Capital Account Convertibility

Prime Minister Manmohan Singh has appointed the Tarapore Committee to design a roadmap to put India on the path to full capital account convertibility (CAC).

Let's get some basics on CAC straight. Full CAC means that individuals and corporations will be able to convert rupees to dollars (or some other foreign currency) freely wihout any limits or permission from the central bank-- the Reserve Bank of India (RBI). Under current regulations, an individual can only engage in transaction upto $25,000/year and companies also have limits in amounts they can invest without any permission. If full CAC is implemented then, people and businesses (Indian and foreign) can invest in each other's stock-markets, take loans and do foreign direct investment, no holds barred. Right now, India has full current (not capital) account convertibility only. This means that when it comes to export or import that is, payments in the trade sector, there are no limits or permission required. By going to CAC, the financial sector will also be free of any restriction.

Economist who favor full convertibility argue that restrictions on capital transactions create costs. By being able to invest wherever they want, companies or individuals can diversify their portfolios and spread risk optimally. In a world with capital controls, the distribution of capital ends up inefficient (i.e not where it is earning its highest return). Moreover, proponents say, protecting domestic financial markets also leads to irresponsible macroeconomic policies. That is, if the financial markets are playing watchdog to the government, there is less likelihood of inflationary policies (to put it in the crudest of terms-- the government is not going to print money to service its debt).

Opponents of full CAC emphasize the dangers of financial crises associated with no controls. The East Asian crisis of the 1990s is the most recent in memory. Basically, with CAC, there is no control on the inflow and outflow of investment especially short-term investment. So, much of a country's markets are subject to the whims of investors. And we all know how speculative the stock market can be, how quickly crashes happen and thus how a crisis can develop if one big foreign investor decides that its capital is better invested somewhere else. The risk of a crisis is enhanced when a country's financial system is not fully developed. For example, if banks are giving out a lot of bad loans, then the risk of cris is exacerbated. Also, heavy inflow of foreign currency can lead to an appreciation of the domestic currency which hurts exports and this is an important issue for export-oriented economies.

Starting to think about full capital account convertibility is a good step for India, but the reform process is not at a stage where full CAC should be implemented in the near future. Indeed India is in a very good macroeconomic position (with a stockpile of foreign exchange reserves) but full CAC is a path strewn with dangers, and policymakers must tread carefully.

India Post & Better Roads

Without better infrastructure, Indian growth will come to a grinding halt. Not that anyone should need anymore convincing about this but as I was reading an article in the recent Economist ("India Post: Rogue Mail") the idea was reinforced. Before I get to the connection to infrastructure, here is some background.

The issue centers around the possibility of amending an 1898 law that established the Indian postal service, India Post, as a government entity. The proposed amendment would increase regulation of private couriers like DHL. Due to the general unreliability of the postal service, private courier companies are doing very well. As the Economist quotes, "of the 11 billion items of post in India, private firms handle 7 billion." Wow, that's huge number. The government wants to curb the revenue power of private couriers (thereby diverting funds to its own coffers) by implementing 3 main rules. They are: 1) setting up a regulator for private couriers, 2) a levy on the private firms that would help finance the postal system's own expenses and 3) having the sole rights to deliver all letters upto 500 grams or 1.1. lbs.

The fundamental principle behind the motivation to change the status quo is good. I believe that postal services fall into the realm of basic services like health or education that all citizens must have cheap and reliable access to. Also, there are security issues associated with post that make it better suited to be under government jurisdiction. The fact that over 60% of mail delivery is in private hand is a sad testament to the government failing its duty. However, privatizing post completely or being a heavy-handed regulator is not the solution. All three of the proposed amendments reflect paranoia and "License Raj" type thinking rather than searching for progressive and innovative solutions. India Post needs to take advantage of its government status like subsidized land and being a government employer to offer the cheapest (and reliable) basic services to Indians. Mandating that private couriers cannot deliver a simple letter will not necessarily remedy any of India Posts's revenue woes. It does not create any incentive for them to fix their reliability issues. Due to economies of scale, India Post can have the cheapest rates, so even if DHL can deliver a simple letter but at a higher cost, people will go with the India Post given that quality of service is the same. Private courier firms may still have an advantage on more higher-end services like express mail but a factory worker in urban India should be able to send his rural family money cheaply and quickly via India Post.

Now to infrastructure. A major reason India Post is not able to maximize its revenue is because its costs are inflated due to poor infrastructure like roads. Transportation is the major cost to postal delivery. Bad roads lengthen delivery time and increase fuel costs. As the Economist states, "in a normal rural post office, revenues cover 34% of costs, in hilly areas just 15%." And in fact 89% of India Post's branches serve rural areas. Why would a private firm want to take on delivery through crumbling roads to a far-flung rural area when they can just concentrate on fast, cost-efficient delivery in the cities?

