A. Seshan

The Second Tarapore Committee is to study the implications of dollarisation of domestic assets and liabilities and internationalisation of the rupee. But A. SESHAN wonders if the Government should invite trouble by going into these areas by introducing fuller CAC now, when the economy is having an easy time in the external sector.

One of the Terms of Reference (ToR) of the Second Tarapore Committee (STC) on fuller Capital Account Convertibility (CAC) of the rupee is "to study the implications of dollarisation in India of domestic assets and liabilities and internationalisation of the Indian rupee." The First Tarapore Committee (FTC) on convertibility ignored dollarisation.

There was no euro at that time. But now one has to speak about not only dollarisation but also euroisation. In the tripolar political world consisting of the US, the European Union and Japan, the last one is still reluctant to play an international currency role despite the maturity and strength of its economy.

On the other hand, the role of the euro in international trade and payments mechanism has been increasing, albeit slowly, which is partly reflected in the strength of the demand for the currency in the international markets and its appreciation over the dollar since its introduction.

Recent data on currency-wise invoicing of foreign trade of India are unavailable but anecdotal evidence suggests that an increasing share is accounted for by the euro, especially after episodes of rupee appreciation over the dollar. The Committee will, hopefully, throw some light on this point. Further dollarisationhas a de jure aspect like in some Latin American countriesthathave adopted the dollar as the national currency whereas here, thereference is to the de facto informal practice. Thus, it would have been more appropriate for the ToR to include currency substitution as a generic term rather than dollarisation.

But this is semantics and nothing prevents the STC from going into the question of currency substitution in general as one would think that the implications for the domestic economy are the same whether it is dollarisation or euroisation. The STC could also review the experience of currency substitution in other countries, something that the FTC did not attempt in an otherwise good recap of the working of convertibility elsewhere.

Internationalisation of rupee

The question of internationalisation of the rupee may be dismissed by the Committee as it is only of academic interest. In fact, it should not have figured at all in the ToR. It would mean that a good proportion of world trade is invoiced in the rupee. Financial instruments such as bonds are denominated in the currency, inter alia, by other countries, commodity prices in global markets are set in rupees also (a la gold and oil in dollars) and international reserves are held partly in rupees. It is far-fetched to think in terms of these developments even by 2025. However, a caveat is in order.

Though there is no possibility of the internationalisation of the rupee in the foreseeable future, it does not preclude speculative attacks on the currency. Perhaps the reference could have been to "international speculation in rupee" instead of its "internationalisation". SAT could study this aspect.

Currency Substitution

What does currency substitution mean? It means the use of a foreign currency in lieu of the domestic one. Money has three functions to perform — unit of account, medium of exchange and store value. Substitution can take place in any one or more of these functions when the public loses its confidence in its national currency.

I have seen currency substitution at close quarters in Freetown, the capital of Sierra Leone, West Africa, during my IMF assignment as Director of Research/Adviser to Governor in the central bank of that country. Rents for houses were quoted for expatriates in dollars and landlords would insist on dollar cheques. Similar was the case for the purchase of automobiles.

As it is, there are instances in India, even in the absence of CAC, of real-estate transactions where the buyer is advised to arrange to remit a part of the price to the kith and kin of the seller living abroad. This is not difficult if the buyer has an import-export business either in his own name or in the name of his relatives abroad. CAC will legally facilitate such transfers and hence the amounts will be larger. Currency substitution has implications for tax revenue, monetary and forex policies — a matter that will need a separate treatment.

Thus, the real risk in CAC is capital flight. It could be massive if there is a national economic crisis. In fact, such a development is welcome in a way. It can alert the Government to re-imposing control, as Malaysia did during the East Asian financial crisis. But what is insidious is the slow haemorrhaging of funds over a period before the government and the central bank wake up to the fact.

Often such capital flight may be camouflaged in the net position on capital account when there are compensating inflows of foreign portfolio investment. But while the latter can move out quickly, the former may be lost irretrievably. Technological advances and financial management have made it possible to transfer funds abroad quickly and at a cost lower than what it was a decade ago. The Committee would do well to take note of this fact given the highly developed status of telecommunications and computerisation in the country. This was not the case when the FTC wrote its report in 1997.

A review of the current status of capital controls would reveal that, as it is, foreigners have the benefit of full convertibility. The only limitation is on the purchase of immovable property, which is outside the ToR of the SAT. Even the residents have many large limits allowed for taking money abroad on current or capital accounts. The mutual fund route for investment in foreign securities is also available to a limited extent. Under the circumstances, it is worthwhile examining whether the CAC is really called for and if there is any additional benefit.

In this context, a review of the working of Offshore Banking Units (OBUs) in the country that were started with fanfare will be useful to have an idea of the working of CAC particularly to understand the implementation of the money-laundering laws. Surprisingly, despite suggestions, the RBI's statutory reports, though free and forthcoming on so many other aspects of the economy, are deafeningly silent on OBUs.

The STC may like to throw some light on this point. Even if it is not in the ToR, the Committee can do so because it is a practical case of CAC on Indian soil though offshore in a legal sense. It is a difference in degree, not in kind. Will the authorities be able to monitor and check money laundering on a larger scale, if they cannot do it in limited geographical areas?

Benefits

One of the commonly stated benefits of the CAC is that it will facilitate the infusion of large amounts of foreign capital to the benefit of the country. This will be true only if it adds to the productive capacity of the economy through direct investment in plant and machinery. Of the total flow of foreign investment of $18.2 billion in 2005-06, portfolio investment accounted for 69 per cent.

On the other hand, direct investments, which can benefit the country immensely, is being stymied. In any case, even under the existing dispensation, foreign capital is flowing in. How much more will a fuller CAC attract?

Tapasya Trayam

Ancient Hindu scriptures provide a classification of the causes of troubles that one may suffer. They may be due to one's own action; could be caused by others; or, may arise out of natural calamities such as earthquake and floods. This may well apply to countries also. The economy is having an easy time in the external sector. Should the Government invite trouble by introducing fuller CAC now?

(The author is a former officer-in-charge in the Department of Economic Analysis and Policy of the RBI.)

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