Debate: Should the Indian rupee be fully convertible?

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Harish H.V.

India has been moving from a regime of extreme capital controls to a much liberalised foreign exchange regime in a calibrated manner. The rupee is partially convertible whereby some capital account transactions are freely permitted, some allowed within parameters like sectoral caps and a few transactions remain prohibited. Partial convertibility has provided a balance between control and liberalisation, and has paved the way for a stable economy over the last 15 years.

Today we are hearing a lot of buzz on moving toward full convertibility which includes capital account convertibility (CAC). The arguments in favour of CAC are many; from making an economy globally competitive, to fuelling growth by increasing investment, to creating confidence in the global marketplace. Almost all developed economies have had full convertibility for several decades. Over the past 25 years, various emerging markets have been moving toward CAC with Latin America leading the way. Peru has full liberalisation while Argentina, Brazil, Chile and Mexico are largely liberalised. Morocco, Nigeria, Egypt, Pakistan, and South Korea, among others, have achieved a large degree of convertibility.

In most of these cases, the initial move towards convertibility saw a huge outward flight of capital with concomitant effects on currency volatility and inflationary trends but, over three to five years, inflows matched the outflows and they achieved some stability in forex reserves.

In India, the move toward currency liberalisation started in 1991 when the country was facing a balance of payment crisis. The call for full CAC is now gaining strength. Some of its advantages can be summarised as follows:

For companies: Companies face a number of challenges in moving across borders; whether it be raising debt, investing overseas, doing M&A globally and even some trading transactions. Full CAC will allow them to match global competitors in terms of structuring their business, raising funds, and transferring resources to where they are required.

For individuals: Individuals have a number of restrictions in moving money for legitimate reasons of education, health or even investment. Full convertibility will give them huge flexibility of owning assets and incurring expenditure for their needs.

For the economy: With the skewed balance of trade position and our dependence on critical imports, full CAC is expected to bring about additional inflows that ensure an overall surplus balance of payments. It is also a strong signal to the global markets that India is now a free trade economy and the economy has achieved scale and strength to go for full convertibility, and that itself will increase investors' confidence and should result in significant capital inflows.

It must be cautioned, however, that the costs associated with the move need to be evaluated carefully. The global crisis of 2008 showed the weaknesses of the control-free currency policy. India was fairly insulated during the period due to its controls and monitoring system.

Any move towards full convertibility could potentially result in an outflow of capital in the short run, creating a drain on our forex reserves. Uncontrolled inflows and outflows will also cause high rupee volatility. Also, unbridled overseas borrowings by companies could lead to payment defaults. Companies may end up taking risks beyond their capability due to their lack of understanding.

In conclusion, while full CAC is desirable as a long-term objective, it is not a magic potion as proved by the China success story. To ensure that convertibility does not become a recipe for disaster, strict macroeconomic controls are needed coupled with a strong monitoring system and fiscal discipline. The Indian model of partial convertibility and calibrated movement toward full CAC has worked.

(Harish H.V. is Partner at Grant Thornton India)

What did radically transform at the Reserve Bank of India between April 15, 2012, and April 10, 2015, to take a diametrically opposite view on full capital account convertibility (CAC), that too in a country as ill-prepared as ours? Was Governor Raghuram Rajan misquoted or quoted out of context as he was talking to students and explaining the basics of monetary policy and other concepts. Or perhaps, being an academic of his stature, he was floating a discussion idea. But the debate is on.

We cannot also ignore Union Minister of State for Finance Jayant Sinha, who stated that "definitely we have to play our rightful, responsible role in the global economy, and to do that we have to move in the direction of CAC".

To put things in perspective, Rajan's predecessor, Duvvuri Subbarao, on April 15, 2012, spoke against CAC, while Rajan on April 10, 2015, after the paper-launch of the International Financial Services Centre (IFSC) in Ahmedabad, expressed optimism that any resident citizen could convert his rupees into dollars or any other currency at will "in a very few short years", which is what CAC means.

Rajan did not elaborate on the merits or demerits of such a step, but Subbarao was very vocal against CAC with specific reasons. Subbarao advocated a gradual move towards CAC only after preconditions like fiscal consolidation and current account surplus are met. "There is no evidence the world over that CAC, regardless of macroeconomic circumstances, has been a positive force? on the contrary, evidence suggests that premature capital account liberalisation can create macroeconomic imbalances with huge costs to growth and welfare," he had said.

To me, there are more reasons to say CAC, at this juncture, could be risky for India. Our combined fiscal deficit is a shade below eight per cent with the Centre's alone at 4.1 per cent in 2014/15. We have a history of running high current account deficit (one per cent of GDP in 2014/15 is due largely to a 65 per cent fall in crude prices), and our import cover is low - at six-and-a-half months with $343 billion in forex reserves. We heavily depend on hot foreign funds to bridge the current account deficit, the trade deficit is widening, we have a fundamentally weak rupee whose strength is mostly determined by the quantum of fund inflows, and we have structurally and fundamentally weak banks with a whopping 12.5 per cent of their assets being dud loans - the list of inclement conditions far outweigh those of conducive situations for CAC.

Moreover, the memories of the plight of the East Asian tiger economies, especially those with full CAC during the 1997-99 currency crisis (we were unscathed with $1 billion in outflows, thanks to our capital controls) should restrain the very thought of CAC. From being a votary of CAC, the IMF now supports selective capital control as the Asian crisis began one year after the then IMF chief Michel Camdessus sought full CAC for all its members. If China, with close to $4 trillion in forex reserves and close to half-a-trillion dollars in current account surplus, and all other economic muscle, is averse to CAC, can we think of CAC? After all, the hottest money in our country is not FII funds, but the rupee. Our insecure psyche will see us convert all our rupees into dollars and empty our meagre forex reserves pronto.

It is a little too ambitious to say that a formal launch of an IFSC can elevate us into a global league. CAC at this juncture can spell bad times for our economy, if we do not get the above-cited inclement conditions corrected before.

After all, our decades-old selective capital control methods - full convertibility on current account and partial on capital account - has stood us in good stead during and after the 1997-99 Asian crisis. If the existing controls are not broke, why should we think of CAC now?

(Gaurav Gupta is Managing Director and Head, Macquarie Capital India. Views are personal.)