Capital Account Convertibility: A boon or a bane By Dr. Bala V Balachandran and Dr. Bobby Srinivasan

May 1, 2015 | Posted by bobbysrinivasan << back to blog

The green shoots are appearing on the scene and the weeds of the past have been blown away. Deep rooted pessimism and dependency are being replaced by hope and a desire to forge ahead. The independent august international body, namely, the IMF has assessed that the Indian Economy is poised to grow around 7.9 percent this financial year, after a 7.4 percent growth in the last fiscal. They have also said that India will be fastest growing economy in the world, even compared to China whose growth rate is expected to taper off to 6.4 percent this fiscal. There are several reasons for this optimism. First, is the budget for the financial year 2015-16. The total amount of money allocated is around 17.76 lakh crore rupees. Compare this with the last fiscal of 17.94 lakh crore. In real terms, given a 5 percent inflation, the current budget allocation is at least 6 percent lower. This clearly demonstrates to the financial world that our government is taking fiscal restructuring seriously. In fact this budget did not offer many freebies and goodies like bigger basic deductions to the individuals and corporates save a few minor changes here and there. The rating agencies which were hell bent on lowering our government bond rating from the current level of BBB^– to BB⁺ a junk status last year, are considering revising it upward by a notch. All these augur well and the signs of steady and good economic growth are on the anvil. Second, RBI is committed to keeping the inflation rate at around 6 percent this fiscal to be followed by 4 percent for the next financial year. This is indeed very heartening to Indian citizens who are used to double digit inflation in the past.

Given the present economic scenario the government is contemplating on permitting capital account convertibility in the next few years. In layman terms, an average citizen could walk up to a bank with Indian rupees and can request them to convey to the US dollar at the prevailing exchange rate with no limits on the amount to be converted and no questions asked about the purpose. This indeed is most welcoming step towards liberalizing the foreign exchange uses. If and when it happens, we will be joining the big league comprising developed countries where conversion from one currency to another is a day to day happening.

However the question to ponder is whether India is currently ready to take this big step and what would be its impact on the capital out flow and rupee exchange rate. Also will RBI take a laissez faire attitude and allow the rupee value to be completely market determined. The government must have released this statement only after the pros and cons of conversion have been looked into.

Before any action is taken we need to look at all the possibilities. First, currently our foreign exchange reserves stands at US $ 343 billion as of this week including gold and SDR. This is relatively a very huge reserves and can easily support 8 to 10 months of imports assuming no exports. Also if all goes well with the economic growth the foreign direct investment to India will keep coming in large amounts more so given the free market orientation of the Modi government. At no be point in time there will be any paucity foreign exchange in the country. Also it will send a very positive signal to the foreign investors claiming that the Indian trade activities are to expand in a big way. This is the same signal Ding Xiao ping, the Chinese President who followed President Mao Zedong gave it to the global markets. Currently their reserves exceed 3 trillion US dollars. Some of the reluctance to act in the past on this convertibility is understandable because of the sudden upsurge in the current account deficit exceeding 4 percent of GDP in the last year. There was a valid reason behind it. At that time the Brent crude oil was trading above 120 dollars a barrel. Today we are looking at a price of around sixty dollars per barrel, literally half. Given the increased production and supply, and thanks to the US shale oil the price of crude is likely to stabilize and this will bring about a major savings in our import bill. Next our government effort to make in India policy when it gains momentum will bring the current account deficit to no more than around 2 percent of GDP. Also our software exports are growing at a rate of 10-12 percent per year. All these are positive signs for our nation’s foreign exchange reserves to go up.

