percent return as against the three percent they get in their own country. So money is lying idle in those countries. Developing countries are short of funds, therefore, the opening up of capital account does augment the investible resources of the home country. Our companies can access the capital and their cost of capital will come down. If we are to rely only on domestic capital, the cost would be high. Some investments will simply not be undertaken.

Export and import of goods and services is good for the welfare of all countries engaged in it. For example, software services from India, we do it much better than developed countries. But we have to import a lot of goods either because other countries produce it better. Then why not apply the same logic to capital.The major fear is not only about foreigners investing here but what if domestic investors start investing abroad. But why should they do it. As a wise investor, who will be tempted to invest abroad and earn three percent when the same investment can yield eight percent in the domestic market. Why should you park your investments abroad if the rate of return is low? Rate of return on investment has come to two percent in Japan.

In India it is 4.6 percent. Unless e are fearing a massive crisis—either a political or economic collapse, the fear about capital account convertibility is not justified. Our political system is working well, government is functioning well, no major political crises is also foreseen? We also do not expect an economic crisis as in Thailand. Foreign capital in India constitutes a very small part of the total capital. Particularly short term capital that has a maturity of six month. That constitutes a much small portion. Even if all of that leaves tomorrow, Indian economy is not going to collapse. Our total foreign debt as a percentage of GDP is very small. Short term debt component in that is still smaller. So this fear about taking foreign capital away from India if capital account convertibility comes is totally unjustified. Today India and China offer the best investment opportunity globally in manufacturing, services and infrastructure. Because of wrong policies in power, roads, ports, investments are not flowing in.
Current account convertibility also means, competition among financial intermediaries, improves efficiency, cuts transaction costs, deepen financial markets.

Specialisation in financial services guided by core competence may be increased, increasing allocative efficiency. Capital account convertibility imposes certain disciplines on federal,state governments and policy makers. Domestic tax regimes and other fiscal parameters must coverge to international standards to prevent capital flight from home. Competition is the best way to increase efficiency in public sector banks and other private banks. Our banking sector requires a dose of competition. Banks, investment companies, mutual funds and insurance sector will only benefit from competition.
Capital accounts convertibility will also lead to specialization in products offered by banks. It also puts a cap on uncontrolled budget deficits, uncontrolled government expenditure thereby putting certain discipline in the Finance Ministry.

Large deficits show up on current account as debits and running up large current account deficits will lose the confidence of foreign investors in meeting our liabilities.
When there is current account deficit, it means imports are more than exports. In normal situations it should not exceed 1.5-2 % of GDP. Anything beyond that is not sustainable and quite dangerous also. In Thailand, the current account deficit for three years was nine percent of GDP.
If we have to keep current account under control then budget deficits should also be under control. They must raise more resources by way of taxation not by way of borrowing. Borrowing creates problems for the future as interest burden will increase. Large deficits will also lead to depreciation of currency.
Imposes discipline on domestic macro economic policy making. Monetary policy must work within the constraints of uncovered interest rate regime must be in tandem with what is happening and cannot be arbitrary.

Right now the country’s capacity to attract foreign capital is substantial. Once the capital account is convertible then the monetory policy, interest rate policy, fiscal policy must converge to international standards a there cannot be any undue restriction on flow of money.
What is the governmen’t attitude to the issue? 1) We must be able to follow our own monetory policy. 2)We must have exchange rate stability 3)Our currency, financial markets should be reasonably linked to foreign markets. But the fact is that a country cannot enjoy all three of them, only two. For eg. If you want freedom with monetary policy and foreign market linkages then exchange rate will not be quite stable. If you want stable exchange rates and linkage with rest of the world, the country cannot have an independent monetary policy. So current account deficits puts restrictions on the ability of government to run independent policies.

