The advocacy for “full convertibility now” has gathered renewed momentum in recent years. Its neatly structured premise is: domestic and foreign markets are perfectly integrated, which has eroded the monetary autonomy of the Reserve Bank of India (RBI). The de facto convertibility of the rupee has already taken place. So, go official: Declare the rupee fully convertible. Alas, facts don’t quite lend themselves to this interpretation. The case for full convertibility right away, seductively dressed with economic policy theorizing, has many a gaping hole.
Also See Policy Trade Off (Graphics)
To start with, onshore-offshore market integration is rather limited. For, close to 80% of daily rupee trading continues to take place onshore. Even at the peak tide of capital flows in 2007, domestic and foreign markets stayed resolutely segmented. With monetary control available in the bulk of the market, theorizing on the irrelevance of monetary control doesn’t quite add up. Hence, the hypothesis of policy trade-offs between exchange rate stability and monetary autonomy—quite valid in integrated markets—has little relevance for India at the moment. Let’s look at the facts closely.
The segmentation is obvious in the onshore–offshore yield gaps between one-year government paper and NDF (non-deliverable forwards) implied yields (ref to Fig 1). The differentials are large and persistent, ranging, on average, between 222 and 462 basis points (bps) since 2004; the minimum average spread was 134 bps in 2006, increasing thereafter due to monetary tightening.
Two, it is entirely possible to have long-term monetary autonomy with short-term loss of control, driven by a deluge of foreign capital. The clanging of “loss of monetary control” climaxed in July 2007, when an unprecedented $5.5 billion of portfolio investments rushed into Indian markets. Did the yield gap converge, albeit temporarily? Tracking this event with daily data, the onshore-offshore spread is observed persistently above 100 bps, indicating continuous market segmentation. Capital flows were routinely unidirectional all this while—inwards—but the spread narrowed only briefly to 118 bps in July 2007.
Three, formal tests for uncovered interest parity confirm that financial integration is far from perfect; while differentials are declining, as increasing integration forces convergence, they remain statistically significant.
Four, the size and structure of markets limit arbitrage opportunities for both residents and non-residents. Daily turnover in the offshore market is assumed to be $750 million compared with $2–3 billion in the onshore forward currency market. A BIS Triennial Central Bank Survey 2008 analysis reinforces the low degree of capital mobility between onshore-offshore currency markets. Non-resident participation in the daily, onshore trading turnover of the rupee is restricted to about 10%; these are more active in the offshore non-deliverable market. India ranks in the lowest range of non-resident participation in the trading turnover of Asian currencies; its share of financial customers in the total daily forex turnover is 17%, the lowest in Asia. Trade is the major driver in the Indian currency market, with the majority of transactions between exporters and importers: The trade flows to foreign exchange turnover ratio is 12, against the global average of 30. And arbitrage routes for residents, besides the conventional trade misinvoicing channel, are limited mainly to overseas borrowings. In the 2007 boom, the sudden increase in overseas loans was associated with carry trade by domestic investors raising loans abroad, depositing the converted rupees into domestic accounts, including non-resident accounts and the hawala route. The temporary rise in NDF trades during volatile market conditions is also associated with resident market participants with trade-linked foreign currency exposures.
The point here is of the scale and persistence in volumes, which simply aren’t there to close the yield gap. So, though some cross-border flows respond to price signals in an increasingly open economy, the existing capital controls still prevent convergence. This is grossly overlooked when eye-popping, aggregate numbers on financial integration are trotted out to make a headline case for full convertibility. How do these numbers prove perfect capital mobility, inefficacy of capital controls and the loss of monetary autonomy? Even when capital flows were way above trend, driven by a heady combination of a global liquidity glut and a booming economy, capital mobility was not sufficient and enduring enough for complete convergence; in the trend case of a net capital account between 4% and 5% of gross domestic product, we should be even less suspicious about the inefficacy of capital controls.
It is thus premature to talk about polar choices—exchange rate management or monetary independence. The weight of the proof actually shows that so far, RBI has been able to choose a policy combination of part exchange rate stability and part capital account openness to operate a hybrid regime that allows it to control the domestic interest rate; consistent with reserve accumulation, this is critical to sustaining monetary independence. As the economy is still on the transition path to fuller capital account openness, an intermediate regime enables non-linear policy adjustments.
A 2008 study by economists Joshua Aizenman, Menzie D. Chinn and Hiro Ito is especially illustrative here; it establishes that all three variables of the trilemma, that is, exchange rate stability, financial integration and monetary independence, have converged for developing countries, suggesting convergence “…towards managed exchange rate flexibility buffered by…international reserves, enabling the retention of monetary autonomy even as financial integration proceeded”. The coefficients on the three macroeconomic policy goals also vary over time, signifying that countries alter the weights on these. Finally, the bulk of empirical evidence on the efficacy of capital controls shows that these have been most successful in providing more autonomy for monetary policy.
So next time, when inflows surge and calls for full convertibility are made, they need to be tempered with a bit more convincing evidence. We just aren’t there yet…
Renu Kohli was until recently with the International Monetary Fund. Comments are welcome at firstname.lastname@example.org