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Be honest, the rupee is fully convertible for crooks Ila Patnaik Posted online: Thursday, March 23, 2006 at 0000 hrs IST What is the capital account? A countrys capital account is a statement of the money that enters or goes out of the country on account of investment or borrowing. If an Indian company takes a loan from, say, an American bank, the loan shows up as an entry in the capital account. If a British company invests in a factory in India, this is classified as foreign direct investment (FDI) and shows up in the capital account. When foreigners buy shares in Indian companies their investment shows up as portfolio investment on the capital account. These are examples of inflows of capital. Similarly, there are examples of outward capital flows. For example, when the Tatas purchased Tetley and Daewoo, capital from India went abroad. A key facet of capital account convertibility is where Indian households, and not just firms, are able to buy assets outside the country. The capital account is about our portfolios. It is where we invest in global assets, and global portfolios invest in Indian assets. It is about foreigners buying Indian shares, bonds, real estate, or giving loans to Indians. Conversely, it is about global diversification for households in India. How far is India from capital account convertibility? Currently there are restrictions on the capital account. There are limits to Indian companies borrowing abroad. There are restrictions on foreigners investing in India. For example, in sectors like telecom and media there are limits on the share the foreign partner can hold. Also, only foreign institutional investors can hold shares in Indian companies, not individuals. There are restrictions on the amount an FII can hold. There are many more restrictions on Indians sending money abroad that does not have to do with importing goods or services. Purchasing a company is allowed but limits exist on the amount that can be sent. Global diversification of household portfolios is almost nonexistent. What will full capital account convertibility do? With full capital account convertibility, there will be no restrictions for foreigners seeking to buy Indian assets. Conversely, there will be no restrictions for Indian households or companies taking rupees out or using foreign exchange for doing global diversification. Why do we need capital account convertibility? There are three sets of reasons. First, it is good for India if foreigners invest in Indian assets this makes more capital available for Indias development. That is, it reduces the cost of capital. When steel imports are made easier, steel becomes cheaper in India. Similarly, when inflows of capital into India are made easier, capital becomes cheaper in India. Second, it is good for India if households are globally diversified in their portfolios; this reduces risk and stabilises the economy. A globally diversified equity portfolio has roughly half the risk of an Indian equity portfolio. So, even when conditions are bad in India, globally diversified households will be buoyed by offshore assets, will be able to spend more, thus propping up the Indian economy. Third, controls on the capital account are rather easy to evade through unscrupulous means. Huge amounts of capital are moving across the border anyway. It is better for India if these transactions happen in white money. Convertibility would reduce the size of the black economy, and improve law and order, tax compliance and corporate governance. Fourth, and most important, convertibility induces competition against Indian finance. Currently, finance is a monopoly in mobilising the savings of Indian households for the investment plans of Indian firms. No matter how inefficient Indian finance is, households and firms do not have an alternative, thanks to capital controls. Exactly as we saw with trade liberalisation, which consequently led to lower prices and superior quality of goods produced in India, capital account liberalisation will improve the quality and drop the price of financial intermediation in India. This will have repercussions for GDP growth, since finance is the brain of the economy. How can capital controls be evaded? The current account has seen sharp growth since 1991 and spectacular growth since 2000 after which it has increased by nearly 2.5 times as both imports and exports have risen sharply. In 2004-05, inflows and outflows on the current account added up to $313 billion, or 48 per cent of GDP. As a countrys trade integration with the world increases, there are innumerable nodes through which money flows in and out. To account for the purpose of each flow gets difficult. For example, gems and jewellery are among Indias biggest exports. Who is to say whether the true value of a polished gem is $100 or $1 million? What will CAC mean for Indian households and companies? They will be able to freely buy and sell rupees legally in India and abroad, to invest in foreign equity to give loans, take loans, accept foreign investment. There will be no questions asked when rupees are converted into dollars or yen, no forms to fill, no limits to be adhered to. The rupee will be a hard currency. What is the danger for India? As more money flows in and out of the country it becomes difficult to control the price of the rupee due to the large amounts involved. This could raise difficulties for the RBI which could have to buy or sell larger and larger amounts of dollars if it wished to manipulate the rupee dollar rate. It would end up building up even larger reserves than it has currently. These create difficulties in setting interest rates according to the needs of the Indian economy. Capital account convertibility means that eventually the rupee has to be allowed to become more flexible. So, what is the one inargu-able reason for India to adopt convertibility? With effective convertibility already in place for all except honest citizens, a policy that penalises honest Indian citizens becomes indefensible. Shifting to convertibility is, to a significant extent, about converting the de facto to the de jure. Moreover, the case for manipulating the exchange rate of the rupee by the RBI is weak. India is a strong and growing economy. When imports rise faster than exports and not being finaced by capital flows, we are likely to witness a weaker rupee. If the rupee were to be artificially propped up, it would be bad policy as it would make expensive imports cheap and encourage their consumption. As the economy grows and becomes larger, these mistakes would become even more expensive. These are good times when inflation is low, when our exports and imports are doing well, when fiscal deficits are on a path to correction and when India has mountains of foreign exchange reserves: near-perfect conditions for capital account

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indianexpress.com :: Be honest, the rupee is fully convertible for crooks


convertibility. Should there be any restrictions on any financial sector post-convertibility?

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In the international experience, the weakest link tends to be banking. Banks have very high debt; they have a debt-equity ratio of 20. This extreme leverage goes with extreme risk. Slight mistakes by a CEO can lead to bankruptcy. As an example, banks themselves generally refuse to lend to a private company which has a debt equity ratio of more than 2. Though the level of loans gone bad (non performing assets) with banks in India is not very high, it is well understood that the incentive structure of a bank owned by the government could be warped. It knows that it will not be allowed to go bankrupt. This is a serious problem in India, where 80 per cent of bank deposits are with PSU banks. A bank could easily take on a lot of currency risk. So, for example, a bank could borrow cheaply abroad in yen and lend at much higher interest rates in India. Its calculations about the profits it expects to make could go horribly wrong if the yen-rupee exchange rate changes drastically. Since the government owns these banks the foreign loans taken by them are effectively loans taken by the government, which will stand by and honour them. Hence, the safe thing for India to do is to move forward on all aspects of convertibility now, but retain tight controls on the globalisation of banking for a few years.

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