The flight is beginning to return

Much of the money that was salted away abroad is perhaps returning to India

N Chandra Mohan Delhi

Imagine a brave new world in which any one of us Indian residents can go to a foreign exchange dealer or bank and freely convert our rupees into dollars, pounds or euros to acquire assets abroad. Or acquire a diversified portfolio of internationally and domestically traded stocks to buy insurance against country-specific risks. Such a world can be imagined when the rupee is fully convertible, a regime that is still out of the question in India despite a steady build-up of forex reserves and healthy external profile.

The reasons are simple. Although the impressive macroeconomic performance of the Indian economy, with tigerish growth rates of 8 per cent during the last three years, is generating pressures for speedier liberalisation on the convertibility front, many economists and the Left have urged caution that such a regime will expose the economy to “unpredictable movements in capital flows” and create the “potential for fragility and crisis which is avoidable”. The big fear is of massive capital outflows with convertibility.

The example cited in this context is of Brazil whose external debt in the beginning of the 1980s was virtually identical to the flight of capital by its wealthy residents. In the Indian context, it is similarly feared that it will be not only the non-resident Indians (NRIs) who might head for the exits but also the domestic residents who will be free to take out any amount of their domestic wealth. As a result, the Indian economy might land up in a massive debt trap like Brazil and other Latin American countries.

Even the Reserve Bank of India (RBI) in its annual report urged caution in moving towards a regime of fuller convertibility or speedier financial liberalisation as the costs of instability are ultimately borne by “…the country, the government and the poorer sections. Avoiding crises is ultimately a national responsibility. The approach to managing the external sector, the choice of instruments and the timing and sequencing of policies are matters of informed judgement, given the imponderables.”

Such fears of massive outflows are not without substance as capital flight has indeed been the norm in India till recently perhaps. The International Monetary Fund (IMF), for instance, put out a report five years ago that $20-30 billion or $1 billion to $2 billion every year might have leaked out of the country during 1971-86. Evidence suggests that capital flight took place even during the era of reforms during the 1990s due to rampant misinvoicing or under-reporting of export and imports year after year.

The exact numbers involved, of course, are difficult to come by. This writer remembers a former revenue secretary telling him that the $1 to $2 billion estimate was on the low side as roughly 5 per cent of India’s export earnings are not repatriated back home and parked abroad. Thus if exports amounted to, say, $80.5 billion in 2004-05, around $4 billion would be the order of capital flight though understating or underinvoicing export receipts. To which one has to add overinvoicing of import transactions, if any. All of which suggests that capital outflows are possibly much higher than indicated by the IMF.

But times are changing. From an earlier state of affairs when foreign exchange was scarce, the country’s external profile today is healthy. For a sense of perspective, reserves of $144 billion exceed the stock of India’s external debt by $20 billion. With the easing of the external constraint, the regime for convertibility has become more liberal. Indian businessmen thus are in a better position to make investments abroad or acquire potential overseas companies today than earlier with no hassles whatsoever.

Thanks to the easing of the external constraint, very few businessmen now have to locate abroad like Lakshmi Niwas Mittal and many others did during the 1970s and 1980s or salt their savings in Swiss banks. No doubt, the environment is not fully businessman-friendly. But with a more liberal regime, he can expand his domestic business and go global much like Mittal can. Although the regime thus has become more liberal, it still stops short of full convertibility for domestic residents.

In sharp contrast, however, foreigners including NRIs virtually enjoy full convertibility as they can freely take their money in and out of the country. Portfolio investments have surged as a consequence, lifting stock market indices through the roof. Such investments hit a record level of $10.7 billion in 2005. There is suggestive evidence in this regard that rich domestic residents who salted their funds abroad are probably bringing back their money in the form of portfolio investments.

For instance, nearly half of the portfolio investments came through participatory notes (P notes), a derivative instrument that allows investments in Indian equities without registering with the Securities and Exchange Board of India. As the ultimate beneficiary of these P notes is not known, and the fact that that such notes cannot be issued to NRIs and persons of Indian origin, there is a strong presumption that domestic residents with funds abroad are resorting to this route to participate in India’s stock market boom.

The notion of a return flight of capital, however, is bound to appear outlandish to people who believe that capital flight is the only reality in the Indian context. This is, of course, in the realm of conjecture so far but there are enough people including economists like Professor Indira Rajaraman who think that this may indeed be possible and that such inflows are augmenting portfolio capital inflows into the economy. The theory is that such inflows are a vote of confidence in an economy that is booming of late.

Hard evidence of a return flight of capital, of course, is as difficult to track as capital flight but there is qualitative evidence that such money is also fuelling the ongoing property boom in the country. As a JP Morgan report indicates, the Indian property market is unorganised thus making it difficult to track even NRI investments in this sector that has seen a doubling of residential prices in cities like Delhi, Mumbai and Bangalore and other metros. Return flight is fuelling this property bubble as well.

This is the broad context in which to understand why some policymakers are pushing for speedier moves to convertibility. Considering the favourable changes that have taken place in the economy, none other than Prime Minister Manmohan Singh argued that there was “merit in moving towards fuller capital account convertibility” when he released the third volume of the history of the RBI on March 18. To prepare a roadmap in this regard, the RBI has appointed a committee headed by SS Tarapore.

The merit for proceeding on a carefully drawn-up roadmap in this direction is, of course, compelling, as we have argued that much of the money that was salted away abroad is now returning to India. This is certainly an area that deserves closer empirical investigation. But whether a convertible rupee is another big-ticket reform whose time has come is a different matter, whose fate ultimately depends on the current political configuration that has proved to be antithetical to economic reforms so far.