I think that if you go by the strict letter of the law, most digital watches would not be allowed. From the 2011 VCAA-produced VCE Exams Navigator booklet (page 4),
"Stopwatches or watches with special functions such as an alarm or stopwatch are not permitted in the examination room".
This I think would rule out a high percentage of digital watches. So I guess analog watches, and digital watches that only tell the time would be allowed on your desk. That being said, last year, I took a digital watch in, set the stopwatch function, placed it on my desk, and nobody said anything about it.
Recently, I asked one of my senior co-ordinators about this issue, and she recommended that I strictly follow the rules, because some schools get audited for correct examination procedure, and they might check to see if this rule is being followed. I think that it's pretty handy to have a stopwatch, but I guess there is some element of risk. I'm still hoping it's one of those rules that is never policed.