Business

Full convertibility, a gradual process

The radical measure will be beneficial only if the economy is put in good shape

THERE HAS been plenty of hype over the possibility of the Indian rupee becoming fully convertible after Prime Minister Manmohan Singh recently suggested that the Reserve Bank of India as the central bank of the country look at the modalities for such a radical measure.

The Prime Minister did not specify a time frame. That has been left to an expert committee appointed by the RBI under the chairmanship of S. S. Tarapore. It is expected that the committee will take four months to submit its report and a road map. Hence there is no reason at all to rush to a conclusion that full convertibility of the rupee is round the corner.

It is important to note that full convertibility is a gradual process, given our present state of integration with the outside world.

Current account

There has already been a substantial relaxation of foreign exchange controls: the rupee has been convertible on the current account since 1994. Resident Indians and companies now have access to foreign exchange for a variety of purposes, including education and travel. They can receive and make payments in foreign currencies on trade account.

Full convertibility means that restrictions on capital account too will be withdrawn. This basically implies that domestic assets — real estate and shares — can be sold to foreigners and payments received without previous regulatory clearance. There will also be a corresponding right for foreigners — not just non-resident Indians — to invest in Indian assets.

Earlier moves

Already there have been substantial moves in the direction of full convertibility. The stock markets have been fuelled by foreign money, which comes in through registered institutional investors. Many categories of resident Indians have been allowed to open foreign currency accounts abroad. India companies have been making overseas acquisitions for which they have given generous access to foreign currency resources.

In practice there can never be a situation where capital moves across national borders totally unhindered by controls. Full convertibility implies fewer but not a complete dismantling of controls. Even developed countries such as the U.S. restrict investments in specific sectors. In India too, it has never been easy even for non-resident Indians (who have enjoyed substantial capital account convertibility for long) to acquire property and real estate. Then again in India, there are caps on foreign direct investment (FDI). It is fanciful to think that all these will be scrapped to permit unrestricted capital flows only to prove that a full convertibility regime has arrived.

Monitoring remittances

Recent steps to check money laundering and the necessity to verify customers' credentials (Know Your Customer rules) have forced banks to monitor remittances into the country. There is no way a full convertibility regime can dispense with those.

One relevant point missed out in the debate over convertibility is this: whether the rupee is convertible or not depends as much on outsiders' preference to hold the currency as on the willingness of the national monetary authorities to "let go". Simply stated, it is not enough if the RBI decrees that the rupee is convertible. There must be demand for the rupee from a variety of legitimate sources — those engaged in trade, investment and so on. Part of the requirements for the rupee need not even be for India-specific transactions.

Debt market needs depth

And demand implies adequate supply of the currency and the infrastructure to cope with the new full convertible status. There should be an active rupee market outside India, a bond market and a facility to hedge rupee transactions over long time frames.

At present there is a felt need within India for a debt market with depth. The latest budget has increased the cap on FII investment in debt securities but compared to the booming equity markets the debt market in India is unlikely to attract anywhere near the same levels of foreign investment even if the rupee becomes convertible on capital account too.

Pertinently, the rupee, although an approved currency in the invoicing of imports and exports, is far less popular compared to the hard currencies, especially the dollar.

Don't ignore the flip side

It is also possible that speculators will take larger bets on the rupee in a full convertibility regime. In fact there are far too many points against full convertibility, even if it could be achieved in the near future.

The exchange rate policy in India, involving a managed float, has been emulated by many other developing countries. It has ensured reasonable stability of the exchange rate and to the extent possible discouraged speculative activity. A full convertibility regime would automatically lead to an exchange rate system in which the rupee will float freely against other currencies.

The benefits claimed — a free flow of capital both ways (to and from India) optimising returns to investors and giving a major boost to the financial markets — are realisable only if all imperfections, not only in India but also in the developed countries, are removed.

Far more likely, there will not only be increased volatility — inevitable perhaps even in the present system of a managed float — but financial instability. As the Indian economy gets more connected with the outside world, it will not be possible to insulate it from outside shocks. Full convertibility, implying no restrictions whatsoever on the movement of currency and capital, is the end result of globalisation. It might be a statement of economic confidence but the path towards it has to be well considered. Needless to add, full convertibility will be beneficial only if the domestic economy is put in good shape first. The expert group working on a roadmap will surely stress the same points favouring macroeconomic consolidation which an earlier committee — also under Mr. Tarapore — had set out in May 1997.

It is worth recapitulating its recommendations if only to show that the path towards convertibility cannot be as smooth as it is assumed. Second, since the major goals set in 1997 (to be reached over the next three years) have not been reached even now, it is evident that there cannot be a compressed time frame.

C. R. L. Narasimhan

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