Tamal Bandyopadhyay: Half way there

Several critical bits of the full convertibility roadmap are in place.

On July 31, the second Tarapore Committee will come up with its report on the roadmap to Capital Account Convertibility (CAC). Whatever it decides, it will first look at just how far we have met the conditions laid out by the first Tarapore report in 1997. Apart from the critical fiscal deficit target, however, most appear to have been met, including those concerned with debt service repayments, volatile capital flows, such as short-term debt and portfolio investments, and a minimum net foreign assets to currency ratio. Unlike countries like Chile and Indonesia, which introduced CAC before doing financial sector reforms, or those like Mexico and Argentina, which embraced CAC as part of a larger package of reforms, India is following the path of countries like Malaysia, Korea and Thailand, who introduced CAC after achieving certain pre-conditions in terms of growth, fiscal consolidation, inflation rate and deregulated financial markets.

Under the Tarapore-I parameters, the ideal pile of foreign exchange reserves varied between $22 billion and $30 billion. Forex reserves have now touched the $150-billion mark. The panel had said that the reserves should not be less than six months of imports. The current level is equivalent of about 13 months' imports. It had also said that the reserves should be enough to cover three months of imports, half of annual debt service payments, and one month's exports to take into account the possibilities of leads and lags. This condition has also been met.

Tarapore-I had suggested that short-term debt and portfolio investments by foreign institutional investors (FIIs) should be 60 per cent of the reserves or even lower. Currently, it is around 37 per cent of the reserves. Tarapore-I had recommended that the ideal net foreign exchange assets to currency ratio should be not less than 70 per cent, while the current ratio is around 150 per cent.

Sanjeev Sanyal, senior economist of Deutsche Bank, says the targets have shifted over the past decade and the RBI would need around $300 billion worth of reserves today for a credible war-chest. The German bank's latest report on India and Capital Account Convertibility says, "This target would rise as the economy expands and, therefore, would be probably higher by the time the capital account becomes fully open." The direct cost of holding the incremental stock of foreign exchange will be about half to 1 per cent of GDP. "The new committee needs to weigh this cost against the likely benefits of free international capital movement," the report says.

One of the most important precondition for CAC, according to Tarapore, was a stable fisc. The panel recommended reduction in gross fiscal deficit from 4.5 per cent budgeted in 1997-98 to 3.5 per cent by 1999-2000, accompanied by a reduction in state's deficit. The Centre's gross fiscal deficit to GDP ratio in 2005-06 was 4.10 per cent. It is estimated to drop to 3.8 per cent in 2006-07. The states' gross fiscal deficit to GDP ratio was 3.2 per cent last year.

The panel was also in favour of the 10th Finance Commission recommendation of setting up a consolidated sinking fund (CSF) for public debt. This has not yet been done. However, the Fiscal Responsibility and Budget Management (FRBM) Act, which the panel had pitched for, is in place.

The committee was in favour of greater independence for the RBI and an average mandated inflation rate of 3-5 per cent. The average inflation rate in fiscal year 2005-06 was 4.45 per cent but no mandate has been given to the central bank for inflation control. In the run up to CAC, the report called for full deregulation of interest rates, removing all formal and informal controls.

The gross non-performing assets (NPAs) as a percentage of total advances should be 5 per cent and banks' cash reserve ratio (CRR) should be 3 per cent to ensure a smooth transition to CAC. Besides, weak banks were to be converted to "narrow banks" and invest only in government securities.

The savings rate is still administered and so is export credit. Besides, "informal" controls do exist on agriculture loans. The gross NPA of the banking system is close to the target at 5.2 per cent, though the CRR is higher at 5 per cent. There is no "narrow bank" in the system as the weak banks have been nursed back to health or merged with stronger peers.

Finally, on the balance of payment indicators, the 1997 panel had said "external policies should be designed to ensure a rising trend in current receipts-to-GDP ratio from the present level of 15 per cent and the endeavour should be to reduce the debt service ratio from 25 to 20 per cent." Both the targets have been achieved. In fiscal year 2004-05, the current receipts-to-GDP ratio was 22.10 per cent, which rose to 25.80 per cent last year. The debt service ratio in 2004-05 was 6.20 per cent. It had risen to 6.9 per cent last year.

So, have enough conditions been met, or not, and have the targets shifted as Deutsche Bank seems to suggest? Watch this space.