Currency Convertibility of a Country

Let us make in-depth study of the meaning, concept, advantages and problems of currency convertibility of a country.

Meaning of Currency Convertibility:

Let us first explain what is exactly meant by currency convertibility.

By convertibility of a currency we mean currency of a country can be freely converted into foreign exchange at market determined rate of exchange, that is, exchange rate as determined by demand for and supply of a currency. For example, convertibility of rupee means that those who have foreign exchange (e.g. US dollars, Pound Sterling’s etc.) can get them converted into rupees and vice-versa at the market deter­mined rate of exchange.

Under convertibility of a currency there are authorized dealers of foreign exchange which constitute foreign exchange market. The exporters and others who receive US dollars, Pound Sterling’s etc. can go to these dealers which are generally banks and get their dollars exchanged for rupees at the market determined rates of exchange. Similarly, under currency convertibility, importers and other who require foreign exchange can go to these banks dealing in foreign exchange and get rupees converted into foreign exchange.

Current Account and Capital Account Convertibility of Currency:

A currency may be convertible on current account (that is, exports and imports of merchandise and invisibles) only. A currency may be convertible on both current and capital accounts.

By capital account convertibility we mean that in respect of capital flows, that is, flows of portfolio capital, direct investment flows, flows of borrowed funds and dividends and interest payable on them, a currency is freely convertible into foreign exchange and vice-versa at market determined exchange rate.

Thus, by convertibility of rupee on capital account means those who bring in foreign exchange for purchasing stocks, bonds in Indian stock markets or for direct invest­ment in power projects, highways steel plants etc. can get them freely converted into rupees without taking any permission from the government.

Likewise, the dividends, capital gains, interest received on purchased stock, equity etc. profits earned on direct investment get the rupees converted into US dollars, Pound Sterling’s at market determined exchange rate between these currencies and repatriate them.

Since capital convertibility is risky and makes foreign exchange rate more volatile, is intro­duced only some time after the introduction of convertibility on current account when exchange rate of currency of a country is relatively stable, deficit in balance of payments is well under control and enough foreign exchange reserves are available with the Central Bank.

Convertibility of Indian Rupee:

In the seventies and eighties many countries switched over to the free convertibility of their currencies into foreign exchange. By 1990, 70 countries of the world had introduced currency con­vertibility on current account, another 10 countries joined them in 1991.

As a part of new economic reforms initiated in 1991 rupee was made partly convertible from March 1992 under the “Liberalized Exchange Rate Management scheme in which 60 per cent of all receipts on current account (i.e. merchandise exports and invisible receipts) could be converted freely into rupees at market determined exchange rate quoted by authorized dealers, while 40 per cent of them was to be surrendered to Reserve Bank of India at the officially fixed exchange rate.

These 40 per cent exchange receipts on current account was meant for meeting Government needs for foreign exchange and for financing imports of essential commodities. Thus, partial convertibility of rupee on current account meant a dual exchange rate system.

This partial convertibility of rupee on current account was adopted so that essential imports could be made available at lower exchange rate to ensure that their prices do not rise much. Further, full convertibility of rupees at that stage was considered to be risky in view of large deficit in balance of payments on current account.

As even after partial convertibility of rupee foreign exchange value of rupee remained stable, full convertibility on current account was announced in the budget for 1993-94. From March 1993, rupee was made convertible for all trade in merchandise. In March 1994, even indivisibles and remittances from abroad were allowed to be freely convertible into rupees at market determined exchange rate. However, on capital account rupee remained nonconvertible.

Advantages of Currency Convertibility:

Convertibility of a currency has several advantages which we discuss briefly:

1. Encouragement to exports:

An important advantage of currency convertibility is that it encourages exports by increasing their profitability. With convertibility profitability of exports increases because market foreign exchange rate is higher than the previous officially fixed exchange rate. This implies that from given exports, exporters can get more rupees against foreign exchange (e.g. US dollars) earned from exports. Currency convertibility especially encourages those exports which have low import-intensity.

2. Encouragement to import substitution:

Since free or market determined exchange rate is higher than the previous officially fixed exchange rate, imports become more expensive after con­vertibility of a currency. This discourages imports and give boost to import substitution.

3. Incentive to send remittances from abroad:

Thirdly, rupee convertibility provided greater incentives to send remittances of foreign exchange by Indian workers living abroad and by NRI. further, it makes illegal remittance such ‘hawala money’ and smuggling of gold less attractive.

4. A self – balancing mechanism:

Another important merit of currency convertibility lies in its self-balancing mechanism. When balance of payments is in deficit due to over-valued exchange rate, under currency convertibility, the currency of the country depreciates which gives boost to exports by lowering their prices on the one hand and discourages imports by raising their prices on the other. In this way, deficit in balance of payments get automatically corrected without interven­tion by the Government or its Central bank. The opposite happens when balance of payments is in surplus due to the under-valued exchange rate.

