Fiscal Adjustment, Financial Intermediation and Capital Account Convertibility Suman Bery Goa, November

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?

Context Pros: 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 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.