Fiscal Adjustment, Financial Intermediation and Capital Account

Convertibility

Suman Bery

Goa, November 1 2002

Context

• Conference theme is “adapting India’s financial sector to a globalising world”

• Implies progressive integration of the domestic financial system with international financial flows.

• Will explore links with macro management

• Not addressed in any other session.

Context

• Should India seek greater international integration of its financial system? Why?

ContextPros:

• Increases competition and reduces inefficiency; aids price discovery

• Allows access to funds at global rates (plus country risk)

• Disciplines domestic policy

• Given India’s financial talent, could promote Bombay’s development as a financial centre

• Capital controls ineffective with open trade, human movement

• Natural direction of evolution

Context

Cons:• No evidence linking improved growth to CAC

(Bhagwati, Rodrik, Stiglitz)

• Increases vulnerability to herd behaviour, contagion, sentiment.

• Downside exceeds upside.

• Reduces monetary, exchange rate autonomy

Analysis

• Tarapore Committee on Capital Account Convertibility (CAC) (1997)

• Committee favoured CAC as a goal to be achieved in 3 years (by 2000)

• Established road map and benchmarks

• Main issue areas: fiscal consolidation, inflation target, financial system, exchange rate management, Balance of Payments

Analysis

• Selected targets:– Central government fiscal deficit below 3.5 % of GDP

– 3-5 % inflation

– Financial system: CRR at 3%; Gross NPAs at 5%; interest rate deregulation; prudential and supervision measures.

– BoP: “Sustainable” current account deficit; build up “adequate” reserves.

Analysis

• Liberalisation of both inflows and outflows proposed, in three phases.

• 1997 Asian crisis, shift in international sentiment, reduced momentum towards CAC

• Steady liberalisation has continued, but not at the pace or with the commitment indicated by the Committee.

Analysis

• Should we, could we go faster?

• Lots of positives:

– Inflation down to world levels

– Low net external debt, strong BoP, high reserves.

– Increasingly efficient, long-term government debt market, price discovery

Analysis

– At the same time large fiscal deficit, high public debt , and a weak, though improving, banking system.

– “Managed” floating exchange rate.

– What are the risks these pose?

– Can they be managed, or are they “fatal errors”?

Analysis

• Fiscal and public debt excesses– Asian experience shows these are not necessary for a

crisis. Exchange rate regime seems to have been more responsible.

– Question still remains: are they sufficient?

– “Latin” story: with open capital account, government deficit will (directly or indirectly) be financed through foreign borrowing.

– These flows are then reversed, leading to crisis.

Analysis

• How relevant are these concerns for India?– Fiscal deficit not spilling over into current account deficit.

Implies structural saving surplus in private sector. (Examples: Italy, Belgium, Japan)

– Banks voluntarily holding large amounts of public debt, partly because of risk-based capital regulations, partly because of high yields.

– High yields may be more due to monetary policy (exchange rate targeting coupled with sterilised intervention) than to fiscal deficit/public debt per se.

Analysis

• Put differently, the banking system is still best suited to channel resources to the public sector.

• It has little capacity or appetite for bearing the additional credit risk involved in a liberal market economy.

• This will change only slowly.

Analysis

• What does this imply for CAC?– Indian savers need to be offered a wider menu of safe

assets than government debt. So outflows should be liberalised further.

– Indian firms need access to a wider range of intermediaries than just the domestic banks.

– (India’s success in private equity shows that there are risk-loving investors prepared to bet on India)

– So inflows should be liberalised further.

Analysis

• The present is an ideal time, with high reserves, low inflation, (and a new Deputy Governor at the Central Bank)!

• Aggregate fiscal adjustment must/should occur, but this will take time. Direction is as important as destination.

• Equally important, though, is improving the quality of public expenditure, both current and capital.

Analysis

• What risks arise from the weak banking system?

• Usual story: Surges in capital inflows encourage imprudent lending by weak banks.

• External investors take refuge in deposit insurance, leaving the government to manage the mess.

Analysis

• How likely is this in India?• Paradoxically risk is probably greater in new

private banks than in fuddy-duddy public sector banks, because of different internal incentives.

• What is important is less average than marginal NPAs.

• RBI supervision has improved; legal sanctions are stronger.

Conclusions

• Conditions seem ripe to put more full-blooded CAC back on the front-burner.

• International community has lost its nerve on this, so India has to figure things out for itself.

• Personal judgement is that the gains, both signaling and substantive, could be substantial, and that the risks, while present, are manageable.

Conclusions

• As noted by Tarapore Committee, need a different framework for exchange rate and monetary management.

• Nominal exchange rate needs to become a shock absorber, and the FX market needs to deepen (significant that this was glossed over by DG last night).

• RBI needs to move from nanny to headmaster.

Conclusions

• An additional risk mitigation device could be continued control on short-term bank flows (Chile style), although they were abandoned there.

Thank you

Analysis

• How relevant are these concerns for India?

– Fiscal deficit not spilling over into current account deficit.

– Banks voluntarily holding large amounts of public debt, partly because of risk-based capital regulations.

– Capital and remittance inflows being diverted to reserves through sterilised intervention of Central Bank.