A better, more accessible and universal postal system is another socio-economic benefit that hinges on the success of the Bharat Nirman project. Given the enormous financial gains associated with a successful postal system, this should be another fat carrot being dangled in front of the government to hurry up on infrastructure development.

Competition for Scarce Resources

In his blog, Atanu Dey conjectures, "that the per capita availability of resources has something to do with the killing sprees that last decades in Burundi, with the Tutsi and Hutus slaughtering each other. It could be nature’s way of redressing the imbalance between people and resources."

Although in India, the low per capita availibility of natural and economic resources has not resulted in conflicts as grave as those in Africa, high population density is taking toll on the environment and infrastructure. Population growth can be a very good thing for the economy providing a young and dynamic workforce. However, a lack of environmental protection and the inability of infrastructure to keep up with a burgeoning population leads to unsustainable growth due to an unhealthy workforce and a declining capital/worker ratio.

A recent Supreme Court ruling which opened up 600 acres of old textile mill land for development in Mumbai, a vibrant city but a city which is ripping at its seams. The development of the NTC land poses a dilemma. By protecting that area for environmental reasons (what the Bombay Environment Action Group petitioned the High Court for and initially won and now lost), the city of Mumbai would have had some much needed open-space, clean air and greenery for its citizens. I believe quality of life and health plays an important role in a country's economic success and prosperity. As Amartya Sen stresses, a successful economy is not always judged on GDP but other social indicators like life expectancy and infant mortality. However, in a city where rapid growth has put incredible pressure on real estate prices (a 20% appreciation last year) and resources, freeing up land for development may lower financial and resource stress on the city. So, although this would not be the environmentally optimal path to take, in terms of per capita availibility of resources and capital, this is a wise decision.

Freeing up all this land in the heart of Mumbai for commercial purposes is a good idea. But development must proceed in a very deliberate and well-planned manner. Most importantly, the infrastructure of the city must be expanded to keep up with the pace of development. Sewage, pipelines, trash disposal, telephone lines, wireless lines, roads and commuter accessibility must all be developed with a well-defined pattern instead of haphazard building which the crumbling infrastructure of the city cannot support. And even though, the whole space cannot be reserved for parks and free space, environmentally-friendly policies must be a high priority on the development agenda.

Nuclear Energy (Accounting) Economics

A US-India nuclear agreement was completed during George Bush visit to India. Loosely speaking, according to the terms of this deal (which needs to be approved by the US Congress), the US will supply technology and uranium to India in exchange for the promise that India will designate 14 of its 22 nuclear sites as civilian and open to inspection. This deal has been analyzed from a motley of perspective like geo-political, energy-related and strategic. However, solely from the viewpoint of energy economics, I think increasing reliance on nuclear power is not the route to energy independence that India should take.

There is absolutely no debate that energy shortages are one of the main stumblings blocks to India's growth. Frequent power cuts are a major cost to businesses and the future of the Bharat Nirman infrastructure project, the key to India's growth potential, relies heavily on the availibility of energy. But nuclear energy constitutes only 3% of installed electrical capacity in India and if India expands its nuclear energy generation to desired goals, it will still only constitute 8-10% by 2020. Let's talk about the economics of nuclear energy. Nuclear power has very high fixed costs (present costs) and lower variable costs (future costs) whereas other energy sources like coal are the opposite. Research using discounted cash flow (DCF) methodology ("Economics of Nuclear Power from Heavy Water Reactors, Economic & Political Weekly) has shown that coal-based energy is cheaper than nuclear energy. In DCF, the timing of inflows and outflows of cash is important. The priniciple underlying the approach is that money received today is worth more than the same amount received later. The general approach is: all costs are discounted to some arbitrary but fixed reference date; the total cost is the sum of present value or future values of costs discounted to this date. After calculating the present value of revenues from electricity generation, we can set the sum of dicouted costs to discounted revenues to get the levelised costs of electricity.

The authors categorise and calculate three main costs of energy: capital costs of construction, fueling+operational+maintenance costs and decomissioning costs (that is, costs associated with shutting down the facility). Using data from Kaiga I& II nuclear reactors and Raichur (coal) power station, they compare the costs of nuclear power and coal. They conclude that, under their assumptions, for a real discount rate (consider this the interest rate) above about 2-3%, nuclear power is more expensive.

And I think this is a conservative estimate since their are many uncertainties associated with nuclear power, and risk only leads to a higher discount rate. The most important uncertainty associated with nuclear power is disposal. No country has yet come up with a sustainable nuclear waste disposal program. Proponents of nuclear power argue that coal is a dirty technology. However, although the risk of meltdowns may be low, even a small amount of radiation has very damaging effects.

The focus of India should be to clean up coal technology and more importantly, develop alternative energy sources like wind, water, ethanol and even biogas!

By the way, Chindabaram should slap a huge tax on energy-guzzling cars. But I will address that in my Union Budget post at a later date....