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India is loosening the reins on its currency. Prime Minister Manmohan Singh has indicated his government's readiness to move towards capital account convertibility -- making the flow of money in and out of the country for investments easier.
The central bank announced the appointment of a six-person committee to produce a "road map" toward that goal by July 31.
The benefits to India? Full convertibility of the rupee should give companies more access to foreign debt markets, cut delays in foreign exchange trades, and enhance foreign investor access to India's banks and debt market, while potentially allowing the rupee exchange rate greater freedom of movement.
Allowing freer flows between companies and investors, domestically and abroad, would promote desired foreign investment in the growing Indian economy. And it would remove a major remaining obstacle to India's integration with the global economy, a reflection of the nation's increased self-confidence.
Currently the rupee can be freely converted for trade in goods and services, but restrictions are placed on international asset acquisition. You need prior approval to move capital across borders, an companies need central bank permission to borrow from overseas. India has set a limit of $15 billion on overseas corporate borrowing for fiscal 2007 (ending March), up from $12 billion in the current fiscal year.
Comfort index
India began to lift restrictions on its currency after 1991, in a series of reforms removing restrictions on current account transactions including trade, interest payments, and remittances, and on some capital assets-based transactions.
A panel set up in 1997 to explore capital account convertibility recommended India move towards full convertibility by 2000, but policymakers abandoned that timetable in the wake of the 1997-78 Asian currency crisis.
There's a prevailing sense that now is a good time for India to pursue a relaxing of the controls. The prime minister expressed confidence that their financial position had become "far more comfortable." India's external debt situation has improved in the past decade, with short-term debt now 6.7% of total external debt, down from 7.2% in March, 1997, and 10.2% in 1991.
It has built up its cushion of foreign exchange reserves to $144 billion, exceeding external debt by about $20 billion and covering 13 months of imports.
Meanwhile, gross domestic product has registered a robust 7% to 8% growth in the past few years, with inflation moderating to 4% to 5% year-over-year in recent months, from over 8% in August, 2004.
More absorbent
Along with benchmarks for economic sturdiness including inflation and foreign reserves, the 1997 committee also stipulated progress in lowering bad loans in the banking system and cutting India's fiscal deficit as prerequisites for greater convertibility.
There has been progress: The federal fiscal deficit is expected to be 4.1% of GDP in the fiscal year just ending, continuing a steady decline from 5.9% in fiscal 2003, although the combined federal and states deficit is much higher, at 7.7% of GDP.
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The committee must also address the potential implications of greater convertibility for swings in the Indian rupee exchange rate, which is currently tightly controlled by the central bank, and domestic asset and liability markets.
India is currently enjoying an improved balance of payments, though for the past year it has been dependent upon a capital account inflow to offset a record current account deficit projected at 2.9% of GDP in fiscal 2006.
Investor confidence
The capital account inflow has been primarily driven by portfolio investment, highlighted by a net $10.7 billion in purchases of Indian equities in 2005 which helped fuel the 42% surge last year in the BSE Sensex index.
The stock market surge reflects growing investor confidence in the Indian economic outlook. Still, some are wary of its vulnerability to a potential reversal of the investment inflow. Presumably a more stable source of foreign capital would be foreign direct investment, which India is anxious to increase.
The government is targeting $10 billion of FDI in 2006, up from $6 billion in 2005. But the 2005 total is only one tenth of the over $60 billion attracted by China last year.
Keep in mind that there is nothing inherently wrong with a current account deficit financed by a capital account surplus, supplementing domestic savings with foreign sources to help fund expanded domestic investment.
Indeed, a primary objective of the move toward capital account convertibility would be to help attract additional foreign capital. Singh estimates that India would need $1.5 trillion in the next five years to sustain annual growth of more than 8% percent (officials often cite a 10% target), of which $70 billion should be foreign direct investment.
SEZ who?
This would come in conjunction with initial steps toward lifting restrictions on foreign investment in special economic zones (SEZs), as part of India's drive to promote investment for upgrading its infrastructure. More money would help address bottlenecks in facilities including roads and ports, a much-cited constraint upon the productivity of the Indian economy.
It is expected that initial steps towards fuller convertibility would focus on giving greater freedom to foreign investors in SEZs. The central bank is scheduled to review its banking policy in 2009, at which point it is expected to decide whether foreign investors can take more than a 5% stake in domestic banks.
It's worth noting that the Prime Minister himself is out in front on this relatively arcane issue. The fact is, Singh is quite the technocrat, a former economics professor with a PhD. in the subject from Oxford who has served both as the central bank governor and finance minister.
Furthermore, such a policy move would be an extension of his market-oriented approach. Taking over as finance minister in 1991 when India was facing a balance of payments crisis, Singh initiated free market reforms, including opening the economy to foreign investment.
Now comes one of his boldest steps yet. Singh's moves to make the rupee more convertible, lowering the barriers to moving capital in and out of the country, and encouraging foreign investment, might be viewed as India's most significant policy development since his sweeping reforms in the early 1990s.
Cohen is director of Asian economic forecasting for Action Economics
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