capital account convertibility a neglected consideration

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Capital Account Convertibility:

A Neglected ConsiderationIn the debate on capital account convertibility, financial andmacroeconomic objectives and constraints have been paramount,with much less discussion on the growth and developmentdimensions of CAC. This article focuses on one hitherto neglectedaspect of first-order importance for long-run growth: the levelof the real exchange rate or what might be called the objectiveof avoiding overvaluation.

Not to prolong the suspense, this con-

sideration is the levelof the real exchangerate or what might be called the objectiveof avoiding overvaluation. This is an issuerelated to the real side of the economy andshould be distinguished from those (stabi-lity and volatility) that are related to themacroeconomic and financial sectors.

Three points should be stressed at theoutset. First, the uncertainties about CACand the arguments in the paper relatingto them are all about non-foreign directinvestment (FDI) related flows. The posi-tive growth impact of FDI appears to be

well-established.Second, the arguments advanced in the

paper need to be appropriately calibrated/modified to take account of the fact thatthe issue being debated currently, and theaction being contemplated by the govern-ment, is not a move from being closed tocapital flows to becoming completely open.India is already quite open to flows involv-ing non-residents. What is under consi-deration would involve perhaps a less dra-matic change, largely affecting residents.

Finally, and most importantly, the cal-

culus of benefits and risks will reflect anumber of factors, including the efficiencyand capital- and resource-augmentingbenefits of CAC, the strength of the finan-cial system, and the macroeconomic pre-conditions. This paper should be seen asadding an element into the calculus with-out claiming decisive status for it.

Successful economic growth anddevelopment are almost always associatedwith the growth of the tradable sector. LeeKuan Yew, delivering the Jawaharlal NehruMemorial Lecture in 2005, expressed this

succinctly and dramatically: Since theindustrial revolution, no country has be-come a major economy without becomingan industrial power. Given that manufac-turing is the tradable sector par excel-lence, the underlying sentiment is thatmanufacturing growth is a concomitant,perhaps even a sine qua non of, overallgrowth. Chart 1 illustrates this proposi-tion, plotting the share of manu-facturing exports in GDP against the levelof income, for the set of successfulgrowers in Asia Singapore, Korea, Thai-land, Malaysia, Indonesia, China, Taiwan,and India; for the sake of comparisonaverages for Latin America and Africa arealso plotted.

Another related stylised fact is thatsuccessful growth is accompanied by theprivate sector undertaking new, varied,and sophisticated activities [Imbs andWacziarg 2003; Hausmann and Rodrik2002]. All economies start off agricultural,and the successful ones diversify awayfrom agriculture toward manufacturing,and within manufacturing from simple tomore sophisticated activities. Diversifica-tion is thus intrinsic to development. Chart 2[drawn from Imbs and Wacziarg 2003]plots a measure of concentration of activi-

ties in manufacturing (which is the inverseof diversification) on the vertical axis fora group of countries. The typical patternis that, over time as countries grow, theytend to diversify (reflected in decliningconcentration) before they specialise. Thechart shows that Asian countries havebeen far more diversified than countriesin Latin America (the line for Asia liescompletely below that for Latin America).Read together with Chart 1, this suggeststhat the fast growing Asian countries havenot only had a bigger tradable sector

but also a richer and more varied set ofactivities within it.3

Enter Exchange Rates

The ability of and incentives for theprivate sector to engage in activities in thetradable sector, to move away from tradi-tional agriculture, and to do new and variedthings are shaped by numerous factors history, endowments, culture, institutions,and so on but also by the policy environ-ment. One key policy that deters

ARVIND SUBRAMANIAN

On any liberal view, capital accountconvertibility (CAC) like free trademust be a consummation devoutly

to be wished. At some deep level, the casefor both is a moral one the freedom ofindividuals to undertake economic transac-tions, including the right to buy and sellgoods regardless of their destination or pro-venance (free trade), and the right to buyand sell future and contingent claims to thesegoods to/from people regardless of theirnationality (capital account convertibility).

