Wednesday, February 20, 2002

Capital Account Convertibility: Looking Back and Ahead- Lessons from the Asian Crises

IntroductionThe Asian crises has come and gone. The period in which forecasts of its negative effects were continuously revised upwards was followed by constant downward revision of these effects. The current consensus is that, even though the initial severity of the crisis was surprising (given that it occurred in economies thought to be “miracles”) the recovery was as quick as in other previous crisis. As in the case of our own BOP crisis of 1991 the “Asian crisis” was due to a mix of underlying Structural Problems, increasing Macro-economic Imbalances and Triggering Factors or Events. In a few countries like S. Korea recovery has been as fast as (or faster than) in India, while in others like Indonesia it is likely to be much slower. The speed of recovery has depended on the vigor with which some of the critical structural and macro problems have been tackled. Both the problems and the solutions are by now reasonably well understood.
It is therefore time to put aside some of the irrational fears unleashed by the “Asian Crisis” and resume the process of moving towards capital account convertibility. As has been our practice so far, this should be done with “all deliberate speed,” that is at a speed which is reasonably fast but does not involve excessive risks.
Lessons from Crises: Old & New
Though the Asian crisis has come and gone, the processes of separating the right lessons from the wrong ones, is not complete. More important, the lessons for the crisis countries may differ in important respects from those for India. It is necessary to be clear about the lessons for India, before we start applying them to the issue of Capital Account Convertibility for India.
We had already learned several lessons from our own crisis of 1991 and the Latin American crisis of the previous decade. The Eighth Plan working group on Balance of Payments (1989) had analysed India’s debt profile and suggested two fundamental changes:
a) A decrease in the ratio of short term to total debt as the former was dangerously high.
b) A strong effort to attract Direct Foreign Investment so as to decrease the external debt-equity ratio of the country.
A Planning Commission paper [1989] showed that the Fiscal Deficit had risen in tandem with the current account deficit. It subsequently became clear that the former was a major cause of the latter and several government economists were internally warning about the dangerously rising Fiscal Deficit (before the crisis).
The fixed overvalued exchange rate was also recognised as a major cause of the sharp rise in the current account deficit and the 1991 crisis. Opening of the current account over the next two years was therefore accompanied by a flexible exchange rate policy. Post-crisis it was also recognised that the regulatory system for banks as well as stock markets had to be modernised and strengthened. Efforts in this direction started in 1992 and have continued steadily (though not very fast in some sub-sectors) since then [PC working paper 2001/4].
The Asian crisis did reinforce (and make widely known) the importance of flexible exchange rates and Banking de-control & regulatory reform. It is now more widely recognised that the banking regulations have to be brought up to international standards.
There were, also, a few more specific lessons, which are of relevance to our move toward capital account convertibility. In each of the affected Asian countries the crisis lasted about a year and recovery has taken place in two to three years after onset. Even in Indonesia the basic crisis lasted for about the same time and continuing uncertainty is largely due to political violence and constitutional upheavals. This pattern of crisis and recovery is very similar to the Mexican crisis of 1994. Fixed exchange rates and excessive external short-term borrowing (defined as less than one year) were the two most common macroeconomic culprits. The obverse of this proposition is that external loans with residual maturity of over one year did not add at all to the crisis, as the crisis was over within a year. Portfolio flows proved to be somewhat more volatile than expected, partly because of the fixed exchange rate; nominal exchange rate had not been allowed to appreciate in the preceding period of large inflows. As expected, however, stock market declines from panic sale of foreign portfolio equity proved to be self-correcting. The problem of declining stock prices and capital flight was limited to less than a year, as net inflows re-started as soon as the bottom had been reached. Further there is a strong suspicion that as in the Tequila crisis, capital flight originated from domestic investors and not foreign ones. Conversely FDI again proved to be much more stable with reductions in net inflows but no net outflow even during the crisis year. Overall lessons, namely the need for flexible exchange rates, flexible interest rates, competitive stock markets and open forward markets are both helpful in avoiding crisis and in ending them rapidly.
On the structural side, the greatest underlying problem was the control mentality and subversion of markets by the government, alone or in tacit or open collusion with business and financial institutions. More specifically, excessive lending for real estate, which may have been part of the problem in some countries, represented bad lending practices and poor regulatory systems. The problem was not equity investment (domestic, FDI or portfolio) in real estate firms per se, but excessively risky lending to firms (high debt-equity ratios). This was part of a more general problem of highly leveraged firms obtaining further loans from banks, which modern prudential regulations could perhaps have identified as excessively risky for the financial system as whole.
Capital Account Convertibility Reform
Formally we became convertible on the current account in 1994. There is a need to eliminate the gap between the theoretical position and the reality. All import controls (QRs) imposed on protection grounds were eliminated by April 1st 2001. The lifting or easing of exchange controls has however been very limited. Use & purchase of foreign exchange by individuals to import goods and services into India should be made virtually free by April 1 2003. This can be effectively achieved by allowing individuals to use international credit cards or bank cheques (FE denominated accounts) for purchasing goods & services up to a value of $100,000 per annum. This limit could be phased in over the next year, in two steps, starting with an immediate announcement of a $50,000 per annum (per resident) limit (R1). The credit card records would be available to RBI (as well as to the Income Tax department) and any violation of the provision would attract penalties under FEMA. The limit could be raised to $100,000 within the next 13 months (R1b).
Asset Purchase: Residents
A significant step towards capital account convertibility could be made, by simultaneously allowing individuals, businesses and Corporations to make capital transfers abroad, including for opening current accounts (R2). This would be up to a limit of US $100,000 per annum per resident, to be phased in the same manner as the limit for purchases. Within this limit employees of Indian companies could also invest in the ESOPs of foreign companies. The resident entity would however be required to keep a record of all such transactions and the assets so purchased, for showing to RBI or other designated authority when required to do so. In fact there could be a single overall limit of $100,000 that includes both current and capital account transfers.
These two recommendations can be combined together into the following single one:
Recommendation 1: Every resident individual should be allowed to use up to $50,000 per annum to purchase goods or services abroad, to open a bank account abroad or to purchase assets abroad.

