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Roadmap to Risk and Volatility

ECONOMIC AND POLITICAL WEEKLY Roadmap to Risk and Volatility The Report of the Committee on Fuller Capital Account Convertibility (CAC Report), released on September 1, apart from setting out

September 9, 2006 ECONOMIC AND POLITICAL WEEKLY
Roadmap to Risk and Volatility The Report of the Committee on Fuller Capital Account Convertibility (CAC Report), released on September 1, apart from setting out “a roadmap towards fuller capital account convertibility” of the rupee, makes a case for a monetarist macroeconomic policy framework and deeper financial liberalisation on the pretext that it is only when these are carried out in tandem will there be a quantum jump in foreign investment leading to a higher rate of economic growth. That the link of this package with higher economic growth is not established theoretically or empirically does not seem to have mattered to the committee. In an important chapter entitled ‘Concomitants for a Move to Fuller Capital Account Convertibility’, the report makes the predicable recommendations regarding fiscal and monetary policy, financial sector liberalisation, sustainability of a current account deficit (CAD) of 3 per cent of gross domestic product (GDP), adequacy of forex reserves, and so on. The stipulation of the Fiscal Responsibility and Budget Management Act and the recommendation of Twelfth Finance Commission regarding the central and the state fiscal deficits, elimination of the revenue deficit and build up thereafter of adequate revenue surpluses are endorsed. The latter, it is recommended, should largely be used to meet repayment of the marketable debt. A strict dissociation of public debt management from monetary policy operations is emphasised. The recommendations of autonomy of the Reserve Bank of India (RBI) from the government along with a reduction in the minimum government (and central bank) share in the capital of the public sector banks to 33 per cent and permission to industrial houses to have a controlling stake in banks and promote new banks, if adopted, would dissociate the RBI’s supervisory and regulatory role from the democratic political process, and hence from public accountability. Based largely on the fact that net capital flows have significantly exceeded the requirements of financing the current account deficit, leading to large accretions to the reserves, the CAC Report confidently asserts that a CAD deficit of 3 per cent of GDP could be comfortably financed. The adequacy of reserves is pronounced without even a mention of the (high) ratio of volatile capital (cumulative net portfolio inflows and short-term debt) to reserves. Having specified the concomitants for the move to fuller CAC, the committee has suggested a time frame of five years, divided into three phases – the current financial year (phase I), 2007-08 and 2008-09 (phase II) and 2009-10 and 2010-11 (phase III) – for the effective dismantling of capital controls, within what it considers reasonable limits. A progressive lifting of capital controls on outflows by resident individuals and overseas borrowing by banks (to be raised substantially in phases to 100 per cent of their paid-up capital and free reserves), and further easing of such controls on capital outflows by resident corporations (from 200 per cent to 400 per cent of their net worth) and other businesses are stressed. Of course, for the non-resident investor (other than the direct participation of the non-NRI non-resident individual), the rupee for all practical purposes is already convertible on the capital account. India formally adopted current account convertibility in 1994 and had been subsequently gradually liberalising the capital account, but most of that past dismantling of capital controls had been in the interest of non-residents and resident corporations only. The committee claims it has sought to treat all non-residents equally and has also extended the benefits of investing abroad for portfolio diversification to resident individuals as well. The CAC Report’s recommendation that foreign institutional investors (FIIs) should be prohibited from investing fresh money raised through participatory notes (PNs) – the instruments through which foreign investors put their money in India without revealing their identity – and that they should phase out existing PNs within a year has predictably stirred up a hornet’s nest, with two of the six members of the committee recording notes of dissent and the union finance ministry apparently rejecting this

recommendation with the terse statement that the “status quo on policy with regard to PNs will continue”. While the Securities and Exchange Board of India seems to have maintained a discreet silence on the issue of PNs, it is well known that the RBI is in favour of prohibiting PNs. A significant proportion of PNs subscriptions are said to have come from tax evaded incomes that had earlier been channelled abroad via foreign banks, and is now being routed through hedge funds and via tax havens back to India, to be managed by FIIs for speculative gains on the Indian stock market. The dissenters in the committee on the issue of PNs would certainly have a lot of support from finance capital, its powerful backers in North Block and the usual stenographers of power in the mainstream media.

All said and done, the basic argument to back a fuller CAC in tandem with deeper financial liberalisation and the adoption of a monetarist macroeconomic policy framework in the belief that this package would lead to higher economic growth through even larger capital inflows is invalid. The package, if adopted, would scarcely give a fillip to inflows of productive capital; speculative capital flows do not add to capital formation. A fuller CAC and its suggested concomitants, if taken on board by the government, would only further pave the way to the pursuit of wealth by a significantly wider set of available means, push the financial sector to even greater ascendancy and make the Indian economy increasingly vulnerable to global volatility, all of which will have a serious impact on the lives of the Indian people. EPW

Economic and Political Weekly September 9, 2006

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