The inevitability of capital account convertibility


Indian Express, 19 Sept 2006


Predicting that 5 to 10 years from today India and China will have much greater financial integration with the world, Larry Summers, Professor and former president, Harvard University, and Former US secretary of Treaury, said that the integration would happen regardless of what the policy makers in these countries want. It would be driven by fundamental forces such as growing trade, investment and capital flows.

Summers major lesson for India at this point of time, when India is trying to define the preconditions for capital account convertibility after the Tarapore 2 report is this: greater currency flexibility will make India's path towards financial integration with the global economy smoother and prevent a wrenching and forced adjustment.

Speaking at the Plenary session of the program of seminars at the annual meeting of the IMF-World Bank in Singapore, Summers made another 4 predictions. The increasing financial integration would not, he argued, be accompanied by the current pace of foreign exchange reserves accumulation in terms of the reserves to GDP ratio. Because to do so, the volume of reserves assets required is unlikely to be politically tenable for countries whose assests are being acquired. In other words, at some point, the US government will not want to be even more indebted to the governments of India and China.

The next decade would witness an appreciation of the real exchange rates of the two countries. This would happen regardless of what the Reserve Bank of India and the People's Bank of China might want. This will happen because of the rapid growth in these countries. The US dollar is likely to decline in real terms with rising US current account deficits.

Exchange rates in India and China will be more flexible than they are today because of the difficulties of managing domestic monetary policy when exchange rates are being manipulated. In the event of external shocks and diverse growth rates of trading partners, it will not be optimal to hand over control of monetary policy to other countries. Greater flexibility in the exchange rate will allow more autonomy of monetary policy and that is why it will inevitably come.

And, finally, India and China would move from current account surpluses to current account deficits. These structural deficits will emerge in China and India reflecting the tremendous opportunity for investment in these countries and reduced opportunity for investment in other countries. Higher consumption in China and India would mean lower domestic savings would have to be exported.

These five developments, according to Larry Summers, will not be policy choices. They will be driven by fundamental forces. What policy choices will be able to determine is the smoothness with which the adjustment to this destination takes place. It will determine the path that each country would follow towards this inevitable destination.

One central lesson from international monetary history, Summers pointed out, is that if exit from a fixed exchange rate system is a forced move, and is easily justified, then the country has waited too long. The incidence of countries leaving fixed exchange rate schemes too late is at least 10 times as common, and has had 10 times as serious consequences, as countries leavings fixed exchange rate schemes too early.

Preventing market forces from bringing about exchange rate appreciation leads to qusetions about sustainability. This has a very important implications for policy. The more flexible the currency, the less tied it is to a particular currency, the smoother will be the path. A flexible exchange rate will ensure that the system is not forced into giving up a pegged exchange rate. Only then will the path be least painful.

The lesson for India is clear. One important pre-condition for opening up the capital account is greater currency flexibility. This is in contrast to what has been proposed by the Tarapore 2 report where they have suggested increasing monitoring or the rupee and following a tight band in terms of the real exchange rate.


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