The operative word, of course, is con-summation. Over the course of history, allsocieties have placed restrictions on thesefreedoms for a number of reasons, somegood and some less so.1 Usually, restric-tions stem from the assessment that indi-vidual freedoms are subordinate to thegreater economic good. But societies doprogressively eliminate the restrictions asthey have become richer: this is true notjust of todays OECD countries but otheremerging market countries as well. Thekey question then is not whether but when.

This article examines one considerationthat should influence the timing of anymove to CAC. Its restricted focus stemsfrom the view that this consideration is offirst-order importance for long-run growth,from the relative in attention to it, and fromthe well-rehearsed arguments for the otherconsiderations. The Tarapore Committee(1997) provided an excellent summary ofthe state of the debate on this issue, in-cluding exchange rate policy, but devotedless attention to the issue that will be thefocus of this piece.2

Insight


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Economic and Political Weekly June 23, 20072414

investment in tradable sectors and mili-tates against diversification away from tra-ditional, simple activities is an overvaluedexchange rate. The exchange rate is keyfor a number of reasons: in contrast to tradeliberalisation, which can help exports, acompetitive exchange rate helps bothexports and import-substitutes (i e, it helpsall tradable sectors); it has the addedadvantage, unlike subsidies, directed credit,etc, and other forms of industrial policy,of being a market-based mechanism, andnot requiring administrative interventionand all the costly rent-seeking that can giverise to; unlike some of these measures itis self-targeting, it helps those sectors thatactually perform because the benefit kicksin when there are actual exports; and finally,it is self-eliminating because the moresuccessful the policy is in promoting

exports and growth, the greater the pres-sure for trend appreciation of the currency,and hence for the natural elimination ofthe policy.

Evidence from the experience of thesuccessful growth experiences is informa-tive. In Johnson, Ostry, and Subramanian(2006), we calculated, based on a standardmethodology, the extent to which coun-tries real exchange rates were over orundervalued using a simple methodology.4

We found that the countries that hadsustained economic growth and growing

manufacturing exports had consistentlyavoided overvaluation. Chart 3 shows thatAsian countries have not had overvaluedexchange rates, while Latin America andAfrica have had bouts of overvaluation.5

In addition, the successful growers in eastAsia had shorter spells (i e, consecutiveyears) of overvaluation and smaller mag-nitudes of overvaluation during thesespells. For example, the Asian economieshad an average spell of overvaluation offour years (compared with seven for LatinAmerica and 14 for Sub-Saharan Africa,

respectively); and the average over-valuation during this spell was 7 per centcompared with 16 per cent and 29 percent for LA and SSA, respectively).Interestingly, India has never suffered aspell of overvaluation, and China hasavoided overvaluation since its growthtook off in 1978.

More formal evidence on the impact ofthe real exchange rate is in Prasad, Rajanand Subramanian (2007) and Rodrik(2007). Both of these contributions docu-ment a statistically and economicallystrong relationship between growth andreal exchange rates: a percentage pointincrease in overvaluation reduces long-run growth by about 0.1 per cent. Prasad,Rajan and Subramanian (2007) also showthat real exchange rates work by affectingthe fortunes of the exportable sector in

developing countries.Of course, investment in tradables is

affected not just by the level but also thevolatility of the exchange rate. Risk anduncertainty about returns have a signifi-cant dampening effect on investment intradables. Here too, the evidence is telling.A measure of volatility is the standarddeviation of changes in the parallel marketexchange rate. For Latin America, thestandard deviation is about 10 times thatfor Asian countries.

So the evidence points to a competitive

and stable exchange rate, and the consis-tent avoidance of overvaluation, as acorrelate and, perhaps even a key ingre-dient, of facilitating sustained growth byeliminating the disincentives for investingin the tradable sector.

CAC and Competitiveness

What is the role of capital accountconvertibility in all of this? The simpleanswer is that the ability to manage anexchange rate is circumscribed by CAC.

The famous trilemma of internationalmacroeconomics says that a country can-not simultaneously attain the three objec-tives of open capital account, monetaryindependence, and a fixed exchange rate.India, which has had a flexible exchangerate for much of its history, can continueto have monetary independence even withCAC.

