FROM BUSINESS WORLD OF 3 JUNE 2005
After
the meltdown
Two months
ago, the Prime Minister gave a speech to the Asiatic Society in Bombay in which
he announced that he had asked Reserve Bank to rework the road map to full
convertibility. His announcement reflected his confidence that he could handle
any external crises that might come our way.
Now
the limited convertibility we have had has led to a small mishap. In 1992, full
convertibility was announced for foreign portfolio investors. Last week, they
took advantage of that privilege and began to withdraw the money they had
invested in Indian equities. That caused a crash in the stock market and
depreciation of the Rupee. We do not yet have full convertibility, so Indian
investors cannot sell out and transfer their capital Abroad. That causes a
certain inequity: whilst overseas investors can roam all over the world in
search of opportunities, their Indian comperes are confined to India with its
risks and uncertainties. Worse, foreign investors can cause a stock market
crash here, whose consequences are borne by Indian investors. The injustice is
not quite so stark, for those foreign investors who do not sell out quickly
will get lower exit prices; and Indian investors too have the choice of exiting
the market. But if they do so, the opportunities for reinvesting their funds in
India are far more limited than those available to foreign investors in world
markets.
Some will infer from this the folly of having allowed foreign
portfolio investment. Others will read in it an argument for full
convertibility which would open up the same global opportunities to Indian as to
overseas investors. But it will now be difficult for anyone to argue in favour
of the current regime. The Prime Minister is a cautious man, and most of the
comment on his proposal has been adverse. But if he seriously believes in it,
he should press on faster towards full convertibility.
True, he has appointed a large committee of experts to advise him. That
committee will huff and puff for months, and finally come up with a divided
report. Some members will be against convertibility on the ground that India is
a capital-short country and that it should use its savings for its own
development. They will ignore the point that full convertibility will make
savings from the rest of the world available to India – provided it offers
attractive investment opportunities. The majority will probably express a
qualified opinion in favour of full convertibility, hedged by all manner of
caveats and conditionalities. And conditions are important. By going
convertible, a country sets itself in competition with other countries as an
investment destination. It must do so only if it is confident of creating a
macroeconomic climate that would make rapid growth profitable.
But essentially, the argument on full convertibility is an argument
about equity – about giving our investors a level playing field. If the Prime
Minister thinks that with the massive exchange reserves he can afford it, he
should make the Rupee fully convertible. It will be a powerful incentive to
improve governance and the quality of macroeconomic management. He should stand
the logic of Reserve Bank and of its sundry committees on its head. They argue
that India should not go fully convertible until it fulfils tough conditions.
But the government is more likely to exert itself to fulfil those conditions if
full convertibility forces it to do so.
Going
fully convertible will not, of course, prevent market crashes. When he was
finance minister, the PM had declared that he did not lose sleep over what
happened in the stock market. Now he has many more things to lose sleep about,
no doubt. But over the past 15 years, the stock market has gained importance.
It will become even more important in the event of full convertibility, for if
it does not function well, Indian
companies will go and access capital markets abroad. Even now, the companies
that are allowed to do so prefer to raise capital abroad where Sebi’s public
issue rationing rules do not apply; they will do so even more once restrictions
on foreign equity issues are removed. That will make international capital
flows even more procyclical and the balance of payments even more volatile than
now.
The prevalent opinion in the government is that large exchange
reserves are sufficient to cope with balance of payments volatility. But
reserves only prevent balance of payments crises. They cannot prevent movements
in reserves from affecting domestic money supply, liquidity, and interest
rates. The government can countervail such movements by open market operations,
but its huge fiscal deficit gravely limits its freedom of manouevre. Changes in
money supply will affect banks’ capacity to lend and hence their profits; and
as long as most of them are owned by the government, they will go and complain
to the government whenever their profits come under pressure. Hence before it
makes the Rupee convertible, the government should balance its own and the
states’ revenue budgets, and it should privatize the banks it owns. These are
the minimum conditions for full convertibility.
