TABLE OF CONTENTS

INTRODUCTIO
1.

2. CURRENCY CONVERTIBILITY.....................................................................................6

2.1 TYPES OF CONVERTIBILITY OF CURRENCY....................................................6

2.2 CONVERTABILITY OF INDIAN RUPEE................................................................7

2.3 EXTENT OF CONVERTABILITY............................................................................9

2.4 ADVANTAGES OF CURRENCY CONVERTIBILITY:..............................................11

2.5 DISADVANTAGES OF CURRENCY CONVERTIBITY............................................13

3. CURRENT ACCOUNT CONVERTIBILITY OF RUPEE:.............................................14

4. CAPITAL ACCOUNT CONVERTIBILITY OF RUPEE................................................14

4.1 PRECONDITIONS OF CAC IN INDIA.......................................................................15

4.2 THE BENEFITS OF CAPITAL ACCOUNT CONVERTIBILITY...............................17

4.3 DISADVANTAGES OF FULL CONVERTIBILITY IN CAPITAL.............................18

5. CONCLUSION.................................................................................................................20

6. BIBLIOGRAPHY.............................................................................................................21
 1. INTRODUCTION

Currency convertibility is one major aspect of International trade where it plays a great role

in facilitating the global trade and capital streams between countries. Free, easy and

unrestricted convertibility of currency into forex market provides for capital flows around the

globe i.e. between countries without any barriers.

Higher rate of economic related advancement and along these lines to upgrade desires living

standards through more imperative trade and capital flows is thus the prerequisite for

convertibility of currencies of different countries has been significantly witnessed.

Countries adopted the fixed exchange rate system under the Bretton Woods system, which

came during the WWII. For maintaining the exchange rate of the currencies in terms of dollar

or gold many countries imposed various means of controls over the use of foreign exchange.

The use of foreign exchange was imposed upon some restrictions and its allocation among

different uses, a countrys currency was converted into foreign exchange on the basis of their

officially fixed exchange rate.

After the collapse of Bretton Woods system in 1971, many countries switched over to the

floating foreign exchange rate system. Under the floating or flexible exchange rate system,

exchange rates between the currencies are allowed to the determined through their market

demand and supply. However, various countries still impose restrictions on the free

convertibility of their currencies depending upon their balance of payment (hereinafter

BoP).

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 2. CURRENCY CONVERTIBILITY

Currency convertibility means that 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.1

The ability to exchange money depends upon gold or some other currencies, which is the

strongest currency at that time, for e.g., dollar, pound sterling etc. which have enjoyed and

they still do the strongest position in terms of the currency. Countries not having

large reserves of strong currency foreign reserves in their best try to restrict convertibility, of

their currency at the full level, as they are not in a position to handle large currency

market operations to support their currency when necessary.2

The exporters and others who receive US dollars, Japanese Yen, Pound Sterlings etc. can go

to the dealers i.e. generally banks and get their dollars exchanged for rupees at the rate of

exchange determined by market. Similarly, under currency convertibility, importers and

others who require foreign exchange can go to these dealers dealing in foreign exchange and

get rupees converted into foreign exchange.

2.1 TYPES OF CONVERTIBILITY OF CURRENCY

There are two types of currency convertability firstly Current Account and Secondly Capital

Account. A currency may be convertible on current account as well as the currency may be

convertible on both current and capital accounts.3

1 Currency Convertibility, available at

http://www.investorwords.com/1241/currency_convertibility.html (last accessed 05.04.2017).

2 Ibid.

3 Currency Convertibility: Advantage, Benefits and Preconditions for Capital Account

Convertibility, available at http://www.yourarticlelibrary.com/economics/foreign-
exchange/currency-convertibility-advantage-benefits-and-preconditions-for-capital-account-

3
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 Sterlings at

market determined exchange rate between these currencies and repatriate them.

Since capital convertibility is risky and makes foreign exchange rate more volatile, is intro-

duced 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.

2.2 CONVERTABILITY OF INDIAN RUPEE

Convertibility of the rupee means that the rupee can be freely converted into dollar, pound

sterling', yen, Deutsche mark, etc. and vice versa at the rates of exchange determined by the

demand and supply forces.

Actually reports indicate that rupee is as of now is convertible in the informal markets but

this is not the situation. Free convertibility deal with authorized market system for conversion

of currency, while non-convertibility can be characterized with reference to transaction for

which foreign exchange can't be lawfully bought or transactions which are controlled and

convertibility/38177/ (last accessed 05.04.2017).

