What if the rupee were to become fully convertible?

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That could be a game-changer for individuals and companies. But the possible shocks to the economy need to be guarded against.

The debate on full rupee convertibility has resumed with RBI Governor Raghuram Rajan talking about India’s ability to move towards a fully convertible currency some years from now. This is not the first time that someone has brought this up. In 1997, Finance Minister P Chidambaram, and in 2006, Prime Minister Manmohan Singh, too, had talked about it.

Today, the rupee is fully convertible on the current account, allowing it to be converted into other currencies and vice versa for transactions such as export and import of goods and services. But it is only partially convertible on the capital account.

It might be a trifle optimistic to envisage full capital account convertibility, at least in the near future. The economy does not appear to be strong enough to withstand the onslaught of an exodus of funds, in case of an adverse global or domestic development. Also, in the absence of controls on overseas borrowings, companies could go overboard, resulting in a situation where the country’s foreign exchange reserves fall short of the external debt obligations.

The financial markets too are not deep and liquid enough to enable foreign investors to invest at will.

But fuller currency convertibility has its positives too. It can be a game-changer for individuals as far as their investments — be it in equity, bonds or real estate — go, as they don’t have to be constrained by geographical boundaries. Companies can also borrow from the cheapest source globally.

What does it mean to you?

Are you fascinated by the idea of owning a villa in an exotic foreign locale? Or are you excited by the thought of investing your money in globally-listed stocks?

Well, there’s nothing stopping you from doing so. But under the RBI’s Liberalised Remittance Scheme (LRS), you can invest only up to a maximum of $2,50,000 in assets such as shares, mutual funds and property in any financial year.

Moreover, this limit, which was revised in February, includes spending on other accounts such as travel abroad, studies abroad, medical treatment and remittances to relatives too.

If the rupee were to be made fully convertible on the capital account, these limits would no longer apply. You would then be able to invest much larger sums of money on assets abroad, subject to the country-specific restrictions, if any.

Take, for instance, July 2014, when the RBI hiked the then LRS limit from $75,000 to $1,25,000. This was followed by an increase in outward remittances — up 44 per cent to $505 million during August-December 2014, compared with the year-ago period.

Money spent on property purchases doubled to $18 million and investment in debt and equity investments rose by over 40 per cent during this time.

With no limits on overseas investments, you can choose from the best-performing stock markets globally instead of restricting yourself to the Indian market. A one-year return comparison shows that the Chinese market has generated almost four times the returns from the Indian market. Over a three-year period, too, the Chinese market has outperformed, though by a smaller margin.

You can also invest in stocks that are not listed in India. For instance, popular social media companies — Twitter, Facebook and LinkedIn — are all listed only on international stock exchanges, such as the NYSE. You can invest unlimited sums of money in these stocks.

In the commodities segment too, Indian exchanges do not allow you to take exposure to many commodities such as platinum, tin and steel since the derivatives on these are not traded here. You can consider dabbling on the London Metal Exchange or the Chicago Mercantile Exchange if metals and agricultural commodities are your forte.

Price discovery of domestically-traded commodities will also improve as the restriction on cross-border trading goes.

Investing in overseas markets comes with yet another advantage — it helps you hedge yourself against the risk that comes from exposure to a single currency, the rupee in this case.

With the outlook for the rupee not all that bright, it would make sense for investors to diversify across assets denominated in different currencies.

If you are a conservative fixed income investor, you can scan the fixed deposit rates offered by banks in various countries and choose the most attractive one.

You will have to take into account the strength of that country’s currency, default risk of the bank and so on.

For instance, you might not want to park your money with a Greek bank, even if it offers you sky-high rates.

With the limit of LRS going away, you do not have to think twice about sending money overseas to your relatives. Want to go on an overseas holiday? You can choose the most expensive destination and binge to your heart’s content.

The flip side is that with individuals having the freedom to move their money outside the country at will, the economy would stand exposed to volatility arising from these sudden outflows.

Checking the outflow of black money from the country too will become a greater challenge.

What’s in it for companies?

Under the existing rules, companies (except those in some sectors such as hotels and software services) can raise a maximum of $750 million as external commercial borrowings (ECBs) during a financial year.

The move towards full convertibility on the capital account may imply removal of this limit.

With domestic banks becoming risk-averse due to mounting bad loans and the primary market in doldrums, many companies have been borrowing abroad to meet their funding needs. The corporate sector’s overseas borrowings stood at $171 billion as of December 2014-end, accounting for 37 per cent of India’s external debt.

The cost of these funds is lower and the excessive liquidity in global markets from the continuous monetary easing by central banks, including the Federal Reserve, the Bank of Japan and the European Central Bank, has meant that global banks have been flush with funds over the last five years. The ECB route might, however, not be open to companies with stressed balance sheets and declining earnings. With India’s credit rating itself at Baa3 (Moody’s), many companies may not be in a position to raise funds from overseas lenders at competitive rates.

What it means for the market

Foreign portfolio investors (FPIs) are already a dominant force and wield great influence on stock prices.

Given the impact cost in Indian markets and the fact that domestic institutional investors such as mutual funds do not churn their portfolios as much as FPIs do, full convertibility can only increase the vulnerability of the Indian equity market.

In the corporate bond market, foreign investments have been capped at $51 billion. As on date, around 80 per cent of this limit has been exhausted, 20 per cent still remains unused. But, when it comes to the government debt market, FIIs have exhausted the maximum permissible limit.

Currently, $5 billion of government securities is held by long-term investors such as multilateral funding agencies, sovereign wealth funds, and insurance and pension funds. A larger part, $25 billion, is held by investors such as individuals, overseas corporate bodies or debt funds. A removal of caps on investment in government debt, which stands at $30 billion currently, which is more likely to attract short-term investors rather than the long-term ones, therefore, poses a big risk.

While only 3.4 per cent of government dated securities (as of September 2014) were held by foreign portfolio investors, given our foreign exchange reserves and weak current account balance, the currency could be badly hit if their numbers swell. Foreign investors in debt are typically short-term investors who can move out at short notice, adversely affecting the rupee as happened in 2013.

With fears of the US Fed taper looming large, foreign investors pulled out over $13 billion from the Indian debt market between June and November 2013. This led to a 9 per cent decline in the rupee during the period.

India’s external vulnerability

India’s foreign exchange reserves have been on the rise over the past one-and-a-half years.

For the week-ended April 24, 2015, the reserves totalled $345 billion, up 11 per cent from the year-ago period. This provides comfort on the country’s external debt front.

As of end-December 2014 (the latest available data), India’s external debt stood at $462 billion, up 8.5 per cent from the same period last year. As a percentage of GDP, however the external debt has remained almost unchanged at 23.2 per cent.

Also, the proportion of short-term debt in the country’s external debt has come down from 22 per cent to 18.5 per cent.

The ratio of short-term debt to foreign exchange reserves fell to 26.7 per cent as at December 2014 from 31.5 per cent as at December 2013. That India’s current account deficit rose to $8.2 billion (1.6 per cent of the GDP) during October-December 2014, almost double of that from the year-ago period, is, however, not very comforting.

The merchandise trade deficit (goods exports minus goods imports) at $39.2 billion during October-December 2014, too, widened on account of declining exports and a rise in imports.

A relatively stable rupee, which minimises pricing uncertainty for exporters, is, therefore, crucial to keep the trade account deficit, and so the current account deficit, under check.

This is, however, unlikely to be so if foreign capital movement becomes unrestricted.