India is moving more swiftly towards a freer rupee to counter big inflows which are giving the currency unwelcome strength, but that doesn't mean the whole programme is likely to speed up.
India, now the world's fastest-growing major economy after China, has seen a burst of incoming capital since the US Federal Reserve's interest rate cut last week renewed investor appetite for higher-yielding assets.
That sent the rupee to a nine-year high of 39.62 per dollar on Wednesday, a gain of more than 2 percent in a week - and almost 12 percent this year - even though traders say the central bank has intervened by selling rupees and buying dollars.
Analysts say the Reserve Bank of India's move on Tuesday to allow firms, mutual funds and ordinary Indians to send more money abroad is a pragmatic step to counter upward pressure on the rupee which dovetails with its longer-term convertibility plan.
"Arguably you can say they have been hurried into this because of recent inflows, but it's not like they haven't had these things planned anyway," said Nizam Idris, strategist at UBS in Singapore. "It is difficult to ascertain that they are accelerating the entire process."
The rupee has been convertible on the current account since 1994. It can be changed freely into foreign currency for specific purposes like trade-related expenses but it cannot be converted freely for activities such as acquiring overseas assets.
Han-Sia Yeo, Bank of America strategist, said the RBI was likely to move gradually from here. "The RBI has never had the habit of making a 'big bang' move," he said. The roadmap was drawn up last year, after one in the late 1990s was shelved due to the Asian crisis, and it sets out a three-phase plan concluding in 2010/11 (April/March).
Bits of the timetable have slipped, such as allowing foreign companies and institutions to raise rupee bonds. Rupee futures are also envisaged but no timeframe has been set. The central bank had already raised overseas investment limits in April. In August it curbed external borrowings to dampen inflows, even though the roadmap indicates the ceiling on borrowings should rise gradually between 2007 and 2009.
Analysts said Tuesday's decision reflected very different fundamentals to the 1990s, from record foreign exchange reserves of $232 billion to growth last year of a cracking 9.4 percent. "Even with the external environment looking less favourable, capital is still flowing," Yeo said. "The composition of capital flow is also changing and that makes it even more pressing for the relaxation to take place earlier than later."
In 2006, India attracted a net of nearly $8 billion in foreign portfolio investment and $19.5 billion in direct investment (FDI). FDI is less volatile than portfolio money, which analysts say may make the RBI more comfortable with greater capital outflows. "FDI has become a more important source of inflow or funding for the current account deficit," Idris at UBS said.
Not everyone views the decision as pragmatic. A.V. Rajwade, a member of the 2006 roadmap panel, told Reuters it was a desperate move to encourage outflows which would not hold back the rupee.
Rajwade said previous limits on overseas investments had not been used up yet, and letting the rupee rise quickly earlier this year had been a mistake as it had increased the dollar-value of stock holdings by foreigners, encouraging more inflows.
The stock market hit its latest record peak on Wednesday. Analysts in a Reuters poll released on Wednesday saw the rupee at 39.90 per dollar by year end. Thio Chin Loo, senior currency strategist at BNP Paribas, forecast 38.50 by year end, although the RBI would try to slow the pace.
"The central bank would need to be seen to be doing something, but it may not be as aggressive compared to the flows going through," she said. The RBI lifted banks' reserve requirements by 200 basis points between December and August to absorb extra cash generated by its rupee-selling intervention.
Analysts say the cost of sterilising this intervention, by issuing interest-bearing bonds, is going up as the interest earned on reserve currencies like the dollar is going down. This means there may be more tightening through reserve requirements. "It's likely to be a repeated theme, tightening through the cash reserve ratio, simply because when they intervene they cannot sterilise everything," UBS' Idris said. "The other obvious choice is to slow down intervention and then you have less money to absorb."