## Thursday, March 23, 2006

### Opening the capital account - II

In 1997, the Tarapore committee took on the convertibility question. For a glance at the zeitgeist of the time, see an article I wrote in ET at the time. The conventional wisdom is that the report was buried after the East Asian Crisis. I disagree. I think Bimal Jalan did an amazing job of chipping away at capital controls through his period as RBI governor, once the early problems of 1998 were put behind. At the level of rhetoric, the word "convertibility" was avoided, while steadily moving forward to de facto convertibility, and obtaining a steady increase in the size of the capital account when compared with GDP.

On 18th (Saturday), Manmohan Singh did a speech in Bombay where he said:

Today, globalization is changing many familiar things the way we think, act and perform. It is changing central banking too. Funds in large amounts move across borders with ease and speed. Maintaining financial stability in the face of such forces of globalization is a challenge. But globalization is an opportunity too as it makes it possible to harness global capital in search of investments for furthering national goals. The Reserve Bank has to remain ahead of the curve so as to minimize the costs and maximize the benefits of globalization for the country.

A proposal to make Mumbai a Regional Financial Centre is already under active consideration. Our economic reforms have accelerated growth, enhanced stability and strengthened both external and financial sectors. Our trade as well as financial sectors are already considerably integrated with the global economy and the trend is irreversible. Mumbai, with all its inherent advantages in terms of human capital and commercial acumen, can be positioned as a viable Regional Financial Centre. We need to work towards this objective.

Given the changes that have taken place over the last two decades, there is merit in moving towards fuller capital account convertibility within a transparent framework. This issue was first examined by the Tarapore Committee. Much water has flown down the Ganga since then. Our own position, internally and externally, has become far more comfortable. I will therefore request the Finance Minister and the Reserve Bank to revisit the subject and come out with a roadmap based on current realities. Progress in this regard will facilitate the transformation of Mumbai into not only a Regional but also a Global Financial Centre.

This was extensively reported in the media in India and abroad. It was a big front-page story in FT. A first round of editorial commentary (e.g. editorial in BS) was supportive.

On 20th (Monday), Chidambaram said some intruiging stuff. E.g., the story in BS says:

With Prime Minister Manmohan Singh favouring full float of the rupee, Finance Minister P Chidambaram today said the government and the Reserve Bank of India (RBI) would, in the next few days, announce steps on capital account convertibility of the Indian currency.

"Prime Minister has made a very definitive statement day before yesterday, and the RBI and the government would announce the next steps (on capital account convertibility) in a few days from now," he said at a CII function this morning.

Chidambaram said the finance ministry and RBI had discussions on capital account convertibility of the rupee, and the issue could have been part of Budget 2006. "It was pulled out of the Budget as it could have overshadowed other fiscal policy announcements," he said.

A few hours later, RBI moved, setting up a RBI-friendly committee that will write a report about where to go next. The committee consists of S. S. Tarapore, Surjit Bhalla, M G Bhide, A V Rajwade, R H Patil and Ajit Ranade. An interesting composition: three Ph.D.s, some macroeconomics (Surjit), some finance (Bhide, Rajwade, Patil). I tried to look up recent writings by Tarapore in FE, but he seems to have stopped writing in recent years.

The speed in setting up this committee is astonishing. E.g. the Percy Mistry committee on Bombay as an international financial centre took one year from budget speech to setting up the committee. In contrast, this was setup in a few hours.

The Tarapore-2 committee will start work on 1 May and submit on 31 July. This differs from announcing steps in the next few days as stated by the FM. It is about putting off steps till 31 July. :-)

In short, I don't understand what is going on. There is some chess game afoot that I'm only dimly comprehending. Why did Manmohan Singh and Chidambaram say what they said, in quick succession? Why did RBI rapidly create this committee? Why these names for the committee?

It took a few days, but top quality commentary has started appearing in the media:

• An editorial in BS argues that moving towards convertibility should leave banks out of the mainstream, and that it's time to fix the debt market and commodity futures regulation. It emphasises that there will be six great currencies in the years to come: the USD, Euro, JPY, GBP, CNY and INR. They say we have to build an INR yield curve which is a target for investment and issuance for the whole world. I will point out that of the six currencies, the institutional structures underpinning the Euro are not yet fully done. E.g. see this recent article by J. Bradford DeLong. And the CNY, of course has huge problems. So prospects for the INR may be a bit better than might otherwise have been the case.
• G. Ramachandran has an excellent piece in Hindu Business Line where he emphasises the link between greater openness and greater currency flexibility.
• Ila Patnaik has an excellent `Gained in Translation' on the subject.

This story started with a speech by the PM on the 18th of March and today is March 23. It's a fast moving game. These developments could also influence the Percy Mistry committee on Bombay in interesting ways.

