From here to eternity

The second committee on "fuller" capital account convertibility (CAC-2) was hurriedly set up by the Reserve Bank when the Prime Minister surprised everyone by bringing convertibility back on the front burner in March. The report is a disappointment, for it puts out a five-year time-frame for fuller convertibility, which is manifestly too long. It is another matter that some of the committee's recommendations (like reducing the government ownership of the large banks from 51 per cent to 33 per cent) may not happen by even 2011. In other words, we are going to witness a repeat of the last such exercise in 1997: a three-year time-frame was set out, but nine years later some of the 3-year goals are still to be met. That by itself is eloquent comment on the pace of India's economic reforms. Perhaps we will have CAC-3, a decade from now, with a fresh set of goal-posts and milestones.

The report largely restates existing positions, other than for allowing Indian corporate houses to set up banks. In some areas, it actually moves in reverse gear: greater currency rigidity and a ban on participatory notes (PNs) are advocated (inviting notes on dissent). Banning PNs, through which half of portfolio flows take place, is an unexpected recommendation from a committee on decontrol, and currency rigidity with open capital flows is an invitation to trouble.

The last remnants of India's inspector raj are found in finance, where hundreds of quantitative controls are manned by thousands of RBI staff. The report engages in a bureaucratic treatment of this system of controls, and fails to rise above the procedural view of a bureaucrat to the strategic view of an expert. The CAC-2 report fails to recognise that de facto convertibility is already upon us: Gross foreign exchange flows across the boundary were 91 per cent of GDP last year, and private agents can move 25 per cent of GDP in and out of India at short notice. We no longer have the luxury of upholding the licence raj, and setting up goalposts for future dates at which the RBI will relinquish controls. The individual recommendations (on the debt market, on removing NRI tax benefits, and so on) are unexceptionable, but they fall short of a quick plan of action.

Comparison with China is instructive. China starts with a more repressed financial system, and it lacks an Indian-quality equity market. But its pace of change and strategic direction are superior. It has removed banking regulation and supervision from the central bank, thus focusing the central bank on only one task""monetary policy. China's capital controls are weaker than India's in many respects, and it has embraced foreign banks as the tool for solving the problem of state-owned banks. It has brought in international scholars to guide inexperienced central bank staff on thinking through the complexities of international finance and macro-economics. The broad strategy""of first obtaining currency flexibility and currency derivatives trading, and then removing capital controls""is part of a consistent macro-economic framework.

What India needs most is a strategic analysis of the situation. What is a consistent monetary policy framework, and institutional architecture, under de facto convertibility? How can convertibility be harnessed to obtain competition and thus efficiency gains in Indian finance? How can outward orientation, i.e. Mumbai as an international financial centre, fuel efficiency and competition in finance while earning $10-20 billion a year in export revenues? These questions remain unresolved.