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Demands a re-think of policy calculus

After the South-East Asian contagion, stability has been held to be sine qua non for growth, especially in developing countries. In the context of the debate on convertibility, perhaps India needs to re-work the policy calculus: Accumulate res erves, aimed at curbing volatility and enabling growth, or trade stability for higher growth?

Capital Account Convertibility is regarded by some modern economists as one of the hallmarks of a developed country the last-mile connectivity to a globalised world. However, given the experiences of the South-East (SE) Asian currency crisis, many economists see in CAC a high-risk policy adventure and, consequently, a model not worth considering.

What made the SE Asian crisis exceptional requires some elaboration. Till this crisis, poor economic fundamentals were usually blamed for currency problems.

But the SE Asian debacle happened despite the affected countries having sound economic fundamentals, as reflected in high savings, robust investment rates, budget surpluses, low inflation and, of course, functioning institutions.

Indeed, that is why they were called Miracle Economies.) of

While the term "Miracle" was a strange prefix to an economy performing well under classical prescriptions, the fact remains that even countries with structured institutions were visited by the currency crisis. It may be noted that the South-East Asian countries received $94 billion in 1996 and another $70 billion in the first half of 1997.

In the second half of 1997, however, there was an outflow of $102 billion. Reversal of such an order can hardly be explained by a lack of fundamentals. Obviously, if the region was visited by a currency crisis, then one has to blame the inherent destabilising nature of the capital flows, not the economic fundamentals. Currency volatility has since then come to be associated with full CAC.

Post-contagion wisdom
In contrast to the thinking during the pre-crisis period, where controls on the capital account were generally viewed as primeval economics, post-crisis there seems to have been a tectonic shift on this subject. Economists began re-discovering the virtues of retaining controls on capital account, and in building up reserves.

Post-contagion, countries began leveraging their undervalued currencies for higher exports. This meant that to retain their competitiveness, developing nations intervened in the market through their central banks to buy dollars.

Simultaneously, through a process of sterilisation, they mopped up the excess liquidity within the economy arising out of sustained forex flows.

In their anxiety to accumulate forex reserves as an insurance against currency volatility, developing countries seem to have developed a fetish for this model. For instance, according to the IMF, developing countries have doubled their reserve accumulation in the past three years, which at last count stood at approximately $3 trillion. And this accumulation of forex reserves, for the rainy day, is across countries.

India is no exception to this. It too has modelled its post-contagion (a time-line; not that it was affected) growth strategy based on this precept. Admitting its fixation with building up forex reserves, the Reserve Bank of India states: "Adequacy of reserves has emerged as an important parameter in gauging its ability to cushion external shocks."

Needless to emphasise, as in the case of other countries, the RBI's interventions in the market to buy dollars serve two purposes: One, prevent the rupee from appreciating and, two, helpbuild reserves. India's recent growth has, like SE Asian countries, been the outcome of this prudence.

Eschew volatility
Questions are now being raised as to whether developing countries are engaged in a policy of "excessive prudence". Economists point out that developing countries have become far too conservative and accuse them of being obsessed with fears of a weak currency and in building up forex reserves.

What makes the debate contentious is the rather low rate of returns from such reserves. While monetary authorities across the globe are loath to disclose the composition of their investment portfolio, experts believe that these reserves in the hands of the developing countries find their way into the treasury bonds of advanced countries, notably the US, yielding paltry 2-3 per cent returns.

For instance, the former US Treasury Secretary, Mr Lawrence H. Summers, told an audience in Mumbai recently that India has reserves in excess of $100 billion. If invested prudently, Mr Summers argued, the increased differential returns would be more than what the government spends annually on health-care in India.

It is indeed sad that a majority of the world's poorest people now live in countries that are ironically flush with huge international financial reserves and fund the ostentatious expenditure of people in rich countries at substantially lower rates of interest.

Obviously, this throws up the fundamental question: Is this the price the developing world needs to pay for stability? Exercising a choice between the two alternatives is quite complex, nevertheless inescapable and needs to be revisited constantly. And in the process, full convertibility will remain a mere context to the entire debate.

What are the choices available to deal with the burgeoning forex reserves? Unilaterally allowing the rupee to appreciate would obviously rob our economy of its competitiveness. Sterilisation process, owing to the costs involved, seems to have its own limitations, at least, in the Indian context. Obviously, the huge forex reserves seem to place the Government in a quandary.

All this means that we need to re-work our economic growth policy calculus whether accumulation of reserves, aimed at eschewing volatility and thus providing the right environment for growth is preferable, can we trade stability for higher growth? Post contagion, stability has been held to be sine qua non for growth, especially in developing countries.

Naturally, as the memories of the contagion fade, one is tempted to once again talk of risk-taking and leveraging reserves for growth.

And unless this broad economic roadmap is decided, debating the lesser roadmap for CAC may be akin to placing the horse in front of the cart. For, should we favour eschewing volatility as a prerequisite for growth, the current debate on CAC may well be a non-starter.

Published at: http://www.thehindubusinessline.com/2006/05/19/stories/2006051900691000.htm

Last modified on Sunday, 07 July 2013 07:36

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