India should stay course on the reforms, including increasing the role of the private sector in the financial markets, without committing to a specific timetable for full rupee convertibility, argue Arvind Panagariya and Purba Mukerji.

TARAPORE Committee-II on capital account convertibility is due to table its report on July 31, 2006. Tarapore Committee-I, also appointed at the urging of Mr. P Chidambaram during his first tenure as the finance minister, had recommended full convertibility within three years, ending 1999-2000 with specific goal posts adopted. The Asian financial crisis sealed the fate of that recommendation but the FM has once again revived the issue.

The Capital Myth: The Difference between Trade in Widgets and Dollars, persuasive empirical evidence on the benefits of full convertibility is lacking. Recent research by one of us (Mukerji) shows that for countries with well-developed financial markets and stable macroeconomic environment, convertibility offers small positive growth effects.

But for countries with weak financial sectors and macroeconomic vulnerabilities, convertibility leads to greater instability in growth without dividend in terms of higher average rates. But even this and related research does not distinguish between limited convertibility in terms of openness to trade and foreign direct and portfolio investment and full-fledged convertibility. Therefore, we have no evidence showing positive benefits from a move from the limited to full convertibility, which is the question facing India today.

Second, on the fiscal front, India remains far from ideal conditions for convertibility. The average growth rate of almost 8% during 2003-04 to 2005-06 has led to increased tax revenues and some reduction in the deficit but not nearly enough. Moreover, we can scarcely be sure that the deficit will not return to the higher level if the GDP growth rate and therefore tax revenue growth revert to the previous trend as happened after 1996-97. With interest payments on the debt amounting to more than 6% of the GDP, gross fiscal deficit of 8% and debt-to-GDP ratio of more than 90%, convertibility is bound to leave India vulnerable to a crisis. One hazard is that the government itself would be tempted to turn to lower-interest short-term external debt to finance its deficits and debt.

Third, the financial sector is still insufficiently developed in India. Banks are predominantly in the public sector and credit markets relatively shallow. Insurance has barely been opened to the private sector with the foreign investment in it capped at 26%. The debt and equity markets are thin and dominated by public sector FIs and FIIs. Because the Indian debt and equity markets are tiny in relation to the worldwide stakes of the FIIs, any time the latter begin to exit the Indian market, the financial markets go into turmoil. Because few FIIs have the incentive to carefully gather detailed information on the future profitability of various firms, such exits are characterized by herd behavior.