Financial markets will become volatile with interest rates, exchange rates fluctuating every minute. Banks, companies, individuals will have to learn to live with it. Financial derivatives have been evolved to manage these volatilities. Financial products to hedge the risks have to be in place.
When foreign capital flows freely in the country in times of a political or economic crisis it can be taken back as freely by investors. In crisis times, every investor is not rational. They follow a herd mentality. The remedy for this is prudent economic management, prudent political management, but keeping political capital out is not the answer.
We have partial capital mobility? At present there are NRI, FCNR bank accounts and FII investments coming in. Will capital account convertibility bring more of those? No according to Jagdish Bhagavati. In China controls on capital and current account has not affected the flow of FDI. Why don’t we selectively open up sectors for foreign investors as China. Some say it is our labor laws and lack of infrastructure that is keeping foreign investment away and not capital controls.
In the case of exchange rate, many countries have tied their currency to the US $ at fixed rate of exchange. Argentina, Hongkong, and China have done that. We have a market determined rate. Exchange rate will be fixed between $ and Rs by a Currency Board, a controversy that is yet to be settled. Many economists say if you want to have a stable current account what is required is a fixed exchange rate.
In capital account convertibility regime, the risk of contagion of inevitable. If some thing goes wrong in Pakistan then investors panic and get away from India even if India is doing well. They might take the view that the entire South Asia is unsafe. This is what happened in the East Asian Crisis. South Korea and Malaysia were doing fine unlike Thailand but investors panicked and withdrew from all similar countries.
Nobody can guarantee that even if inflation rates are moderate, budget deficits are low, current account deficit is low, then no crisis will occur. If neighbouring countries are not performing well, then investors might panic about a similar situation occurring in India.

Investors in developed countries do not distinguish between well-managed strong emerging economies and ill-managed weak economies. For them all emerging economies are emerging economies. South Korea and Malaysia were doing fine but when things went wrong in Thailand and Indonesia investors withdrew from all the places.

Before we move to a full current account convertibility we need to have other pre-requisites. Government must bring down fiscal deficit, RBI should be given full control of monetary policy. RBI cannot be under the rule of Finance Ministry. RBI Governor should have full freedom to determine interest rates and cash reserve ratio. In developed countries, the Central Bank has full autonomy. In the US, the President cannot tell the Central Bank what to do with monetary policy. President cannot impeach the Central Bank Governor and he can be removed only if a fraud has been committed. So India also needs to have monetary authority full independent of the government.

Inflation rates are modes-4 percent to five percent. Our current account deficit at the worst of times has not been more than 2.5 to 3 percent of GDP. Foreign exchange reserves are more than adequate.

Our banking system is not fully in good shape especially with regard to non-performing assets. Some nationalized banks have huge NPA’s and they also face competition from foreign and domestic private banks. Some of the weaker nationalized banks may have to be bailed out by government. Financial regulation is fairly good under RBI and SEBI. Sometimes they control too much, they should actually control less. The Exchange Control Manual is voluminous one and I wonder whether bankers themselves have read it fully. For eg. Forward foreign exchange contracts that were once allowed freely have been restricted to either importers or exporters and sometimes as in 1998, RBI said cancelled contracts cannot be recouped.

Somehow, RBI is under the impression that Indian companies do not know what to do with the facilities. On the other hand, RBI should spread knowledge about indulging in foreign exchange dealing and their negative consequences if something goes wrong. Company managements are responsible to their shareholders and therefore it can be assumed that they would not indulge in dealings that could result in a loss.

The banking sector is opening up in the country, the statutory liquidity ratio requirements have been done away with. Therefore, most of the pre-conditions for current account convertibility are present in Indian economy.

Now we have to over come the fear about a Thailand or Indonesia-like crisis occurring here. Nobody can give a 100 percent assurance that it will not happen. Our experience with foreign investments by and large has been good. Economy is dong well and we have the capacity to absorb large amounts of foreign capital.

Critics of full convertibility argue that there are other ways of attracting foreign capital than implementing full convertibility. If labor laws are reformed, improvements in infrastructure are made then FDI will automatically flow in. Therefore, don’t open up financial markets.