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Don't rush into full convertibility
ARVIND PANAGARIYA AND PURBA MUKERJI
Tarapore Committee-II on capital account convertibility is due to table its report on July 31, 2006. Tarapore Committee-I, also appointed at the urging of Mr P Chidambaram during his first tenure as the finance minister, had recommended full convertibility within three years, ending 1999-2000 with specific goal posts adopted. The Asian financial crisis sealed the fate of that recommendation but the FM has once again revived the issue.
We offer five reasons why India should not rush into convertibility. First, as Prof Jagdish Bhagwati forcefully argued in his celebrated 1998 article: The Capital Myth: The Difference between Trade in Widgets and Dollars, persuasive empirical evidence on the benefits of full convertibility is lacking. Recent research by one of us (Mukerji) shows that for countries with well-developed financial markets and stable macroeconomic environment, convertibility offers small positive growth effects.
But for countries with weak financial sectors and macroeconomic vulnerabilities, convertibility leads to greater instability in growth without dividend in terms of higher average rates. But even this and related research does not distinguish between limited convertibility in terms of openness to trade and foreign direct and portfolio investment and full-fledged convertibility. Therefore, we have no evidence showing positive benefits from a move from the limited to full convertibility, which is the question facing India today.
Second, on the fiscal front, India remains far from ideal conditions for convertibility. The average growth rate of almost 8% during 2003-04 to 2005-06 has led to increased tax revenues and some reduction in the deficit but not nearly enough. Moreover, we can scarcely be sure that the deficit will not return to the higher level if the GDP growth rate and therefore tax revenue growth revert to the previous trend as happened after 1996-97.
With interest payments on the debt amounting to more than 6% of the GDP, gross fiscal deficit of 8% and debt-to-GDP ratio of more than 90%, convertibility is bound to leave India vulnerable to a crisis. One hazard is that the government itself would be tempted to turn to lower-interest short-term external debt to finance its deficits and debt. Third, the financial sector is still insufficiently developed in India. Banks are predominantly in the public sector and credit markets relatively shallow. Insurance has barely been opened to the private sector with the foreign investment in it capped at 26%.
The debt and equity markets are thin and dominated by public sector FIs and FIIs. Because the Indian debt and equity markets are tiny in relation to the worldwide stakes of the FIIs, any time the latter begin to exit the Indian market, the financial markets go into turmoil. Because few FIIs have the incentive to carefully gather detailed information on the future profitability of various firms, such exits are characterised by herd behaviour.
Fourth, India is still far from fully integrated on the trade front. For this reason, ensuring a competitive exchange rate is a high priority. A move to the capital-account convertibility is bound to bring more capital inflows initially and force an appreciation of the rupee.
If the appreciation ends up being large and persistent, it could put trade integration into jeopardy. Furthermore, even if the appreciation is only temporary, convertibility could hurt export growth by making the real exchange rate more volatile.
Finally, the embrace of full capital-account convertibility can place the ongoing reforms in other areas at grave risk. In the Indian political environment, building a consensus for even most straightforward reforms such as privatisation and trade liberalisation is an uphill task. Therefore, if capital account convertibility were to culminate in a crisis or even create greater volatility in growth, the cause of reforms would be set back.
The advocates of speedy convertibility sometimes make two counter arguments. First, the adoption of convertibility will speed up the reform, especially in the financial sector. For instance, giving individuals and firms access to the global markets may bring pressure on the domestic banks to become more competitive. Likewise, the possibility of a crisis may force the government to act more urgently on fiscal deficits and debt.
While these outcomes can indeed follow the embrace of convertibility, the opposite can also happen. Both the government and the firms will be tempted to quickly proceed to accumulate short-term external debt and rapidly move the economy towards a crisis.
he question is largely empirical. On balance, the weight of the empirical evidence favours erring on the side of caution: whereas the countries that ended up in a crisis following the premature adoption of convertibility are many, those that reformed more speedily and smoothly on account of the premature embrace of convertibility are few.
The second argument in favour of moving rapidly to convertibility is that this will help India turn into a major financial centre in Asia. Given its vast pool of skilled labour force and rapidly developing information technology industry, India certainly has the potential to become such a centre. It is also true that full convertibility is a necessary condition for becoming a hub of financial activity. Yet, the argument is misleading.
Currently, the financial sector in India is heavily dominated by the public sector, which account for 70% of its assets. It is implausible that India would turn into a major financial centre in Asia without the reforms that give primacy to private sector in the financial markets. It is even more implausible that the government will relinquish its control of the financial markets overnight - just calculate the prospects of bank privatisation!
Though India must eventually adopt full convertibility, which is a defining characteristic of all mature modern economies, our arguments lean against the kind of approach the Tarapore Committee I recommended. We should instead stay the course on reforms including increasing the role of the private sector in financial markets without committing to a specific timetable for convertibility.Economic Times JULY 26, 2006