India has chosen an Exchange Rate Management policy geared towards encouraging exports and introducing total convertibility of the Rupee in stages.
India has been, with the exception of 1993-94, running a Current Account Deficit of 1.5% - 2% of GDP and an Import cover of just about 5 months in 1995-96. The Trade Deficit in 1995-96 was $ 4.5 billion and should be contained within $ 4.0 billion in 1996-97. The Rupee is intrinsically vulnerable and there is an acute awareness that long term foreign exchange stability can be brought about only by a healthy reserves position built up by a sustained rise in exports. As such, support for the export sector is at the heart of the RBI's exchange rate management rationale.
There is a large saving investrment gap in India - though the Savings Rate at 24% is high by Western standards, it is lower than the average of around 35% for the Asian tigers. And India needs an investment of $ 200 billion to upgrade its infrastructure, according to the Finance Minister Sri P Chidambaram's estimate. This gap can only be financed by foreign capital inflows.
But government deficit (6% of GDP, or 5% as per the 96-97 Budget), inflation and the demand for capital keep real interest rates pretty high, in the region of 15% p.a. Total Capital Account Convertibility at this juncture could lead to a very high volume inflow of "hot money" triggering off a surge in money supply and inflation which could land the country into a situation akin to Mexico in 1994.
As such, total capital account convertibility cannot be expected until the country achieves a higher growth path (in the region of 8-10% p.a.), lower inflation, a more robust export performance and a much more comfortable foreign exchange reserves position.
To be fair, some measure of convertibility on the Capital Account does exist - Foreign Institutional Investors can invest in the debt and equity markets and can repatriate their profits, NRIs can repatriate their FCNR and corporate deposits (though after a lock in period of 3 years), multinational companies can repatriate profits to their parent companies, majority and even 100% stake in companies is allowed to foreigners, Indian corporates can invest abroad in specified areas or with specific RBI approval, and so on.
However, with the economy on a sounder footing today as compared to 5
years back, laws regarding foreign investment in Indian debt and Indian
equity are being continually relaxed. Indian corporates have now been
permitted to increasingly borrow in foreign currency while foreign
investors have been permitted to buy into Rupee denominated debt.
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