Don’t rush into full convertibility

India should stay course on the reforms, including increasing the role of the
private sector in the financial markets, without committing to a specific
timetable for full rupee convertibility, argue Arvind Panagariya and Purba
Mukerji.

TARAPORE Committee-II on capital account convertibility is due to table its report on

July 31, 2006. Tarapore Committee-I, also appointed at the urging of Mr. P
Chidambaram during his first tenure as the finance minister, had recommended full
convertibility within three years, ending 1999-2000 with specific goal posts adopted.
The Asian financial crisis sealed the fate of that recommendation but the FM has once
again revived the issue.

We offer five reasons why India should not rush into convertibility. First, as Prof
Jagdish Bhagwati forcefully argued in his celebrated 1998 article:
The Capital Myth: The Difference between Trade in Widgets and Dollars, persuasive
empirical evidence on the benefits of full convertibility is lacking. Recent research by
one of us (Mukerji) shows that for countries with well-developed financial markets
and stable macroeconomic environment, convertibility offers small positive growth
effects.

But for countries with weak financial sectors and macroeconomic vulnerabilities,
convertibility leads to greater instability in growth without dividend in terms of higher
average rates. But even this and related research does not distinguish between
limited convertibility in terms of openness to trade and foreign direct and portfolio
investment and full-fledged convertibility. Therefore, we have no evidence showing
positive benefits from a move from the limited to full convertibility, which is the
question facing India today.

Second, on the fiscal front, India remains far from ideal conditions for convertibility.
The average growth rate of almost 8% during 2003-04 to 2005-06 has led to
increased tax revenues and some reduction in the deficit but not nearly enough.
Moreover, we can scarcely be sure that the deficit will not return to the higher level if
the GDP growth rate and therefore tax revenue growth revert to the previous trend
as happened after 1996-97. With interest payments on the debt amounting to more
than 6% of the GDP, gross fiscal deficit of 8% and debt-to-GDP ratio of more than
90%, convertibility is bound to leave India vulnerable to a crisis. One hazard is that
the government itself would be tempted to turn to lower-interest short-term external
debt to finance its deficits and debt.

Third, the financial sector is still insufficiently developed in India. Banks are
predominantly in the public sector and credit markets relatively shallow. Insurance
has barely been opened to the private sector with the foreign investment in it capped
at 26%. The debt and equity markets are thin and dominated by public sector FIs
and FIIs. Because the Indian debt and equity markets are tiny in relation to the
worldwide stakes of the FIIs, any time the latter begin to exit the Indian market, the
financial markets go into turmoil. Because few FIIs have the incentive to carefully
gather detailed information on the future profitability of various firms, such exits are
characterized by herd behavior.
Fourth, India is still far from fully integrated on the trade front. For this reason,
ensuring a competitive exchange rate is a high priority. A move to the capital-
account convertibility is bound to bring more capital inflows initially and force an
appreciation of the rupee. If the appreciation ends up being large and persistent, it
could put trade integration into jeopardy. Furthermore, even if the appreciation is
only temporary, convertibility could hurt export growth by making the real exchange
rate more volatile.

FINALLY, the embrace of full capital account convertibility can place the ongoing
reforms in other areas at grave risk. In the Indian political environment, building a
consensus for even most straightforward reforms such as privatization and trade
liberalization is an uphill task. Therefore, if capital account convertibility were to
culminate in a crisis or even create greater volatility in growth, the cause of reforms
would be set back.

The advocates of speedy convertibility sometimes make two counter arguments.

First, the adoption of convertibility will speed up the reform, especially in the
financial sector. For instance, giving individuals and firms access to the global
markets may bring pressure on the domestic banks to become more competitive.
Likewise, the possibility of a crisis may force the government to act more urgently on
fiscal deficits and debt.

While these outcomes can indeed follow the embrace of convertibility, the opposite
can also happen. Both the government and the firms will be tempted to quickly
proceed to accumulate short-term external debt and rapidly move the economy
towards a crisis. The question is largely empirical. On balance, the weight of the
empirical evidence favors erring on the side of caution: whereas the countries that
ended up in a crisis following the premature adoption of convertibility are many,
those that reformed more speedily and smoothly on account of the premature
embrace of convertibility are few.

The second argument in favor of moving rapidly to convertibility is that this will help
India turn into a major financial centre in Asia. Given its vast pool of skilled labor
force and rapidly developing information technology industry, India certainly has the
potential to become such a centre. It is also true that full convertibility is a necessary
condition for becoming a hub of financial activity. Yet, the argument is misleading.
Currently, the financial sector in India is heavily dominated by the public sector,
which account for 70% of its assets. It is implausible that India would turn into a
major financial centre in Asia without the reforms that give primacy to private sector
in the financial markets. It is even more implausible that the government will
relinquish its control of the financial markets overnight — just calculate the prospects
of bank privatization!

Though India must eventually adopt full convertibility, which is a defining

characteristic of all mature modern economies, our arguments lean against the kind
of approach the Tarapore Committee I recommended. We should instead stay the
course on reforms including increasing the role of the private sector in financial
markets without committing to a specific timetable for convertibility.