Towards Capital Account Convertibility

Though timing and phasing of Capital account convertibility (KAC) may involve micro issues, KAC is in essence a macro-economic issue. It relates basically to the gap between domestic Saving and Domestic Investment. Almost by definition a Developing country like India is characterised by an excess of the latter over the former. This has two important implications; a) macro-economic equilibrium in India will be characterised by net inflow of capital, b) any effective constraint on outflows results in a corresponding reduction in gross inflows and higher domestic interest rates. I therefore predict that a complete opening of the capital account (convertibility) in India will result in increased net inflows and a reduction in the real interest rate/cost of capital.
One of the few areas in which the “level playing field” argument has some validity is with respect to restricted access of Indian firms to international capital at international rates. Capital account convertibility will ensure that this source of competitive disadvantage for Indian industry is removed. The cost and availability of risk capital (both equity and long term debt) will improve. This will benefit not only large firms and exporters with direct access to world markets, but also (in due course) Infrastructure developers, Venture capitalists, and individuals with innovative ideas. A completely level playing field requires complete removal of restrictions on borrowing abroad by Indian producers. Foreign inflows may however continue to be restricted into specified short term assets like bank deposits.
As in many other similarly placed countries, KAC is likely to increase the reverse flow of flight capital into India. This forecast is contrary to popular perception that the chief danger from KAC is of potentially large outflows of flight capital. A recent, much quoted paper purporting to show large capital outflows (including over invoicing of aircraft imports) is dangerously misleading. The reduction in NRI deposits and the increased remittances accompanying current account convertibility point in the opposite direction.
The increased capital inflows which are likely to follow KAC will create upward pressure on the rupee and lead to some real appreciation(adversely affecting exports). This problem can only be minimised by removing remaining import restrictions and rapidly freeing export of capital. Fears about exchange rate volatility are highly exaggerated. Cross-country comparison suggests that in a period without KAC( last 3-4 years) the rupee(real exchange rate) volatility was one of the highest. KAC by itself need not lead to higher volatility, though the policy instruments for damping volatility may be more circumscribed. This problem can be handled (during transition) through limits on borrowing by financial companies, banks and large companies for purchase of FE, as individual capital flows will not be significant contributers to volatility. Competitive pressure on banks will intensify and certain policies such as directed credit may have to be overhauled to protect the weakest banks.
In my experience, ex-ante the time is seldom “ripe” for a bold policy reform, ex-post everybody sees it as an obvious next step. If one is convinced about the usefulness and importance of a reform, risk minimising phasing can be devised. This was demonstrated by the 1992 move to partial convertibility.
There are no absolute pre-requisites. Policy reforms should, however, be accelerated to minimise risk (e.g. political) and macro-management difficulties. The Centre & States’ primary deficit must move to zero, the fiscal down trend be maintained, and tax reforms completed. Operational controls on banks must be removed to provide flexibility and access to skilled manpower. The laws must be changed to allow new instruments such as futures & forwards and securitised debt so that economic agents can hedge their risk.