India's central bank is likely to continue its strict vigil over the currency market despite moving towards fuller rupee convertibility, one of its deputy governors said in a speech released on Saturday.
A committee appointed by the central bank started work last month to lay down a road map for a fuller float of the rupee, the biggest reform measure in more than a decade. It is expected to submit its report by July-end.
"Fuller capital account openness will lead to a confrontation with the impossible trinity of simultaneous attainment of independent monetary policy, open capital account, and managed exchange rate," Rakesh Mohan said in a speech organised by Stanford Center for International Development and Stanford Institute for Economic Policy Research.
"Only two out of the three would be feasible," Mohan said. "With a more open capital account as a given' and if a choice is made of an anchor' role for monetary policy, exchange rate management will be affected," he said in the speech delivered on Friday.
Mohan said a freely floating exchange rate would threaten the independence of monetary policy adding that the impact of exchange rate changes on the real economy could be quite adverse for developing countries like India.
He said the more mature and well developed financial markets and economies could absorb the risk associated with exchange rate fluctuations with negligible spillover on the real activity due to greater access to high-end technology.
"On the other hand, for the majority of developing countries which specialise in labour-intensive and low and intermediate technology products, profit margins in the intensely competitive markets for these products are very thin and vulnerable to pricing power by large retail chains," he said.
"Consequently, exchange rate volatility has significant employment, output and distributional consequences. In this context, managing exchange rate volatility would continue to be an issue requiring attention."
India's central bank usually intervenes through state-run banks in the foreign exchange market to contain excessive volatility and to maintain export competitiveness.
While the rupee is fully convertible on the current account, there are restrictions on free movement of capital. Analysts in J.P. Morgan say the new committee is likely to link the move towards fuller convertibility to the lowering of the deficit, which a fiscal responsibility law aims to cut to 3 percent of gross domestic product (GDP) by 2008-2009.
India has progressed in cutting its stubbornly high fiscal deficit to 4.1 percent of GDP last year from 5.9 percent in 2002/03 and is expected at 3.8 percent this year.
Mohan said fuller capital account convertibility will lead to a greater presence of foreign banks in India over time but a number of regulatory issues would arise.
India's banking sector is relatively closed to foreigners and foreign banks have to seek the central bank's permission if they want to pick up more than a 5 percent stake in banks. Mohan said that the presence of large global banks would pose a huge challenge to smaller Indian banks.
He also said the attention of top management of foreign banks to operations in countries like India are low since developing countries do not contribute much to their overall business.
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