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More on Capital Account Convertibility

More on Capital Account Convertibility GURBACHAN SINGH This note comments on some of the papers on capital account convertibility We also attempt to further contribute to


More on Capital Account



his note comments on some of the papers on capital account convertibility (CAC) (May 13, 2006, pp 1848-84). We also attempt to further contribute to the debate. In particular, we will discuss the role of a line of credit, a brief literature review to indicate how fiscal policy can be useful in the absence of an independent monetary policy, and two weaker versions of CAC. These can be useful for policymaking, if full convertibility is decided against.

First, we will discuss three preconditions for allowing CAC. This is not an exhaustive list. Instead, it includes only those conditions that are not as yet met in India. Second, we will make a few comments relating to excessive risk taking by banks, trade credit, loss of independent monetary policy, and currency board. Third, we will consider two weaker versions of CAC. The final part offers some concluding remarks.


First, as has been pointed out by many others, before CAC is allowed, one important precondition that must be met is a reduction in the fiscal deficit. A commonly used measure in this context is the ratio of fiscal deficit to gross domestic product (GDP). However, it may be better to use the ratio of fiscal deficit to government revenues instead. The reason why the ratio of fiscal deficit to government revenues is more appropriate in comparison to the ratio of fiscal deficit to GDP is that we are concerned about the ability of the government to repay, and hence about its ability to collect taxes.1 As a somewhat extreme case, suppose the ratio of fiscal deficit to GDP is almost zero in some country. Does this imply that there is nothing to worry about? Not necessarily. If in such a country, the ratio of fiscal deficit to government revenues is very high on a sustained basis, then there is cause for concern. This is not to say that it is unlikely that such an economy can solve the problem. However, if this feature persists, then there can be a fiscal crisis (for a somewhat related model, see Romer (2001), chapter 11). An analogy maybe useful here. Consider a bright student who does very little work. Clearly, sooner or later, there will be a problem simply because having a potential is necessary but it is not sufficient. This is an extreme example. But to some extent, the case of Indian fiscal condition is similar. There maybe a potential to raise revenues, but at some stage, the government has to translate this potential into reality. It is true that in many cases the government need only ensure that the debt can be rolled over, instead of actually repaying the debt. However, even the roll over finally does depend on the government’s ability and willingness to repay.

Second, one precondition for allowing CAC is investor protection. To see this, consider an important aspect of CAC. “…information is imperfect in capital markets…borrowers in rich countries who have higher initial endowments of capital will be able to borrow more. …capital will flow from poor to rich countries” [Dutt 2006: 1851]. Note that there are three important determinants of fund flows – return on projects, information on the borrower and on the project, and contract enforcement [see Tirole 2006, chapters 3 and 16]. The way each of these factors affects access to funds is as follows. First, access to funds increases with the expected return on the projects, adjusted for risk. Second, it increases with the initial endowment of capital with the borrower, given the asymmetry of information. Third, it increases with the degree of contract enforcement. Dutt is possibly referring to the second factor, and he is right. There can indeed be a flow of funds from less developed countries (LDCs) to developed countries, if CAC is allowed.

One way to counter the reverse flow of funds is as follows. The return on many projects in LDCs is high. However, firms (particularly small ones) may find it difficult to access funds if contract enforcement and investor protection is weak. In such a situation, the potential borrowers cannot credibly commit to repayment2 , and hence cannot get adequate loans. The policy implication is clear. There is a need to improve investor protection. Given the latter and the high return on projects in LDCs, there is a disincentive against flow of funds from LDCs to developed countries. This disincentive may be stronger than the incentive for funds to shift to developed countries due to asymmetry of information coupled with higher initial capital with borrowers in developed countries (the concern expressed by Dutt). So an important precondition for allowing CAC is strengthening investor protection. Of course, this implies that investor protection is strengthened not only for foreign investors but also for domestic investors. This may seem a pro-investor policy. However, it need not be. Strong investor protection improves access to funds for the borrower. So both the investor and the borrower may stand to gain.