Of course one of the fears that will linger in our government mind is the extreme volatility that appeared in the East Asia Currencies in the second half of 1997 often referred to as the Asian currency crisis. At that time the emerging market economies faced the reverse flow of funds back to the US because of the change in the US interest rate. The outcome was a massive depreciation of the local currencies along with very high levels of volatility. For example Thai bhat dropped against the dollar from 25 to 56. Malaysian Ringgistt from 2.49 to 4.22 to a dollar and the worst hit was Indonesian Rupiah which dropped from 2400 to 17500. The hedge funds used non-deliverable forward contracts and literally decimated those currency values. Is there a lesson to learn from this? Yes or No: Yes: there is a remote possibility it could happen to us but by exercising caution and putting a limit on the size of convertibility initially and then can deal with it later on by removing the limit it when sufficient experience and confidence prepares us to deal with such outlier events if ever it happens. No: the currency is not over valued except perhaps marginally. The market price discovery pricing of the currency will automatically take care of this problem. Besides, our overseas activity is approximately 15 percent and so our exposure to the world economy is very limited as a proportion of the total economy. Also, our foreign trade is less than 2 percent of the global trade. Compare this with China’s 15 percent it is relatively small. So any apprehension in this regard is seriously misplaced.

Currently the foreign institutional investors are having a bonanza by investing in our market. We put a limit of 30 billion US for the FIIs to invest in our bond market and they actually subscribed many fold. Our stock market with the current price earnings ratio of 18 is extremely attractive given the 10 years US treasury is yielding around 1.5 percent. Besides the large part of the FII money is here to stay only for many years to come. In all likelihood the Indian economy will continue to forge ahead with a 8 plus percent growth in the near future. In that growth environment, the corporate profit growth can be expected to be around about 15 percent. For the FIIs, it is easy math to compute, as compared to the other emerging markets, India will be the best bet for them. They will compare looking at putting money in Russia, Brazil and Chinese market. Russian currency the Rouble this year has dropped 50 percent in value. Similarly the Brazilian Cuizero is down 30 percent against the dollar. The Chinese real estate bubble is expected a burst any time. In this emerging market environment, the Indian market will be the best destination for them. They have already invested more than 200 billion dollars over time. It will not be a big surprise if much more monies come in to our market in the next few years thus pushing our reserve probably close to $ 400 – $ 450 billion US dollars.

Currently our government have a clear understanding of the source and use of funds. They are in the process of passing the GST bill which will definitely enhance the revenue into the government coiffeurs. The fiscal and the cash deficit will definitely move to a much lower level as a proportion of GDP. Thus many of the concerns relative the current account convertibility is overdone. Given, the right fiscal along with the monetary policy, we can expect our rupee to actually appreciate. Therefore it is almost time that the government looked into the current account convertibility and take a proactive stand. Perhaps not to throw away to winds, a precautionary approach to start with will be very helpful. First a set of limit, may be set for convertibility like total amount and how often can be done in a years time etc. All we can say is that as our economic growth starts picking up momentum, the need for foreign capital will increase significantly. Currency convertibility will infuse so much confidence to both the local and foreign investors who may invest here for a longer time. Thus India has the power to join the big league of developed countries sooner or later and let us hope it is sooner.

Finally setting pre-requisites like low currency value volatility and preventing hedge fund intervention may not be realistic, given that all currencies face the same possibilities. For example, when Dr. Marro Draghi, ECB President decided and implemented to lower the euro interest rate last year from 0.15 to 0.05 percent to tide over the Greek liquidity difficulties, the market took it as a sell signal and pushed the value of euro from 1.39 to 1.08 to a dollar. Similarly when the crude oil prices plunged, the Russian Rouble value against the dollar fell from 32 to 63 rouble. Luckily, India’s global investment is minimal and so our rupee stayed in the trading range of 60 to 62 to a dollar. Thus, volatility is part and parcel of the game and Indian rupee cannot be an exception. However our currency may not be subjected to such large fluctuations since we are a fast growing economy. The capital account conversion will certainly lead to the globalization of Indian currency. Indian companies whose activities are limited due to limited gross capital formation and domestic savings rate will now be in a position to borrow rupee (not the dollar) overseas and this will help them to realistically compare their real cost of capital since no foreign exchange risk is involved.

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