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Liberalising Capital Account

Chapter 2 deals with the operational aspects of capital account liberalisation in Liberalising Capital Account terms of a macroeconomic perspective. The conclusion that India

Reviews

Liberalising Capital Account

Lessons and the Great Dilemma

Liberalising Capital Flows: India’s Experience and Policy Issues

by Renu Kohli; Oxford University Press, New Delhi, 2005; pp xvii+241, Rs 550.

SUGATA MARJIT

I
ndia’s experiment with reforms is poised at a crucial juncture with a clear nod from the finance ministry in favour of capital account convertibility. What does it really have in store for us? What are the experiences of the other developing countries? What is our experience with the management of the exchange rate so far? How does the Reserve Bank of India actually intervene in the market? What are the constraints faced by the apex institution? These are the questions, which usually confront a serious and diverse group of readers such as students, researchers, and policy-makers. Renu Kohli’s timely book on these issues serves a great purpose by providing detailed and lucid analyses of various facets of the problem. Taking capital in and out of India without any constraint, be it for consumption or investment is essentially what is meant by full capital account convertibility. Enhancing the ability of private capital to fly out at will, often poses serious problems. Substantial capital flight may lead to severe exchange rate adjustments, interest rate upswings and closure of business units, unemployment and eventually social unrest. On the other hand, a flexible option provided to the foreign investors favourably alters the perception of the international capital market, reducing the chances of capital getting stuck in barriers. Decline in risk premiums attracts more investment, spurting growth and providing the necessary funds for capitalstarved enterprises. A more post-modern perspective will be to take into account the possibility that if an Indian investor wishes to acquire foreign business units for strategic and synergic reasons, a relatively open capital account becomes particularly useful. The problem is not one of understanding the pros and cons of such a policy but to assess its possible impact in our specific context.

If one could formally write down a kind of “social objective function” involving the costs and benefits of capital account liberalisation, the problem would boil down to weighing the “derivative” of policy initiatives, keeping in mind that the marginal cost of such a move has to receive a far greater weight than the marginal benefit. If a 1 per cent potential increase in the growth rate has to be weighed against the potential risk of unemployment and closure of numerous enterprises, a democratic nation should think deep before embarking on such a path. Therefore, one has to know about the basic theory and historical outcomes of the capital account liberalisation process.

Overview

Chapter 1 of Kohli’s book starts with an overview of the problem, discussing various theoretical works and empirical evidence in a global context. Unrestricted capital flows destroy the capacity of the monetary authorities to alter interest rates and control exchange rate movements. This is undesirable from the point of view of a regulator. The main contribution of this chapter, apart from being a nice survey of the existing literature, is a fine discussion of the major competing arguments. In particular Dani Rodrik’s scepticisms regarding the positive impact of capital inflows on per capita GDP growth is pointed against Sebastian Edwards’ analysis of capital account openness and faster productivity growth. The general morale of the story seems to be a cautious approach, first, through the hierarchical sequencing of trade reforms and capital account reforms and then through a gradualist approach towards full capital account convertibility.

Chapter 2 deals with the operational aspects of capital account liberalisation in terms of a macroeconomic perspective. The conclusion that India’s fiscal and financial reforms have not evolved fast enough is analysed in greater detail in subsequent chapters. The credibility of external sector reforms is reflected in a low rate of inflation, levels of short-term external debt, a small and reasonably sustainable current account deficit and sizable foreign exchange reserves. However, these cannot overshadow the fiscal profligacy of the central and state governments. Several indicators cited in the book denote the problem of public debt almost to the tune of a possible debt trap for the nation as a whole.

Subsequent chapters focus on the macroeconomic impact of capital inflows, in particular on real exchange rate appreciation, reserves accumulation and stock market volatility. Although the book typically uses data up to 2000-01, such issues continue to occupy the centre stage of India’s macroeconomic policy. A related theme evolves around the central bank’s policy of sterilisation in the face of sizable accumulation of foreign exchange reserves and in apprehension of an undesired impact on money supply. The rapid pace of monetary growth is already taking a toll on debt management as a huge amount of government bonds are needed for such an operation. In the event of full convertibility of capital account, such a problem may become even more difficult to handle. This is not explicitly stated in the book. But one could draw such a conclusion from the arguments developed here.

