THE sub-prime mortgage loan crisis in the US, which has led to a global meltdown of stock indices, has had a devastating impact on the Indian capital market. But the Indian rupee, which has been gaining strength, has finally started heading southwards, bringing cheer to exporters.

The impact of the American credit crisis was first felt on the bourses late last month, when global investors began pulling out funds from the market. Since then, the total market capitalisation on Indian stock markets has plummeted by a whopping Rs3.3 trillion (about $80 billion), tumbling to Rs42.75 trillion from over Rs46 trillion over the past three weeks.

The Sensex, the benchmark index on the Bombay Stock Exchange, tumbled by nearly 650 points on Thursday, the second biggest one-day fall in terms of absolute value. Virtually all the blue-chips on the Sensex have seen sharp erosion in values in recent weeks, dragged down by the sub-prime loans crisis in the US.

Worse, while domestic bulls were hopeful a few days ago of salvaging the situation, it appears that the pullout of foreign funds from the markets is likely to accelerate over the coming weeks, dampening overall sentiments. They have already pulled out nearly $750 million in August, and signs are hundreds of millions of dollars will be sucked out of the markets in the coming days.

Foreign institutional investors injected about $10 billion into the Indian stock markets this year, and about half of it was by hedge funds. The sub-prime crisis has hit hedge funds the worst, and they are now desperately trying to withdraw funds from high-risk emerging markets like India. Many of these funds were lured by the high-returns promised by Indian stock markets, but the funds they had borrowed to invest in India were backed by high-risk assets like sub-prime mortgages.

With growing redemption pressure in the US and likely losses in the sub-prime market, the hedge funds – and even leading financial institutions – are desperately seeking an exit from emerging markets like India. According to market sources, it is not just the hedge funds that are facing a crisis; even financial giants like HSBC, Citibank and Merrill Lynch are under pressure and are cutting their exposure to Indian stocks. Each of them has up to $10 billion invested in the domestic markets.

Banking stocks in India have also been plummeting, forcing senior officials of some of the leading banks to claim that their institutions had virtually no exposure to the sub-prime market. ICICI Bank, the largest private sector bank, claimed it did not have exposure to the sub-prime market, and had a “very small” exposure to collateralised debt obligations(CDOs).

The Indian rupee, which has been on a steady rise for much of the year – gaining by over 10 per cent – took a sharp U-turn last Thursday, tumbling by a huge 1.5 per cent, the second biggest fall in nearly 12 years.

This follows the massive withdrawal of funds by foreign institutional investors (FIIs), who have been dumping shares on the bourses and making a hurried exit, to meet their obligations in the US.

The rupee closed at a four-month low of 41.36/37 to the dollar, upsetting projections by analysts who had predicted it would breach the 40-mark in a few weeks. The rupee, which had hit a high of 40.2 against the dollar last month, is still 12 per cent above its low of August 2006. But analysts are already talking about the rupee crossing the 42-mark and turning weaker.

Exporters, who had gloomily witnessed a resurgent rupee over the past 12 months, are overjoyed. They are holding on to their foreign exchange earnings, hoping it will fetch better yields over the coming days.

India’s foreign exchange reserves are overflowing, having peaked at nearly $230 billion this month. The Reserve Bank of India (RBI), the country’s central bank – which has refrained from interfering in the currency market, to bail out exporters – is unlikely to intervene at this stage.

Earlier this month, the central bank unveiled a twin-pronged attack to curb the excessive inflow of foreign exchange. Last week, the RBI imposed restrictions on companies raising foreign funds through external commercial borrowings (ECBs), slapping a ceiling of $20 million that could be brought into the country.

Any borrowings about $20 million would be allowed only for foreign currency expenditure for permissible end-use, the RBI directed borrowers. Many Indian corporates have been raising cheap funds abroad through the ECB route, avoiding more expensive domestic rupee loans.

The Indian government has been imposing curbs on companies raising funds through ECBs; in May it had barred real estate firms from raising cash through ECBs for developing integrated townships, and had also put blocks in the path of small and mid-sized companies from raising overseas funds.

The government felt that the growing inflow of foreign funds would lead to inflation; the new rules do not prevent companies from raising large funds abroad – companies are allowed to raise more than $20 million abroad, but the sums have to be earmarked for their foreign expenses and cannot be brought to India. Last fiscal, Indian companies had raised about $21 billion through ECBs.

In another move to cool down the foreign exchange reserves position, the RBI last week decided to allow resident Indians to open accounts in banks abroad and repatriate up to $100,000 a year without getting its approval.

Under the liberalised remittance scheme (LRS), the RBI allows resident Indians to invest up to $100,000 every financial year, to acquire and hold immovable property, invest in financial instruments and other assets without seeking its approval. The money could be kept in foreign bank accounts, invested in mutual funds, venture funds, unrated debt securities and promissory notes as well.

While the relaxation is part of the RBI’s move to drain out excess foreign exchange, it also reflects the government’s determination to gradually go in for full convertibility of the rupee on the capital account. The Indian rupee is already fully convertible so far as Non Resident Indians are concerned; Indian corporates too can take out huge sums for acquisitions abroad and for setting up overseas ventures.

Now even individuals are allowed to invest up to $100,000 a year without taking government clearance.

Ironically, in the past – before India removed restrictions on remittance of foreign currencies – many Indians were desperate to have access to foreign funds. The ‘havala’ market thrived because of the shortage of dollars, and there used to be a thriving black market in greenbacks.

But ever since the rules were amended and the LRS introduced in 2004, there has been lacklustre response from residents to the new rules relating to repatriation.

Thanks to better returns in the domestic markets — which are far superior to international yields — less than $50 million have been transferred abroad by Indians since the scheme was introduced.

Many NRIs have also been converting their convertible rupee deposits (Non-resident external rupee accounts – NRE deposits) into ordinary rupee accounts (NRO deposits) because of the better returns. To curb the inflow of excessive foreign exchange, the RBI had imposed a cap on interest rates on NRE deposits, discouraging NRIs from putting their money in these accounts.

NRIs are willing to even pay tax on interest earned in the NRO deposits – against tax-free interest in NRE accounts – as the difference is still significant. Nearly $700 million have been withdrawn by NRIs from their NRE accounts in recent months, and much of it has been re-deposited in NRO accounts.

Indeed, India’s buoyant foreign exchange reserves position has brought about a sea change in the country’s exchange rules, benefiting domestic businesses and even individuals, who can now have access to huge sums of foreign exchange.