The problem will arise when there aresignificant upward pressures on the ex-change rate as a result of capital inflows(or foreign currency borrowing by domes-tics). In this case, the government mightwant to resist this pressure for the sake ofpreventing undue pressures on the tradablesector. In other words, it might de factowant to maintain a fixed or a semi-fixedexchange rate, and the trilemma will thenbite.6

It is not that preserving competitivenesswill become impossible. In recent years,India and especially China have sought tokeep a lid on the exchange rate and havedone so with some success. But there arelimits and costs. These have been wellillustrated by developments in India overthe last few months.

Inflation in India picked up during early2007 while capital inflows continued tosurge. These twin developments placedthe RBI in a quandary. Combating infla-tion required a tightening of monetary

policy, which can be achieved by a com-bination of rising interest rates and anappreciating currency. On the other hand,maintaining competitiveness requiredresisting the appreciation pressures stem-ming from the capital flows.

What did the RBI do? To prevent thenominal appreciation it intervened in theforeign exchange markets (that is, it boughtup the dollars). But this increased thesupply of liquidity which ran exactlycounter to what the doctor orderedfor combating inflation. To offset this

Chart 2: Diversification, 1970-98Chart 1: Manufacturing Exports to GDP (1960-2005)(in Per Cent)

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30

20

10

0

ManufacturingExportstoGDP

Asia

Latin America

China

Sub-Saharan AfricaIndia

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Year

Asia

China

Latin America

India sub-Saharan Africa

1970 1980 1990 2000

.2-

.15-

.1-

.05-

Year

HerfindahlIndexof

Concentration

China

India

Asia

Latin America

Note: The Herfindahl index measures concentration the inverse of diversification.


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liquidity expansion, it sterilised the inter-vention, by issuing interest-bearing secu-rities to the banks, which in return sold the

rupees back to the RBI. But when youincrease the supply of interest-bearingsecurities, their price, namely interest rates,tend to go up, or more strictly tend to behigher than otherwise. Domestic agents,especially corporates, found it advanta-geous to borrow in dollars, which resultedin further inflows. The tail started to wagthe dog.

The inducement to borrow in dollarswas, of course, facilitated by the RBIsthen apparent policy of holding the rupee.Domestic firms were, in effect, given a

huge, albeit implicit, subsidy: they couldpocket the difference between domesticinterest rates and those in dollars withoutsuffering any losses from rupee deprecia-tion, which had been (sort of) ruled outby RBI policy. In other words, thoseborrowing in dollars and investing in rupeeassets were given a one-way bet a freelunch.

Thus, the limits to sterilisation are set bythe fact that with an open capital account,sterilisation adds to the very pressures thatit is meant to address, creating a cycle of

flows, sterilisation, further flows etc. It isthe inability to manage this that led the RBIto abandon this policy and allow the rupeeto float.

The costs of sterilisation are really theflip side of the subsidy to domestic bor-rowers of foreign currency. The financialcost is the difference in interest ratesbetween the paper issued and the returnson the foreign asset, while the underlyingor the real cost is the forgone investmentand growth opportunity as interest rates areforced to be higher than they otherwise

would be in the absence of capital flows.The point is that with CAC, exchange

rate movements are dominated by finan-

cial flows and asset markets: in theory,movements generated by asset marketbehaviour should be consistent with theunderlying fundamentals, namely the realside of the economy. But experience hasshown that there can be systematic andprolonged divergences between the two(the current level of the US dollar beinga good example) and that the process ofcorrection described by Calvo (2005) assudden stops can be abrupt and dis-ruptive, involving overshooting and realcosts, to the detriment of a countrys ability

to manage the exchange rate with an eyeto maintaining the vibrancy of the tradablesector.

The assertion here is not that opennessto capital inflows is the sole cause ofovervalued exchange rates. Both could bethe outcome of deeper political economyfactors, reflecting the power of elites whohave an interest in overvalued exchangerates (and thus cheaper access to imports),and in open capital accounts as protectionagainst future expropriation. It could alsobe the case that exchange rates are ulti-

mately determined by demographics: forexample, overvalued exchange rates canonly be avoided if there is a large andgrowing labour force (which could explainthe behaviour of Asian exchange rates).Regardless of the deep determinants, at thevery least, it seems that some restrictionson capital are a necessary, proximate,condition for being able to sustain com-petitive exchange rates and avoid persis-tent overvaluation. Evidence for this is inChart 4, reproduced from Prasad, Rajanand Subramanian (2007), which shows

that countries that witness more flows,regardless of type, tend to see greaterovervaluation of their currencies.

