Subir Gokarn: A bridge too far?

In recommending a narrow band for exchange rate movements, the Tarapore report may increase risks of a currency crisis.

The title of this article (without the question mark) is borrowed from a book written by Cornelius Ryan. It described the failure of a campaign in 1944 by Allied forces in Europe to capture three bridges behind enemy lines, which would have blocked off the withdrawal of German forces from the Netherlands back into Germany. This would, presumably, have left them no choice but to surrender to the main body of advancing Allied armies.

It failed because two key assumptions underlying the tactic proved to be invalid. One, the Allied armies could move fast enough to put the encirclement into effect. Two, the small force of paratroopers, which was dropped in to capture the bridges, could hold off the pressure of the withdrawing German troops. In the event, the bridge could not be held by the advance force and the war went on to be fought hard in Germany for the next few months.

Clearly, the failure did not alter the course of events; the Allied forces would have prevailed sooner or later. But, like many other instances from military history, the episode illustrates the often destructive interplay between various forces in planning and decision-making. Unbridled ambition can often lead to an overestimation of one's own strengths and an underestimation of the opponent's weaknesses. Information or intelligence that supports the decision is played up, while contradictory facts are dismissed. And so on. There is undoubtedly a large number of lessons for both managers and policymakers. Two important ones: don't take risks when you absolutely don't have to. And, a good plan is one that anticipates and provides for a worst-case scenario.

This is broadly the context in which I view capital account convertibility. Since the first Tarapore Committee submitted its report in 1997, even without the formal acceptance of its recommendations, the economy has moved steadily down the road towards full convertibility. Current account convertibility is real and tangible, but, more importantly, we have moved quite far on capital convertibility as well.

Of the three key stakeholders in this process""foreign investors, broadly defined, domestic companies, and resident individuals""the first two already have more or less unrestricted access as far as taking money out of the country goes. The third category is allowed limited access with a ceiling of $25,000 per individual, an opportunity that doesn't seem to have been extensively used, not least because returns on investments in India have been quite attractive over the last couple of years. From this perspective, "full" convertibility would have emerged sooner or later, as the remaining restrictions, however minor, on all stakeholders were steadily removed.

I didn't, therefore, quite see the need for another committee to ponder the issue and make recommendations. That act itself heightened expectations of a deviation from the steady, incremental and largely unexciting path towards full convertibility""expectations which clearly have not been met. However, once the committee was set up, I really did not expect the broad tenor of the recommendations to be very different from what they were.

The true test of a financial system in an open capital account environment is how it stands up to a surge of outflows. When an economy is doing as well as India's is today, offering attractive returns with relatively low risk to the global investor, this eventuality may seem remote, even abstract. But, visualise a scenario in which, because of oil, infrastructure or political upheaval, our growth rate drops by 3 or 4 percentage points and current account and fiscal deficits threaten to balloon out of control. Foreign investors will exit in droves, of course, but now every citizen with a reasonably-sized portfolio has the option to move his assets to a more attractive location (assuming there is at least one)! What then?

In tune with the lessons referred to above, the priority clearly needs to be on strengthening the financial system's capacity to withstand a severe shock, as both foreigners and citizens encash and exit. This relates to the substance of the second Tarapore Committee recommendations. They emphasise two requirements for the banking system.

One, the structure has to evolve towards larger, more efficient banks. This was also the recommendation of the first Narasimham Committee in 1992 and has been a constant theme in any discussion on financial sector reforms. The Reserve Bank of India's roadmap for removal of entry restrictions on foreign banks stretches to 2009 on the premise that the structure of the domestic banking sector is sub-optimal and a process of consolidation will take that long. The Tarapore Committee could, presumably, have chosen to challenge that premise, but did not.

Two, risk monitoring and management systems of banks may be attaining compliance with Basle II norms, but the test of these systems, so far, has been restricted to domestic exposures. Would we want to assume that they will automatically stretch to cover risks related to global exposures, not just direct ones but indirect ones as well? The committee chose not to do so again. Instead, it recommended calibrating the move towards fuller convertibility with the establishment of appropriate risk monitoring, management and, crucially, supervision processes.

Both lessons drawn above""don't take risks that aren't necessary and provide for the worst-case scenario""are evident in the recommendations. Nobody would argue that fuller convertibility is essential to sustaining or giving an additional boost to the current growth momentum. There is, therefore, no compulsion to rush, which is why I believe, incidentally, that a committee was not really necessary. But, having been set up, it was given the opportunity to implement the second lesson, which it did for the most part.

Having said this, however, there are two issues on which its recommendations may have lost sight of the lessons. One, in recommending the banning of P-notes, it introduces the risk of deterring significant investment flows, while possibly underestimating the capabilities of the system to accommodate the risks.

Two, in recommending a narrow band for exchange rate movements, it may actually increase the risks of a currency crisis. All currency crises in recent times have one factor in common: a pegged or tightly bound exchange rate regime. This completely absolves people from heading their foreign exchange exposures. When the central bank can no longer hold on to its peg and the currency collapses, these people are completely vulnerable. When the market is credibly allowed to determine the exchange rate, people will have an incentive to hedge against its volatility.

The author is chief economist, Crisil. The views here are personal