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Capital Account Convertibility: A Neglected Consideration

In the debate on capital account convertibility, financial and macroeconomic objectives and constraints have been paramount, with much less discussion on the growth and development dimensions of CAC. This article focuses on one hitherto neglected aspect of first-order importance for long-run growth: the level of the real exchange rate or what might be called the objective of avoiding overvaluation.


Capital Account Convertibility: A Neglected Consideration


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Economic and Political WeeklyJune 23, 20072417the tradable sector is represented by manu-facturing. The Kuznets hypothesis sug-gests that the manufacturing will first risewith development and then fall as incomesrise. Thus, the share of manufacturing inGDP should follow an inverted U shape.One could posit that tradables should ceaseto be a “target” of development around thepoint that its share in the economy startsdeclining: at this point, a developingcountry is more like a developed country.What is the income level associated withthis turning point? We can actually do asimple calculation to ascertain this. For thelatest year for which data are available, werun a regression of the share of manufac-turing in GDP against per capita PPP GDPand its square for over 100 countries forwhich data are available. The Kuznetsrelationship is indeed confirmed by thisregression. The regression also yields aturning point for this relationship of about$15,000 per capita in PPP terms. Assum-ing a country was “normal” and that itfollowed the typical pattern, this could bethe level at which manufacturing ceasesto be the focus of development policy.7A number of good arguments could beadvanced for why India is not a typicalcountry: because of its idiosyncratic de-velopment strategy, it might have a smallerrole for manufacturing in the future thanthe normal country; and because it is alreadyhighly diversified, much more so than thetypical country, it needs to provide lesspolicy assistance to promote diversifica-tion [Kochhar et al 2006]. But even so, ata per capita income level of about $ 2,600,the question remains whether Indianpolicymakers can afford to take their eyesoff the tradable sector.8Current ConjunctureThe issue of CAC has acquired newresonance because of the dramatic shift inthe policy of the RBI in response to acombination of recent inflows and infla-tionary pressures: from a managed float,the RBI seems to have moved to a moreflexible exchange rate policy.But the permanence of this policy cannotbe taken for granted because there willinevitably be pressures for further appre-ciation of the rupee and already we seeclamour for “something to be done” aboutthe exchange rate.In the current context, three remarks canbe made about the role of CAC. First, itis difficult to contemplate any major re-versal of Indian policy toward CAC. Thecosts in terms of damaging market con-fidence in India’s reform credentials wouldbe high, even prohibitively high. That said,policymakers should not further under-mine flexibility by taking policy actionsin the direction of further liberalisinginflows. There may even be a case fortightening external commercial borrow-ings (ECBs) that were surprisingly relaxedlast year. If feasible, some tightening ofshort-term (hot) flows might be warranted.Skill and timing will be essential in imple-menting any such tightening so as not todisrupt markets. One possibility would beto reduce caps on ECBs whenever they arenot fully met and to continue this processas long as the slack allows.Second, the point is made that given themagnitude and increase in capital flows,it is simply foolhardy to try and manageor reverse this process. According to thisview, India should codify what is de factoan open capital account and just get onwith it. But the real issue here is not howmuch capital is coming in “naturally,”which obviously should be allowed to comein, but what the future policy actions shouldbe. If ECBs, even as they are now, playa role in limiting inflows, it seems that theyshould be managed carefully, and notliberalised on the grounds that agents willalways find it easy to circumvent controls.As long as policy has some impact, thatflexibility should be retained. Similarly,another major area where there is stilleffective policy control in inflows relatesto inflows into the bond market. Again,these should not be liberalised prematurelywithout taking into account the effect onthe exchange rate.Third, some have argued that one wayto manage the exchange rate consequencesof capital flows is to liberalise outflows,taking some pressure off the exchangerate. While such action might help, thereare two consequences of liberalising out-flows that should be considered.Liberalising outflows, often, engendersadditional confidence in policy and resultsin further inflows. A second and moresubtle point relates to international politi-cal economy. The more a country liberalisesoutflows, the less easy it becomes to justifythe asymmetry between policies to out-flows and inflows. Trading partners willinevitably ask why they should be ex-pected to open their economies to Indiancapital when India does not similarlyreciprocate. In other words, liberalisingoutflows could easily lead to pressuresfrom partners on India to further liberaliseinflows. India should be mindful of thisconsideration.Concluding RemarksDecisions on CAC will no doubt becomplex, involving the juggling and rec-onciliation of multiple objectives andconstraints. In the debate in India, finan-cial and macroeconomic objectives andconstraints have been paramount, withmuch less discussion on the growth anddevelopment dimensions of CAC. Ofcourse, the growth dimension cannot bethe only, or even the most important,ingredient determining CAC, but it wouldseem to merit more consideration, givenits consequences.One reason why Indian policymakershave devoted less attention to this issuethan it merits, and have not seen exchangerate policy as being a constraint on devel-opment, may be because of having man-aged it so well. Exchange rate policy mustbe rated as one of the few consistentpolicysuccesses in India, reflected in theconsistent avoidance of exchange rateovervaluation.And this success may havebred a certain sanguineness about, andhence some inattention to, exchange ratemanagement in what could be a verydifferent era of CAC. It is striking – evenshocking – to read the two Tarapore Com-mittee reports and find such little discus-sion of the exchange rate, and discussionsof the potential problems in managing itin a world of greater capital movements.The philosopher Santayana famouslycautionedagainst repeating the mistakesof the past. Reading the Tarapore Com-mittee reports in light of recent experiencebrings home the realisation that perhapsthere is alsowisdom in not repeating thesuccesses of the past.At the end of the day, CAC might wellturn out to be an overblown issue: a talefull of sound and fury, signifying muchless than the strong views of proponentsand opponents alike might suggest. Thispaper raises the question whether thesegains and risks are symmetrically moder-ate if the competitiveness and growthconsequences from an early move to CACare fully taken into account. Echoing StAugustine, if Indian policymakers were tosay, “let us have CAC but not yet,” wouldit be a case of undesirable procrastinationor of wisely heeding the precautionaryprinciple? The answer to that question maywell be the former but it would be a wholelot reassuring if it were arrived at after

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