To complete the argument, let us go further and consider the case where the benefits are shared unequally, the benefits go more in favour of the investors than the borrowers, and the investors are richer than the borrowers. In this case, the policy of strong investor protection is pro-rich. However, there can be a corrective policy. If the tax laws, the tax administration, and the redistributive administrative machinery is strengthened, then we can ensure a transfer from the rich to the poor within the country, and hence, we may be able to overcome the possible negative side of strong investor protection. So an important safeguard is a change in tax subsidy structure.

One change in taxation that maybe explored is as follows. Taxes on firms that are sole proprietorships or partnerships are perhaps more easily evaded than taxes on corporations. If this is true, then there is a need to encourage corporations. This will increase taxes, which can be used for redistribution. There is an additional possible benefit. If a corporation is

Economic and Political Weekly August 19, 2006 more productive than a non-corporate enterprise, then we can get additional output as well.

The third precondition is a line of credit. To see this, note that perhaps the most devastating feature of east Asian crises was that “episodes of booms in capital inflows, especially short-term capital flows, end abruptly and turn into sharp outflows” [Dutt 2006: 1851]. As Williamson points out, there is a substantial difference between the ability of developed countries and that of LDCs to borrow in times of a crisis [Williamson 2006: 1849]. Furthermore, in such situations, “…the IMF…exacerbates the instability…” [Dutt 2006: 1852]. Considering all this, an important safeguard in future can be the use of an ex ante credible line of credit contracted by the government of a country before it allows CAC. This can be contracted with commercial banks in the international markets for a price. Though one thinks of commercial banks in this context, there is no reason why the same arrangement cannot be done with foreign central banks.

The line of credit enables the country in difficulty to demand funds as a loan as a matter of right. The institution providing the line of credit on the other hand can satisfy itself, ex ante, on the ability of the borrowing country to repay. The price of extending a line of credit will possibly increase with the probability of a crisis, and decrease with the potential borrower country’s ability to repay. This gives an incentive for the potential borrower country to reduce the probability of a crisis, and to improve its ability to repay a loan. It is true that for some countries such a facility may not be available at a reasonable price. Such countries, of course, are ill advised to allow CAC. Instead, they need to put their house in order so that they can indeed buy a line of credit at a reasonable price at a future date, which is when they can allow CAC. Indeed, if a country finds that it is unable to get a line of credit, then it can use this as a signal that it is not ready for CAC, and that it needs to show improvement.

It may be argued that such a market for a credible line of credit hardly exists even for countries that are well placed. This may be true. However, we need to keep in mind that at present, the IMF can be viewed as an institution that in a sense does extend this line of credit. But the experience of many countries has been that this line of credit is not very credible. Moreover, the conditionality imposed by IMF can also have political motives, given that governments of some developed countries can have considerable influence. If the disappointment with IMF continues and grows, it is possible that a market for a credible line of credit does come up on the surface. On the other hand, if there is no disappointment with IMF, then the latter can be relied upon to provide an implicit line of credit, in which case no other supplier is required.

The use of a line of credit can to some extent also substitutes for the large foreign exchange reserves. The opportunity cost of holding large reserves can be high. On the other hand, a line of credit has its own price. Given these costs, what is required is an optimal mix of the two

– foreign exchange reserves and a line of credit.

We have so far discussed each precondition in isolation. Let us now put the pieces together. If the first two preconditions are met, then it is likely that the third precondition too can be met. Why? This is because if the first two preconditions are met (along with others that we are not considering here), then a supplier of a line of credit is very likely to be forthcoming. This implies that it is easy for the central bank of the LDC to meet the third condition too.

Some More Observations

“…Bank credit tends to grow quickly following an inflow of capital. This leads to funding of high-risk projects…” [Sen 2006: 1855]. It is not clear if banks that indulged in excessive risk taking had adequate capital. If it is the case that risk taking occurred despite capital adequacy, then indeed we have problem. However, if risk taking occurred where bank capital was inadequate, then there is a possibility that the adverse outcome of excessive risk taking could have been avoided with capital adequacy (for a somewhat related model, see Gangopadhyay and Singh (2000)). So capital adequacy is an important precondition for allowing CAC. However, this condition is already met in India, given that Basel norms are indeed appropriate.