5. Specialisation in accordance with comparative advantage:

Another merit of currency convertibility ensures production pattern of different trading countries in accordance with their comparative advantage and resource endowment. It is only when there is currency convertibility that market exchange rate truly reflects the purchasing powers of their currencies which is based on the prices and costs of goods found in different countries.

Since prices in competitive environment reflect that prices of those ‘goods are lower in which the country has a comparative advantage, this will encourages exports. On the other hand, a country will tend to import those goods in the produc­tion of which it has a comparative disadvantage. Thus, currency convertibility ensures specialisation and international trade on the basis of comparative advantage from which all countries derive benefit.

6. Integration of World Economy:

Finally, currency convertibility gives boost to the inte­gration of the world economy. As under currency convertibility there is easy access to foreign exchange, it greatly helps the growth of trade and capital flows between the countries. The expan­sion in trade and capital flows between countries will ensure rapid economic growth in the econo­mies of the world. In fact, currency convertibility is said to be a prerequisite for the success of globalization.

Capital Account Convertibility of Rupee:

Under Capital Account Convertibility any Indian or Indian company is entitled to move freely from the Rupee to another currency to convert Indian financial assets into foreign financial assets and back, at an exchange rate fixed by the foreign exchange market and not by RBI. In a way, capital account convertibility removes all the restrains on international flows on India’s capital account.

There is a basic difference between current account convertibility and capital account convertibility. In the case of current account convertibility, it is important to have a transaction – importing and exporting of goods, buying and selling of services, inward or outward remittances, etc. involving payment or receipt of one currency against another currency. In the case of capital account convertibility, a currency can be converted into arty other currency without any transaction.

The Reserve Bank of India appointed in 1997 the Committee on Capital Account Convertibility with Mr. S.S. Tarapore, former Deputy Governor of RBI as its chairman. Tarapore Committee de­fined capital account convertibility as the freedom to convert local financial assets with foreign financial assets and vice-versa at market determined rate of exchange.

In simple language, capital account convertibility allows any one to freely move from local currency into foreign currency and back. The purpose of capital convertibility is to give foreign investors an easy market to move in and move out and to send a strong message that Indian economy was strong enough and that India had sufficient forex reserves to meet any flight of capital from the country to any extent.

The Benefits of Capital Account Convertibility:

The Tarapore Committee mentioned the following benefits of capital account convertibility to India:

1 .availability of large funds to supplement domestic resources and thereby promote economic growth.

2. improved access to international financial markets and reduction in cost of capital.

3. incentive for Indians to acquire and hold international securities and assets, and

4. improvement of the financial system in the context of global competition.

Accordingly, the Tarapore Committee recommended the adoption of capital account convert­ibility.

Under the system of capital account convertibility proposed by this committee the following features are worth mentioning:

(a) Indian companies would be allowed to issue foreign currency denominated bonds to local investors to invest in such bonds and deposits, to issue Global Deposit Receipts (GDRs) without approval of the RBI or Government to go in for external commercial borrowings within certain limits, etc.

(b) Indian residents would be permitted to have foreign currency denominated deposits with banks in India, to make financial capital transfers to other countries within certain limits, to take loans from non-relatives and others upto a ceiling of $ 1 million, etc.

(c) Indian banks would be allowed to borrow from overseas markets for short-term and long- term up to certain limits, to invest in overseas money markets, to accept deposits and extend loans denominated in foreign currency. Such facilities would be available to financial institutions and financial intermediaries also.

(d) All-India financial institutions which fulfill certain regulatory and prudential requirements would be allowed to participate in foreign exchange market along with authorized dealers (ADs) who are, at present, banks. In a later stage, certain select NBFCs would also be permitted to act as authorized dealers in foreign exchange market.

(e) Banks and financial institutions would be allowed to operate in domestic and international markets and they would also be allowed to buy and sell gold freely and offer gold denominated deposits and loans.

Preconditions for Capital Account Convertibility:

The Tarapore Committee recommended that, before adopting capital account convertibility (CAC), India should fulfill three crucial pre-conditions:

(i) Fiscal deficit should be reduced to 3.5 per cent. The Government should also set up a Consolidated Sinking Fund (CSF) to reduce Government debt.

(ii) The Governments should fix the annual inflation target between 3 to 5 per cent. This was called mandated inflation target — and give full freedom to RBI to use monetary weapons to achieve the inflation target.

(iii) The Indian financial sector should be strengthened. For this, interest rates should be fully deregulated, gross non-performing assets (NPAs) should be reduced to 5 per cent, the average effec­tive cash reserve ratio (CRR) should be reduced to 3 per cent and weak banks should either be liquidated or be merged with other strong banks.

