The larger question

The Reserve Bank of India continues to take small steps in an effort to roll back the dollar waves coming in from across the ocean, but it is likely to have as much success as King Canute. Thus, the RBI has significantly increased the room for Indian companies and individuals to transact in foreign exchange. Companies can now spend up to 400 per cent of their net worth to invest abroad, as opposed to 300 per cent till now. They can also pre-pay up to $500 million of their foreign loans every year, up from $400 million, and make portfolio investments up to 50 per cent of their net worth, up from 35 per cent. Individuals can now invest up to $200,000 abroad, double the amount allowed so far, and the aggregate investment limit for mutual funds has been raised from $4 billion to $5 billion. Overall, the scope of foreign companies in which Indians can invest has been widened by the removal of the 10 per cent reciprocal shareholding requirement; so far, Indians could only invest in foreign companies that had commitments in India.

In the RBI's statement, these measures constitute acceleration in the implementation of the second Tarapore Committee recommendations, which itself visualised a five-year time horizon. That may be, but the decision was undoubtedly motivated by the upsurge in capital inflow during the year, a flow that was temporarily moderated in the immediate aftermath of the financial turbulence in the US and other markets, only to resume with renewed force after the US Federal Reserve acted decisively last week. In the past few months, faced with making a choice between absorbing a substantial proportion of the higher inflows and letting them flow into the market, the RBI has opted for the latter, resulting in a significant appreciation of the rupee's exchange value. The obvious accompaniment to this decision would have been to try and increase the private sector demand for foreign exchange as quickly and by as much as possible so that a more robust market would determine the exchange rate. These measures represent a step towards the end objective of effective capital account convertibility, bringing residents and non-residents more on a par with each other as far as their portfolio diversification opportunities go.

However, as far as timing goes, the RBI is caught in a somewhat paradoxical situation. Yes, companies are investing abroad, but for many who need to take money out of India, 300 per cent of net worth was hardly a binding constraint. Besides, the larger Indian companies have little problem raising substantial funds abroad to finance acquisitions, amounts which don't enter the domestic picture since this can be done by subsidiaries incorporated outside the country. As far as individuals are concerned, there are very few markets today as attractive as India; those that are need to be studied and understood much more before becoming routine diversification options for the mass of Indian investors, even the more savvy ones. In short, the paradox is that the best time to introduce capital account convertibility is when it is least likely to be used.

So, as desirable as the measures may be from a long-term perspective, they are unlikely to make any significant difference to either the capital account balance or the value of the rupee, which will continue to appreciate if allowed to do so. Since markets are more interested in outcomes than in instruments, the RBI still needs to answer the question about what its exchange rate policy is. Do these measures presage movement towards a floating rate or will it resist appreciation by absorbing inflows that domestic companies and individuals do not buy up?