I have found the chapter on the pace and sequencing of reform very useful from a historical perspective. It actually traces the entire history and design of specific policies, which have been pursued with eventual capital account convertibility as the target. If one needs to go back and analyse in detail how the banking sector, financial sector and external sector reforms were interrelated in the initial phase of liberalisation, this naturally becomes a very useful source to look at.

A dramatic rise in foreign capital inflow has its likely impact on the exchange rate. Greater integration with the financial market in the rest of the world leads to

Economic and Political Weekly May 13, 2006 a more volatile response in nominal and real exchange rates. We have been experiencing an era of managed float as the RBI intervenes periodically in the foreign exchange market. The author identifies some features of exchange rate behaviour, which differ quite a bit from reform related experiences in other countries. They are – very low exchange rate volatility, thanks to the interventionist strategy of RBI, a clear break in the longterm depreciating trend of the real exchange rate and rise in foreign exchange reserves volatility, although I feel that in the last few years, such volatility must have come down. The fear of a steady and sharply appreciating rupee as a deterrent of exports has induced authorities to intervene in the market, although there is not strong evidence that a depreciating rupee is the crucial factor promoting our exports.

Problem of Plenty

In a way the possible criticism of the approach of the book will be a lack of precise theoretical foundations behind such policy-making in India. For example, one fails to find a systematic discussion on how the exchange rate is supposed to behave in the event of a liberalised capital account transaction. Usually as a developing country, hitherto insulated from international capital flows, liberalises its capital account, there is a fear that there will be severe capital flight or exchange rate fluctuations will increase substantially as capital quickly moves in and out of the country. While textbook type theoretical work suffers from too much emphasis on capital outflows, India provides a good example where managing huge capital inflows has become a real problem. Possible exchange rate appreciation and its adverse effect on our exports, sharp rise in foreign exchange reserves and its impact on monetary growth and inflation, cheaper loans abroad affecting the business of local banks, etc, all point towards a problem of dealing with “plenty”. This should have come out more clearly in the analysis.

A natural cause of worry seems to be associated with the sterilisation process itself. This is nicely portrayed in the analysis of “quasi-fiscal” costs of maintaining huge resources, when interest rate on foreign assets is lower than the available domestic counterpart. Sterilisation refers to the sale of government bonds to mop up excess money supply from the system. Continuous sterilisation has led to a drastically reduced supply of stocks of tradable securities. While the author rightly points out the substantial costs of maintaining reserves, one does not find much discussion on what should determine some sort of an “optimal” reserves base. Is there any way of utilising such reserves in more productive ways? These problems do not find any ready answer in the theoretical literature. More analytical discussion on these issues would have been welcome.

Discussion on the banking sector reform is quite comprehensive and adequate. One problem, that became quite transparent during the Asian crisis, had to do with the increasing exposure of banks to foreign liabilities of short-term maturities. Any speculative flight of capital under such circumstances exposes the entire banking system and hence small depositors to serious problems. Thanks to judicious regulatory behaviour of the apex bank and the ministry of finance, Indian banks so far have not experienced a huge surge of deposits of this kind.1 Restrictions on bank privatisation, accumulation of foreign deposits, etc, have insulated our banks a bit from foreign disturbances. However, the scarcity of bank deposits has not been a cause of concern over the years given the general household attitude towards savings. Unfortunately strict prudential norms and moderate growth in the demand for bank credit among so-called non-risk borrowers have led banks to pile up government securities well beyond the statutory liquidity ratio requirements. Again, I felt that the book needed a chapter on what one should have expected in terms of standard theory and how the Indian case actually differed from conventional wisdom.

This brings us to the core issue of investment and growth and its relation to liberalised capital flows. One way to motivate the case for the free flow of capital is to speak of its possible positive impact on overall rate of investment, productivity and growth. The argument can be developed in two stages. First, through clarifying how sensitive foreign investment, direct or portfolio, is to the removal of restrictions and secondly, demonstrating how such investments can uplift the overall rate of investment and productivity in the economy. Since India has already experienced a gradual loosening of capital controls, some evidence is available for useful assessment.

