The capital flows puzzle
Business Standard, 19 September 2007
In Indian economic policy, capital flows represent an important and difficult puzzle. To most people, the desirable long term destination is that of an advanced country where there are no capital controls. The puzzle lies in deciphering the next steps. The present policy framework -- of blocking the development of financial markets, and of devoting the lever of monetary policy to the pegged exchange rate -- is running into difficulties at an increasing rate owing to growing openness. Achieving a new policy framework involves synchronised progress on finance and on the monetary policy regime, so as to catch up with a more globalised India, and pave the way for full convertibility. This will not come about by muddling along; it requires intricate policy work and challenging the status quo.
India has made significant progress on opening the current account, and on growing Indian multinational firms. Finance follows trade - so where trade blossoms, there is both a heightened need for international financial services and myriad opportunities for evading capital controls. Convertibility has now been achieved, for all practical purposes, for inbound and outbound FDI, for NRIs and for the equity market. This evolution towards convertibility has generated increasing stress when juxtaposed against traditional policies on finance and macroeconomics.
The television sound bite question - Should India do convertibility and when? - is unfortunately not a very relevant one. India has already done considerable convertibility, and convertibility is deepening every day. What India now needs is policy work on many fronts, so as to catch up with the consequences of this convertibility, and pave the way for a safe and sound elimination of all capital controls.
Two sound bite answers are also not useful. On one hand there is the dirigiste solution of bringing back the level of capital controls required to obtain India as a closed economy. While this sounds like an easy choice, it is actually untenable because of the costs that it would impose on the real economy. On the other hand is the hope of muddling along, of doing a few incremental things, of respecting institutional sanctity, and hoping things will work out okay. This muddling-along has been tried in recent years, and has landed policy makers in one difficulty after another. The difficulties from muddling along will get progressively worse as India's globalisation progresses.
Resolving the difficulties of the present situation, and moving forward towards full convertibility, requires intricately interlinked work on four fronts:
- The fiscal crisis: The first hurdle continues to be the fiscal problem. India has made considerable progress on the fiscal crisis. Far-reaching institutional change has taken place owing to the FRBM Act and the 12th finance commission. The consolidated fiscal deficit that has dropped from 9.63% of GDP in 2001-02 to 6.36% of GDP in 2006-07: a gain of 3.27 percentage points in five years. However, the battle is only half won. The apparent improvement in the fiscal situation is overstated because perhaps 1% of GDP of trouble on food, fertilisers and oil has been placed off-balance-sheet. In a business cycle downturn, tax revenues will drop sharply. The existing destination of fiscal reform - a consolidated deficit of roughly 6% of GDP - remains unacceptably high for delivering a steady decline in the debt/GDP ratio. Greater convertibility demands greater fiscal responsibility. A responsible fiscal policy involves correctly measuring all liabilities, and then delivering a declining debt/GDP ratio year after year.
- The BCD Nexus: Well functioning macro policy in an open economy critically requires a well functioning Bond-Currency-Derivatives Nexus. Some of the woes of macro policy today derive from the lack of these markets as shock absorbers, the missing monetary transmission that they would induce, and the lack of valuable information that they would produce.
The equity market is a living role model, showing the liquidity and market efficiency that can be achieved, under Indian conditions, if a proper market design is put into place. Particularly with the success story of the equity market in hand, it is time to recognise the failure of the status quo on the BCD Nexus. The MIFC Report has offered a concrete game plan for how this can be done. - Banking: As the international experience has shown, banks are an achilles heel in the movement towards convertibility. While many Indian banks appear to be healthy right now, the situation is likely to deteriorate in coming years owing to deep forces that are presently at work. The mainstream argument in India is that convertibility should be blocked because the banks are immature. This is reminiscent of the infant industry arguments which were used to block trade reform. India's progress is more important than the sheltering of infants.
The domination of PSUs is considered an inexorable problem holding back Indian banking. However, as the examples of insurance, mutual funds, telecom and airlines have shown, it is possible to ignite tremendous change in a PSU-dominated sector through a focus on ample competition and technically sound regulation, even without a political consensus for privatisation. Particularly with these four success stories in hand, it is time to recognise the failure of the status quo on banking policy and regulation. An independent banking regulator needs to be setup, with a technically sound professional focus on a high quality banking system, without the conflicts of interest faced in RBI. - Monetary policy: The prevailing monetary policy framework, of a pegged exchange rate, involves a loss of monetary policy autonomy given deepening capital account convertibility. A fresh design effort is required on rethinking the monetary policy framework. In addition, the institutional mechanisms of monetary policy need redesign in order to address the issues of conflicts of interest, independence, accountability, transparency and predictability.
The question of capital flows cannot be dodged. There are no easy answers, and the option of doing nothing is unviable. What the situation demands is a blend of understanding of open economy macroeconomics, in a worldview of modern finance, so as to think through the strategy and tactics of moving forward on all four fronts -- fiscal, monetary, banking and the BCD Nexus. A mere insistence that convertibility and sophisticated financial markets are dangerous, based on a "fear of finance" worldview, does not get things done. Making progress in the situation that we face requires a considerable effort of empirically grounded economics, rooted in a open economy setting, with a institutional understanding of financial markets.
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