Jamal Mecklai: Who's afraid of convertibility?

MARKET MANIAC

Over the past month or so, I have been on a road show meeting clients around the country to talk about capital account convertibility, and, to my amazement, I have encountered a fair amount of concern about what could happen if we opened up our capital account. I had thought such concerns were strictly limited to regulators (whose job it is to be concerned) and theoreticians""anyone who is doing business in India should be eager for more openness, which translates directly into more opportunity.

Of course, the flip side of opportunity is risk, and more opportunity also means more risk. But (to use an outdated chauvinistic phrase) "faint heart never won fair lady" and I have no doubt that India today is strong and smart enough to manage the increased risk.

Nonetheless, let me address some of the concerns, most of which centred around the various debt and payment crises faced by emerging market countries in the post-Bretton Woods era, the loudest of which (in our context) was the South-east Asian crisis of 1997.

Studies have shown that poor financial infrastructure (which resulted in both high-risk lending and over borrowing), low returns on investment, implicit guarantees by the state, speculative boom in equity and real estate markets and inadequacies in macro-economic policy were the recurring themes in every financial crisis over the last two decades. Interestingly, imbalances in government finances, though an obvious suspect, were not a major driver of crises, unless, of course, the imbalances are huge and growing""a situation that does not describe India today. And, again, in most of the potentially problem areas, India is quite soundly placed.

Financial infrastructure: Notwithstanding occasional blips, our equity markets have extremely high-quality risk management practices. Equally important, banking supervision also has a strong focus on risk management, with a clear timeline for compliance with Basel II norms. Significantly, there was little global guidance on systemic risk management as recently as five years ago. In India today, provisioning norms, capital adequacy and accounting practices conform closely to global standards, and the entry of foreign banks and investment institutions has strengthened competition in the market. The only area where evolution has been inadequate has been with regard to derivative products.

On balance, it is clear that India's banking sector is managed well enough so that even if there were a surge in capital outflow as a result of, say, a sharp rise in US interest rates in the event of a dollar collapse, we would not see any banking failures. Sure, the rupee may fall but that is part and parcel of the market""the key point, which is structurally different from what obtained in Southeast Asia, is that our financial sector would not collapse.

Overborrowing: Though there has been a spurt in the external commercial borrowings recently, foreign debt is less than our forex reserves, and external debt in proportion to GDP at below 25% is quite comfortable, as compared to, say, 45-60% in the case of Malaysia, Indonesia and Thailand just before the crisis. This does suggest that we need to be cautious about removing the overall ceiling on ECB as we go forward.

Short-term debt as at end Dec 05 was less than 7% of foreign reserves""a non-issue as compared with Thailand's 122% and Indonesia's near-300% right before the crisis. We have very little to be concerned about in this regard.

Returns on investment: In Southeast Asia before the crisis, corporate returns were extremely weak""in a sense, the flip side of overborrowing and "crony capitalism". In India today, we are in an amazing boom and corporate earnings are at historic highs.

Moral hazard""implicit guarantees: The government no longer provides explicit guarantees for commercial borrowings by public sector undertakings or banks. While there is implicit support, PSUs are largely able to borrow on their own strength. The government, however, may not allow any major bank to fail, whether in the public or private sector. There is some more work to be done in this area, but, given the current strength of the economy, this is a moot point at the moment.

Speculative boom: Both equity and real estate markets are soaring, and there are some concerns that these could be forming bubbles that, if popped, could have a significant adverse impact on the financial sector. However, at least as far as the equity market goes, there is some educated thinking that sees this as simply a re-rating of emerging markets as a result of globalisation, with India at one of the leading edges. Real estate, too, could be following this path, although that market is notoriously unreliable.

Nonetheless, even if these booms turn out to be largely speculative""i.e. unsupported by fundamentals""they are unlikely to affect the stability of financial markets, since the RBI is strictly vigilant in controlling banks' exposures to these sectors. Note, in particular, the RBI's increase in risk-provisioning norms in the last monetary policy.

Macro economic policy: Macro economic policies have long ceased to be protective, with the opening up of the economy and adherence to WTO agreements. Fiscal policies are on track to reduce the deficit to below 3% of GDP, and while there is no such thing as zero political interference, the RBI is reasonably autonomous in its operations.

Thus, it is clear that if we distil the general fears of a possible meltdown into specifics, India is quite comfortably placed with respect to these key risk factors.

Which is not to say that there are no concerns. We need to focus on structural imbalances in the economy and Tarapore II should""and, considering its composition, likely will""focus as much on the real economy as the financial sector in laying down its (hopefully) express road map.