The Hindu Business Line : Capital account revisited

Full convertibility will put in place enabling conditions for Indian corporates and banks to be more effective players in the global scene. But the Tarapore Committee (II) will have to assess the risks to the economy in the light of the emerging current account deficit and the increasing play of hedge funds in the Indian market, says S. VENKITARAMANAN.

I was privileged to be present when the Prime Minister, Dr Manmohan Singh, made his historic announcement that India would take a step forward towards introduction of capital account convertibility. He was addressing an invited audience at the RBI, where he inaugurated the Centre for Financial Learning.

His announcement seemed to take the audience by surprise as Parliament is in session and the Prime Minister is very sensitive to Parliamentary conventions. But he had a point in announcing the decision to formulate a roadmap towards CAC (capital account convertibility), which is not the same thing as announcing a decision to introduce CAC. Perhaps, it was appropriate that he did so in the presence of both the Governor, RBI, and the Finance Minister, Mr P. Chidambaram, who have both to be on board the journey towards the declared destination. He continued with a nudge in favour of making Mumbai a global financial centre, for which CAC will be an important precondition.

Another precondition he mentioned was appropriate in view of the presence of the Maharashtra Chief Minister, Mr Vilas Rao Deshmukh, and the State's Governor, Mr S. M. Krishna. This was about the need to fit the infrastructure of Mumbai to help it achieve its dream role as India's Shanghai or, shall we say, Hong Kong.

There have been a number of enquiries about why the decision is being taken now when, nearly eight years ago, the first Tarapore Committee had come out with a report on capital account convertibility.

Preconditions of first report

It laid down certain preconditions, such as attainment of fiscal deficit norms, financial sector improvements, level of forex reserves and a defined inflation target to be set by Parliament. Although some of these preconditions have been almost attained, it seems difficult to realise some others, such as a legislatively determined inflation target, especially in the light of globally volatile crude prices.

The purpose of these conditions was obviously to make India's macroeconomic situation stable enough to meet the vulnerabilities endemic to a free forex regime, which CAC implies.

While conservative fiscal targets per se make sense, it does not seem particularly clear how fiscal performance and capital account flexibility are interrelated. The US, for instance, has a higher than normal fiscal deficit, but has capital account convertibility. What seems more relevant is that the Government should not be borrowing in the external markets nor lend its support to domestic banks and other financial entities raising short-term funds abroad beyond a prescribed limit. The sizeable forex reserves that India now has are well above the Tarapore Committee's indicated limit of $22 billion. On another basis, reflecting the debt service payments, the same report mentioned a figure of $24 billion. On yet another basis, relating the required level of reserves to the level of short-term debt stock and portfolio investments, the Committee mentioned a figure of $31 billion. These are among the number of alternative formulations used by the Committee to define the adequacy of forex reserves the country should have to meet the possible risks from CAC.

Fortunately, India today has a level of reserves well in excess of all these recommendations of the Tarapore Committee.

Let us now look at the current account deficit. The Tarapore Committee had introduced a slightly different concept, namely the ratio of current receipts to GDP which, in its view, is more relevant than the ratio of current account deficit to GDP. This downgrading of the importance of current account deficit is puzzling.

It is, in fact, the size of the current account deficit that determines how much, in the form of debt or non-debt liabilities, the country has to incur to meet the gap. Current receipts may be higher, but if current outgos, such as imports, are much higher, their rising ratio is irrelevant. In any event, the Committee seems to have been rather restrained in its estimate of how much India's current account deficit would rise post-liberalisation.

On this count, the Committee's recommendations of a current account deficit of 2-3 per cent as the pre-requirement do not seem to have been met. But it views favourably the decline in the debt service ratio as a necessary concomitant of sustainable balance of payments. This seems to have been improved in recent years. The rising current account deficit does, however, cause concern.

I am citing some of the conditions prescribed by the Tarapore Committee only to emphasise the fact that the macroeconomic scene is continually changing and it is time to review it. It is appropriate that the Government has asked the RBI to set up another Committee under Dr S. S. Tarapore's chairmanship to lay out the roadmap for capital account convertibility.

The Committee has its task cut out, especially in the light of the doctrinal debate that followed the East Asian crisis, which was blamed by some observers on the introduction of capital account convertibility at a premature stage. The Asian crisis gives further cross-country experience to guide the Tarapore Committee (II) in its further deliberations. The Prime Minister's announcement has raised expectations of a radical change in the financial sector with the coming of CAC, expected to be ushered in following the Tarapore Committee (II)'s roadmap. But we are already well on the way to capital account convertibility with the relaxation of limits on foreign investments by Indian residents in the recent period.

Enabling competitiveness

So far as the corporate issue of equity and debt abroad is concerned, there are a lot of relaxations. All that full convertibility will mean is that even the limited permissions that corporates and individuals need to get to acquire financial and other capital assets abroad will be removed.

The Tarapore Committee (II) has also to examine how the Chinese are handling their integration into the global economy without introducing full capital account convertibility. Their fiscal situation is better, their reserves much higher than India's on every dimension and their current account in significant surplus. There must be some rationale for their resisting the blandishments of the global financial community to embark on full capital account convertibility.

Perhaps, they are afraid that their porous borders with the Hong Kong SAR will result in substantial transfers of Chinese deposits abroad. Anyway, the Chinese experience is worth detailed investigation by the Tarapore Committee (II).

The coming of capital account convertibility is a process, not a "once for all" event. It is also significant that while it does not immediately change the working conditions of the average citizen, it brings into being certain enabling conditions for Indian corporates and banks to be more effective players in the global scene.

The consequent risks to the economy as a result of CAC have to be assessed in the light of the emerging current account deficit and the play of hedge funds on an increasing scale in the Indian market. The roadmap drawn up by Tarapore Committee (II) will, no doubt, take into account these aspects of vulnerability when making its recommendations on the introduction of CAC for India.

More Stories on : Forex | Insight | Financial Policy

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Dhaka-New Delhi ties going nowhere

REGULATOR IN THE PIPELINE

Capital account revisited

Nehru and election

Vitality hiring — who gains and who doesn't?

`I am focussing on structural issues in specific sectors'