By IPS Correspondents
NEW DELHI, Apr 7 2006 (IPS)

After decades of running a closed economy, India is now gingerly taking steps towards freeing the rupee from all official controls – a move analysts say is fraught with dangers such as capital flight, that other Asia Pacific countries are only too familiar with.

The time, analysts say, is not right to take a decision on full capital account convertibility for the rupee, no matter what the pressure is on India to open up faster than it has been doing in 15 years of economic reforms.

Prime Minister Manmohan Singh raised the topic, last month, while on a visit to the Reserve Bank of India (RBI), the country’s central bank and apex monetary authority, located in Mumbai city. Singh and his finance minister Palaniappan Chidambaram see this step as a move towards what is being described as the ‘second phase’ of economic reforms and an indication of the growing resilience of the Indian economy.

Singh said India’s external financial position had become comfortable with foreign exchange reserves going up sharply. In addition, the country’s external debt profile had improved with short-term debt now accounting for only 6.7 percent of total external debt – down from 7.2 percent in March 1997 and 10.2 percent in 1991.

Those supporting full capital account convertibility say the move would ease capital flows in and out of India and bring more foreign investments into the country. However, those opposed to it point out that India was insulated from the worst effects of the Asian financial meltdown in 1997-98 precisely because of the existence of controls on free movement of currencies.

A group of over 160 economists described the move as ”unnecessary and dangerous”. In a statement issued by Prof. Prabhat Patnaik of Jawaharlal Nehru University (JNU) on Mar. 29, the economists said the move would expose the country to ”unpredictable movements in capital flows” and create ”a potential for fragility and crisis which is completely avoidable”.

Citing the example of Brazil, the statement said the country’s total outstanding external debt in the beginning of the 1980s was almost equal to the estimated capital flight by the resident rich. ”The costs of servicing this debt and pursuing the conditionalities required to renegotiate the debt were borne by the working poor,” Patnaik noted, adding that similar outcomes of a full currency float on capital account were observed in other developing nations such as Turkey, Indonesia and Mexico.

Soon after Singh made his announcement in Mumbai, India’s commercial capital, the federal bank announced the appointment of a six-person committee to come up with a ‘road map’ towards full capital account convertibility by the end of July.

Curiously, the committee will be headed by former deputy governor of the RBI, S. S. Tarapore, who had led a similar panel that came out with a report in 1997, which had to be shelved because of the Asian meltdown.

One view is that with full capital account convertibility, the rupee could strengthen bringing in higher inflows of U.S. dollars and other hard currencies like the Euro, the yen and the pound sterling. Such confidence stems from the size of India’s foreign exchange reserves, currently in excess of 140 billion US dollars, equivalent to more than 15 months’ imports.

India began to gradually lift restrictions on currency transactions after Singh initiated a first round of economic reforms after he became finance minister in 1991. He then gradually removed restrictions on current account transactions including those relating to trade, interest payments, remittances and certain capital assets.

Harvard University chairman Lawrence Summers, on a recent visit to India, said that around 15 percent of the country’s current foreign exchange reserves are in excess. This implies that the “excess” reserves of over 20 billion US dollars could be used to improve the country’s creaking physical infrastructure. Summers argued that infrastructure development could generate more domestic demand and absorb further inflows of foreign capital.

Not everyone is in agreement with this point of view. ”Despite our bulging foreign exchange reserves, we have just not been able to use these for infrastructure development and I don’t see it happening in a hurry,” economist Charan D. Wadhva told IPS in an interview.

”At this stage, we are not ready for full capital account convertibility,” added Wadhva, professor emeritus at the New Delhi-based thinktank, the Centre for Policy Research, who believes India should liberalise existing exchange controls in a slow, phased manner.

Broadly speaking, full capital account convertibility would mean freedom for firms and residents to freely buy into overseas assets such as equity shares, bonds, property and acquire ownership of overseas firms. It would further mean free repatriation of funds by foreign investors.

Some of the benefits of capital account convertibility being listed include the following: Indian companies will have easier access to foreign debt markets, delays in foreign exchange transactions will come down and foreign investor access to India’s banks and debt market will be enhanced.

Currently, the rupee can be freely converted for trade in goods and services, but there are restrictions on international asset acquisition by Indian citizens. Official approval is needed to move capital across borders and companies need permission to borrow overseas.

Just as there are arguments in favour of full capital account convertibility, there are equally compelling arguments against it. Communist parties, on whose support the centre-left Indian government depends, fear that full convertibility will lead capital flight from India. There are others who argue that full convertibility should take place only after the country has a robust debt market in place and the economy’s absorptive capacity goes up substantially.

The first Tarapore committee had recommended that India move towards full convertibility by 2000 but only if certain pre-conditions were met.

Some of the committee’s pre-conditions are yet to be fulfilled. These include a sharp fall in the fiscal deficit as a proportion of gross domestic product (GDP) to 3.5 percent, a fall in the inflation rate to between three and five percent over a three year period and a reduction in the gross non-performing assets of the banking system -a euphemism for unpaid loans – to five percent of total loans advanced.

India’s GDP has grown between seven and eight percent over the last three years, while the inflation rate has varied between four and five percent in recent months, down from over eight percent in August 2004.

While the federal government’s fiscal deficit is expected to be 4.1 percent of GDP during the financial year that ended in March, down from 5.9 percent in 2002-03 and 6.2 percent in the year before that, the combined fiscal deficit of the federal and state governments is much higher at 7.7 percent of GDP. Non-performing assets or bad bank loans have narrowed to 5.2 percent of total loans advanced, down from 13 percent a decade ago.

The stock market is surging, reflecting the growing confidence of foreign investors in the Indian economy. The government is targeting an inflow of 10 billion US dollars worth of foreign direct investment (FDI) in 2006, up from six billion dollars in 2005.

Still, such an inflow of FDI would be a tenth of the over 60 billion dollars that China reportedly attracted in 2005.

Singh has estimated that India would need total investments worth 1.5 trillion dollars over the next five years to sustain an annual GDP growth rate of more than eight percent, of which 70 billion dollars should be in the form of FDI. Much of these investments are meant for developing the country’s infrastructure.

Nevertheless, economists remain unconvinced that full capital account convertibility would attract more foreign investments. Says economist C. P. Chandrashekhar, also professor at JNU: “The claim that convertibility would attract more foreign investments is belied by China’s example. China continues to attract investments from abroad while retaining exchange controls.”

He told IPS that the government is contemplating full capital account convertibility ”under pressure from a small section of wealth-holders in India to provide them the option of hedging their portfolio choices across countries and across currencies in the form of capital assets”. Chandrashekhar says the issue of convertibility should not be linked to the alleged ‘lack of self-confidence’ in the strength of the Indian economy.

Depending on the relative confidence reposed by this section of Indian wealth-holders on different currencies of different countries, full capital account convertibility would “straightaway lead to some flight of capital from the country,” he claims.

”For all intents and purposes, the rupee is fully convertible for everybody other than resident Indians seeking to purchase capital assets outside the country,” Chandrashekhar points out, adding that ”only a minuscule section of super-rich Indians would benefit from full capital account convertibility”.

Says Wadhva: ”We have a long way to go and I don’t see the second Tarapore committee recommending full convertibility in three or even, five years down the line.”

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