By Shamik Paul and Manoj Kumar
MUMBAI (Reuters) - India imposed restrictions on foreign exchange outflows on Wednesday in its latest attempt to prop up the rupee, as a spike in inflation heaped more pressure on policymakers to curb a crippling external deficit.
Finance Minister P. Chidambaram also reiterated his pledged to narrow the current account deficit - the main source of the rupee's weakness - to 3.8 percent of gross domestic product this fiscal year and said the currency would not be allowed to slide into "free fall".
The Reserve Bank of India's latest steps to support the currency, which has plumbed record lows against the dollar, included cutting the amount of overseas direct investments allowed by Indians, as well as lowering the limits on remittances overseas and banning the use of such remittances for overseas property purchases.
"This is obviously an extreme action, but these are extraordinary times and require extraordinary measures," said Sujan Hajra, chief economist of brokerage Anand Rathi in Mumbai.
The steps came as data showed the headline inflation rate jumped above the central bank's target range of 4 to 5 percent in July for the first time since March, making it even harder for the bank to refocus on supporting India's slowing economy.
The authorities fear further falls in the rupee will exacerbate the current account deficit in the short term, deter investment and put a further brake on economic growth.
RBI action to tighten rupee liquidity in mid-July and other steps have failed to halt the slide in the currency, which set new record lows on August 6.
Chidambaram sought to address scepticism in financial markets after he first unveiled his target on Monday to cut the current account deficit from a record high 4.8 percent of GDP in the year ended in March to $70 billion, or 3.8 percent, with proposals to curb imports and increase dollar inflows.
"I make a commitment on the current account deficit on behalf of the government. We will leave no stone unturned to contain the current account deficit at about $70 billion," Chidambaram told lawmakers.
"We cannot allow the rupee to go into a free fall."
The partially convertible rupee slipped to 61.45 per dollar on Wednesday.
It is down 2.5 percent since the RBI launched its major support effort on July 15, which included raising short-term interest rates.
Of the RBI measures announced on Wednesday, analysts said the biggest impact would be on overseas direct investments which reached $3.2 billion in July according to central bank data.
However, the RBI separately on Wednesday sought to ease some of the liquidity constraints at banks by exempting some requirements on the types of cash and government securities lenders must keep with the central bank.
Chidambaram also said on Wednesday that the central bank's mandate must include growth and employment, while Arvind Mayaram, economic affairs secretary at the ministry of finance, told reporters that any measures put in place would not be permanent.
"As and when we believe that the speculative pressure on the rupee is easing and the rupee is finding its stable environment, then the Reserve Bank of India and the government of India will revisit these restrictions and take an appropriate decision," Mayaram said.
Traders had previously criticised mixed signals from the government and central bank officials, saying it was contributing to the rupee's weakness.
'VERY UGLY'
India's headline inflation rate, measured by the wholesale price index (WPI), accelerated to 5.79 percent annually in July from 4.86 percent in June, data showed on Wednesday.
With fears growing that India is headed into a phase of slowing growth and high inflation, 10-year bond yields surged to as high as 8.55 percent, their highest in more than a year.
Rupa Rege Nitsure, chief economist at Bank of Baroda in Mumbai, expected economic growth to weaken to between 4.8 percent and 5 percent in the fiscal year ending next March, below the decade low of 5.0 percent notched last year.
"The central bank's focus will remain on currency and financial markets stability even if that means a further risk to growth," Nitsure said.
Analysts said the bad news on inflation, particularly on prices for imported oil prices, was due in part to the rupee losing 12 percent against the dollar since the start of May and higher food prices.
"The July print for headline inflation is very ugly," Bank of Baroda's Nitsure said. "Despite an acute slowdown in domestic demand, the manufacturing prices have remained elevated due to rising input costs on account of massive depreciation of rupee."
The need to bolster confidence has become more pressing. Foreign investors have sold a net $11.6 billion in debt and equities since late May, a bad omen given markets could weaken more when the U.S. Federal Reserve rolls back its monetary stimulus.
Ultimately, analysts say Prime Minister Manmohan Singh's minority government will need to implement bolder reforms to restore the economy, notably to improve the investment climate and expedite infrastructure projects.
However, there remain grave doubts about its ability to take unpopular steps as an election, due to be held by May 2014, approaches.
(Additional reporting by Subhadip Sircar, Swati Bhat & Abhishek Vishnoi in MUMBAI and Manoj Kumar & Rajesh Kumar Singh in NEW DELHI; Writing by Rafael Nam; Editing by Simon Cameron-Moore and Susan Fenton)