But there is evidence on the detrimentaltrade and export impact of capital flowsfrom another, unlikely, quarter. Note thatthe argument about the impact of capitalflows on tradable goods via the exchangerate is not confined to private flows.

Analytically, the argument also applies toofficial flows, i e, to foreign aid. Rajanand Subramanian (2005) show that aidflows have a negative impact on labour-intensive and export sectors. In particular,they show that in countries that receivedmore aid, labour-intensive and exportablesectors grew much slower, and that thiseffect was mediated through exchange ratechanges. On their estimates, a 1 percentagepoint increase in aid reduces the growthof manufacturing by about 0.5 per cent.Charts 2 and 3 illustrate the association

between sub-Saharan Africas poor manu-facturing export performance and its con-sistently overvalued exchange rates. Thus,the experience of Asia, Latin America, andeven Africa, are all consistent in suggest-ing possible effects from openness to capitalflows to exchange rates and the growth ofthe tradable sector.

There is another subtler way in whichCAC can affect the exchange rate andtradable goods. When confidence in thecurrency is high, domestic corporates cantake advantage of interest differentials and

borrow in cheaper non-rupee liabilities.Their balance sheets will start gettingdollarised on the liability side. Once thishappens, the ability of the exchange rateto act as an effective tool of increasingdomestic demand and helping the fortunesof the tradable sector will be reduced. Thereason is the balance sheet effect [Kaminskyand Reinhart 1999]. On the one hand, anydecline in the exchange rate will increasedemand through normal channels (exportsbecome cheaper and imports become moreexpensive); on the other, such a change

will simultaneously be contractionarybecause domestic firms (and householdswill face) significantly higher debt servic-ing in rupee terms as a result of currencychanges. Frankel (2005) has argued thatdevaluations, which used to be expansion-ary before the 1990s have now becomeless so because of the contractionary tugexerted by balance sheet effects.

To summarise, CAC has two distincteffects: first, it reduces a countrys abilityto influence the exchange rate; andsecond, because of possible balance sheet

Chart 3: Exchange Rates Deviation from Long-run-Equilibrium (1960-2000)(+ deviation signifies overvaluation)

60

40

20

0

-20

-40

-60

Asia

Latin America

Sub-Saharan Africa

1960 1965 1970 1975 1980 1985 1990 1995 2000

sub-Saharan Africa

Asia

Latin America

Overvaluation

Year


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the tradable sector is represented by manu-facturing. The Kuznets hypothesis sug-gests that the manufacturing will first risewith development and then fall as incomesrise. Thus, the share of manufacturing inGDP should follow an inverted U shape.One could posit that tradables should ceaseto be a target of development around thepoint that its share in the economy starts

declining: at this point, a developingcountry is more like a developed country.What is the income level associated withthis turning point? We can actually do asimple calculation to ascertain this. For thelatest year for which data are available, werun a regression of the share of manufac-turing in GDP against per capita PPP GDPand its square for over 100 countries forwhich data are available. The Kuznetsrelationship is indeed confirmed by thisregression. The regression also yields aturning point for this relationship of about

$ 15,000 per capita in PPP terms. Assum-ing a country was normal and that itfollowed the typical pattern, this could bethe level at which manufacturing ceasesto be the focus of development policy.7

A number of good arguments could beadvanced for why India is not a typicalcountry: because of its idiosyncratic de-velopment strategy, it might have a smallerrole for manufacturing in the future thanthe normal country; and because it is alreadyhighly diversified, much more so than thetypical country, it needs to provide less

policy assistance to promote diversifica-tion [Kochhar et al 2006]. But even so, ata per capita income level of about $ 2,600,the question remains whether Indianpolicymakers can afford to take their eyesoff the tradable sector.8

Current Conjuncture

The issue of CAC has acquired newresonance because of the dramatic shift inthe policy of the RBI in response to acombination of recent inflows and infla-

tionary pressures: from a managed float,the RBI seems to have moved to a moreflexible exchange rate policy.

