The current situation clearly emphasises the risk in full convertibility on the capital account.
During the last couple of weeks, the external value of the rupee has come under increasing pressure and, at one stage, the rate had crossed Rs 52 to a dollar. In a way, the fall against the dollar exaggerates the depreciation of the rupee, as the dollar has appreciated against other major (the pound, euro and yen) and not-so-major (the Korean won, Indonesian rupiah and so on) currencies. In REER index terms, by my estimate, the current level is comparable to the average for 1998-99.
Historically, the current account has been much stronger in the fourth quarter of a fiscal year than in the earlier three. Even this year, the merchandise trade deficit on a customs-cleared basis has started narrowing, thanks to a large extent to the drop in the price of oil. For the year as a whole, on a balance of payments basis, it may come to somewhere between $110 billion and $115 billion. On the other hand, invisible surplus may also fall in the fourth quarter — there are signs that the IT sector is slowing, and a large number of Indians working in the oil-rich countries are returning back, which would affect remittances. Overall, the current account is likely to remain significantly negative in 2009-10 as well.
I was looking at resumption of capital inflows in the second half of the current year. This seems less likely now as the global financial markets are still nowhere near normal. And, there are India-specific factors as well. Reports suggest that both because of the state of the global market, and the problems in Satyam and Subhiksha, private equity flows could drop in the current year — from deals worth $10 billion in 2008. And then there is the very poor fiscal situation. Reports suggest that the fiscal deficit is likely to be much larger than budgeted, one, because of the tax concessions announced post-Budget and, two, because the revenue had apparently been overestimated by as much as Rs 50,000 crore! These are frightening numbers and also suggest that the net government borrowings in 2009-10 (net of redemptions and MSS borrowings getting converted) may amount to as much as Rs 400,000 crore — a staggering amount compared to the likely bank deposit growth (Rs 650,000 crore in the current year). The growth number for the current fiscal year may well fall short of the estimates made by both the Economic Advisory Council and the Central Statistical Organisation as recently as in January. But for the one-time effect of the pay revision for the Central government employees, Q3 growth would have been 4.2 per cent. And, the recent rate cut may not do much to change the scenario. Inflation has dropped sharply since the peak of August 2008, but so has the growth in bank credit from 30 per cent in October to less than 20 per cent by February 13. Lower growth, a horrendous fiscal deficit and political uncertainties are hardly a scenario to attract the foreign investor.
Coming back to the current demand and supply in the exchange market, one wonders whether part of the pressure on the rupee is also because of residents transferring savings outside the country. In fact, to my mind, the current situation clearly emphasises the risk in “full convertibility” on the capital account. One of the articles of faith for laissez faire economists, it can easily propel us into a vicious circle of an economy in difficulties, downward pressure on the rupee, residents and non-residents taking money out, thus putting further downward pressure on the exchange rate. Such cycles make it very difficult for the central bank to act in a counter-cyclical fashion and reverse the trends, even in the best of circumstances. Just imagine what would happen if residents transferred, say, Rs 100,000 crore of domestic savings ($20 billion) to foreign currencies! Clearly, this would substantially exacerbate the downward pressure on the rupee and also a shortage of liquidity in the banking market. The herd, once unleashed, is very difficult to stop.
If this is one risk in “full convertibility”, many countries in central and east Europe are experiencing a different problem. Preparatory to joining the euro, these countries had liberalised their capital account. A very large number of individuals (for home loans) and businesses have borrowed the euro, at much lower than domestic currency interest rates. When, as part of the current crisis, there was a capital flight, their currencies plunged, with all that this means for the debt-servicing ability of the borrowers. Several such countries have had to hurriedly negotiate balance of payments packages financed by IMF, the European Bank for Reconstruction and Development, and other EU agencies totaling ¤24 billion. Iceland has also faced a crisis thanks to a liberal capital account — and so have a large number of British depositors with Icelandic banks. A liberal capital account is not as benign as some seem (or at least seemed) to think.
But all this apart, the next finance minister will have a tough agenda to tackle.