Ready to convert?

Last week the IMF-World Bank annual meeting in Singapore included a programme of seminars attended by policy-makers, academics and officials, to discuss the big questions in development economics facing the world today. The reason for the focus on the 8220;Giants8221; as India and China were termed became clear. It was primarily about other countries asking what it means for them. The main question asked was: what does the emergence of India and China mean for the global economic environment in other countries? Can low-income countries hope to do well on low labour cost products, now that India and China are supplying those? Will middle-income countries continue to get investment flows or will all these be attracted by India and China? Will the rich countries lose jobs as the BPO industry in India grows larger? Will carbon emissions by India and China tip the world towards global warming? Will 8220;global financial imbalances8221; 8212; jargon for America8217;s large domestic and foreign borrowing from developing countries, especially China 8212; play out smoothly? These are the urgent questions in the global economy today, and they are all connected with India and China.

In international trade China and India are already seen as Giants. Trade integration of the Giants with the world, with East Asia and in relation to Latin America and Africa is going to grow. The only question is, how fast or slow. In international finance, China is the seventh largest holder of foreign direct investment, with 4.1 per cent of the world8217;s total. China and India hold the second and the fifth largest foreign exchange reserves respectively, and are now turning into important sources of FDI for other countries.

One of the biggest concerns appears to be: how would the financial sectors of China and India integrate with the world?

Larry Summers, former US treasury secretary, said that the financial integration of China and India is bound to happen in five to ten years. It will be driven by fundamental forces such as growing trade, investment and capital flows. And, it will happen regardless of what policy-makers in these countries want. What policy-makers control is only the ease or pain with which this process takes place.

His advice for India is: greater currency flexibility will make India8217;s path towards financial integration with the global economy smoother and prevent a wrenching and forced adjustment. His understanding clearly differs from the CAC-2 report, which has recommended reduced currency flexibility.

Summers predicts that the next decade will witness an appreciation of the real exchange rates of the two countries. This will happen regardless of what the RBI and the People8217;s Bank of China might want. It will happen because of the rapid growth in these countries. The American dollar is likely to decline in real terms, with rising US current account deficits. As the pressure mounts, exchange rates in India and China will be more flexible than they are today because of the difficulties of managing domestic monetary policy when exchange rates are being manipulated. In the event of external shocks and diverse growth rates of trading partners, it will not be optimal to hand over control of monetary policy to other countries. Greater flexibility in the exchange rate will allow more autonomy of monetary policy.

These developments, according to Summers, will not be policy choices. They will be driven by fundamental forces. What policy choices will be able to determine is the smoothness with which the adjustment to this destination takes place. It will determine the path that each country could follow towards this inevitable destination.

One central lesson from international monetary history, Summers points out, is that the incidence of countries leaving fixed exchange rate schemes too late is at least 10 times as common, and has had 10 times as serious consequences, as countries leaving fixed exchange rate schemes too early. If the exit from a fixed exchange rate system is a forced move, and is easily justified, then the country has waited too long.

The policy advice for India and China from the seminar was clear: one important enabler for opening up the capital account is greater currency flexibility. Governor Zhao, of the People8217;s Bank of China, who also spoke at the same session, said that China was going to move towards capital account convertibility and was committed to greater currency flexibility.

Ever since the release of the CAC-2 report, debate in India has focused on whether we want convertibility or not. Some analysts seem to think we have a choice of not integrating financially with the world. Such an approach appears naive in the context of the global picture and where India and China stand. The Reserve Bank of India has made no commitment towards convertibility unlike Governor Zhao. It makes much more sense for the RBI to make a similar public commitment and then focus on the task of how to smoothen the path towards this destination.