Dangers of full convertibility

The call to revisit Capital Account Convertibility at a time when the country's rich are sitting pretty, seems to be driven by some other objective.

INDIA should revisit the issue of "capital account convertibility" (CAC) of the rupee that first surfaced in the mid-1990s, Prime Minister Manmohan Singh said in Mumbai in early March. Immediately after it first surfaced in the form of the Tarapore Committee Report, the South-East Asian crisis of 1997, which afflicted Asian countries with more open capital accounts but left untouched countries like China and India with restrictions on cross-border capital account transactions, had put paid to that idea. The situation has changed substantially since then, according to the Prime Minister, with high growth, low inflation and large foreign exchange reserves warranting a rethink on the issue.

Taking its cue from there, the Reserve Bank of India (RBI) has constituted a committee to draw up a new road map to convertibility, with former RBI Deputy Governor S.S. Tarapore, a CAC votary, at the helm, and a majority of members who favour such a transition. Moreover, Finance Minister P. Chidambaram has decided to launch a campaign in support of the move to full convertibility, even publicly admonishing unnamed RBI officers who have reservations on the issue.

What does CAC in the current Indian context signify? The phrase, we must not forget, is largely descriptive. Convertibility on the capital account does not exist if there is a ban either on residents converting rupees into foreign exchange for investment in real or financial assets (termed capital as opposed to current account transactions), or on foreigners converting foreign exchange into rupees for similar purposes. A country is characterised as having partial convertibility on the capital account if there are restrictions on either residents or foreigners converting currency for the above-mentioned transactions but no ban on at least one side resorting to such conversion.

It needs to be noted that having the right to convert currency for acquisition of assets or investment abroad does not imply that any and every kind of investment can actually be undertaken. That depends on the foreign investment rules relating to the specific sector in the country in which investment is being contemplated. Many countries with convertible currencies have strong restrictions on foreigners acquiring real estate for personal use or investing in the media, for example.

Seen in this light, the distinction between countries that have or do not have CAC is meaningless. For example, there is virtually no country now where foreign investment, or the conversion of foreign currency into domestic currency by foreigners for acquisition of assets, is not permitted. In fact, in most not only are such acquisitions possible, but post-acquisition returns from those assets earned in local currency can be "converted" and repatriated or those assets can be sold and the proceeds repatriated abroad as foreign currency. This is possible in India too, though, as elsewhere, there are some restrictions on the sectors in which this is possible and norms on the maximum share of equity that can be acquired in single firms in individual sectors. But there are no restrictions on the aggregate amount of foreign currency that can be brought into the country by a single entity for investment purposes.

Capital account convertibility is partial in India because there are ceilings on the amount of foreign exchange that can be purchased by residents or firms registered in the country for acquisition of assets abroad. Under FEMA (Foreign Exchange Management Act) Regulations, for some time now resident corporates have been allowed to invest overseas up to 100 per cent of their net worth or $100 million in an overseas joint venture or wholly owned subsidiary. (The figure was $10 million in the case of registered partnership firms.) This ceiling was adjusted in 2004 to allow resident corporates and registered partnership firms to invest up to 100 per cent of their net worth in overseas ventures without any separate monetary ceiling. Further, for a few years, individual Indian residents were allowed to open accounts abroad and transfer into them up to $ 25,000 a year to be used for any purpose whatsoever.

In the circumstance, the move to fuller or full convertibility only implies that domestic residents and domestic entities would be allowed to convert any amount of rupees into foreign currency for investment purposes. Whether they can actually make the investment they want to would depend on the laws that prevail in their target country.

What are the benefits that can come from such a shift? Principally, it would allow the wealthy in India to widen their portfolio of assets, to benefit from differentials in financial returns and hedge against the risk associated with investing in assets in a single country. A host of factors result in an ambience in post-colonial societies like India where wealth-holders have more confidence in foreign assets than in national ones. Thus, further liberalisation is bound to result in some capital flight from the country.

The problem is that the process may not lead to a new "equilibrium" in terms of the distribution of domestic wealth-holding between domestic and foreign assets. This is because perceptions of the relative returns from and the relative risks of investing in foreign assets vis-a-vis holding wealth in India would determine the extent of outflow of capital once such convertibility is permitted. Such perceptions tend to change rapidly and are biased in favour of investment abroad.

The dangers of opening doors on this front are clear from the experience of a number of developing countries, especially in Latin America. The exit of resident rather than foreign capital was responsible for balance of payments and currency crises there. If any set of factors, domestic or external, generates the expectation that the domestic currency (say, the rupee) might depreciate, the exit from domestic assets would be far greater than in a situation where only foreign investors have the right to opt out. This could happen, for example, if the trade and current account deficits widen because of an increase in oil prices, as is happening now. The resulting outflow could lead to expectations being realised, in the form of an actual depreciation of the rupee, which can result in capital flight. This is only one of the many dangers, though an important one, that full CAC would open the country too.

Advocates of CAC argue, of course, that there is no need for such lack of self-confidence given India's recent economic performance. But the experience of the "miracle" countries of South-East Asia during the late 1990s indicates that economic strength, economic performance and even better macroeconomic indicators may not insulate countries against financial fragility. The case for caution cannot, therefore, be dismissed as reflecting a lack of confidence.

Given this prospect, unless full CAC is going to deliver something that India currently lacks, there is no need to even consider it. It is argued that the move to full CAC may increase the confidence of foreign investors and result in more foreign capital inflow into the country. The point is, India today is receiving more capital that it can absorb, forcing the RBI to purchase foreign currency and invest it in liquid foreign assets that offer a far lower return than what is garnered by the investors who brought that currency in. But this, CAC votaries argue, is foreign portfolio investment and not foreign direct investment (FDI), which is what the country needs. The obvious response to this is that China, which receives the largest share of aggregate FDI flows to developing countries, is no paragon of openness on the capital account.

In short, the call to revisit CAC at a time when the country's rich are sitting pretty, seems to be driven by some other objective. It could, for example, be that domestic financial investors are sensing that the ongoing unprecedented and irrational stock market boom is bound to go bust. That would result in financial and real asset deflation that could make paupers out of princes. But if wealth-holders have the option to sell out and leave, they may be able to escape that outcome. The government may be giving in to pressure and paving the way for the very rich to exit leaving the rest of us with bales of worthless paper.