Capital Account Convertibility: Neo-liberalism’s New Threat to India

                                       Amitayu Sen Gupta

                                       Shouvik Chakraborty

ON the inaugural function of the 16th Asian Corporate Conference (March 18, 2006), the prime minister Dr Manmohan Singh, stated that there is merit in India’s moving forward towards fuller Capital Account Convertibility. In an immediate response, the RBI set up a committee under the Chairmanship of Mr S S Tarapore to pave the way for the Capital Account Convertibility. This article provides a basic analysis of the problems involved with the issue of Capital Account Convertibility in India.

WHAT IS CAC?

In India, the foreign exchange transactions (transactions in dollars, pounds, or any other currency) are broadly classified into two accounts: current account transactions and capital account transactions. If an Indian citizen needs foreign exchange of smaller amounts, say $3,000, for travelling abroad or for educational purposes, she/he can obtain the same from a bank or a money-changer. This is a “current account transaction”. But, if someone wants to import plant and machinery or invest abroad, and needs a large amount of foreign exchange, say $1 million, the importer will have to first obtain the permission of the Reserve Bank of India (RBI). If approved, this becomes a “capital account transaction”. This means that any domestic or foreign investor has to seek the permission from a regulatory authority, like the RBI, before carrying out any financial transactions or change of ownership of assets that comes under the capital account. Of course there are a whole range of financial transactions on the capital account that may be freed form such restrictions, as is the case in India today. But this is still not the same as full capital account convertibility.

By “Capital Account Convertibility” (or CAC in short), we mean “the freedom to convert the local financial assets into foreign financial assets and vice-versa at market determined rates of exchange. It is associated with the changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by the rest of the world. …” (Report of the Committee on Capital Account Convertibility, RBI, 1997) Thus, in simpler terms, it means that irrespective of whether one is a resident or non-resident of India one’s assets and liabilities can be freely (i.e. without permission of any regulatory authority) denominated (or cashed) in any currency and easily interchanged between that currency and the Rupee.

PROBLEMS WITH CAC

Several economists are of the view that the full Capital Account Convertibility (and allowing the exchange rate to be market determined) has serious consequences on the wellbeing of the country, and this may even lead to extreme sufferings of the common masses. Some of the reasons are highlighted below.

• During the good years of the economy, it might experience huge inflows of foreign capital, but during the bad times there will be an enormous outflow of capital under “herd behaviour” (refers to a phenomenon where investors acts as “herds”, i.e. if one moves out, others follow immediately). For example, the South East Asian countries received US$ 94 billion in 1996 and another US$ 70 billion in the first half of 1997. However, under the threat of the crisis, US$ 102 billion flowed out from the region in the second half of 1997, thereby accentuating the crisis. This has serious impact on the economy as a whole, and can even lead to an economic crisis as in South-East Asia.

• There arises the possibility of misallocation of capital inflows. Such capital inflows may fund low-quality domestic investments, like investments in the stock markets or real estates, and desist from investing in building up industries and factories, which leads to more capacity creation and utilisation, and increased level of employment. This also reduces the potential of the country to increase exports and thus creates external imbalances.

• An open capital account can lead to “the export of domestic savings” (the rich can convert their savings into dollars or pounds in foreign banks or even assets in foreign countries), which for capital scarce developing countries would curb domestic investment. Moreover, under the threat of a crisis, the domestic savings too might leave the country along with the foreign ‘investments’, thereby rendering the government helpless to counter the threat.

• Entry of foreign banks can create an unequal playing field, whereby foreign banks “cherry-pick” the most creditworthy borrowers and depositors. This aggravates the problem of the farmers and the small-scale industrialists, who are not considered to be credit-worthy by these banks. In order to remain competitive, the domestic banks too refuse to lend to these sectors, or demand to raise interest rates to more “competitive” levels from the ‘subsidised’ rates usually followed.

• International finance capital today is “highly volatile”, i.e. it shifts from country to country in search of higher speculative returns. In this process, it has led to economic crisis in numerous developing countries. Such finance capital is referred to as “hot money” in today’s context. Full capital account convertibility exposes an economy to extreme volatility on account of “hot money” flows.

