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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

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