By definition, capital account liberalisation is a free flow of capital without any controls and restriction in terms of debt, portfolio equity, direct and real estate investment. India has been gradually liberalising its capital account aiming at creating conducive environment for full convertibility. The FDI, portfolio investment and some sort of capital outflows have been liberalised in a phase-wise manner. India has recently announced its readiness to open the capital account as well.

India has not only achieved a high economic growth, with contained inflation and reasonable foreign exchange reserve, but also maintained higher productivity of foreign investment as indicated by a fairly lower capital output ratio than that of China. Now, the Reserve Bank of India has asked an expert committee to look for more practical modality to judge the Central/State fiscal deficits, among others. This indicates the possibility of a phase-wise start of some sort of a geographical road map on selected sectors and special economic zones. Nevertheless, India is ready for currency convertibility, whatever the modality, either in one go or with some caution, reflecting a forward approach with better backup of more orderly, gradual and well-sequenced manner.

For many years, Nepal has pegged its currency to the Indian currency (IC) at a fixed exchange rate, adopting flexible exchange rates with other major currencies. Given free flow of goods and services, open border, unlimited convertible facility for IC and on top of these India being the largest trade partner, Nepal chose a soft-step option to peg its currency to IC. Because of the progressive performance of the Indian economy, Nepal benefited in the past till its political situation was relatively stable, and it also managed to avoid exchange rate misalignment. Now people are curious about what will happen in Nepal if India opted for full currency convertibility.

Tentatively, Nepal will have three options: to follow suit, fixed rate with band flexibility or capital control. Obviously, a greater degree of openness, diversified international trade structure, greater degree of economic and financial development, higher capital mobility together with strong macro-economic fundamentals will help it to move in the capital account convertibility. Nevertheless, Nepal should not have a double dilemma if India shifts its policy regime, of either capital outflow in case of capital account liberalisation or to face serious consequences on capital inflow in case of conservative move — both of which may lead the economy into a more troublesome future.

Looking at the present socio-economic and political situation, Nepal has been facing the problems of lack of confidence, low performing economy and intensified political instability, reflecting an ideal situation for capital outflow. The financial system is not sufficiently and efficiently strengthened, thus lacking the symmetric information — a situation in which all parties taking part in the transaction should have equal access to information, which may result in the adverse selection, moral hazard and herding behaviours leading to more inefficient and unstable financial markets. Also, in the absence of strong domestic financial sector, the external liberalisation move may lead to serious economic problems, more potentially the financial crisis. Since Nepal lacks well-established equities and bond markets, real estate development and related financial instruments, it would no doubt be fun for foreign investors. If Nepal decides on currency convertibility, it will have potentially damaging consequences for the economy.

The second way is to offer relaxation with adjustment for the new exchange rate alignment with the IC. For this, the possibility is to devaluate domestic currency with IC as pay principle for the move with the relatively strong partner and fixed with IC providing a certain band rate for market flexibility. If so, the IC will be transacted in the market with the given band rate, which may also produce frequent severe shocks if the band is crossed by the market rate. However, given the sub-optimal situation, the pervasive result of partial convertibility would also create the situation of red carpet corridor for the overall capital outflow. For this, Nepal is free to decide its currency strength to pair up with IC. Also, if the authority makes use of partial flexibility in certain sectors and places, it is also not easy because of unlimited convertibility.

The third option is to make use of capital control like Malaysian type pegged exchange rate. However, the capital control is not so easy without any dynamic backup of the overall socio-economic and political fundamentals. Nonetheless, controlled regime further backtracks the development efforts, thus creating an acute shortage of financial resources. Also, it will lead to anti-clock direction of global integration. There is no cookbook recipe, let us wait and see how the dynamic policy decree will emerge.

Dr Paudel is ex-economic advisor, NRB