Story Of The Week

The Tinderbox of Rupee Vs Dollar Conversion

The rock star RBI governor, Raghuram Rajan & the highly lauded Minister of State for Finance, Jayant Sinha advocated the ‘Full convertibility’ of rupee recently. In fact, several committees took up the same matter in the past & often IMF, World Bank, developed nations, & the corporate circle demand for the same. At times, they even criticize India for not having it. Let’s have a look of the same.

Movement of capital across the nations is not always free. Controls are used by the state to protect the economy from financial instability.

 What is convertibility?

Convertibility is the ease with which a currency can be converted into gold or another currency. It is crucial for international trade & commerce. When a currency in inconvertible, it poses a risk and barrier to trade as the seller will not be ready to take an inconvertible currency. The reason for international trade & commerce generally being done in dollars is, it is a hard currency, meaning it is acceptable to majority of the parties; it is globally traded, & is in demand.

Current Account & Capital Account:

Any country’s Balance of Payment, is divided in to the Current account & Capital Account. Simply put current account records exports and imports of goods, services, & unilateral transfers while capital account records transactions relating to purchase and sale of foreign assets and foreign liabilities.

The rupee has been convertible on the current account since 1994, meaning it can be changed freely into foreign currency for purposes like trade-related expenses, i.e. for exports & imports but it cannot be converted freely for activities such as acquiring overseas assets. While if you take the case

Though countries like Singapore & Dubai have fully convertible currency regimes, New Delhi allows rupee convertibility in current account transactions for needs like travel or education purposes only. Few transactions like overseas investments or acquisition of assets, which are classified as capital account transactions, need prior approval of RBI. It means India allows convertibility but limited, which we term as ‘‘Partial convertibility’’. So now investors cannot liquidate their assets overnight and leave the country without approval.

Capital account convertibility (CAC) refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange.

The demand for full convertibility has been a long standing demand of the financial sector. Finally an initiative was taken long back in 1997 but it’s going on a snail speed.

Yes! Of late Capital flows have been liberalized but to have a full CAC, we need better macroeconomic management. For example, fiscal deficit has to be limited to 3.5% of GDP and inflation has to be between 3% and 5%, as suggested by a committee in 1997. These conditions are not easily attainable, as both fiscal deficit and inflation have been on the higher side even in recent years. As the inflation becomes stable and as the Fiscal deficit is being managed efficiently, the demand for full convertibility is on the rise.

Need for convertibility:

Many experts say that, For India to become a global economy we need to move towards full capital account convertibility regime.

In fact, they argue that Domestic and foreign markets are perfectly integrated, & that eroded the monetary autonomy of the Reserve Bank of India (RBI). The de facto convertibility of the rupee has already taken place. So now make it de jure: Declare the rupee fully convertible.

Full convertibility is expected to facilitate higher investment leading to higher growth & efficiency in the financial sector through greater competition.

What’s the track record of RBI?

RBI & Government of India has been fairly open to the inflow of foreign funds but due to their sensitivity there are a few areas, such as short-term debt markets in which there is a tight control. Mismanagement of this segment may lead to the collapse of the economy of the nation. RBI also put some restrictions on sectoral limits, cost of debts, usage of the debt money, external commercial borrowings etc…

To its credit it is this RBI policy of partial capital control, which saved India from Southeast Asian crisis of late 90’s. Most of those SE Asian had a currency meltdown because of their full capital convertibility.

Figure 1. Exchange rate of Rupee vs Dollar (Source: Bloomberg)

In fact in 2013 as well, the same capital control helped the India withstand the effects of speculation of the US Fed tapering its monetary stimulus programme, despite India seeing as much as $20 bn being pulled out by foreign investors. The high demand for dollar on August 30th, 2013 (marked in Figure 1) is because of pulling out by the investors.

Everything looks right on the part of RBI but there is a problem with this policy. With the level of high interest rates in India, business is becoming costly. A start-up that is facing enormous hurdles in accessing credits from banks is able to get huge funding from investors, who will eventually try to wrest the control of the company. The famous case is, of to the legendary Steve Jobs, who was kicked out of his own company. The Indian corporations are not able to compete with the international players which have access to the global financial markets because of the conditions in the West.

Untitled23

The benefits to fuller capital account convertibility include:

  • Increased diversification of investors & elimination of monopoly.
  • Greater access to capital & reduced cost of capital.
  • Higher integration with world economy & more exposure to the best practices.
  • Huge push for start-ups & reduces brain drain.
  • Induces competition & ultimately efficiency in the financial sector.
  • Maintains govt’s political & economical discipline.
  • Reduces Hawala transactions.

However, policymakers, financial institutions, and their clients may typically face some side-effects of fuller capital account convertibility.

The challenges of ‘Full Convertibility’ are:

  • Flyaway investors & Economy’s increased exposure to risk.
  • With high current account deficit, a capital account deficit will be a death blow.
  • Possibility of succumbing to the pressure of foreign investors.
  • Will lead to a highly complex matrix of transactions, in which mala-fide are tough to be detected.
  • High volatility in the exchange rates.
  • Chances of rise in speculative trends & hot money.
  • Any shoddy govt investor or industrial policy may collapse the economic system.
  • Compromises the quality of the investors.
  • Easy money moves in good times & moves out in bad times.
  • There is a high probability of misallocation of Capital inflows.
  • Maintaining domestic savings is essential for the domestic investments.

Is convertibility, the only solution?

Of course, the answer is No! It is one of the many ingredients those make India a safe destination for Investments.

Take an example of china. It has no market based convertibility; rather in the recent past has a fixed exchange rate, in which the govt decided the rate. So what? It became the destination for long term investments & became a symbol of manufacturing & growth.

A state of art industrial environment, transparency, efficiency, stable policy & tax regime, simplified tax filing procedures, world class infrastructure, & skilled manpower will bring investors.

Conclusion:

For a country that has been humiliated in 1991-92, the journey towards fuller convertibility of rupee will necessarily have to be gradual, sequenced and calibrated to the overall macro-economic situation and future needs of the economy.

India’s inflation, interest rates, and trade and financial system would have to be globally competitive before it allows free movement of capital in and out of the local currency.

Capital markets are highly scandal prone & are with larger than visible bubbles. For India to bring in full currency conversion, our economy must be more robust, global economy more benign. There is a need to be cautious in approach but that does not mean that we should be nomadic.

A good treatment is when the desired results outweigh the side-effects. Remember, whatever policy is taken, India’s interest must be the prime motive.

References:

  1. http://www.pwc.in/en_in/in/assets/pdfs/publications-2010/india-captial-market.pdf
  2. http://www.livemint.com/Money/vgRaFtU6Ts28JigGFn8RLL/Fuller-capital-account-convertibility-soon-Unlikely.html
  3. http://www.livemint.com/Politics/bynkqCq9x9ya99mdRklwlL/India-favours-full-rupee-convertibility-to-become-top-econom.html
  4. http://www.bloomberg.com/quote/USDINR:CUR/chart
  5. http://www.livemint.com/Money/11gHCPARmkrZPhiu7pWRVJ/Dejargoned-Capital-account-convertibility.html
  6. http://www.slideshare.net/NehaChheda/currency-convertibility
  7. http://www.economicsdiscussion.net/difference-between/difference-between-current-account-and-capital-account/635
  8. http://www.slideshare.net/amnnma/final-ppt-currencyconvertibility
  9. http://www.scribd.com/doc/21814664/Currency-Convertibility-and-its-impact-on-BOP#scribd
Advertisements

Categories: Story Of The Week