Bharthi-MTN deal reopens the debate of full convertible rupee. Its been in discussion for good part of decade but I couldn't find good study on impact of this. below article from TheHindu was published in 2003 is still more relevant I think (except the numbers).
Share your thoughts(& links) on pros and cons on this.
Capital account convertibility — Why it's better for India to go slow:
THE international financial system is in a state of introspection, jolted by several financial crises caused by violent capital movements over the last two decades. On their part, Indian policy-makers are also in a state of revisionism and are moving the country to greater capital account openness after several decades of extensive controls.
This article examines the arguments in favour of and against full capital account convertibility and, considering India's experience with partial convertibility in the 1990s, concludes that it would be in India's interests not to move to full capital account convertibility in the near future.
Gains from full mobility: Theoretical arguments...
The proponents of full capital account convertibility advance these arguments in its favour:
An arbitrary (i.e. pre-capital mobility) distribution of capital among different nations is not necessarily efficient, and all countries, irrespective of whether they borrow or lend, stand to gain from the reallocation caused by freer capital mobility. National income goes up in the country experiencing capital outflows due to higher interest incomes, while that in the debtor country increases as the interest paid is less than the increase in output.
Capitalists in the labour-abundant economies tend to lose with a fall in the marginal productivity of capital, and the opposite happens in labour-scarce countries, so that developing nations, which are usually capital-scarce, are doubly blessed under unhindered mobility of capital — the inflow of capital raises the national income and produces a healthy, egalitarian impact on income distribution as well.
It is argued that if there is only a small correlation between the returns on investment in different countries, risk can be reduced by the ownership of income-earning assets across different countries. Free mobility of capital, thus, helps reduce the risks that each country is subjected to.
Finally, it is argued that when full capital account convertibility is in place, government profligacy and distortionary policies are likely to be followed by currency crises that threaten to make the government highly unpopular. Therefore, under capital account convertibility, the salubrious effects of capital mobility are magnified through a change in domestic policy in the right direction.
... the evidence and the counter-arguments
This rosy picture painted by traditional neo-liberal thinking is sullied when we look at what actually happened to developing nations that have gone the full-capital account convertibility way in the 1980s and 1990s.
In a widely quoted study, Dani Rodrik (1998) finds little evidence of any significant impact of capital account convertibility on the growth rate of a country. Worse, a 1999 World Bank survey of 27 capital inflow surges between 1976 and 1996 in 21 emerging market economies found that in about two-thirds of the cases, there was a banking crisis, currency crisis or twin crises in the wake of the surge.
Since the early 1970s, there have been several crises triggered by speculative capital movements: the Southern Cone financial crisis in the late 1970s; the Mexican crisis of 1994-95 and the `Tequila Effect'; the East Asian crisis of 1997; the collapse of the Brazilian real and its impact on the rest of Latin America; the Russian crisis of 1998 and the Argentine crisis of 2001.
Here are the theoretical counter-arguments why full convertibility is correlated with the crises and why, even otherwise, it is not such a good thing:
Contrary to the assumption of the neo-classical model, a large volume of capital inflows into developing countries has actually been used for speculative purposes rather than for financing productive investments.
Capital account convertibility exposes the economy to all sorts of exogenous impulses generated through financial channels, as domestic and foreign investors try to shift their funds into or out of a country. Since financial markets adjust very quickly, even minor disturbances may exacerbate into major ones.
Under flexible exchange rates, capital inflows lead to an appreciation of the domestic currency directly. On the other hand, in a fixed exchange rate regime, increased capital inflows lead to monetary expansion and price inflation (unless there is substantial unutilised capacity), which also causes a real appreciation. In both cases, therefore, capital inflows tend to cause a real appreciation and the possibility of swollen current account deficits because of cheaper imports and uncompetitive exports which, if not controlled in time, will lead to loss of confidence and capital flight.
Because of the massive volume and high mobility of international capital, it has been observed that the government tries to play it safe by keeping interest rates high, thus discouraging domestic private investment. The government also desists from spending on public investment because, through an expansion in government spending, it could send signals of impending increases in fiscal deficits that have the potential of destabilising capital markets and inducing capital flight.
Policy implications for India
The experience with liberalisation of inward capital flows in India has been similar to the economies of Latin America and East Asia, only the magnitude of these flows has not been large enough to cause serious macro and micro management problems.
Based on the experience of other countries, the following issues are of concern for India:
Flexibility in exchange rate: To prevent a nominal appreciation because of the capital inflows, the RBI has been adding billions of dollars to its reserves; the foreign exchange reserves with the RBI are a whopping $69 billion.