It is true that “…a depreciation that used to stimulate exports, does not do so anymore because of the paucity of trade credits” [Sen 2006: 1854]. However, with hindsight, we are now wiser. In future, the central bank can take steps to ensure that allocation of credit is such that it does not come in the way of an increase in exports in the event of a sharp depreciation of the local currency. There maybe difficulties in completely solving the problem, but the central bank can cover some ground.

It is true that with CAC, there is less scope for an independent monetary policy for stabilisation [see Wray 2006]. However, all is not lost with a loss of independent monetary policy. There are other policies that can be used for stabilisation, e g, fiscal policy. Indeed, the classic paper on bank runs in Diamond and Dybvig (1983) does not advocate the use of monetary policy for stabilisation. Instead, it relies on the fiscal policy. Yet another example is the issue of public and private supply of liquidity. Holmstrom and Tirole (1998) use fiscal policy and not monetary policy. Observe that both these papers deal with liquidity, which, one would have thought, would require intervention of monetary authorities. However, in both cases, it is possible to use fiscal policy alone to correct a market failure. If fiscal policy can be used to intervene effectively in the context of liquidity, then this suggests that it can be used in many (if not all) other contexts as well. So even if fiscal policy is not a perfect substitute for monetary policy, it can be a very useful policy.

It is true that some countries have had a bad experience with allowing CAC, e g, Argentina [see Ricottilli 2006]. However, in the latter case, CAC was allowed in a regime of currency board, which amounted to using US$ as the numeraire, and taking recourse to 100 per cent reserve banking in some ways. Both these features can have negative consequences, as they did in Argentina. So an important safeguard is that we avoid a currency board. In any case, there is no plan by the government of India to introduce a currency board in India. So the experience of Argentina is not very relevant in India.

Two Weaker Versions of CAC

If the government decides against allowing full CAC, then we can try two weaker versions of CAC.

First, we can try quasi-restrictions on sudden and large outflows. These quasirestrictions may take the following form. While foreign investors are given the freedom to switch from one asset to another within the country, they are not

Economic and Political Weekly August 19, 2006

allowed to make sudden and large withdrawals from the country. For this, the borrowing country on its part may pay a liquidity premium. This argument can be extended to a group of emerging economies. The foreign investors may be given the freedom to shift funds from one country to another within the group. However, they are not allowed to shifting funds from the group as a whole. On the other hand, it maybe possible for member countries to come to each other’s rescue, given that there is little aggregate uncertainty due to the quasi-restrictions. The latter have two advantages. First, there is less scope for contagion effects that hit many countries simultaneously. Second, the investors can credibly threaten to leave a country if there are difficulties in that particular country. Ex ante, this can reduce the scope for moral hazard by the borrowers [see Diamond and Rajan 2001]. Of course, there is a possibility of collusion between the emerging economies but it is not clear if it can be a lasting collusion. So there may be some scope for this arrangement.

Second, observe that one feature of CAC is that it allows domestic residents to invest abroad. Domestic residents may wish to do so for two reasons. One is the desire to invest in a safer or better foreign firm or financial institution, and the other is to use some strong currency, say, the US$ as the numeraire. Usually an investment abroad involves both but it is important to distinguish between the two objectives. Note that the first objective can be somewhat met by allowing (a subsidiary or a branch of) a foreign bank to operate in the home country instead of allowing outflow of capital. So we may say that we have a partial substitute for CAC.

Now consider the objective of using a foreign currency as the numeraire. Usually, the domestic residents invest in banks in the home country by using the local currency as the numeraire. Suppose now that the banks in the home country issue deposits and give loans that are denominated in foreign currency. So on both sides of the balance sheet of domestic banks, there are instruments denominated in foreign currency, and so there is no mismatch. The rate of interest on instruments denominated in foreign currency is determined by demand and supply for funds that are denominated in foreign currency, say US$, without loss of generality. This market for funds denominated in US$ operates alongside the market for funds denominated in rupees. This market with local currency as the numeraire would have its own rate of interest. So there would be two rates of interest – one applicable to loans denominated in US$, and the other applicable to loans denominated in rupees. It is true that even at present, there are two rates of interest. But typically at present the rupee rate of interest is used internally and the US$ rate of interest is used in transactions with the rest of the world. What is suggested here is the possibility of use of both rates of interest domestically by agents who are not necessarily involved in any deal with the external world.

