Should the Indian rupee be made fully convertible? This is one of the burning issues of economic debate in India today. Convertibility already exists for current account transactions. I argue below that a rapid move to capital account convertibility (CAC) would be extremely unwise.
Of course, CAC can bring some important benefits. It can augment investment, diversify risk and make the financial sector more efficient. But these benefits can be enjoyed in substantial measure by liberalization of foreign direct and portfolio investment, which the Indian government has already instituted.
The outstanding question is whether it should go further and scrap the controls on short-term capital movements, in other words, on “hot money”.
The Tarapore Committee, which examined this issue recently, argued that because hot money flows are unstable, CAC should be approached gradually, along with certain requirements such as low fiscal deficits, low inflation and a healthy banking system.
The idea is that if economic policy is sound and seen to be sound, speculative attacks will be deterred. And if an attack does take place, the damage will be contained if banks are robust. I do not dissent from this general approach. However, an even more important argument against an immediate move to CAC is that it would hugely complicate the conduct of macroeconomic policy.
The macroeconomic argument for capital controls is that exchange rate targeting and monetary autonomy are both desirable goals, but they cannot be feasibly combined with that of CAC. Any pair of these goals can be achieved by adopting a suitable policy regime, but requires abandoning the third goal. (Economists will note that this argument is closely related to the “Impossible Trinity” theorem.)
Consider each pair of goals in turn: i) An exchange rate target could be combined with CAC, but only at the cost of losing monetary autonomy, i.e. the power to vary the home interest rate independently of the foreign interest rate. This is because any interest rate differential would be eliminated by capital flows. Could the flows not be sterilized? No, because the flows would be large enough to make sterilization impossible.
ii) Monetary autonomy could be combined with CAC by floating the exchange rate, but this would obviously imply giving up exchange rate targeting. iii) Exchange rate targeting could be combined with monetary autonomy, but only by abandoning CAC. Capital controls break the link between the exchange rate and the home-interest rate, enabling the authorities to separate monetary and exchange rate policy.
The next step in the argument for retaining capital controls is that exchange rate targeting and monetary autonomy are both essential ingredients of Indian macroeconomic policy.
The case for monetary autonomy follows directly from the need to vary the interest rate in order to stabilize economic fluctuations. For example, in the early years of the present decade, the Reserve Bank of India (RBI) lowered interest rates in response to a slowdown in growth.
This year, it has reversed the fall in order to cool an overheating economy. The case for exchange rate targeting is that the level of the exchange rate is a matter of legitimate policy concern at the country’s present stage of development. In the last 25 years, India has experienced growth that has been rapid but capital-intensive, skill-intensive and “jobless”.
An export drive in labour-intensive manufactured goods will be a crucial component of employment creation policies, especially given the expected rapid growth of the labour force. A durable export boom will, in turn, need to be supported by a policy package that includes a competitive exchange rate.
CAC would imply that one or other of exchange rate targeting and monetary autonomy would have to be given up, a point that is very relevant for current policy. The RBI has recently raised interest rates for anti-inflationary purposes and may have to raise them further.
If the country had CAC, the consequent capital inflows could cause the rupee to appreciate to an uncompetitive level. If, instead, the RBI targeted a competitive level of the exchange rate, its attempt to raise interest rates would be negated, in the presence of CAC, by capital inflows that are large enough to make sterilization infeasible. The only way to retain the ability to target the interest rate as well as the exchange rate is to retain some focused controls on hot money movements.
In the long run, capital controls are incompatible with realizing India’s potential comparative advantage in financial services, and indeed with India’s status as a global economic power. So they should not be continued indefinitely.
The issue is one of timing and sequencing. After another five to ten years of rapid growth of exports and national income, as well as deeper economic reform, the need to target the exchange rate will fade and the country will be ready to adopt a floating exchange rate, CAC and inflation-targeting.
In the meanwhile, a rush to CAC should be avoided as it could lead to loss of macroeconomic control and consequent disruption of the country’s business environment and reform agenda.
(Send your comments to businessatoxford @livemint.com)
The author is a fellow of Merton College, University of Oxford. As part of Oxford’s historical and continuing engagement with India, this column will present the views of academics, students and alumni on issues of relevance to the Indian business environment. In the coming weeks, the articles will encompass a range of intellectual and disciplinary interests, and contribute to the current debate on matters pertaining to public and social policy.