Conditions not right for capital account convertibility

There is once again a debate over introducing capital account convertibility in India. I wasn't amazed when two of the country's top policy makers - RBI Governor Raghuram Rajan and Minister of State for Finance Jayant Sinha - touched upon the sensitive subject early this month. Rajan, though known for conservatism, said he hoped India would get to full capital account convertibility in a short number of years. Sinha, whose father was once a finance minister, said India would have to move in the direction of full capital account convertibility in order to play a meaningful and responsible role in the global economy.

Experts have already started taking sides on whether India needs to go for full capital account convertibility at this juncture. I remember precisely the same discourse on earlier two occasions. In 1997, the then Finance Minister, P. Chidambaram, set in motion the move towards full capital account convertibility by mentioning it in his Budget. Soon after, the then RBI Governor, C. Rangarajan, formed a committee under Deputy Governor S. Tarapore to suggest a road map. Later, in 2006, the then Prime Minister, Manmohan Singh, talked about the need for revisiting the subject. But on both occasions India stepped back.

At present, India has current account convertibility. There are numerous restrictions on foreigners who want to invest in India, especially in debt, or in industries by way of FDI or buying real estate. Similarly, there are restrictions on resident Indians and companies wanting to borrow or spend or invest abroad. If there is full capital account convertibility, money will freely move in and out of India.

So, is India ready for full capital account convertibility? I really don't see the right economic conditions for that. First of all, India has been suffering deficits-trade, current and fiscal-for a long time. While the current account deficit has plunged from 4.8 per cent of gross domestic product, or GDP, in 2012-13 to 1.7 per cent in 2013-14, the credit for this actually goes to falling oil prices and curbs on gold imports, the two largest import items. Imagine having full capital account convertibility with resident Indians free to import as much gold as they want to. Similarly, India runs a fiscal deficit without any discipline. In 2014-15, the fiscal deficit was contained at the targeted level of 4.1 per cent of GDP, but this was possible mainly because of spectrum auction and proceeds from disinvestment of PSUs. The NDA government, led by the BJP, has already extended the target of 3 per cent fiscal deficit from two to three years.

A higher current account deficit indicates vulnerable position of the domestic currency, while the fiscal deficit has implications for inflation as well as interest rates.

Second, reliance on hot money or foreign institutional investor (FII) inflows into equity markets is a cause for concern. India is also not ready to attract a lot of FDI, which is more stable money. The reasons are well-known. This new government's Make in India initiatives, coupled with relaxation of FDI norms, will help, but dividends from these initiatives will flow over a long period of time.

Third, foreign exchange reserves of over $340 billion can be called adequate but not comfortable. While these easily provide India an import cover of 12-14 months, the rising external debt is a worrying signal. Today, the external debt of over $460 billion is well over the foreign exchange reserves. The short-term debt, at $85 billion, is also rising, which is not a good sign as it matures in less than a year. In a recent economic survey , the government talked about targeting foreign exchange reserves of $750 billion to $1 trillion, which I believe would be one of the ideal parameters for kick-starting capital account convertibility.

Last but not the least is the banking system. It has to be strong for capital account convertibility. The country's banks today are facing twin challenges - capital as well as asset quality. Two-third of the banking system, which comprises PSU banks, is in dire need of capital. Similarly, asset quality is deteriorating fast, restricting their ability to write new business. Gross NPAs of the banking system are over 4 per cent. Restructured  loans are around 6 per cent. This takes stressed assets to 10 per cent of the loan book. It's nothing but scary if one is thinking about moving to capital account convertibility. Also, balance sheets of Indian banks are more rupee than dollar denominated. The first step will be to allow Indian banks to build a dollar book to handle the risk associated with foreign currency dealings.

So, if we try to make haste to win some laurels abroad,  I believe India will be as vulnerable as the East Asian countries were in 1997. The way currencies from Thailand to the Philippines crashed, it showed the developing world the dangers of a weak currency bringing the house down.