But the permanence of this policy cannotbe taken for granted because there willinevitably be pressures for further appre-ciation of the rupee and already we seeclamour for something to be done aboutthe exchange rate.

In the current context, three remarks canbe made about the role of CAC. First, itis difficult to contemplate any major re-versal of Indian policy toward CAC. The

costs in terms of damaging market con-fidence in Indias reform credentials wouldbe high, even prohibitively high. That said,policymakers should not further under-mine flexibility by taking policy actionsin the direction of further liberalisinginflows. There may even be a case fortightening external commercial borrow-ings (ECBs) that were surprisingly relaxed

last year. If feasible, some tightening ofshort-term (hot) flows might be warranted.Skill and timing will be essential in imple-menting any such tightening so as not todisrupt markets. One possibility would beto reduce caps on ECBs whenever they arenot fully met and to continue this processas long as the slack allows.

Second, the point is made that given themagnitude and increase in capital flows,it is simply foolhardy to try and manageor reverse this process. According to thisview, India should codify what is de facto

an open capital account and just get onwith it. But the real issue here is not howmuch capital is coming in naturally,which obviously should be allowed to comein, but what the future policy actions shouldbe. If ECBs, even as they are now, playa role in limiting inflows, it seems that theyshould be managed carefully, and notliberalised on the grounds that agents willalways find it easy to circumvent controls.As long as policy has some impact, thatflexibility should be retained. Similarly,another major area where there is still

effective policy control in inflows relatesto inflows into the bond market. Again,these should not be liberalised prematurelywithout taking into account the effect onthe exchange rate.

Third, some have argued that one wayto manage the exchange rate consequencesof capital flows is to liberalise outflows,taking some pressure off the exchangerate. While such action might help, thereare two consequences of liberalising out-flows that should be considered.Liberalising outflows, often, engenders

additional confidence in policy and resultsin further inflows. A second and moresubtle point relates to international politi-cal economy. The more a country liberalisesoutflows, the less easy it becomes to justifythe asymmetry between policies to out-flows and inflows. Trading partners willinevitably ask why they should be ex-pected to open their economies to Indiancapital when India does not similarlyreciprocate. In other words, liberalisingoutflows could easily lead to pressuresfrom partners on India to further liberalise

inflows. India should be mindful of thisconsideration.

Concluding Remarks

Decisions on CAC will no doubt becomplex, involving the juggling and rec-onciliation of multiple objectives andconstraints. In the debate in India, finan-

cial and macroeconomic objectives andconstraints have been paramount, withmuch less discussion on the growth anddevelopment dimensions of CAC. Ofcourse, the growth dimension cannot bethe only, or even the most important,ingredient determining CAC, but it wouldseem to merit more consideration, givenits consequences.

One reason why Indian policymakershave devoted less attention to this issuethan it merits, and have not seen exchangerate policy as being a constraint on devel-

opment, may be because of having man-aged it so well. Exchange rate policy mustbe rated as one of the few consistentpolicy successes in India, reflected in theconsistent avoidance of exchange rateovervaluation. And this success may havebred a certain sanguineness about, andhence some inattention to, exchange ratemanagement in what could be a verydifferent era of CAC. It is striking evenshocking to read the two Tarapore Com-mittee reports and find such little discus-sion of the exchange rate, and discussions

of the potential problems in managing itin a world of greater capital movements.The philosopher Santayana famouslycautioned against repeating the mistakesof the past. Reading the Tarapore Com-mittee reports in light of recent experiencebrings home the realisation that perhapsthere is also wisdom in not repeating thesuccesses of the past.

At the end of the day, CAC might wellturn out to be an overblown issue: a talefull of sound and fury, signifying muchless than the strong views of proponents

and opponents alike might suggest. Thispaper raises the question whether thesegains and risks are symmetrically moder-ate if the competitiveness and growthconsequences from an early move to CACare fully taken into account. Echoing StAugustine, if Indian policymakers were tosay, let us have CAC but not yet, wouldit be a case of undesirable procrastinationor of wisely heeding the precautionaryprinciple? The answer to that question maywell be the former but it would be a wholelot reassuring if it were arrived at after


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factoring in the exchange rate and growthconsequences of CAC.

