T C A Srinivasa-Raghavan: CAC - Look before you leap

OKONOMOS

"Full capital account liberalisation promises no large benefits, while it increases the risk of things going badly wrong."

Following Don Patinkin's famous four-quadrant diagram of macroeconomic equilibrium, which is achieved only if the other three quadrants (depicting the labour, product and financial markets) are in equilibrium, one can say that India has done nothing in the first, something in the second and the most in the third. In that sense, India's economic reforms have been lopsided. The standard explanation for this, trotted out by naïve academics, is the "reform-by-stealth" argument. This explanation, now accepted by all, says that only painless reforms are undertaken and even that is done very quietly.

But, if you ask me, there is another explanation. This is that the US has always wanted India to liberalise its financial sector because that is where its comparative advantage lies. It had been trying without success for decades, but after the collapse of the USSR and the BoP crisis of 1991, it could no longer be resisted. India had to finally give in.

Be that as it may, D M Nachane, who is amongst the more sober voices in the babble that characterises the debate on financial sector reform, has written a wonderfully comprehensive, lucid and temperate paper* on a key aspect of financial sector: capital account convertibility. "In recent years, emerging market economies are facing increasing pressures from multilateral institutions and developed countries to liberalise their capital accounts," he says, and proceeds to explain why India needs to tread carefully.

He does not deny that full convertibility has its benefits on global resource allocation, domestic monetary policies, trade, exogenous shocks and so on. But every coin has two sides and he points out that countries need to bear in mind "moral hazard, asymmetric information and agency problems."

Once you do this, he says full convertibility begins to look less attractive. "Besides," he adds, "there are the special problems created by short-term capital mobility in terms of financial market instability, asset bubbles and other micro-economic distortions."

When all is said and done, and all precautions taken, an intractable problem remains. "The efficient markets theory, advanced as an alternative to Keynes' sombre view of financial markets, fails to address the issue of the destabilising effects... of speculative behaviour by 'noisy traders.'" So what seems to work well in theory doesn't always in practice.

Certainly, where developing countries are concerned, the evidence is overwhelming that full convertibility doesn't work except for traders looking to make a fast buck through ever-larger commissions on the growing range of financial products. Full convertibility simply enlarges the trough from which they can feed.

Nachane is sharply critical of the government and the RBI (on whose monetary policy committee he serves). He says the government likes the idea (US pressure?) and the recommendations of the RBI's two committees (Tarapore I & II) are not very convincing. "It is not very evident that these committees (especially Tarapore II) have really gone into a detailed examination of all the risks attached to CAC, and devoted sufficient attention to measures such as Trip Wires, Speed Bumps Approach (TWSBs) which have recently been experimented with in several countries."

The TWSB approach consists of identifying a few basic indicators as trip-wires. When these deteriorate below some previously defined threshold, the central banks' certain safety measures are triggered off to prevent massive capital flight. Nachane says several developing countries have started to look at this option seriously. Their main effect is to reduce agency and moral hazard problems and reassure the good guys that their money is safe from speculative attack.

His final paragraph has a message, an inadvertent one I am sure, for the Planning Commission which has set up a committee to suggest some more financial sector reform. "The overwhelming evidence against CAC, however, may not necessarily convince some of the die-hard reformers among India's current policymakers...this group has conveniently decided to regard all advice emanating from resident Indian economists as otiose... I can do no better than to quote from one of the leading architects of the erstwhile Washington Consensus, John Williamson: At this stage full capital account liberalisation promises no large benefits, while it increases the risk of things going badly wrong."

*Capital Account Convertibility In India: Revisiting The Debate; ISAS Working Paper No 24, August 2007