According to Joseph Stiglitz, the former Chief Economist at the World Bank and a Nobel Laureate in 2001,

“Capital market liberalization entails stripping away the regulations intended to control the flow of hot money in and out of the country- short term loans and contracts that are usually no more than bets on exchange rate movements. This speculative money cannot be used to build factories or create jobs- companies don’t make long term investments using money that can be pulled out on a moment’s notice- and indeed, the risk that such hot money brings with it makes long-term investments in a developing country even less attractive.”- (Globalisation and its’ Discontents, 2002.)

EXPERIENCES OF DEVELOPING COUNTRIES WITH CAC

Over the past two decades, under the diktat of the IMF-World Bank, several developing countries have undertaken measures to open their capital account as part of a broader process of financial liberalisation and international economic integration. Several developing countries like Argentina, Kenya, Mexico and the South East Asia (Indonesia, South Korea, Malaysia and Thailand) liberalized their capital accounts over the last few years.

The early 1990s experienced a boom in capital flows internationally followed by the reversal of such flows especially in the second half of the 1990s. The first reversal occurred in the aftermath of Mexico’s currency crisis in December 1994. It was, however, limited to some Latin American economies and capital flows resumed soon after. The second reversal, which was more severe and enduring, came in 1997 and resulted in the East Asian crisis. This was followed by the Russian default in August 1998 and the Brazilian crisis in 1998-99, followed more recently by the collapse of the Argentine currency in 2001 and the spate of corporate failures and accounting irregularities in the USA in 2002. Needless to say, all the developing countries faced major crisis due to such vagaries of finance capital, whereas the only gainers were the handful of financers who control the flows of such capital.

But, these crises did not affect the Indian economy since India had regulations on capital account. Even a conservative economist like Jagadish Bhagwati recognized this point when he argued that “It is noteworthy that both India and China escaped the Asian Financial crisis; (since) they did not have Capital Account Convertibility.” – (US House of Representatives Committee on Financial Services, April, 2003).

WHO BENEFITS FROM “CAC”?

The class which benefits from the CAC primarily compromises the big business houses and the finance capitalists, who invest in the stock market for speculations. The policies like CAC are pursued mainly to gain the confidence of the speculators and punters in the Stock Markets, and do not have any beneficial effects on the real sector of the economy, like increasing the employment level, eliminating poverty and decreasing the inequality gap. However, the irony is that under a crisis, the burden is borne primarily by the common masses. This may come in the form of a sharper reduction in subsidies, less investment for social welfare projects by the government and an increase in the privatisation process. The foreign speculators and the domestic players may walk out of the market (by converting their assets to foreign currency) and insulate themselves from any damage.

BACKGROUND OF CAC IN INDIA

By August 1994, India was forced to adopt full current account convertibility under the obligations of IMF’s article of agreement (Article No. VII). The committee on Capital Account Convertibility, under Dr S S Tarapore’s chairmanship, submitted its report in May 1997 and observed that international experience showed that a more open capital account could impose tremendous pressures on the financial system. Hence, the committee recommended certain signposts or preconditions for Capital Account Convertibility in India. However, the agenda of Capital Account Convertibility was put on hold following the South-East Asian crisis. Even the finance minister acknowledged this point that “...the idea of Capital Account Convertibility was floated in 1997 by the Tarapore Committee, but could not be implemented as the Asian Crisis cropped up”. (The Hindu, March 25, 2006). The RBI over a period of time has accepted the point that the South East Asian crisis was a bad example for Capital Account Convertibility and that India had been insulated from the crisis because it had not allowed Capital Account Convertibility.

“The growing global macroeconomic imbalance – as evidenced by the large and sustained current account deficit of the US – suggests that markets may at times allocate global saving differently from what is perceived by the policy makers as appropriate and sustainable in the long-run. Like the effect on resource allocation, the beneficial effects of capital account liberalisation on growth are ambiguous.” – (Report on Currency and Finance 2002-03, RBI.)

