Rashmi Shankar Mishra: FDI and forex convertibility

The recent interest rate hikes "in response to global monetary tightening" and "possible over-heating" refocused attention on whether India is ready for full convertibility. The debate should really be over India's failure to attract FDI relative to volatile and pro-cyclical portfolio flows, and whether the RBI should intervene in forex markets.

Pegged exchange rates have failed to anchor domestic inflation in any sustained manner in other emerging markets. Besides managing exchange rates places an unnecessary burden on monetary policy which should be focused on credit expansion to fuel domestic growth. Given the need for massive capacity creation to sustain growth in jobs, it isn't clear that there is even a robustly positive correlation between growth and inflation. This would mean that monetary policy could stimulate growth without generating macroeconomic volatility, at least in the medium term, provided it didn't have to concern itself with stabilising the exchange rate. Countries tend to peg because large dollarised liabilities relative to assets, imply depreciations could have costly balance sheet effects. Obviously this is not an issue in India, with a relatively low aggregate external debt to GDP ratio.

Could the motivation to peg come from a desire to provide a stable returns differential to portfolio investors? One sincerely hopes not as portfolio flows are unlikely to finance, in a sustainable manner, the current account deficit. Since India pretty much has de facto convertibility, the question is really how we can change the composition and increase the volume of inflows.

Relative to China, India has had greater success in attracting portfolio flows than FDI, which is typically less volatile. Of roughly $ 61 billion net FDI to Asia-Pacific emerging markets, India attracted just over $ 5 billion in 2005. Rising input costs, particularly salaries in the organised sector, interest rate increases in the US, and a global slow-down could see a slowing down of capital inflows in general. The good news however is that FDI inflows can move independently of other capital flows, and are more likely to do so when the exchange rate regime is liberal and there are no capital controls.

Clearly this is not a sufficient condition for attracting FDI. What would allow India to out-compete other emerging markets and go from $ 5 billion to $50 billion of FDI? The consensus is that countries that can absorb capital effectively and provide high returns on a sustained basis without any risk of back tracking on capital controls do better and are less vulnerable to sudden stops.

This means that the fundamentals that have to be right to attract FDI include not just the latest GDP growth numbers, but also political coherence and cohesion on the commitment to reforms, integrated domestic credit markets, sound infrastructure, transparent labour market laws, and so on. That is certainly not an exhaustive list of things to be done. Coincidentally, the same list would have to be worked through for full convertibility to be worthwhile, and eliminate any justification to fear floating.

The author is at the Department of Economics and International Business School, Brandeis University.