Leap To CAC With Lilliputian Knots

Updated: Jan 22 2003, 05:30am hrs
The January 10, 2003 measures along with the barrage of measures announced earlier during 2002 together constitute a very major step toward Capital Account Convertibility (CAC).

The Reserve Bank of India has done a superb job of a step by step liberalisation and there has been no significant backtracking. The major driving force for the recent liberalisation appears to be the mounting foreign exchange reserves which, in early January 2003, were $70.7 billion. With large capital inflows, there is a commensurate increase in the need for reserves but even taking this into account, the reserves are more than adequate. Liberalisation of the capital account, far from bringing down the reserves, is going to add to the bulge, at least in the initial stages. Some observers argue that the recent liberalisation will make an annual dent in the reserves by $10-15 billion. In all probability, there would be a net accretion rather than a depletion of the reserves. Thus, if the sole purposae of the measures is to reduce the reserves, this objective is unlikely to be achieved.

The Committee on CAC, in May 1997, set out a set of preconditions and a sequencing of measures to be implemented by 1999-2000. While some of the preconditions, such as inflation control and attendant conditions like the level of reserves, have been more than attained, other preconditions, such as reducing the fiscal deficit, bringing down non-performing assets (NPAs) and strengthening of the financial sector are yet to be attained.

If one were to go by the advice of international experts, like Jagdish Bhagwati, Stanley Fischer, Larry Summers, the late Rudiger Dornbusch, John Williamson and Ronald McKinnon, one would want to go slow on CAC. But the kind of caution all these luminaries are talking about is very different from the nuisance of Indian exchange controls. Hence, one cannot fault the Indian authorities for the gradual freeing up of these controls.

A question that is often asked is how the recent measures bear up to the recommendations of the CAC Committee. Such a question is not meaningful. First, the Committee envisaged a horizon up to 1999-2000, while the present set of measures are being taken toward the end of 2002-03. Second, the economic parameters have changed substantially since the Report was written in 1997 and hence any evaluation of the measures cannot be undertaken strictly in accord with the Report.

There is, however, one aspect regarding which an evaluation is still possible. The CAC Report recognised that the preconditions may take longer than three years to be attained as they indeed have and such an elongation of the time frame for measures is quite legitimate.

Another area wherein an evaluation could be undertaken relates to the technique of liberalisation. On this criteria, in contrast with the Committees recommendation, the authorities have gone way beyond the recommendations and for good reasons but while undertaking the liberalisation, the authorities have resorted to Lilliputian Knots.

While the Committee favoured an initial phased opening up for individual residents and the same pace was to be applied for non-repatriable funds of non-residents Indians (NRIs), the authorities have opted to open first on a large scale for non-repatriable funds of NRIs. The Committee envisaged that when opening up for resident Indians, annual ceilings should be fixed $25,000 in the first year, $50,000 in the second year and $1,00,000 in the third year. But once these ceilings were prescribed, the Committee did not envisage restrictions on the form in which the capital assets could be held or how they could be disposed of this was the essence of CAC for individuals.

The authorities have in a sense gone overboard and substantially raised the repatriation limits for up to $1 million per calendar year for non-repatriable balances of NRIs. While this is as good as it gets, the liberalisation for residents is of a totally different genre. For corporates the investments abroad are now subject to 25 per cent of the companys net worth, while for individuals it is without any monetary limit. It is not clear as to why no limits are set for individual residents. Are there no dangers of such investments without limits On the surface, it appears a massive liberalisation but Lilliputian Knots keep Gulliver bound.

Individuals are permitted to invest abroad only in equities and that too in listed equities of those companies which have at least a 10 per cent holding in an Indian listed company. Here is the familiar dilemma of one instrument with multiple targets. The rationale of the 10 per cent stipulation is to ensure that multinationals do not continue to get themselves delisted from the Indian bourses. Most residents have lived with a blanket prohibition all their lives. Brave is the Indian resident individual who would have the courage to invest in stipulated equities abroad. While mutual funds are allowed to investments in rated debt instruments, resident individuals are prohibited from such investments. Again, one would have thought that resident individuals would be first permitted to hold foreign currency interest bearing deposits abroad but this basic investment avenue is denied. This is particularly galling for small investors. No wonder one is led to believe that all this is for the plutocrats!

But there is hope as the finance minister has planned more in the ensuing period. If one could have a wish list, it would include the following: (i) all restrictions of entry into the forward exchange market would be removed viz., anyone allowed in the spot exchange market should be allowed entry into the forward market; (ii) Banks in India are free to invest abroad without limits but are subject to severe restrictions on the borrowing side. The borrowings investment regime should be symmetrical and subject to prudential limits; (iii) Resident individuals and mutual funds should be subject to reasonable monetary ceilings without knots.

The purpose of CAC is to reward good macro-management and punish bad management. It is here that we have to give up fears that foreign gnomes will punish us unfairly. We have enough controls to take care of marauders wrecking our economy. What we need to do is to totally do away with exchange controls for individuals for current and capital transactions, within an overall annual single monetary limit with no questions asked. There is an imperative need to distinguish between capital flight, money laundering and terrorist funds on the one hand and tyranny of the exchange controls for individuals on the other. u