Too Much, Too Soon?

There's good news for resident Indians desperate to tie upshovels of strangles foreign investment or open a high-yielding foreign currency accountin a bank, at home or abroad. The road map to full rupee convertibility is finally here,thanks to a superfast job by recently retired RBI deputy governor Savak Tarapore. But itmay be too early to give two cheers. The tightrope-walking by the report, which seeks toprecariously balance the economic needs of the country with political compulsions in amere three years, puts a wet blanket on any merrymaking by corporates and investors.

What is capital account convertibility (CAC)? Why is it considered thecat's whiskers for you and me or company X and company Y? The Tarapore Committee definesit as "the freedom to convert local financial assets into foreign financial assetsand vice versa at market-determined (as opposed to RBI-fixed) rates of exchange".With the rupee made convertible in the current account in August 1994, this facility wasopened to exporters, NRIS and foreign portfolio investors with some restrictions. WithCAC, this benefit will be enjoyed by all financial institutions, corporates, investors andindividual Indians. In other words, they can freely buy or sell foreign exchange and useit.

CAC translates into different things for different people. Some of themain gains.:

• Individual Indians and corporates/businesses will be immediately allowed to hold $25,000 (a little over Rs 9 lakh) in banks abroad. The limit will double every year till 2000. They can also hold deposits in any foreign currency in an Indian ban (settlement only in rupees) or freely take a loan up t $250,000 from an NRI for any purpose or term, with interest not higher than LIBOR (limit doubles every year).
• Corporates/businesses can issue debt to residents in foreign currency, invest in such bonds/deposits, and access capital markets abroad; investment in Indian joint ventures/wholly owned subsidiaries overseas allowed up to $50 million automatically.
• Banks are allowed to borrow up to 100 per cent of Tier I capital. Banks and FIs are allowed to operate in local and foreign gold, commodity and forward exchange markets. Investment institutions can invest up to $2 billion overseas by 2000.
• Finance Minister sources explain that for an investment-deficient country like India, CAC has immense benefits: a higher net inflow of foreign capital can take his pick from the rates offered in the global financial markets. This lowers business risks and increases variability of returns. In the long term, as the local price and tax regime converge with global ones, macro-economic stability increases, stimulating innovation and productivity.

But all this freedom, says the Tarapore Committee, comes at a cost.Non-competitive business has nothing to look forward to. Nor has a central bank motheringan inefficient administration and banking system any right to such freedom. In short,before the rupee can sail smoothly in international waters, there's a three-year period ofturbulence when banks have to shape up.

The report clearly indicates that except in terms of forexreserves-touching $22.7 billion in April-the country is not yet ready for CAC. But it canbecome so by 2000 provided it starts this year itself and satisfies a longish set ofconditions. Briefly, the signposts are:

• The gross fiscal deficit (GFD) should come down to 3.5 per cent of GDP.
• Separation of monetary policy from public debt (PD) policy and setting up a consolidated sinking fund and separate office for PD.
• Parliament should mandate an inflation rate of between 3 per cent and 5 per cent and give the RBI the freedom to manage it within that level.
• Complete deregulation of interest rates by current year-end.
• Bring down the gross non-performing assets (bad debts) of banks from 14 per cent now to 5 per cent by 2000 and the average effective cash-reserve ratio (money banks must keep with the RBI) from 9.3 per cent to 3 per cent.
• Minimum forex reserves of $15 billion and desirable level of over $26 billion.
• Intervention by the RBI within a 5 per cent bank of the Real Exchange Rate of Rupee to check volatility.
• The ratio of current receipts to GDP should increase progressively from 15 per cent now and debt-servicing ratio decrease from 25 per cent to 20 per cent.
• Impose tough capital adequacy norms.

The general consensus outside the Finance Ministry, though, is thatthese preconditions are not impossible to achieve in such a short term. Says Bibek Debroy,a former consultant to the ministry: "There isn't the foggiest chance that we canattain these by 2000. But it would be stupid to interpret that all this would have to bein place before CAC can happen. Both have to come gradually in phases." Adds B.Bhattacharya, dean, Indian Institute of Foreign Trade: "While the recommendations areperfect, the road map's too ambitious. Perhaps 2005 would have been more realistic."

TAKE the GED target. A lower fiscal deficit has traditionally beenachieved at the cost of development and there's no guarantee that it would not happen now.The current year's fiscal deficit projection is 4.5 per cent, which hinges on optimisticrevenue hopes. Besides, this target itself could be highly understated as the budgetaryestimate does not take into account the fiscal deficits of states and their departmentalundertakings, public sector losses, or the oil pool deficit.

Secondly, cutting NPAs of banks so fast would involve massive loanwrite-offs, resulting in still weaker financial health for overexposed banks. Thestipulation that weak banks stick to only government securities is an effectiveprescription for winding them up. Thirdly, it's doubtful whether Parliament can evenachieve consensus on a mandated rate of inflation. Says Bhattacharya: "Inflation inIndia is dependent on a number of exogenous variables. We have never achieved 3 per centinflation in the last 30 years. It is difficult even for the OECD countries."

Also, is the government serious about the report? Even the NarasimhamCommittee had recommended consolidation of the financial sector, which hasn't yethappened. The Tarapore report, which is only a meticulous extension of the SodhaniCommittee report on forex controls, is much more ambitious on banking reforms. Especiallyin terms of the role it envisages for the RBI, modelled on the Central Bank of NewZealand, whose main job is inflation management. Is it possible for the RBI to achievesuch revolutionary autonomy so fast?

A bigger worry is whether, in the absence of a proper traffic controlmechanism, capital will vote with its feet. Experts are divided on the prospect of capitalmoving out of the country after CAC. Theoretically, as returns on both debt and equity arehigh in India, the immediate impact of CAC would be to attract huge overseas capital. Ifthe rupee could become unstable and trigger capital flight, as happened in Mexico.Starting off in haste without strong macroeconomic fundamentals, some of these countrieshave had to reimpose capital controls.

Bhattacharya, in fact, warns of such a crisis in a few years.Especially, given that all current account and trade restrictions have yet to go. CAC, hesays, "is not a priority right now. Till current account convertibility is a totalreality, capital controls should not be touched." Agrees Debroy: "The committeehas definitely been conservative on the foreign trade front where reforms could have beenspeeded up." Ironically, such an ambitious CAC regime does sound highly incongruouswith India's trying to buy time from the US to remove the quantitative restrictions onimports!

How real is the prospect of capital flight from India? At 4 per cent,our export growth last year has been one of the poorest, our forex resources are still lowseen in the backdrop of debt servicing and, given the rampant hawala malpractices, CACwith no end-use restrictions will only legalise enormous capital transfers. To counterthis, India needs a much deeper foreign exchange and securities market. New instrumentsfor hedging risk-like futures, forwards and securities debt-should become popular withmarket players. Can this happen in three years?

Says a senior Finance Ministry advisor: "To counter large inflowsin exports, we can take off import curbs and allow export of capital. Also, a controlmechanism has to be devised to limit borrowing or purchases of foreign exchange byinstitutions. Poor policies can lead to exchange crises. Policy instruments for dampeningvolatility are thus crucial."

While CAC would open up the economy to external pressures and the thatof capital flight, it should be noted that the last time the rupee witnessed highvolatility, India didn't have full convertibility. These dangers and the constantmonitoring of exchange behaviour may force responsible policy choices in a country notfamous for sound macro-economic management. Also, with all trade restrictions set to go by2000, can CAC remain a distant dream? There may be quibbles on S.S. Tarapore's favouriteproject but they do not undermine the crying need for India to integrate with the worldeconomy.