This policy would at one stroke introduce virtually complete convertibility for 99% of our population, without giving rise to a significant increase in either capital outflows or import of goods and services. That is for those operating with tax paid income and assets. Capital account convertibility has already effectively exists and has existed for decades for those operating with so called ‘black money.’
Recommendation 2: Corporations and Businesses be allowed to make financial capital transfers abroad (including opening bank accounts with check facility) up to a limit of $50,000 per annum.
They would be subject to certain transparency requirements such as credit card payment, cheque payment from FE account and record keeping.
GDR/ADR: Resident Companies
Issue of GDRs or ADRs is the least risky form of equity issue from the issuing country’s perspective. It is dollar denominated and trading occurs between non-resident. There is therefore no direct effect on the country’s foreign exchange or equity market at the time of a crisis.

Recommendation 3: Issue of ADRs or GDRs by resident companies (Public or Private limited) should be completely de-controlled.
No prior approval would be required from government (or RBI), but the issue would have to be reported to RBI within a reasonable period after it has been made.
Foreign Employees should be allowed to participate in the Employee Stock Option Plan (ESOP) of an Indian Company with full repatriation benefits, subject to the FDI rules on aggregate foreign equity holding. Such ESOPs are going to be very important in the development of Knowledge based Industries & Services such as IT and Drugs & Pharmaceuticals. The automatic route would also apply to such ESOPs. For instance a company, in a sector in which automatic 100% foreign equity is allowed as per FDI policy, can issue any amount of ESOPs to foreigners by going through the automatic route to RBI.

Recommendation 4: Indian companies should be allowed to issue ESOPs to foreign employees on the same basis as the FDI policy applicable to the sector in which they are operating.
External Commercial Borrowing
As our analysis of the Asian crisis showed there is little risk to the country in external borrowing of maturity above one year. The only thing to be watched carefully is the amount of loans with residual maturity of less than one year. The two together should be kept well within the foreign exchange reserves. It therefore follows that ECB policy can be drastically liberalised without excessive risk. At present ECB of maturity greater than 10 years is outside the ECB limits (i.e. de-controlled). We should plan for complete de-control of ECB and FCCB of maturity greater than one year by 2003-4. These should be phased in starting with immediate de-control of ECB of average maturity greater than 5 years and above, followed by,

Recommendation 5: De-control of ECB (and FCCB) of average maturity of three years or more by resident companies.
Indian Direct Investment Abroad
True Globalisation requires that Indian companies should go out into the world and compete across the globe. This is the most effective way of learning and developing competitive skills. It is difficult enough for companies that have been protected for long to do so without us creating restrictions and hurdles for them.

Recommendation 6: De-control the flow of Indian Direct Investment Abroad by Indian Companies up to a limit of $50 million per annum. Remove the conditions on repatriation of earning by way of dividends etc.

Recommendation 7: As a corollary to the above policies, a coupling of FDI and Indian Direct Investment Abroad in the form of Swap of Equity between an Indian and a Foreign Company would also be permitted (freed) within the allowed FDI ceilings.
Portfolio Investment
One of the lessons of the Asian crisis is that foreign equity investors can display a herd instinct, when they are confronted with extreme uncertainty and lack of information. This creates volatility in portfolio flows. It is a standard principle of financial markets that the more diverse the set of owners of financial assets the less likely it is that they will have the same expectations and act in the same way. Any decrease in controls on portfolio investment in India by foreign residents, that results in a more diverse set of foreign equity holders, is therefore highly desirable. Thus within the prescribed aggregate equity limits for FIIs , we should encourage all non-residents to invest in the Indian equity market.

Recommendation 8: All non-residents (venture capital funds, insurance companies, pension funds, endowments, wealthy individuals etc.) should be encouraged to make portfolio investment in India through a SEBI registered intermediary (portfolio manager, mutual fund etc.). The direct holding of any non-resident should not exceed 5% of the total shares of any given company.

Recommendation 9: NRI’s, FII’s and other non-residents should be allowed to hold equity up to 100% in listed companies, venture fund companies and in the IPOs of venture fund assisted companies. In the case of listed companies, this will be subject to a board resolution.

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