Fiscal Adjustment, Financial Intermediation and Capital Account Convertibility

1. Fiscal Adjustment, Financial Intermediation and Capital Account Convertibility Suman Bery Goa, November 1 2002

2. 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.

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

4. 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

5. 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

6. 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

7. 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.

8. 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.

9. 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

10. 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”?

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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.

19. 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.

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

21. Thank you

22. 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.