Column: Open up the capital account

Written by Ila Patnaik | Updated: Mar 15 2014, 08:19am hrs
India's path to capital account convertibility will be an important question for the new government. Left thinkers have attacked financial globalisation, pointing to the risks it brings to emerging economies, especially after the financial crisis. For the new India with world class multinationals, with a skilled labour force and the potential for becoming an international financial centre, the Left arguments perpetuate backwardness. The next government needs to move forward with rationalisation, liberalisation, removal of bureaucratic overhead, and establishing the rule of law so that Indian companies and citizens have greater freedom to manage their finances and access to world-class products and lowest prices. Missteps on this process will generate shocks to the exchange rate and to the economy.

India has a large and complex system of permanent and pervasive capital controls. Numerous agencies have been given powers to interfere with cross-border transactions. It is often not clear why certain controls are in place. For India to succeed, the relevant question is: How to open up sensibly

The first element for policy is the hygiene of good governance. The principles of transparency, accountability and rule of law, which have gained prominence across all parts of the working of the state, are equally relevant here. Across the landscape, there is unhappiness about the bureaucratic overhead faced in doing simple thingsit is time to slash the red tape and simplify procedures. This is just the hygiene of sound public administration. The government is in the process of voluntarily implementing the governance-enhancing features of the Indian Financial Code that was drafted by Financial Sector Legislative Reforms Commission (FSLRC). These will yield major gains when applied to the working of capital controls.

Percy Mistry, whose report argued for making Mumbai an international financial centre, has long reminded us that there are no accidents on a village road not because the traffic police is effective, but because there is no traffic. Whether we should have financial globalisation is no longer a question for India. The question now is: How can we open up to the world and, at the same time, undertake measures to become strong and

resilient For example, steps to increase the liquidity of derivatives markets, removing caps on rupee-denominated debt and enabling firms to hedge their foreign currency exposure will make the economy more

resilient. Engagement with the world introduces new risksand the best way to deal with those risks is to have deep and liquid markets as shock absorbers. So far, RBI has prevented the emergence of a deep and liquid market for the exchange rate and for bonds. This needs to be reversed.

In the minds of some policy makers, there is the idea that capital controls can be switched off and on at will, based on the movement of the exchange rate that is desired. This idea is flawed at numerous levels.

First, the existing evidence shows that these attempts at tinkering with capital controls do not yield the desired impact on the exchange rate. The hoped-for outcome is not realised.

Second, there are important costs. To make an analogy, consider the export of onions. If India repeatedly switches off and on the export of onions, this frustrates the development of sophisticated firms with long-range contracts and a deep understanding of the international onion trade. In fact, the very possibility that a government might shut off a business hinders firms from investing in developing those capabilities. If the government threatened that they would shut down barber shops in the future at whim, there would be fewer and inferior barber shops.

Participation in the global onion trade requires complex firms with a rich network of human networks and long-term contracts. So it is with international financial activity. For Indian firms to grow roots in global finance, and for global firms to grow roots in India, both sides have to invest considerable amounts in the long-term objective of building organisational capability. When India indulges in a ban, this kills off organisational capability. When India even threatens to impose a ban in the future, investments in building this capability are reduced.

The defining problem in a safe and sound engagement with financial globalisation is that of overcoming asymmetric information. When the global financial system does not have a deep understanding of India, it is more likely to make mistakes, with capital surges, sudden stops, mistakes in investment flows, knee-jerk responses to events, etc. To avoid these maladies, we require that global financial firms have a deep knowledge of India. This deep knowledge is impounded in the organisational capital of global financial firms: in their staff, in their processes, in their long-term investments in learning India. But for this to happen, we have to stop banning cross-border activity and change laws so that there is no possibility of bans in the future.

To simplify the complex system we have, we need to ask what is the objective of each and every control in place and to undertake the task of steadily dismantling unnecessary restrictions. Some controls were put in place to prevent capital from flowing in and while others were imposed to prevent capital from flowing out. These channels of flows get circumvented by investors and overall inflows and outflow occur based on economic conditions, but the restrictions create distortions. The task is challenging, but necessary for India to become globally competitive.

The author is RBI Chair Professor, National Institute of Public Finance and Policy. Views are personal