Email: [email protected]

Notes

[The author is grateful to Udaibir Das, OlivierJeanne, Simon Johnson, Sanjay Kathuria, KalpanaKochhar, Jonathan Ostry, Raghuram Rajan, and

Dani Rodrik, and to participants at various seminarsfor helpful discussions.]

1 Jagdish Bhagwatis widely citedCapital Mythis the classic analysis for why restrictions oncapital are more justified than restrictions onfree trade.

2 Reddy (2004) is a brief but excellent discussion ofmany of the important issues. Prasad and Rajan(2005) suggest a modality for moving towardCAC without taking a strong view on timing.

3 Although not shown, both Asia and LatinAmerica are substantially more diversified thancountries in sub-Saharan Africa.

4 It should be stressed that all methodologies forestimating equilibrium exchange rates arefraught with problems.

5 It is interesting that during the period 1960-

1980, when Latin American and Asian growthwas close, their competitiveness positions werenot that dissimilar (see Chart 2).

6 This suggests that greater exchange rateflexibility need not per se address the problemof capital flow-induced threats to competitiveness.

7 It is worth mentioning that a number of industrial

countries the UK, France, Italy, Greece, andIreland moved to full CAC at income levelswell above $ 15,000 per capita.

8 An alternative way of calculating such a turningpoint is to look at diversification withinmanufacturing. At what point does diversi-fication cease to be important for a country inthe development process? A similar exerciseyields a turning point of about $ 18,000. Thisis broadly consistent with the figure obtainedabove when the question is posed in terms ofmanufacturing. Again, India, despite being an

outlier, is far away from the turning point.

References

Acharya, Shankar (2006): Essays on Macro-economic Policy and Growth in India, OxfordUniversity Press, London.

Bhagwati, Jagdish (1998): The Capital Myth,Foreign Affairs.

Calvo, Guillermo (2005): Crisis in EmergingMarkets: A Global Perspective, NBER WorkingPaper No 11305, Massachusetts, Cambridge.

Chinn, Menzie D and Hiro Ito: What Matters forFinancial Development? Capital ControlsInstitutions, and Interactions, NBER WorkingPaper No 11370, Massachusetts, Cambridge.

Frankel, Jeffrey (2005): Contractionary Currency

Crashes in Developing Countries, Mundell-Fleming Lecture, Staff Papers, InternationalMonetary Fund, Vol 52, No 2.

Hausmann, Ricardo and Dani Rodrik (2002):Economic Development as Self-Discovery,NBER Working Paper No 8952, Massachu-setts, Cambridge.

Imbs, Jean and Romain Wacziarg (2003): Stagesof Development, The American Economic

Review, Vol 93, March, No 1.Johnson, Simon, Jonathan D Ostry and Arvind

Subramanian (2006): Prospects for Africa:Benchmarking the Constraints, mimeo,International Monetary Fund.

Joshi, Vijay (2004): Myth of Indias OutsourcingBoom, Financial Times, November 16.

Kaminsky, Graciela and Carmen Reinhart (1999):The Twin Crises: The Causes of Banking andBalance-of-Payments Problems, American

Economic Review, Vol 89 (June), pp 473-500.Kochhar, K, U Kumar, R Rajan, A Subramanian

and I Tokatlidis (2006): Indias Pattern of Deve-lopment: What Happened, What Follows?, IMFWorking Paper 06/22, Journal of Monetary

Economics, forthcoming.Prasad, Eswar and Raghuram Rajan (2005):

Controlled Capital Account Liberalisation: AProposal, Policy Discussion Paper, Inter-national Monetary Fund, No 05/7.

Prasad, Eswar, Raghuram Rajan and ArvindSubramanian (2007): Foreign Capital andEconomic Growth, forthcoming BrookingsPapers on Economic Activity.

Reddy, Y V (2004): Speech Delivered at the 2004Central Bank Governors Symposium, Bankof England.

Rodrik, Dani (2007): Real Exchange Rates andEconomic Growth, 2007, Razin Lecture,Georgetown University, Washington DC.

Rodrik, Dani and Arvind Subramanian (2004):Why India Can Grow at 7 Per Cent a Yearor More: Projections and Reflections,

Economic and Political Weekly.

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capital account convertibility a neglected consideration

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