As reported in a leading financial daily, at the pre-Budget consultation meeting with the finance minister, "economists asked the government to consider capital account convertibility [CAC]" in view of the mounting forex reserves. |
To my mind, the level of foreign exchange reserves, by itself, is hardly an adequate or sufficient reason to move to CAC. Surely the objectives of major policy moves have to be the promotion of investment, growth and employment. |
The question is whether these objectives would be nearer achievement with full CAC, implying, as it may, an erratically volatile exchange rate. |
The second question that arises is whether the mounting level of reserves is really a major problem, and whether, as contended, CAC would solve it. |
Turning to the second question first, I do feel that the "problem" of mounting reserves is perhaps being exaggerated "" after all, as a percentage of GDP, our reserves are significantly less than those of many other Asian countries. |
Second, there is no guarantee that CAC would lead to more outflows of foreign exchange, thereby reducing the level of reserves. The residents have not shown much appetite for foreign currency assets, as witnesses the poor response to the $ 25,000 scheme. |
For all one knows, CAC may well attract even larger capital inflows, when things are going well. Again, the lack of CAC is also not hindering Indian DFI abroad, which has crossed $ 10 billion. |
Overall, it seems to be an extremely doubtful solution to a problem whose scale is surely not as frightening as being painted by some. |
Turning to the question of investment, growth and jobs, that CAC is needed to attract foreign direct investment (FDI) is a myth. Foreign investors are happy to make direct investment in excess of $ 50 billion a year in China without the currency being convertible even on current account. |
On the other hand, if, as I apprehend, with CAC, the central bank loses control on the exchange rate, this could well be a negative factor for capital investments, at least in the tradables sector, which incidentally is the fastest growing. |
Surely a volatile exchange rate adds to the risks of investments in this sector (exporting or competing with imports). And, as I have argued earlier in this column, employment on the required scale cannot be generated except through a fast growth in labour-intensive manufacturing industry. |
The roots of the problem in attracting FDI seem to be elsewhere "" for instance, the procedures and time taken to start businesses. |
A recent World Bank report points out that it takes 11 procedures and 89 days to start a business in India as against 12 procedures but only 41 days in China. |
Labour laws and small-scale industry (SSI) reservations also militate against labour-intensive investments. Subsidies, many of them to the not-so-poor, leave no resources for investment in infrastructure and its poor state dissuades investors. |
And CAC will not solve any of these problems, indeed it will worsen some of them like adding to uncertainties about the exchange rate. To my mind, at the current stage of the economy, the risks of CAC outweigh the possible rewards. |
Before we spend any more energy on solving the "problem" of high reserves, it is as well to not forget a couple of points. |
First, the current account has gone into a significant deficit in Q2 2004-05 "" $ 6.4 billion (even before the peak in oil prices in October). |
This has converted the Q1 surplus of $ 3.1 billion into a first half deficit of $ 3.3 billion, which contrasts with a surplus of $ 2.2 billion in the corresponding period last year. |
A negative variance of, say, 1 per cent of GDP is not such as to cause worry, but is not insignificant either. To the extent it is because of non-oil imports, the deficit is a positive feature reflecting both industrial growth and investment pick-up. |
Second, to my mind, there are question marks whether portfolio inflows would continue on the current year's scale, if only because equities do seem fully priced: the trailing index P:E ratio is 18 and that based on expected profitability for the current year is a little less than 15. |
Equities may not be overpriced, but they are not a bargain either. Equally, there would be temptations for taking profits. (I must confess, however, that my expectation of portfolio flows in the current year was much, much lower than what has actually happened.) |
Having said this, it also needs to be acknowledged that foreign institutional investor (FII) flows, while not as stable as FDI, can hardly be considered "hot money". |
For one thing, since the capital account was opened for portfolio investment 10 years ago, inflows have been positive every year, except post-Pokhran 1998. |
Even more importantly, the stock today is so large that there is no way the money can go out easily. The east-Asian crisis also confirmed this "" in fact, it evidenced that bank debt is far "hotter" than FII investments in terms of reversal of flows. |
The hottest money? Residents' savings! |
Tailpiece: After reading the various reports about the fraternal dispute appearing in the pink press, my respect for the Ambanis' management abilities has gone up so much! |
It is amazing that after spending time in all the complicated investment structures, cross shareholdings, a couple of hundred investment companies, some of them promoters, some of them not quite promoters but acting in concert, issue and surrender of sweat equity, they still have time left to manage their businesses.
E-mail: avrco@vsnl.com |
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper