TCS Daily


Singhing the Praises of Capital Convertibility

By Christopher Lingle - March 31, 2006 12:00 AM

Bali, INDONESIA -- For most of India's post-colonial era, the views guiding economic policy and those expressed by opinion makers reflected a deep-seated contempt for markets. Despite the failings of socialist economic policies at home and the successes of market reform elsewhere, India has been slow to embrace capitalism. However, there are signs that the Indian government is reconsidering capital account convertibility -- a vital part of economic growth.

The socialist instincts of its founding fathers are reinforced by an imbedded legal obligation that dominates India's modern political culture. These conditions impede skeptical introspection into how policy choices contributed to persistent poverty and lagging domestic economic growth.

Mahatma Gandhi embraced economic autarky that was imposed on many socialist countries. And central planning was a key feature introduced by Nehru. But his daughter, Indira Gandhi, imbedded socialism in India's constitution during a period of martial law declared by her when she was prime minister.

In the late 1970s, Mrs. Gandhi used extraordinary powers to modify the opening lines of the Indian Constitution to read that "India is a sovereign, secular, socialist republic". She also amended the Representation of Peoples Act to require all recognized and registered political parties to swear by the Preamble. Since all political parties must support socialism, it is illegal to espouse classical liberalism or individualism.

This explains why there is so little explicit support for aggressive pro-market reforms. Even so, Prime Minister Manmohan Singh is widely lauded as a reformer that seeks to expand the role of the market.

However, his coalition government depends upon support of Neanderthal socialists and communists. Despite these problems, progress is being made. Singh recently pointed to improved economic conditions as evidence that India should move towards complete capital account convertibility.

While current-account transactions involving trade in goods and services are open, Indian citizens and companies face sharp restrictions on borrowing or investing overseas. It also means that households do not have the ability to seek higher returns on their savings by placing them overseas. As such, Indians pay a heavy high price for controls that distort investment decisions and lead to the misallocation of capital.

Uncertainty remains as to how quickly New Delhi will move on this change. It turns out that a plan was tabled in June 1997 that would have made the rupee fully convertible on the capital account within three years. But the devaluation of the Thai baht the following month marked the beginning of widespread turmoil on Asian currency markets and led to the plan being shelved.

This time the plan might move forward since there is a growing consensus of the need for capital inflows to keep India's economy powering ahead. Estimates are that India's must attract foreign direct investment of around $70 billion over the next five years in order to lift economic growth to an annual target rate over 9 percent.

Presently, India's currency is convertible only on the trade or current account whereby companies or individuals exchange rupees for foreign currencies to trade in goods and services. The Reserve Bank of India regulates the exchange of rupees for other currencies for investment purposes and decides on the circumstances under which it can be done.

These rules also restrict currency conversion for foreign entities that wish to invest in India and Indians that would invest overseas. And Indian companies face an annual limit of $500 million for foreign borrowing.

Ending India's capital restrictions is plausible given a relatively-low fiscal deficit, tame price inflation and a manageable proportion of non-performing assets of domestic banks. With foreign-exchange reserves exceeding $140 billion and GDP growth of almost 8% a year, India's economic conditions are stable enough to cope with sudden capital outflows.

With per capita GDP of $580 and a current account surplus of $9 billion, India's economy has a relatively small footprint on global markets. The potential for growth as an exporter and magnet for FDI is evident in that domestic demand accounts for 87 percent of GDP, much higher than in most trading countries.

Allowing more international outflows of capital could increase foreign investment inflows and help end the lingering distortions introduced by Nehru's socialist planners. Full convertibility of the rupee would integrate India more completely into the global economy by allowing individuals and businesses to invest overseas. Meanwhile, large companies could gain easier and cheaper access to foreign debt.

Combining an end to exchange controls with more aggressive privatization would increase the competitiveness of domestic capital markets and overall pricing efficiency. These transformations would allow capital to find its most productive uses and so aid in attracting more foreign investments.

A free flow of foreign exchange for investment purposes might lead to greater volatility in the rupee. But this would be offset by gains in efficiency since domestic companies would have more options for managing and raising capital funds.

When globalized capitalism meets failed socialism, political leaders must choose between protecting their own interests to promoting the broader interests of citizens. Continuing down the socialist path will inhibit the development of India's human potential by restricting the free movement of capital and undermining economic growth.

Christopher Lingle is Senior Fellow at the Centre for Civil Society in New Delhi.

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