Apart from these thee essential pre-conditions, the Tarapore Committee also recommended that:

(a) RBI should have a monitoring exchange rate band of 5 per cent around Real Effective Exchange Rate (REER) and should intervene only when the real exchange rate (RER) is outside the band:

(b) The size of the current account deficit should be within manageable limits and the debt service ratio should be gradually reduced from the present 25 per cent to 20 per cent of the export earnings:

(c) To meet import and debt service payments, forex reserves should be adequate and range between $ 22 billion and $ 32 billion; and

(d) The Government should remove all restrictions on the movement of gold.

It was generally agreed that full convertibility of the rupee, both on current account and capital account was a welcome measure and is necessary for closer integration of the Indian economy with the global economy.

The major difficulty with the Tarapore Committee recommendation was that it would like the capital account convertibility to be achieved in a 3 year period – 1998 to 2000. The period was too short and the pre-conditions and the macroeconomic indicators could not be achieved in such short period.

Basically, the Committee failed to appreciate the political instability in the country at that time, and the complete absence of political will and vision to carry forward the process of economic reforms and economic liberalisation. The outbreak of Asian financial crisis at this time was also responsible for shelving the recommendation of Tarapore Committee.

Conclusion:

In a speech at RBI on March 18, 2006, Prime Minister Dr. Manmohan Singh stated: “Given the changes that have taken place during the last two decades, there is merit in moving towards fuller capital account convertibility with a transparent framework… I will, therefore, request the Finance Minister and RBI to revisit the subject and come out with a roadmap based on current realities.” Promptly, within two days RBI constituted the “Committee on Fuller Capital Account Convertibil­ity” with S.S. Tarapore again as chairman. This Tarapore Committee submitted its report in Septem­ber 2006 (more commonly called the Second Tarapore Report).

The second Tarapore Committee had drawn up a roadmap for 2011 as the target date for fuller capital convertibility of rupee and mentioned that the conditions were quite favourable.

These conditions were:

1. Strong fundamentals of the Indian economy

2. A good amount of foreign exchange reserves of $ 165 million that existed in 2006.

3. More liberalized use of foreign exchange already in place.

4. A financial system better geared to deal with external capital flows

The fuller capital convertibility of rupee seemed to be desirable at the end of 2006 when the committee submitted its report. However, economic events, especially global financial crisis of 2007-09, roughly about a sea change in the economic situation. The Indian economy would have been greatly affected by the global financial crisis if we had implemented the recommendations of Tarapore Committee recommendations. We could not have coped with the extent of capital outflows that took place during 2008-09.

Problems:

It may be noted that convertibility of currency can give rise to some problems. Firstly, since market determined exchange rate has been generally higher than the previous officially fixed exchange rate, prices of essential imports rise which may generate cost-push inflation in the economy. Secondly, if currency convertibility is not properly managed and monitored, market exchange rate may lead to the depreciation of domestic currency. If a currency depreciates heavily, the confidence in it is shaken and no one will accept it in its transactions. As a result, trade and capital flows in the country are adversely affected.

Thirdly, convertibility of a currency sometimes makes it highly volatile. Further, operations by speculators make it more volatile. Further, operations by speculators make it more volatile and unstable. When due to speculative activity, a currency depreciates and confidence in it is shaken there is capital fight from the country as it happened in 1997-98 in case of South East Asian econo­mies such as Thailand, Malaysia, Indonesia, Singapore and South Korea.

This adversely affects economic growth of the economy. In the context of heavy depreciation of the currency not only there is capital flight but inflow of capital in the economy is discouraged as due to depreciation of the currency profitability of investment in an economy is adversely affected.

Managed Float System in India:

It is important to note that India as most of other countries including USA, Great Britain, France, there is at present flexible or floating exchange rate system. Besides, like other countries India has not adopted a perfectly flexible or floating exchange rate system. The changes in exports and imports, capital outflows and capital inflows bring about a large fluctuations in foreign exchange rate of rupee.

It may be noted that large depreciation or appreciation of exchange rate adversely affects the economy, especially its exports and imports. In order to prevent large appreciation and depreciation of Indian rupee, Reserve Bank of India often intervenes to ensure that exchange rate should remain within reasonable limits.

When the rupee is depreciating too much, Reserve Bank of India intervenes and sells dollars from its reserves of foreign exchange. This increases the supply of dollars in the market and prevents the depreciation of the rupee.

On the other hand, when rupee is appreciating too much. Reserve Bank of India intervenes and buys dollars from the market. This reduces the supply of dollars in foreign exchange market which prevents the appreciation of exchange rate of rupee.

Therefore, through the intervention by Reserve Bank of India, exchange rate of rupee is not allowed to change beyond certain limits. Therefore, such a system that has been adopted by India is not completely flexible or floating exchange rate system. Therefore, it is called managed float system.