India considers capital controls

New Delhi :  India's government is weighing capital controls with the rupee on the rise amid fears of "hot money" flowing into the country as investors pile back into Indian assets.

Unlike fellow emerging market giant China, India allows its currency to float freely and the central bank has warned of the dangers of "sharp and volatile" exchange rate movements that could hurt India's economy.

With the rupee riding at 18-month highs against the dollar, one idea Reserve Bank of India Governor Duvvuri Subbarao is airing to curb sudden big movements in the currency's value is a tax on foreign exchange transactions, known as a Tobin tax, similar to one Brazil introduced last year.

"Depending on what flows come in, we would employ measures, including if necessary something like the Tobin tax," Subbarao said last week, referring to a proposal first aired in the 1970s by Yale economics professor James Tobin.

"We prefer long-term flows to short-term flows," he told a Washington audience in a speech posted on the bank's website.

Tobin, a Nobel laureate for his work on financial markets, proposed a small levy on every sum changed from one currency into another to curb short-term speculation, stabilise currency markets and encourage long-term investment.

Portfolio flows into India from foreign countries between April and December 2009 nearly equalled the total from 2000 to 2005, driving up demand for the rupee and causing it to strengthen against other currencies.

A further surge in capital inflows "could force [Indian] policy makers to resort to more active means, a la Brazil," noted economist Hemant Mishra at Standard Chartered Bank in a recent commentary.

The currency has risen five per cent against the dollar since the start of the year to trade at around Rs44.36 per dollar on Friday, following a record low in October 2008.

The rise has been similar against the yen in 2010 and more impressive against European currencies. The rupee is up close to nine per cent against the pound and 11 per cent against the euro.

Analysts say the Indian currency could be trading below Rs44 to the dollar by June.

But India knows all too well what can happen when foreign investors' ardour for its assets wanes.

As the credit crisis spread across the globe in 2008 and risk appetite evaporated, the rupee slid by 27 per cent to breach the 50-rupee level to the dollar in the space of months as foreign investors stampeded for the exits.

India is in desperate need of investment to update its dilapidated roads, ports and other infrastructure, but speculative capital flows can be destabilising, resulting in sharp movements in asset prices, economists say.

Along with strong economic growth — officially forecast to reach 8.75 per cent this financial year, foreign investors have also been lured by interest rates that are on their way up as the Indian central bank seeks to clamp down on inflation.

Although the currency has yet to regain all its previous strength — it hit a 10-year peak of Rs39.4 to the dollar in early 2008, the Reserve Bank is under pressure from exporters to stem its appreciation.

The government must also weigh the fact that as a higher rupee hits exporters, it helps dampen inflation running at a 17-month peak of 9.9 per cent by making imports cheaper, economists say.

Exports only account for around 15 per cent of the gross domestic product of India's still inward-looking economy.

"Inflation concerns trump exporters' complaints about competitiveness with the central bank," said Moody.com economist Nikhilesh Bhattacharyya.