Paisa wise, Rupee foolish

Indian Express, 4 September 2006

The Report on Fuller Capital Account Convertibility is unlikely to make any difference to 'business as usual' for India's path to capital account convertibility(CAC). Under 'business as usual' the RBI would have continued the gradual process of loosening one control, and tightening another. It would not have done away with quantitative controls in the financial sector, the last bastion of the control raj in India. The committee does not recommend that it do so. In fact, the report reinforces quantitative controls. India has made no progress towards on the question of convertibility.

Despite an attractive title, some optimistic media headlines, and a few apparantly critical paragraphs, the report largely endorses what RBI is doing today. This includes actions that will very clearly accentuate controls. Most importantly, it gives its seal of approval to every physical control and even adds some to the list.

A committee set up by RBI and expected to submit its report to RBI is likely to have two problems. One, an RBI committee is likely to defend the institutional interests of RBI and the job security of RBI staff. Second, the staff are so used to the worms eye view, of twiddling with a system of controls, that they will find it difficult to think at a conceptual level. Having an RBI committee addressing capital controls is like expecting a Ministry of Labour committee to propose labour reforms.

The delay in making the report public appears inconsistent with the speed with which the committe was set up. The PM made a speech on March 18, 2006 asking the Finance Minister and the Reserve Bank to make a roadmap to CAC. The committee was appointed by the RBI on March 20. The report was submitted on July 31 and only released to the public on September 1. RBI has created yet another group with a report submission date of 4 December. The net result of these bureaucratic exercises is that India will be standing on 4 December 2006 in the same place as it was on 18 March 2006.

The report recommends a ban on participatory notes (PNs), the channel through which half of India's equity inflows are coming. This is perhaps not the sort of thing one expects from a committee on decontrol. External Commercial Borrowings upto USD 500 million per year are currently allowed under automatic approval : no change is proposed. Import linked short term credit upto USD 20 million is currently allowed: no change is proposed. In most places it is difficult to see a shift in policy in the proposed three phases. The report recommends continuing further on the path on which RBI is going, where there is no progress.

A surprising element of the report is a recommendation that the rupee be pegged more tightly. First year economics textbooks, in a simplified model of what is known as the "impossible trinity", teach us that an open economy with a fixed exchange rate will lose monetary policy independence. A country cannot have all three things at once - an open economy, a fixed exchange rate and monetary policy autonomy. The tighter peg, proposed by the committee, will make RBI lose its ability to raise and lower interest rates based on the needs of the domestic economy. In an expanding economy, increasingly getting integrated with the world, a pegged rate amounts to giving over the reins of Indian monetary policy to the US Fed, something India can ill afford to do.

The top economists of the world see this exactly upside down. The right thing to do is to first have greater (not lesser) currency flexibility, and then to move on with easing capital controls. The renowned economist, Maurice Obstfeld, recently recommended that given deepening convertibility, China must not tinker with adhoc capital controls any more, and focus on first increasing its currency flexibility.

The lack of a theoretical perspective and framework that could guide the committee towards thinking of the "big picture", as Surjit Bhalla says in his dissent note, is precisely what results in a piecemeal approach and treatment of each sector, market, instrument, area and control as a specific issue. As in the case of licence permit raj of the 1970s, the report is lost in a maze of quantitative restrictions, tweaking one after another, without a foundation of economic logic or rationale.

As India gets increasingly integrated into the world financial markets, it will become more and more difficult to manipulate the currency. If India were to follow the Committee's recommendations, India would keep tweaking capital controls, fighting with their effects on the currency, periodically having knee-jerk responses of banning this or that, and so on. This would not lead us to a healthier and stronger open economy, which is resilient to external and internal shocks.

The real problem for India is that convertibility is already upon us. This is not a time for discussing preconditions for convertibility. Very soon, we will have a GDP of $1 trillion per year, with the dollars moving across the boundary adding up to $1 trillion per year. What we need are policies that make Indian firms and households able to cope with the inevitable ups and downs of globalisation. Convertibility is increasingly upon us, whether we like it or not. At such a time, it is dangerous for India to have an RBI which believes it can grimly hang on to the license-permit raj. This sets the stage for India to have an unpleasant crisis.

Manmohan Singh and P. Chidambaram need to setup a new committee on how India should handle this inevitable convertibility, which is staffed with people who know modern macroeconomics, and lack an institutional loyalty to the RBI and the existing license-permit raj.

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