Dr. P.V. Viswanath



Economics/Finance on the Web
Student Interest


Arguments for and against Capital Account Convertibility: The case of India

  P.V. Viswanath, 2006

(From Banknet India) Convertibility of a currency implies that a currency can be transferred into another currency without any limitations or any control. A currency is said to be fully convertible, if it can be converted into some other currency at the market price of that currency. If currency has to be convertible, it shall not be subjected to these restrictions.
Current account convertibility refers to currency convertibility required in the case of transactions relating to exchange of goods and services, money transfers and all those transactions that are classified in the current account.
On the other hand, capital account convertibility refers to convertibility required in the transactions of capital flows that are classified under the capital account of the balance of payments.
At present, the Indian rupee is partly convertible on current account. In 1997, the Tarapore Committee on Capital Account Convertibility (CAC), constituted by the Reserve Bank,had indicated the preconditions for Capital Account Convertibility. The three crucial preconditions were fiscalconsolidation, a mandated inflation target and,strengthening of the financial system.

The Case for Convertibility (from Amitava Krishna Dutt, "Flawed Logic of Capital Account Liberalization," Economic and Political Weekly, May 13, 2006, pp. 1850-1853)

The output-enhancing effect of capital account liberalization can be seen from a simple textbook model in which one good is produced in two countries with two factors of production, “capital” and “labor”, with given technology under conditions of diminishing returns to each factor. Suppose that the only difference between the two countries is that one – a developed country, DC – has a higher stock of capital than the other, an LDC. Under the assumption of perfect competition, but with labor and capital immobile between the two countries, the return to capital – or the rental rate – will be higher in the LDC than in the DC. If capital is allowed to move from the low-rental country to the high-rental country in search of higher returns, it will move from the rich country to the poor country, lowering its cost of capital, and adding to its production and income after paying the rental to the rich country (also adding to world production and income, since capital has a higher marginal product in the LDC than in the DC). To the extent that the accumulation of capital leads to higher growth such international capital flows increase growth in LDCs.

The consumption-stabilizing impact can be shown with another simple model in which a country with a representative agent can borrow or lend at a given world interest rate. Suppose that the representative individual receives a stream of income which is subject to exogenous fluctuations. If consumption exhibits diminishing marginal utility, the individual (and country) will be able to increase its inter-temporal utility if it can participate in the international capital market and stabilize consumption.

The Case Against Convertibility (from Amitava Krishna Dutt, cf. above, and Gurbachan Singh, "More on Capital Account Convertibility," Economic and Political Weekly, August 19, 2006, pages 3617-19)

Imperfect Information: The standard model underlying the output-enhancing effect is based on th eassumption of perfect information. However, if lenders do not know exactly what borrowers do with borrowed funds and it's very costly to institute monitoring, lenders will require collateral. Since high quality assets and legal reliability exist to a greater extent in developed countries than in developing countries, capital account convertibility could very well lead to flow of capital out of developing countries and to developed countries. The problem cannot be solved by substituting equity capital for debt capital because of the relative illiquidity of equity markets in many developing countries as well as the lack of reliable corporate governance.

Another problem has to do with the lack of reliable information. Faced with fundamental uncertainty, investors form expectations based on flimsy foundations. In forming such expectations, they may use conventions, such as following the lead of others, which gives rise to a herd mentality. The problem with this is that such expectations and conventions are subject tto large changes in reaction to new information. Furthermore, they may cause contagion effects, whereby a drop in confidence in one country's markets leads to asset withdrawals from nearby or otherwise similar countries. This is likely to lead to high volatility in asset flows. Furthermore, since information regarding the extent of investment in similar assets and in similar countries is not available easily to all borrowers, they may not be able to assess the likelihood of funds being called or downturns in the capital markets that they rely on. Furthermore, individual borrowers are not going to take into account the negative externalities that affect the entire economy and are likely to overextend themselves, relative to the social optimum.

Some economists feel that the IMF exacerbates these problems by demanding austerity from governments at the time of capital flight and national contraction and thus increasing the amplitude of the resultant boom-bust cycles. Furthermore, policies of lending out imprudent lenders leads to a moral hazard problem.

"The instability caused by capital flows increases uncertainty and reduces investment. The resulting fall in output and reduced external financing can lead to cuts in social programs and increased poverty among the vulnerable sections of the population.

Gurbachan Singh feels that a precondition for capital account convertibility is a sufficiently small ratio of fiscal deficit to government revenues. Considering that capital account convertibility can lead to (and is even designed to lead to) higher debt ratios for the economy, it makes sense to have requirements similar to those for individual firms that want to borrow. Another precondition that he suggests is investor protection to reduce the imperfect information problem noted above. Finally, he feels that a developing country should contract for a line of credit ahead of any financial instability with a view to strengthening the economy when there are currency outflows.

He makes two interesting suggestions that fall short of full rupee convertibility. One, to allow Indian investors to hedge against fluctuations in the value of the Indian rupee or to protect themselves against drops in rupee value, the suggests allowing investors to keep bank accounts using a foreign currency, such as the dollar, as numeraire, even though all fund movements will be in rupees. To the extent that Indian investors wish to invest in strong foreign financial institutions, this may be achieved by allowing foreign banks to open local branches. Two, he suggests that foreing investors not be allowed to make large withdrawals in exchange for a liquidity premium. In fact, he suggests that capital movements be allowed to be made, provided that funds are not taken out of a defined list of developing economies. This would prevent contagion effects, but at the same time, would prevent moral hazard and opportunism on the part of individual countries, since each country would have to worry about flows to one of the other countries in the group.