1. Ajay,
Full convertibility should be the ultimate goal. However, many people think that the BSE is overvalued, and a future correction is eminent. Do you agree with this? If you do, doesn't volatility associated with a completely convertible ruppee become a big issue in the short term?

2. Sir
Today’s economic times has a news item, which says, all India reserve bank employees associations has strongly opposed the government move to revisit CAC. The question is are we moving a little too fast. Is the economy mature enough to deal with crises situation if arises. We are moving in towards full CAC slowly. Should we follow the same pace or take a big step, which the committee will be suggesting.

As Ila Patnaik said ‘the capital account is about our portfolios. It is where we invest in global assets, and global portfolios invest in Indian assets”. Quite right, but the question at this stage is are the limits creating problem. For instance the limit set for the qualified Indian intuitional investor to invest abroad. They are no way near that. It applies for the banks also. The Indian bond markets is also a concern. In this situation how far the full CAC will create value to the economy. I think we should wait a little and allow the economy to gain some more strength before we move to full CAC. I think it will not be a bad idea.

3. Jay, I think that the P/E of the Indian stock market fluctuates from week to week. Yes, it will go up and down. Stock prices must move. I think that's really divorced of the convertibility question, which is about long-run stuff. E.g. all over Europe, countries moved to convertibility in the early 1970s and stayed that way. That is a big picture, long-run, structural reform which improves efficiency in the economy. In that sense, in the long run, it is good for the companies and good for stock prices.

In the short run, of course, I should remind you that for FIIs, India is already convertible! It is only you or I who are blocked from moving our money across the border.

4. Hmm, Rajesh, let me think.

One aspect is quite obvious: that's the conflict of interest. RBI staff benefit from the diwali gifts associated with manning capital controls. It is not surprising that some of them object to liberalisation. It's not unlike the feelings of the employees of the Ministry of Steel when it came to decontrol of steel, or the feelings of employees in the Ministry of Finance and the Ministry of Commerce when trade liberalisation was done.

But to go one step further, when you see a "RBI staff trade union", why do you think there is competence on macroeconomics and finance? :-) Ooops, I just noticed these great authorities weighing in on the subject. Yes, of course, given the thoughtful judgment of such supremely knowledgeable people, we should be incredibly careful and not do convertibility.

To all of us who feel convertibility is new and breathtaking, I would like to take you back to 1992. What would you have felt if you were told in 1992, that all goods would be on OGL and that the peak customs rate would be 12.5? We're in for another similar ride. The only big difference is that to a big extent, a lot of convertibility is already with us. The only ones facing restrictions are the honest resident Indian.

5. Hi Sir,

True. It is only us who are not allowed to invest abroad as much as FIIs do it in India. RBI does allow individuals to invest upto USD 25,000 per annum in international securities.

But, Sir, is the rule as simple as buying shares of google (from someone like e-trade of charles schwab) and make the payment via our credit cards ?

Another question that comes to my mind is that does RBI fall under the convertibility umbrella ? If yes, then how does it invest billions of dollars into the US treasury ? If it is indeed allowed, then why not us ?

Besides, its a different (distressing) story that while the Norwegian Central Bankers are here to invest in "risky" assets like "Indian equity", our dear old RBI remains invested in the poorly paying US "soveriegn" paper.

--
Ravi.

6. Ravi: Yes, the essence is that you or I should be able to open bank accounts with any bank in the world, denominated in any currency of our choice, so that we can then buy a house in the south of France if we feel that houses in south Bombay are too expensive. :-)

Think global diversification, not individual stocks. Think of index funds of the top 20 countries making up your portfolio - maybe market cap weights or maybe country GDP weights. There are also global index funds out there - e.g. there's something called "GEMS" I think.

Norway is not quite official reserves. It is an institutional mechanism to put aside oil money so it doesn't mess up the country.

7. I am trying to fathom what the loony lefties are on about?
They are worried about hot money moving in and out causing the currency to swing wildly?

But,isnt that already allowed?.The foreigners can enter and exit without any barriers.It is just local Indians whose hands are tied.

Do these lefties even know what they are talking about?. If I were their school teacher, they would score 0/100 Marx in Commonsense 101

8. There is no empirical evidence that removal of capital controls have resulted in faster economic growth or lower inflation rates. Overall, it has only created havocs like the Southeast Asian crisis of 1997. However, capital account convertibility is a necessary—though unwanted—condition of the existence of the market as a whole of finance capital. Because the capital market runs on the same principles as those of the manufactured products’ market. This simple reality is the logic of capital account convertibility. This scientific understanding, however, cannot justify the perils of unbridled movement of capital across the borders of nations. Paul Krugman says that “sooner or later we will have to turn the clock at least part of the way back: to limit capital flows for countries that are unsuitable for either currency unions or free floating.” (Write to me manoj_freeman@yahoo.com)

9. It is rather interesting for me to read that post. Thanks for it. I like such themes and everything that is connected to this matter. I definitely want to read more on that blog soon.

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