Saturday, Dec 28, 2002
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By C. R. L. Narasimhan
The Reserve Bank of India's announcement last Saturday (December 21) to modify certain rules relating to the forex market has been hailed as a major step in the ongoing moves to ease exchange controls. Exchange control liberalisation, it certainly is, but is it a decisive step towards capital account convertibility (CAC) as well? Full convertibility of the rupee is probably on the horizon, but the march towards it has been calibrated in India. At a broader level, there are ample reasons to support the view that the Indian model of integrating with the outside world has stood the test of time and is in fact worthy of emulation by a few other countries similarly placed. Yet, ever so often there is speculation that CAC is around the corner. The present juncture is one of those moments. The expectation is based on two developments, one dealing with the RBI's relaxation of exchange controls and the other on the growing confidence in the external account. The level of burgeoning reserves has crossed $68 billion and the rupee has been appreciating against the dollar recently. The RBI's new liberalisation measures give corporates the freedom to rebook cancelled forward contracts without any limit. Also multinationals can hedge the exchange risk on the investments brought into India after 1993, without the permission of RBI. Banks can invest freely in overseas markets. These are definitely significant steps, affecting all market players. When seen in conjunction with two other recent liberalisation measures — permitting mutual funds to invest in overseas markets and allowing residents to open foreign currency accounts in India — they seem to suggest that the RBI is hastening the pace towards CAC. Such a conclusion may still be premature. In fact since 1992 the expression "full convertibility'' has caught the fancy of important sections, who in a globalisation context have equated it with economic reform and therefore consider it a highly desirable goal. There is once again a case to understand CAC in its entirety. In fact the rupee has always been convertible against major foreign currencies even during the IMF regime when it was on a peg. Liberalisation/relaxation moves since 1992 have progressively whittled down the rigour of controls on the current account, but not brought about capital account convertibility. Under a fully convertible currency regime, resident Indians can invest abroad and borrow from overseas sources. Similarly non-residents will have no restriction whatsoever to invest or borrow in India. In short irrespective of whether one is a resident or non-resident his assets and liabilities can be freely denominated in any currency and easily interchanged between that currency and the rupee. It will be possible under CAC for resident Indians to buy a bond in the U.S. or London. A foreign company can if it wishes to tap the Indian debt market, raise rupee resources and repatriate the proceeds to its head office. In short there will be no restrictions on funds flow between India and outside, whether it is for trade or long-term investment. (However, countries can and do keep discretionary powers to check undesirable flows or transactions). Yet none of the attributes that will bring about CAC in India can be hastened or ordered to happen. Quite simply, the recent relaxations while they go far to make rupee an international currency, akin to the pound, the yen, the euro or the dollar, are by themselves not enough. For instance, banks are permitted to quote dollar-rupee swaps and non-residents can hedge their forex risks substantially. However, mere policy relaxations in India do not automatically result in conferring an exalted status for the domestic currency. An active rupee money market ought to exist. There must be a substantial increase in the levels of invoicing in Indian rupee in international trade. Banks must be willing and able to offer a two-way quote in rupees against the dollar freely and for longer periods as well. Another way to look at the recent liberalisation measures is to examine their likely efficacy. As timing is important, will the recent RBI moves count for much in a situation where reserves are mounting and the rupee is on an appreciation path? For instance, the facility given to banks as also to mutual funds earlier to invest abroad might not result in an exodus of flows. Mutual funds may be running an interest risk by investing in overseas markets where the interest rates are at unprecedented lows. Also, the rupee appreciation may nullify the realisation of even those modest yields. Similarly the other relaxation — permitting residents to open foreign currency accounts — will deliver far less than what some think it would do. To begin with only a small portion of dollars that is available with residents will find their way into those accounts. Banks will have to incur high transaction costs to maintain those accounts. One last point that can buttress the current policy stance of a calibrated move towards CAC: the BOP crises in Southeast Asia and East Asia were caused by a flight of capital by residents and non-residents alike. In times of great turmoil even a forex cushion upwards of $68 billion will not be of help. Finally, macro economic policy has to look at a number of ingredients simultaneously. Policy issues concerning control over money supply, interest rates, exchange rate policy and free mobility of capital cannot be looked at in isolation from one another.
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