Full convertibility: manage it all the way

By C. R. L. Narasimhan

The subject of capital account convertibility of the rupee has resurfaced - not because someone in authority is advocating its early introduction. On the contrary, policymakers feel vindicated at having charted a measured course towards full convertibility. The Reserve Bank of India Governor, Dr. Bimal Jalan, for one has said that the recent pressures on the rupee could, to a large extent, be contained because of the Government's step-by-step approach towards full convertibility. The ongoing developments in the forex markets should chasten anyone who is rooting for capital account convertibility for the rupee in the near term.

In fact, the accent not only in India but in most developing countries is on managing capital account liberalisation. It is not fashionable anymore to talk of a summary abolition of exchange controls. The present approach - based on gradualism - involves an analysis of several inter-connected issues, the special problems of developing countries and the contours of a regulatory framework to manage the impact of free forex flows. In a recent speech* the RBI Deputy Governor, Dr. Y. V. Reddy, touched upon some of these substantive issues mainly from the Indian angle.

Global capital flows can enhance efficiency and improve growth prospects but they can also trigger instability. Current focus therefore is on enhancing the efficiency of such flows while minimising their deleterious consequences. Recent trends in international trade, technology transfers and the like necessitate greater attention to the issues connected with capital account liberalisation vis-a-vis control or regulation.

Even granting that capital account liberalisation is desirable, it should be gradual, well-sequenced and undertaken in conjunction with several other measures at the micro and macro levels. There is a need to monitor a country's short-term debt more effectively. Alternative forms of capital flows need to be judged in relation to their individual costs and benefits. Most important of all, each country needs to tackle the issues and set the pace depending upon its own circumstances.

This point is especially valid because at times of crisis, it is the national governments which have to undertake ameliorative measures. That is why gradualism is in order. In India, the move towards full convertibility is a process: the medium term objective is liberalisation but in the short-run there is flexible use of controls and regulation. India like other developing countries will have to reckon with certain key factors: size and structure of the economy, especially the share of the external sector; socio-political orientation to risk- taking; the potential benefits of liberalisation; the level of development of the domestic financial sector.

There is a global context too that each country has to assess before embarking on convertibility. These are (a) the state of global arrangements for preventing crises; (b) the extent and speed at which support will come from international financial institutions; (c) arrangements in international financial architecture for burden-sharing between domestic and global as also between public and private sectors; (d) the perception of a developing country on the potential for magnification of possible inadequacies in domestic policies by the international financial community.

In India there is considerable support for cautious liberalisation on capital account. Stability being a primary concern, a cautious well-sequenced approach has always been favoured. Elsewhere too, the mainstream opposition to capital- controls has given way to a debate on the efficacy of such controls and consequently the framework and operation of such controls. A control regime can help in prioritising different types of capital flows. The desirability of certain types - for example, foreign direct investment (FDI) over portfolio flows - can then be built into the framework.

There is a distinction between a control framework and a regulatory framework. The former can be inefficient but the latter can be used effectively to moderate the ebb and flow of capital flows. Each country has to develop a regulatory framework appropriate to its own needs. Flexibility - to respond swiftly to developments within the country and outside - should be the key. It might even be that controls will have to be reintroduced or regulation tightened to meet specific contingencies never mind that the latter goes against the grain of liberalisation.

A successful transition to a full convertibility regime will involve the pursuit of certain complementary policies and a thorough understanding of the linkages. In the former category are strengthening the banking system, spreading intermediation between banks and non-banks, and sound development of financial markets and co-ordination between domestic and global regulators. By understanding the linkages, capital account controls can become effective. Capital flows in the guise of current transfers can be avoided. In India, repatriation and surrender of current receipts of residents is a must, while forex payments are made only for genuine transactions and that too in moderate amounts. The adequacy of forex reserves is another parameter. Very recently in India the RBI has started factoring in the liquidity risks associated with different types of inflows.

Exchange rate is currently a hot topic in India. As persistent misalignments in the domestic forex markets occur because of a few external factors, the developing countries need to be armed with measures to counter them. Finally, linkages among different financial markets - money market, debt market, - forex market and the stock markets are becoming strong. These linkages have to be thoroughly understood before further liberalisation on capital account takes place.

One last issue in the Indian context: what would be a reasonable time frame for full convertibility? In 1997 the Committee on Capital Account Convertibility recommended fiscal consolidation, inflation mandating and strengthening of the financial system before further liberalisation on capital account. Even as we are grappling with these, the issue of convertibility has come alive in the forex market's context. Far from being in the sidelines, the convertibility issue - encompassing as it does several critical areas - will remain at centrestage. But it does not seem likely that the rupee will become fully convertible anytime soon.

Dr. Y. V. Reddy - Issues in Managing Capital Account Liberalisation - RBI Bulletin, August 2000.

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