But at the same time, the RBI had started talking about Capital Account relaxations, under pressure from the business classes in India. However, given the obvious pitfalls of CAC policies, the RBI talked about a cautious approach to CAC.

“In India, it is recognised that the pace of liberalisation of the capital account would depend on both domestic factors (especially progress in the financial sector reform), and the evolving international financial architecture. The regulatory framework is being used in several combinations to address problems of excessive inflows and pressures towards outflows.  In this regard, an integrated view of the state of development of activities in financial markets needs to be taken.”  - (Report on Currency and Finance 2002-03, RBI.)

It is interesting to note here that there already exists a great amount of freedom in transacting foreign currencies today:

• Indian residents and companies (listed in the share markets) can invest in foreign companies, provided a) the foreign company has 10 per cent share holding in some Indian company and b) the domestic country does not invest an amount more than 25 per cent of the company’s total valuation. However, if an Indian company has a “proven track record” it can invest an amount up to 100 per cent of its total valuation in a foreign entity engaged in a “bonafide” business activity.

•  There is no monetary limit on such aforesaid investments by individuals.

• Indian banks can invest their “unutilised” FCNR(B) funds (Foreign Currency (Non-Resident) Accounts (Banks)- accounts in which NRI’s and PIO’s can deposit in any Indian bank) abroad in only long term fixed income securities which have some minimum ratings (read credibility) internationally.

• An Indian exporter can give “loans” out of its foreign earnings to foreign importers without any limit; i.e. the foreign exchange earned need not necessarily be deposited in the country.

• Indians can have Residents Foreign Currency (domestic) Accounts in which they can hold their savings in foreign currency without any limit. They can also remit these foreign currencies to acquire foreign securities (from foreign stock markets) under Employees Stock Option Plan (ESOP) without any limits.

• NRI, PIO and non residents can take up to US$1 million per year out of the country from balances held in Non Resident Ordinary (NRO) accounts/ sales of Indian assets. Such assets may include those acquired through inheritance/legacy.

Any further relaxations would render the Indian economy susceptible to the kind of crisis faced by the other developing countries.

Why then is the government interested in introducing Capital Account Convertibility?

The UPA government, since its inception, had has been pursuing the policies of liberalistion and privatisation, which underscore its commitment to neo-liberalism. Notwithstanding certain policy announcements in the NCMP, the government is unwilling to change course and is in essence pursuing the same policies as the NDA. A policy like Capital Account Convertibility is a reflection of this. Such policies solely benefit the rich business houses, investors in the stock markets and those who control the international finance markets. The prime minister and the finance minister are more than eager to serve the vested interests of these classes.

Dani Rodrik, an eminent Harvard economist, has argued that

“The greatest concern I have about canonizing capital-account convertibility is that it will leave economic policy in the typical “emerging market” hostage to the whims and fancies of two dozen or so thirty-something country analysts in London, Frankfurt, and New York. A finance minister whose top priority is to keep foreign investors happy will be one who pays less attention to developmental goals. We would have to have blind faith in the efficiency and rationality of international capital markets to believe that these two sets of priorities will regularly coincide.”---  (“Who Needs Capital Account Convertibility?” February 1998.)

CONCLUSION

The moral of the story is that with Capital Account Convertibility financial crises will always be with us; and there is no magic wand to stop them. These conclusions are important because they should make us appropriately wary about statements of the form, “we can make free capital flows safe for the world if we do x at the same time,” where x is the currently fashionable antidote to crisis. In India today the x is “strengthening the domestic financial system and improving the prudential standards.” Tomorrow’s x is anybody’s guess. If we are forced to look for a new series of policy errors each time a crisis hits, we should be extremely cautious about our ability to prescribe a policy regime that will sustain a stable system of capital flows. Hence any conclusions by the special RBI committee would be just another such wishful thinking that others before us have undertaken, whereas such policies may not be enough from preventing a crisis in India. The only way to avoid such a crisis is to have regulated capital inflow into the economy, the purpose of which is defeated by CAC.