Observe that the use of US$ within the home country is restricted as a numeraire in the case of a few assets such as bank deposits. The domestic residents continue to use rupee as the numeraire in all other transactions within the country. Moreover, even in the case of deposits and loans that are denominated in US$, the latter is to be used as a numeraire only. This means that all withdrawals and deposits are made using the local currency. A depositor deposits rupees in a bank and the latter credits the account of the depositor by an equivalent number of US$, depending on the prevailing exchange rate. Similarly, at the time of redemption, a bank observes the balance denominated in US$, calculates the equivalent balance in terms of rupees, and redeems the deposit by paying rupee notes. So US$ notes are not involved at any stage. This analysis is based on New Monetary Economics [see Cowen and Krozner 1994]. Further, note that there is no loss to the home country in the form of seignorage, if US$ is used as the numeraire for some transactions in the economy.

To sum up this aspect, in the absence of CAC at present, agents in the economy are restricted to using only rupee as the numeraire. Under CAC, they will have an opportunity to use both rupee and US$ as the numeraire. Our point is that US$ can possibly be used as the numeraire even in the absence of CAC, provided the central bank allows this.

Concluding Remarks

In our view, there are three questions. First, is India ready for CAC at present? Second, can India be prepared for CAC in the near future? Third, will the authorities actually prepare India for CAC in the near future? The first question is easy to answer. Our answer is no. This conclusion is in line with the case against rushing into CAC [Sen 2006]. The second question is relatively difficult. However, given the analysis here, and given our experience in handling changes in the past, e g, the post-liberalisation phase (post-1991-92), our answer to the second question is yes. It is the third question which is the most difficult to answer particularly for an economist. We can leave this for others.




1 Wray (2006) writes that “… the sovereign government’s ability to make payments is neither revenue-constrained nor reserve constrained” (p 1859). While this maybe true if the author is referring to the short run, and in the context of nominal values, it is doubtful if this claim holds in the context of real values and a budget constraint that is inter-temporal [see Romer 2001, chapter 11].

2 Observe that this argument holds even in the absence of asymmetric information.


Cowen, Tyler and Randall Krozner (1994):

Explorations in the New Monetary Economics,

Basil Blackwell, Oxford.

Diamond, Douglas W and Philip H Dybvig (1983): ‘Bank Runs, Deposit Insurance and Liquidity’, Journal of Political Economy, 91, pp 401-19.

Diamond, Douglas W and Raghuram G Rajan (2001): ‘Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking’, Journal of Political Economy, p 109.

Dutt, Amitava Krishna (2006): ‘Flawed Logic of Capital Account Liberalisation’, Economic and Political Weekly, May 13, pp 1850-53.

Gangopadhyay, Shubhashis and Gurbachan Singh (2000): ‘Avoiding Bank Runs in Transition Economies: The Role of Risk Neutral Capital’, Journal of Banking and Finance, 24, pp 625-42.

Holmstrom, B and J Tirole (1998): ‘Private and Public Supply of Liquidity’, Journal of Political Economy, 106, February, pp 1-40.

Ricottilli, Massimo (2006): ‘Capital Movements and Currency Board in Argentina’, Economic and Political Weekly, pp 1861-64.

Romer, David (2001):Advanced Macroeconomics, Second edition, McGraw-Hill International Edition.

Sen, Partha (2006): ‘Case against Rushing into Full Capital Account Convertibility’,Economic and Political Weekly, May 13, pp 1853-57.

Tirole, J (2006): The Theory of Corporate Finance, Princeton University Press, chapter 16.

Williamson, J (2006): ‘Why Capital Account Convertibility in India is Premature’, Economic and Political Weekly, May 13, pp 1848-50.

Wray, L Randall (2006): ‘Currency Sovereignty and Policy Independence’, Economic and Political Weekly, pp 1857-60.

Economic and Political Weekly August 19, 2006

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