Will India free the Rupee? Free floating Rupee/US Dollar Forex

India is loosing 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.Rupee / US DOLLAR FOREX TRADING 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." Currency trading fully convertible Indian rupees 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. The financial system has also consolidated. Bad bank loans have narrowed to 5.2% of total loans, from 13% a decade ago, presumably because they're better able to absorb swings in global capital flows.

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. Transfer your US Dollars to Rupees 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 Mumbai 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 (FDI), 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.RUPEE EXCHANGE RATE VOLATILITY 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.

At first glance, there has never been a more opportune time for India to consider floating the rupee.

Foreign currency reserves and direct investment inflows have risen to unprecedented levels, the economy is expanding at a healthy clip, and the business community displays a heady confidence not seen since the country first embarked upon economic reform in 1991.

But the political impediments to such a bold step remain daunting. No matter what timetable for full convertibility is proposed by the panel that was appointed last month by the Reserve Bank of India, the most optimistic analysts expect only careful, gradual changes to the status quo.

"I doubt that there will be a big-bang approach to full convertibility," said Monish Tahilramani, head of global markets at HSBC in India.

The Reserve Bank panel is scheduled to start work on May 1 and submit its report by the end of July.

India's annual growth rates have hovered around 8 percent over the past three years, making its economy the second fastest-growing in the world, after China's. Foreign reserves recently reached $140 billion, exports have grown at 20 percent annually in the past three years, and nearly $11 billion in foreign portfolio inflows in 2005 helped push the stock market to unprecedented heights.

Nonetheless, there are good reasons to doubt that India is really ready to subject the rupee to the vagaries of global currency markets.

One problem is India's profligate deficit spending, still swollen by corruption, home-state projects for power brokers in Parliament, and a host of industrial and agricultural subsidies.

No matter how strong the demand for rupees may be from foreign investors, consistently high deficit spending would leave it vulnerable to speculative attack in a fully convertible environment.

"With fiscal deficit currently at 8 percent of the gross domestic product, it is unlikely that we will see full convertibility anytime soon," said Chetan Ahya, India economist and senior vice president at JM Morgan Stanley, a financial services firm. "The optimum level of deficit of 4 percent is at least three years away," he said.

Indian law mandates a reduction in the fiscal deficit to 3 percent of GDP by 2009. But meeting that goal will require huge spending cutbacks, a formidable challenge involving fundamental shifts in the way Indian politicians operate.

With the survival of Prime Minister Manmohan Singh's Congress-led coalition government subject to the cooperation of India's leftist and Communist parties, such shifts appear improbable.

The Communists have wasted no time in objecting to capital account convertibility for the rupee, calling the new policy a "significant departure" from a joint agenda made among the governing coalition and the leftist parties.

It is also unclear whether the prime minister can muster enough support even within the Congress Party to apply the painful fiscal discipline required for a fully convertible rupee. Party leaders would find it difficult to tamper with subsidies and social programs before national elections in 2009.

For example, the federal government has not dared to touch food subsidies, which were introduced by a leftist government to help the poor in the 1990s but are in practice enjoyed by large swaths of the population, especially in the vote-rich northern states.

Like the Chinese yuan, the rupee is already freely convertible on the current account, meaning that businesses and individuals can buy foreign currency with rupees to pay for imported goods and services. Strong rupee / yen trading However, cross-border capital account transactions, including overseas investments above $25,000 and all borrowing, are subject to numerous restrictions imposed by the central bank.

India first began preparing for capital account convertibility in 1997, setting up a committee of experts to advise the government. But the Asian currency crisis in 1997 prompted the government to postpone the plan.

New Delhi's recently enhanced limits on overseas corporate borrowings, to $15 billion in the next fiscal year, ending in March 2007, from the current $12 billion, still represent a small fraction of its foreign exchange reserves. But companies have generous limits for overseas acquisitions. RUPEE / EURO REMAINS STRONG IN FOREX TRADE Foreign investors can freely buy equities, hedge investments and repatriate profits, but they face strict limits when investing in corporate and government debt instruments.

Signaling a change in thinking, the prime minister said last month that India's financial position was now "far more comfortable," making it an opportune time for the government to examine the issue of full convertibility.

A successful move to a free-floating rupee would be a strong signal to overseas investors of the government's commitment to reform. "The free flow of capital and seamless transfer of funds in the capital account will instill a greater sense of confidence in India among foreign investors," said Siddharth Roy, who heads the department of economics and statistics at Tata Sons, one of the country's largest industrial conglomerates.

Already, the move toward capital account convertibility has been progressing in phases. The government has approved more than $20 billion in foreign direct investment into Special Economic Zones, which are seen as testing grounds where foreign investors will be given greater economic freedom.

Full convertibility of the rupee would remove longstanding irritants for Indian industry like restrictions on foreign currency loans, said D.D. Rathi, director and chief financial officer of Grasim Industries.IN PLAY: GOLD / RUPEE REMAINS STRONG "With free flow of capital, the country can expect to grow at the rate it needs to," Rathi said.

Singh has said that India's economy needs sustained GDP growth of about 10 percent annually over several years to eradicate poverty in this country of 1.1 billion people.

Foreign investors will be greatly encouraged by the removal of capital restrictions, but "the government will need to put in some safeguards against flight of capital," Rathi said.

There is some concern over the likely outflows from the system if domestic savings are permitted to be turned into dollars. Currently the government allows resident Indians to freely remit and invest $25,000 overseas.

"But given the minimal interest in this existing scheme, freeing up is not likely to have a material impact," Tahilramani of HSBC said.

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. EXPECT THE INDIAN RUPEE TO BE STRONG VS. GOLD IN THE COMING MONTHS. 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.