Capital Account Convertibility – A Chronicle of Arguments

Foreign exchange reserves rose by $937mn to touch $213bn during the week ended June 29. The steady rise in foreign exchange reserves over the last few fiscals has sparked off a lively debate – ‘Is the time ripe for capital account convertibility (CAC)?’ This has been one of the nagging questions which policy makers have tried to answer in the last few years. While the left party has been waving their red flag as always, there is a definite case to take a cautious approach.

Flipping a few pages of history

In 1996, five Asian economies (South Korea, Indonesia, Malaysia, Thailand, and the Philippines) received net private capital inflows amounting to $93.0 billion. One year later (in 1997), they experienced an estimated outflow of $12.1 billion, a turnaround in a single year of $105 billion, amounting to more than 10 percent of the combined GDP of these economies! Consequently, three of these economies Indonesia, Thailand, and South Korea) are mired in a severe economic crisis the magnitude of which would have seemed inconceivable even to the most knowledgeable and insightful observers of the region. Well that’s CAC for you – a sudden influx and efflux of currency with unpredictable boom and bust cycles.

And this too will pass

In the old legend wise men finally boiled down the history of mortal affairs into a single phrase, “This to will pass”. That’s exactly what we need to understand. It’s easy to be deluded to think that opening up of capital accounts will bring in a lot of funds in, when the country is in the cusp of robust growth. What if the conditions change? The efflux is much faster and happens with such a brutal force that it leaves the state coffers gasping.

Close parallels

A fully convertible capital account can be closely compared to the financial markets. Financial markets are known traditionally for high volatility for no specific reasons. One of the arguments favouring CAC is that – ‘if convertibility is good for goods and services (India has a virtually fully convertible current account) why should we be wary of capital account’. The reason they say is that financial markets operate with a wide degree of uncertainty. Market failures from asymmetric information and inefficiencies are endemic to financial markets. Markets for goods and services are rarely textbook-perfect, but they operate in most instances with a certain degree of efficiency and predictability.

Is it mostly fundamentals?

A counter-argument is that financial markets get it mostly right, and that sharp reversals of capital flows are usually the result of changes in fundamentals, such as external shocks or policy mistakes. While at least a grain of fundamentals surely underlies every financial crisis, the magnitude of the crisis is often incommensurate with any plausible change in the fundamentals. There was nothing terribly wrong with the economies of Malaysia, South Korea and other Asian countries in 1996.

Every crisis spawns a new generation of economic models. When a new crisis hits, it turns out that the previous generation of models was hardly adequate. The moral of this twisted story is twofold: (a) financial crises will always be with us; and (b) there is no magic bullet to stop them. These conclusions are important because they should make us appropriately wary about statements of the form, “we can make free capital flows safe for the world if we do x at the same time,” where x is the currently fashionable antidote to crisis. Today’s x is “strengthening the domestic financial system and improving prudential standards.” Tomorrow’s is anybody’s guess.

Lies, damned lies, and statistics

A scatter plot on capital account liberalization vis-à-vis per capita GDP increase and inflation shows no evidence in favour of CAC. Secondly policy choice regarding CAC is endogenous and to a certain extent determined by economic performance itself. Thirdly reverse causation clouds interpretation because countries are likely to remove capital controls when their economic performance is good.

The other side

Those who advocate full convertibility in capital account list out the possible benefits for the country, including greater confidence levels of global investors in India, the present feel-good factor and strong macro economic parameters of the nation and so on. In such arguments, there has been no mention about `the appropriate figure' of forex reserves considered the safe level for any country. The other way of looking at the issue is: What is it that present foreign exchange market lacks that CAC is going to dramatically change? Such a proper figure and rigorous mathematical models are difficult to arrive at. However we can say that CAC should work fairly well with countries having good financial institutions. Appropriate macroeconomic policies can reduce the risk.

There is a widespread belief that convertibility causes crises. If this belief were true, the countries which faced the East Asian crisis should have been circumspect about convertibility. However, barring Malaysia, none of these countries suspended convertibility either during or after the crisis.

Inevitability of capital flows

In a global village capital flows will expand irrespective of government policies. Current account convertibility and capital account convertibility go together in the “package deal” of harnessing globalisation. There is a line of capital controls manned by RBI staff, but enough holes have been punched in it so that there is substantial, and increasing, de facto convertibility. “Should India go for convertibility” is no longer a meaningful question. The question that India faces is about how the intellectual framework and institutional capacity of monetary policy and financial regulation can be rapidly overhauled to match the needs of a trillion-dollar rapidly globalising economy. There’s no escape – India has to open up. The real question is - How do we put systems in place to manage this? Do we have the stomach to live through boom and bust cycles?