However, intervening foreign currency purchases to stabilise the exchange rate and accumulation of forex reserves have implications for domestic monetary management, which can be seriously impaired by divided short-term monetary responses during a capital surge.
On the other hand, the option of a more flexible exchange rate would cause an appreciation in the value of the rupee, which may hurt exports.
Hence, the usual macroeconomic trilemma (Obstfield, M and A. M Taylor 2001) where only two of the three objectives of a fixed exchange rate — capital mobility and an activist monetary policy — can be chosen. Since the government has already liberalised inflows of capital to a large extent, the authorities could attempt to deal with this problem in one of the following ways: It could begin relaxing capital controls, allowing individuals to exchange rupees for dollars. Indeed, some piecemeal measures in this direction have already been taken. But this, perhaps, is a risky proposition.
For one thing, the embrace of full convertibility is itself likely to bring more dollars into the country in the initial phase and add to the existing upward pressure on the rupee. More important, given the lack of regulatory capacity, such convertibility runs the risk of a future financial crisis that may scuttle the growth process.
Alternatively, the government could tap this opportunity to liberalise imports. Further liberalisation will stimulate imports and create the necessary demand for dollars, mopping up the excess supply of dollars and relieving the government of the burden of low-yielding foreign exchange reserves.
Inasmuch as the imports are used as inputs for further exports, the move will kill two birds with one stone — it will relieve the upward pressure on the rupee, and bring the usual efficiency gains. In this regard, therefore, import liberalisation seems to be a distinctly better option.
Banking and capital market regulatory system: The relatively greater contribution of portfolio capital towards India's capital account, and the fact that these inflows could increase to significant levels in the future as India's financial markets get integrated globally, show that an important sphere of concern is their skilful management to facilitate smooth intermediation.
Banks intermediate a substantial amount of funds in India — over 64 per cent of the total financial assets in the country belong to banks. However, many Indian banks are undercapitalised, and their balance sheets characterised by large amounts of non-performing assets (NPAs).
Unless banking standards are duly brushed up, viable competition introduced and government interference reduced, it would be reckless to go in for full capital account convertibility, which requires flexibility, dynamism and foresight in the country's banking and financial institutions.
Transparency and discipline in fiscal and financial policies: It is well known that the last thing that a government wanting to gain the confidence of investors should do is to be fiscally imprudent. However, New Delhi does not seem to be paying heed to this consideration at all.
The ratio of gross fiscal deficit to GDP increased to 10.4 per cent in 1999-2000 from 6.2 per cent in 1996-97 and 8.5 per cent in 1998-99, and has hovered around the 10 per cent figure since then. Such high fiscal deficits can prove to be unsustainable and frighten away investors.
Hence, there is an immediate need for putting brakes on government expenditure, and until that has been satisfactorily done, opening up the capital account fully would carry with it a big risk of sudden loss of faith of investors and capital flight.
Caution on outflows
Whatever the apparent theoretical benefits of capital account convertibility, they have not yet been vindicated by the actual empirical evidence; rather, the experience of the countries in the developing world that have experimented with capital account convertibility has been that of increased market volatility and financial crises.
Moreover, at least a part of the large inflows of capital into India are a consequence of the recessionary conditions elsewhere. The country's macroeconomic fundamentals, though better than before, are not good enough to warrant long-lasting confidence from foreign investors. The reform process is not proceeding with adequate speed, banks are saddled with large volumes of non-performing assets, the financial system is not deep or liquid enough and the country ranks high in the list of corrupt nations.
Once the conditions in the rest of the world improve, and the interest rate differentials between India and the rest of the world narrow further, this capital may move on to greener pastures. Hence, one cannot bank on the continuous supply of foreign capital to finance whatever outflows occur from the country.
Therefore, we believe that India should be extremely cautious in liberalising capital outflows any further.
While it should leave no stone unturned to promote inward FDI, which, because of its very nature, is less susceptible to sudden withdrawals and also tends to promote productive use of capital and economic growth, it should be wary of short-term capital flows that have the potential to destabilise financial markets
The `slow and steady' stance that the RBI has taken towards capital account convertibility is to be appreciated.
It must be emphasised that only over time will the Indian economy be mature enough to be comfortable with full capital account convertibility — financial markets will deepen, macroeconomic and regulatory institutions grow more robust and the government will learn from past mistakes.
The Government would do well to focus at present on the fundamental processes of institutional development and policy reform because, in the long run, these would serve the country better than an early move towards full capital account convertibility.