Full convertibility: Must we have it?

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Should India embrace full capital account convertibility in the near future? And was Prime Minister Mahathir of Malaysia wise to reintroduce controls in the wake of a crisis? The answers to these questions are asymmetric: while India is well advised to wait before entering the world of convertibility, Mahathir was ill advised to exit it.

Why should those of us who support free trade be hesitant to support free currency convertibility? The answer is provided by Professor Jagdish Bhagwati of Columbia University in an article provo-catively titled ``The capital myth: the difference between trade in widgets and dollars''. Writing in the May/June, 1998 issue of Foreign Affairs, Bhagwati argues that while free trade has been shown to generate net positive benefits, evidence of similar gains from free capital mobility has simply not been provided.

There is a tendency on the part of many to present capital mobility as an all or nothing choice. Yet, many forms of capital flows can and do take place without free currency convertibility. The Resurgent India Bonds, foreign direct investment (FDI) and investments by Foreign Institutional Investors are but a few examples.

The case against moving from this partial mobility to full convertibility is based on two premises. First, most of the benefits of capital mobility can be reaped via partial mobility, principally equity and direct foreign investment.

And second, full convertibility invariably brings with it enhanced risk of the ``twin crises'', one in the currency market and the other in the banking sector. China's experience since mid-1980s provides support for the first of these premises.

To date, China does not enjoy even current account convertibility, let alone capital account convertibility. Yet, attracted by its macroeconomic stability and high rates of return on investment, foreign investors have flocked to the country.

According to the Asian Development Bank, today, China ranks first among developing countries and second among all countries in terms of FDI. During 1993-96, 38 to 40 per cent of the FDI into developing countries went to China. In 1996, the absolute level of this investment was $46 billion.

In the same ear, the total private capital inflow into the country was twice that received by its nearest developing-country rival, South Korea. Admittedly, under currency convertibility, these capital inflows would have been even larger.

But how much larger and at what cost? Given China's already high share in the inflows to developing countries and the presence of competing destinations, the additional flows would have been of second order importance. And given the ongoing financial crises, the cost of convertibility would have been very large.

Regarding the second premise, an opposing view is that currency crises can be largely avoided by adopting flexible exchange. Surjit Bhalla (Economic Times September 14) in effect argues that the crises in east and south-east Asian economies could have been avoided had these economies been on flexible exchange rates.

Under this scenario, the local currency would have appreciated with capital inflows, the return on future inflows would have declined and the volume of capital inflows would have been automatically arrested before reaching crisis proportions. Admittedly, the logic underlying this argument has an important policy implication: if a country must embrace capital-account convertibility, on balance, it is better off opting for flexible exchange rates.

Fixed rates seem to be inherently incompatible with freely flowing capital. It is not altogether implausible to suggest that the Bretton Woods system, conceived at a time when capital flows were negligible and designed primarily to facilitate trade in goods, broke down under pressures generated by increased capital mobility subsequently.

That said, it will be a mistake to conclude that flexible exchange rates eliminate the risk of currency and banking crises. Just because a price is determined in the market does not mean that it cannot be subject to precipitous movements.

No price is more flexible than the stock price and yet no market is more susceptible to a crash than the stock market. Crisis-proportion movements in the flexible exchange rate are also not unusual. As recently as this month, between October 1 and 8, the dollar depreciated against the yen by 20 per cent! Within last one year, the floating Mexican peso has slid down more than 30 per cent.

A negative side effect of flexible exchange rates is that the appreciation of the currency, resulting from capital inflows, has an adverse effect on the competitiveness of the country's exports. This was perhaps a key reason why the countries in east and southeast Asia opted for fixed exchange rates. To the extent that exports affect growth, under flexible rates, the countries would have had to sacrifice real income.

Flexible exchange rates also do not rule out banking crises which result from capital mobility. This is especially true when banking sector is itself vulnerable as in India. There is a general agreement among specialists that capital mobility played a crucial role in triggering the banking crisis in Japan. According to a highly simplified account provided by Professor David Weinstein of the University of Michigan, in the late seventies and early eighties, via complex regulations, Japanese banks were effectively allowed to function as a cartel.

The banks, in turn, helped many inefficient firms stay afloat through a ``cash-flow insurance'' whose burden fell on the larger, more profitable firms. Liberalisation by Japan in early 1980s led the larger, profitable firms to defect in a big way to the Euro-dollar market.

That left the domestic banks with less profitable firms as their only borrowers. Seeking more profitable investments, the banks turned to the real estate market and East Asia. The rest, as we all know, is history.

The lesson to be derived from the Japanese and similar other experiences is that, unlike the goods markets, the liberalisation of financial markets is a complex affair. Before we embark upon full currency convertibility, it is advisable to at least get our banking sector on its feet. Otherwise, we risk currency and banking crises and with them the risk of administering a serious setback to the more urgent reforms. It may be sobering to recall that some of the European countries such as Portugal, Spain and Ireland did not opt for capital account convertibility until late 1980s or early 1990s.

In spite of these arguments against introducing capital-account convertibility in India, why was Malaysia's decision to introduce capital controls ill conceived? The answer is that having already been on convertibility for some years, Malaysia faces a situation quite different from that of India.

Its problems were twofold: persuading the departed capital to return and encouraging the capital still within its borders not to depart.

The controls have given exactly the wrong message to the departed capital: if you return, there may be no exit doors for you.

As for the capital that remains within Malaysia, any success in controlling it will be short-lived. Professor Carmen Reinhart of the University of Maryland has carefully studied the episodes in which countries having been on convertibility for some time tried to combat capital outflows by re-introducing capital controls (Spain in 1992, Chile in 1991, an Brazil and Malaysia in 1994).

Her conclusion is that the success of such controls in stemming outflows is temporary.

Having once been there, the residents and banks seem to be quickly able to devise channels that circumvent the controls. The bottom line is that convertibility is a one-way street. Or as Bhagwati quips, having once entered the Mafia underworld, if you want out, you leave in a coffin.

Economic Times, October 26, 1998