Commentary: Freeing the rupee might rein in New Delhi's spending
International Herald Tribune
MARCH 27, 2006
Andy Mukherjee

In the week since Prime Minister Manmohan Singh of India announced his intention to make the rupee fully convertible, several economists and currency strategists have panned the decision.

Their biggest objection is that the plan could be risky. What if India went to war or had a massive earthquake? In the current system, only the registered foreign investors can sell their equity investments or short the market for their hedge-fund clients.

With full convertibility, residents might also scramble to switch out of their rupee-denominated bank deposits - not to mention their investments in domestic stocks and property - and park their wealth in the safety of U.S. dollars, euros or yen.

Indians hold almost three times as much money in rupee- denominated bank accounts as the $146 billion that the central bank has in its foreign-exchange kitty. As a result, full- fledged capital flight could thrust the country into a serious banking and currency crisis.

Grave as the challenge is, it is not insurmountable.

And no, the answer doesn't lie in springing a Mahathir bin Mohamad on unsuspecting investors. There is a better way out of an unexpected crisis than trapping money with sudden capital controls, such as those imposed in 1998 by Mahathir, then the prime minister of Malaysia. The solution involves a basic change in the workings of the International Monetary Fund.

Two economists at the fund, Jonathan Ostry and Jeromin Zettelmeyer, suggested the outline of the change in a paper they wrote last year titled "Strengthening IMF Crisis Prevention." They proposed a rating system that would pre- qualify countries for emergency access to IMF funds, based on the quality of government policies in normal times.

"If a country's policies are judged to be sensible, its access to automatic financing in case it is hit by an unexpected shock improves," the fund's chief economist, Raghuram Rajan, said in a speech at New York University's Stern School this month, elaborating on the Ostry-Zettelmeyer recommendation.

It is an important proposal, and the Indian authorities would do well to persuade the board of the IMF to consider it seriously as part of their efforts to prepare for full convertibility.

If India were to follow policies that assured it of automatic help from the International Monetary Fund in case of a crisis, both residents and foreigners would know that the central bank was unlikely to run out of dollars.

Cutting the chronic budget deficit, which amounts to about 9 percent of gross domestic product, would be a good start. That would ensure that the rupee does not become the target of a self-fulfilling one-way bet for eventual devaluation.

This brings us to the other question that economists have asked about the Indian proposal for full convertibility: Is all this risk worth the gain?

The yuan, after all, is not convertible. And if China can get all the capital it needs for 10 percent economic growth, why should India be in a hurry to embrace full convertibility and all its attendant risks?

The counterpoint to that argument is quite simple. India's decision to move to a convertible rupee is about finding cheaper capital.

India needs about 3.5 units of capital to produce one extra unit of goods and services. So for gross domestic product to expand 10 percent, India would require an investment-to- GDP ratio of 35 percent. According to the latest available statistics, the domestic savings-to-GDP ratio is about 29 percent.

If the government could stop living beyond its means, the national savings rate would go up by about 2.5 percentage points.

With that, the gap between investments required for 10 percent growth and locally available savings would narrow to 3.5 percentage points of GDP.

That is the amount India will have to find overseas. And the nation is already attracting that much capital from abroad to finance its current account deficit.

In other words, India doesn't need to make the rupee fully convertible to achieve 10 percent economic expansion. The key to speedier growth lies in improving the state of government finances - and that will precede convertibility, not follow it.

With full convertibility, a lot of capital will enter India, attracted by higher rates of return. That will bring down the cost of capital for Indian companies. More of their new projects will become viable with lower financing costs.

Even as foreigners are allowed easy access to Indian assets, local investors will jump at the chance to buy overseas stocks, bonds and properties. A convertible rupee will thus magnify gross capital flows into and out of India.

It does not matter if the net gain - inflows minus outflows - is the same as the current level. Money going in and money going out will need financial intermediation. Higher gross flows will add high-paying jobs in the banking, fund management and brokerage industries in Mumbai.

That, too, will have a salutary impact on economic growth.

Prime Minister Singh and Finance Minister P. Chidambaram deserve kudos for putting full convertibility back on the nation's agenda, from where it had slipped following the Asian financial crisis in 1997.

Now they should weather the criticism and make their plan a reality before the end of the government's term in 2009. 

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