It goes without saying that the booming stock market in India is primarily fuelled by foreign institutional investors. In fact, the Sensex belies all expectations and continues to overachieve at a formidable rate. Therefore, a complete withdrawal of restrictions on capital movement cannot be justified on the ground that the share market needs it, unless one can show that there is scarcity of funds for investment. This takes us to the second stage of analysis.

Stagnant Investment

Remarkably in the post-reform period, the overall rate of investment as a proportion of GDP has been quite stagnant. As private investment picked up a bit, public investment came crashing down. It has been pointed out elsewhere2 that a booming stock market and gradual decline in interest cost of borrowing could not elevate the aggregate rate of investment substantially in many countries. The current high rate of GDP growth in India again is not caused so much by an increase in the rate of physical investment, but possibly by an increase in the productivity of capital stock. Also one is not sure whether further liberalisation in capital flows is essential for growth since no study has actually looked at that effect. Investment in infrastructure does require a facelift and there is no guarantee that such flows will solve this problem. It is quite possible that the limited amount of FDI and runaway stock markets may not have affected productivity in general, although this is the crucial factor behind our high rate of GDP growth. The tremendous performance of our share market has never been a good predictor of movements in corporate and private investment, which have increased moderately.

A more profound problem is to assess whether increasing capital flows actually affects numerous other indicators of India’s development. Since we cannot afford only to dance at the growth rate, being a nation of substantially uneducated, malnourished, poverty-stricken masses, one has to judge how we can use international capital flows to solve some of our deeper problems. This is glaringly missing in the entire policy agenda and somewhat neglected in the present work. In fact, the entire macroeconomics literature on capital account convertibility or capital account liberalisation seldom raises concern over the impact of capital inflow on overall economic development. While the primary purpose of opening up capital account transactions is not to affect the health, education, and other social sectors directly, there are ways

Economic and Political Weekly May 13, 2006

and means by which foreign resources can be directed towards providing better social infrastructure. For example, with roaring foreign capital inflow, a small tax on such transactions may ease out volatility and generate public resources at the same time.

One would have appreciated a discussion on the theme of partial versus full capital account convertibility from a more analytical point of view. One aspect of such analysis would be to focus on the concern for management of such flows along with its impact on the financial sector. This is well performed by the volume, but possibly a more crucial aspect would be to judge what such convertibility has achieved so far in terms of its impact on investment, growth, productivity and employment. A clear cut econometric exercise should look at the usefulness of such a move in the Indian context. How exactly should one respond to the political urge for free capital flows when public capital expenditure itself drops from 3.6 per cent (2004-2005) to 1.9 per cent (20052006) of GDP? The success and failure of larger capital inflows in a wider socioeconomic context depends a lot on complementary public investment. Such issues cannot be neglected while evaluating the performance of an apparently market-friendly policy.

All said and done, Renu Kohli’s work is a very useful addition to the debate on capital account convertibility. If anyone has to be aware of the background of the debate, the theoretical and empirical evidence available so far and how exactly our monetary authorities deal with such problems, this is an ideal source material.

EPW

Email: smarjit@hotmail.com

Notes

1 Although very recently, since March 2004, the ratio of short-term debt to total debt has increased from 4 to 7.5 per cent, this is an interesting development (Macroeconomic and Monetary Developments in 2005-2006, April 18, 2006, Reserve Bank of India).

2 Guha-Khasnobis et al 2003, 2005; Marjit 2005.

References

Guha-Khasnobis, Basudeb and Faisal, Bari (2003): ‘Sources of Growth in South Asian Countries’, in Ahluwalia and Williamson (eds), The South Asian Experience with Growth, Oxford University Press, New Delhi, India.

Guha-Khasnobis, Basudeb, and Sugata Marjit (2005), ‘Financial Reforms, Investment and Growth: Analytical Issues Related to the Developing Countries’, Conference Paper, United Nations University, WIDER, July 1-2.

Marjit, Sugata (2005), ‘Financial Sector Reform for Stimulating Investment and Economic Growth: The Indian Experience’, www.adb.org/ Documents/Reports/Consultant/TAR-IND4066/macroeconomics/marjit.pdf.

Economic and Political Weekly May 13, 2006

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