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March 27 (Bloomberg) -- In the one week since Indian Prime Minister Manmohan Singh announced his intention to make the rupee fully convertible, several economists and currency strategists have panned the decision.
Their biggest objection to the plan is that it could be risky. What if India went to war or had a massive earthquake? In the current system, it's only the registered foreign investors who can sell their equity investments or short the market for their hedge-fund clients.
With full convertibility, residents might also scramble to switch out of their rupee-denominated bank deposits -- not to mention their investments in domestic stocks and property -- and park their wealth in the safety of U.S. dollars, euros or yen.
Because Indians hold almost three times as much money in rupee-denominated bank accounts as the $146 billion the central bank has in its foreign-exchange kitty, full-fledged capital flight could thrust the country into a serious banking and currency crisis.
Grave as it is, the challenge isn't insurmountable.
And no, the answer doesn't lie in doing a Mahathir Mohamad on unsuspecting investors. There's a better way out of an unexpected crisis than trapping money with sudden capital controls, such as the ones imposed in 1998 by Mahathir, then the prime minister of Malaysia. The solution involves a basic change in the workings of the International Monetary Fund.
IMF Rating
IMF economists Jonathan Ostry and Jeromin Zettelmeyer suggested the outline of the change in a paper they wrote last year titled ``Strengthening IMF Crisis Prevention.'' They proposed a rating system that would pre-qualify countries for emergency access to IMF funds based on the quality of government policies in normal times.
``If a country's policies are judged to be sensible, its access to automatic financing in case it is hit by an unexpected shock improves,'' IMF Chief Economist Raghuram Rajan said in a speech at New York University's Stern School this month, elaborating on the Ostry-Zettelmeyer recommendation.
It's an important proposal, and Indian authorities will do well to persuade the board of the IMF to consider it seriously as part of their efforts to prepare for full convertibility.
If India were to follow policies that assured it of automatic help from the IMF in case of a crisis, both residents and foreigners would know that the central bank was unlikely to run out of dollars. Cutting the chronic budget deficit, which amounts to about 9 percent of gross domestic product, would be a good start.
That would ensure that the rupee doesn't become the target of a self-fulfilling one-way bet for eventual devaluation.
Savings, Investment
This brings us to the other question that economists have asked about the Indian proposal for full convertibility. And that is, ``Is all this risk worth the gain?''
The Chinese yuan, after all, isn't convertible. And if China can get all the capital it needs for 10 percent economic growth, then why should India be in a hurry to embrace full convertibility and all its attendant risks?
The counterpoint to that argument is quite simple. India's decision to go in for a convertible rupee is about finding cheaper capital.
India needs about 3.5 units of capital to produce one extra unit of goods and services. So for gross domestic product to expand 10 percent, India will require an investment-to-GDP ratio of 35 percent. According to the latest available statistics, the domestic savings-to-GDP ratio is about 29 percent.
If the government could stop living beyond its means, the national savings rate would go up by about 2.5 percentage points.
Gains From Convertibility
With that, the gap between investments required for 10 percent growth and locally available savings will narrow to 3.5 percentage points of GDP. This is the amount India will have to find overseas. And it's already attracting that much capital from abroad to finance its current account deficit.
In other words, India doesn't need to make the rupee fully convertible to get 10 percent economic expansion. The key to speedier growth lies in improving the state of government finances and that will precede convertibility, not follow it.
With full convertibility, a lot of capital will enter India, lured by higher rates of return. That will bring down the cost of capital for Indian companies. More of their new projects will become viable with lower financing costs.
Even as foreigners are allowed easy access to Indian assets, local investors will jump at the chance to buy overseas stocks, bonds and properties. A convertible rupee will thus magnify gross capital flows into and out of India.
Gross Flows Matter
It doesn't matter if the net gain -- inflows minus outflows -- is the same as the current level. Money going in and money going out will both need financial intermediation. Higher gross flows will mean more high-paying jobs in the banking, fund management and broking industries in Mumbai.
That, too, will have a salutary impact on economic growth.
Indian Prime Minister Singh and Finance Minister P. Chidambaram deserve kudos for putting full convertibility back on the nation's agenda, from where it had slipped following the Asian financial crisis in 1997.
Now they should weather the criticism and make their plan a reality before the end of the government's term in 2009.
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