Convertibility Is Tempting -- At A Price

India is setting sail for the promised land of capital account convertibility of the rupee to open up a new world of foreign funds at cheap interest rates.

Allowing diversification of domestic investment into international stocks comes somewhere down the list of benefits arising from life in a convertible world.

India desperately needs money to revamp a creaking infrastucture and satisfy corporate investment demand in order to fuel economic growth of above seven per cent annually and beat the race against internal debt and population pressures.

But massive capital inflows could upset India's monetary balance just as the arrival of gold and silver from Peru enriched Imperial Spain during the late Middle Ages but expanded the monetary base and caused uncontrollable inflation.

 

Economics has moved on since then, and no one expects India's authorities to throw away the gains made, bringing inflation below six per cent, but some acceleration is still expected. "If we get inflation of eight to nine per cent, but get huge inflows, it will be worth it," Nupur Joshi, economist at Jardine Fleming (India) Broking Ltd, said.

Finance minister P Chidambaram has said that he wants foreign direct investment (FDI) inflows of $10 billion annually over the next few years, compared with actual inflows of just $2.59 billion in 1996-97 .

Total foreign inflows, which includes FDI plus foreign institutional investment and corporate Euroissues, totalled $6.43 billion in 1996-97.

Covering the saving gap -- the difference between the domestic savings rate and domestic investment, which equates to the current account deficit -- is Chidambaram's goal.

"The attraction of capital account convertibility is that it will open the window to foreign funds to cover the saving gap," Rajan Govil, economist at HSBC B&K Securities, said. Corporates can borrow at cheaper interest rates and it will also integrate the Indian economy internationally. "The main aim is to increase the availability of investible funds," Joshi said. "Increasing the investment to GDP ratio will lead to growth, thats the bottom line."

But increasing access to foreign capital markets should move in tandem with lowering domestic interest rates. And the government will have to slash its own borrowing needs to allow the central bank to engineer lower rates.

Nearly 50 per cent of government spending this year will fall in the black hole of interest payments on public debt, which equates to nearly half the country's GDP. That does not bode well for a country zeroing in on full convertibility and hoping to close the gap between domestic and world interest rates through reductions in its fiscal deficit. The interest rate differential will be key to determining the size and direction of capital flows.

For a major Indian company, which has to pay around 15 per cent to borrow from a state-run bank, rupee convertibility will be a major boon.

On the international market the same company will have to pay around two per cent above Libor plus a five per cent forward premium -- taking the end cost up to around 13.0-13.5 per cent. (Reuter)

The 1.5 percentage point differential is attractive enough but if domestic interest rates go higher the rush to borrow abroad will accelerate. A medium sized Indian company currently has to pay 17 per cent, but the bait of cheaper foreign funds abroad could help bring management goals into sharper relief.

"They need to get a good rating from a reputable agency. That means becoming more competitive and getting their house in order to go and access the international capital markets," Joshi said. "This is part of the reform process." (Reuter)

"The attraction of convertibility is that it will open the window to foreign funds to cover the saving gap"

--Rajan Govil, economist at HSBC B&K Securities,