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For once, the 'Left' is 'Right'!

Sep 6, 2006

India is truly called one possessing a unique advantage of 'unity in diversity'. While this factor is a cause of strength for a democracy, it becomes a hindrance when there is too much diversity and too little unity in terms of thoughts of policymakers who have a whimsical attitude towards running this country and, at many times, its economy. One recent examples of this diversity of thoughts among policymakers is with respect to the road to 'fuller' convertibility of the Indian rupee, also known as capital account convertibility, or simply CAC.The road to convertibility in India has been a calculated and gradual transition path that began in the early 1990s when the Rangarajan committee, on Balance of Payments, recommended the introduction of a market-determined exchange rate regime. To begin with, India achieved the current account convertibility in August 1994 by accepting Article VIII of the Articles of Agreement of the International Monetary Fund.

Then, the Tarapore Committee, which was set up in May 1997, chalked out a three-stage process to achieve full convertibility. This process was, however, to be completed by 1999-2000. The committee had indicated certain signposts to be achieved for the introduction of capital account convertibility. The three most important of them were: fiscal consolidation, a mandated inflation target and strengthening of the financial system. Some of the key recommendations of the committee and the actual performance as at the end of 2005-06 are enlisted in the table below.

Tarapore report 1997: Targets Vs Performance
 Targets for 1999-2000Position in 2005-06
Gross fiscal deficit of the Centre (as % of GDP)3.5 4.1
Inflation rate 3.0 - 5.0* 4.6 #
Gross NPA's (as % of total advances)5.0 5.2 $
Average effective CRR of the banking system (%)3.0 5.0
* Average for 1996-97 to 1999-00; # Average for 2002-03 to 2005-06; $ 2004-05 figure

Importantly, the point to note is that none of the core conditions of the Tarapore committee have been met even till 2005-06 (see table above). However, the RBI has now released another report from the Tarapore Committee, which aims at a fuller capital account convertibility over a period of next 5 years in three phases - 2006-07 (Phase 1), 2007-09 (Phase 2) and 2009-11 (Phase 3).

Now, unlike last time (1997), the issue is that the finance ministry and the Reserve Bank of India (RBI) are at loggerheads over the committee's latest recommendations. Even the Left has a view on it, although it seems to be on the 'right' side this time! The Left's opposition to the Tarapore committee's latest recommendations stem from the government's inability to put its house in order as required by the recommendations outlined in the 1997 report.

It is, in fact, right in stating that the "Tarapore Committee has failed to draw the most important lesson from the spate of currency crises faced by several developing countries over the past one decade. The common feature of all the crisis-afflicted countries was their liberalised capital account. India could avoid such a predicament precisely because of the capital controls, much of which has survived till date despite the recommendations to remove them by the first Tarapore Committee of 1997." While the fact that India has miniscule foreign capital inflows in time of the Asian currency crisis of 1997, is one major reason why we were successful in avoiding the contagion, the fact that our capital account was not fully convertible during that period was also an important reason for our economic survival (full marks to the Left on this argument!). As such, while currencies like the Indonesian Rupiah, Korean Won and the Philippine Peso depreciated by 70%, 32% and 28% respectively against the US Dollar in 1998, the Indian Rupee declined by a much sober 12%.

In its statement to Politburo members, the Left has also indicated that the "nature of capital inflows into India in the recent past is a cause of serious concern." It cites the latest RBI Report on Foreign Exchange Reserves, which shows that the ratio of short-term debt to foreign exchange reserves has increased from 4.2% at the end of March 2004 to 7.0% at the end of March 2006 (see adjacent chart). Also, as reported by the RBI, the ratio of volatile capital flows (which includes cumulative portfolio inflows and short-term debt) to reserves has increased from 35.2% at the end of March 2004 to 43.2% at the end of March 2006. We believe that this is concerning, as while these short-term and portfolio investments do not contribute meaningfully to economic growth, when coming in large numbers, they have the tendency to create a bubble-like situation in the economy and its asset markets (remember the recent equity crash of May and June 2006?).

One of the major points of differentiation between the finance ministry and the Tarapore committee report relates to the 'sanctity' participatory notes (or P-Notes)**. The committee is of the view that Foreign Institutional Investors (FIIs) should be prohibited from investing fresh money raised through P-Notes. Also, existing P-Notes holders may be provided an exit route and phased out completely within a year's time. The basis for this recommendation is that "in case of P-Notes, the nature of the beneficial ownership or the identity is not known unlike in the case of FIIs. These P-Notes are freely transferable and trading of these instruments makes it all the more difficult to know the identity of the owner."

Now, on the contrary, the finance ministry is of the view that since over 40% of foreign portfolio investments (FII) in India come through P-Notes, it will not be a right option to do 'anything that upsets the applecart'. And this is the reason that the ministry has 'ordered' a status quo P-Notes, reversing the Tarapore committee's latest recommendations.

What's our view?
Apart from the long-term benefits that CAC shall provide to investors in India, it should be noted that, if there is a financial contagion, an open capital account has the ability to throw the financial system into a state of mess. This is on the back of a financial system's 'unholy trinity', according to which a country may not simultaneously have an open capital account, a fixed exchange rate and an independent domestic monetary policy. Instead, domestic macroeconomic management becomes hostage to the need to manage foreign capital flows. This might require the central bank to raise interest rates (and consequently dampen domestic credit offtake) when private capital is expected to exit the country, even for reasons that are entirely external to the domestic economy, such as a rise in interest rates elsewhere in the world.

International experience shows that the more open the country's capital account and the more volatile the capital flows in the global economy, the more binding is the constraint on national policymakers (see what happened with policymakers in Southeast Asian countries in the 1997 financial crisis as currencies collapsed on the back of massive capital outflows). The impossibility of this trinity stems from the fact that if CAC is accepted, according to theory, you either have the choice of giving up monetary independence or giving up the stable currency objective and letting the exchange rate float freely so that monetary policy can then be directed to inflation control.

Despite all these issues, we still believe that a move towards full convertibility on the capital account is a step in the right direction towards aligning with the globalisation mantra that we have practiced so closely. But, once full convertibility is achieved, investors in all asset classes (debt, equity, real estate) might have to bear additional bouts of volatility as the Indian currency will then be more aligned to the world financial markets and thus be more prone to 'jerks' in the global system.

** P-Notes are derivative instruments that investors not registered in India or Mauritius use to trade in Indian markets. These investors place their order through brokerage houses that have Mauritius-based FII accounts. The brokerage houses then repatriate the dividends and capital gains back to these entities. In this case, the broker acts like an exchange. It executes the trade and uses its internal accounts to settle the trade. They keep the investor's name anonymous. That is why capital market regulators (Securities and Exchange Board of India (SEBI)) dislike P-notes. (Source: Businessworld)


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