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endorsed on the premise of facts and circumstances. A move towards free convertibility infers

a decrease in the number/volume of the above types of transaction4.

For example, meaning of convertibility of Indian rupee is that anyone who has foreign

exchange (like US dollars etc.) may get them changed into rupees and vice versa at the

foreign exchange rate which is determined by the market. There are authorised dealers of

foreign exchange under convertibility.

In the economic reforms of 1991 rupee was made partly convertible under the Liberalised

Exchange Rate Management Scheme where 60% of market receipts can be converted into

Indian Rupees in foreign exchange market whereas 40 % has to be surrendered to the RBI at

official fixed exchange rate.

Purpose of this 40% exchange receipts on current account is to meet the government

expenditure for foreign exchange and for paying for imports of essential commodities.

Therefore, it was a dual exchange rate system.

This partial convertibility of Indian rupee on current account was adopted with the goal that

essential imports could be made available at low exchange rate to guarantee that their costs

don't rise much. Further, full convertibility of rupees at that stage was thought to be

dangerous in perspective of big deficit in balance of payments on current account.

Even after partial convertibility of Indian rupee foreign exchange value of rupee stayed

steady. In the budget of 1993-94 full convertibility on current account was declared. From

March 1993, rupee was made convertible for all trade in merchandise. Remittances and

invisibles from abroad were permitted to be freely convertible into Indian rupee at market

determined exchange rate but on capital account rupee remained non- convertible.

4 Convertibility of Indian Rupee, available at http://www.caclubindia.com/articles/convertibility-of-indian-

rupee-1945.asp, (last accessed 05.04.2017).

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2.3 EXTENT OF CONVERTABILITY

2.3.1. PARTIAL CONVERTIBILITY: -

Indian rupee is partially convertible because of the control of RBI on investments flowing

inside and outside from the country. In most of the domestic transactions no specific

requirement is there, but there are significant restrictions on the investments internationally

and special permission is required to convert Indian rupee into other currency. Control by the

central bank is necessary in this convertibility because when an economy is in transition

period from controlled to market based economy , international investments and movement

of capital can be highly destabilising and disruptive. Therefore, it is essential that capital

flows be regulated during initial movement of convertibility. The partial convertibility regime

was brought to combine the advantage of relatively suitable managed float and the BOP. This

regime contains two exchange rate channels:

Market Channel: In this channel market forces of demand and supply decide

exchange rate and access is free for all transactions.

Official Channel: In this channel the exchange rate continues to be determined by

RBI on the base of the value of rupee in relation to the basket of currencies, but

access to the market is restricted.

On 1st March 1992, RBI introduced the Liberalized Exchange Rate Management System

(LERMS), to give effect to partial convertibility regime. After that control of all the foreign

exchanges taking place in India was given to RBI by authorised dealers and then RBI made a

foreign exchange available for approved purposes.

RBIs retention ratio was reduced from 100% to 40% of all foreign exchange remittances

received with effect from 1.3.1992. The ADs applied the official exchange rate in calculating

the value of rupees to be paid to the remitter for this 40% and surrendered the exchange to the

RBI in new system. The remaining 60% of the value of the remittance had to be purchased by

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AD at a market-determined exchange rate. AD s, had to retain that 60% portion for sale to

other AD s, authorized broker or buyer of foreign exchange.

Government released a list of import items, authorised by Ministry of Finance, where the

import could be made available at the official exchange rate. Import for Government

departments needs, Crude Oil, Diesel, Kerosene, Fertilizer, Import of Life-saving drugs and

equipment, imports under advance licenses and improt licenses and import for replenishment

of raw materials for gem and jewellery exports are some of the areas where imports are

available at the official exchange rate.

The reason for making available certain imports at official exchange rate was that:

Some of the above government transactions are of non- commercial nature, which are

relatively inelastic from the Domestic supply/demand perspectives. Thus, purchase of

public goods like departmental non-commercial imports, defence equipments

equipment, space research etc come under this category.

Some other items covered under the special set of transaction at the official rate have a

potentially significant cost-push effect on the economy like Crude oil and fertilizers.

These are goods whose domestic demands and supply price elasticity are low and which

from a significant input to an economy.

2.3.2. FULL CAPITAL ACCOUNT CONVERTIBILITY: -

U.S. dollar is an example of a fully convertible currency. There are no restrictions on the

amount of dollars that can be traded on the international market. Also U.S. government does

not impose a minimum or fixed value on the dollar in the international market.

Capital Account Convertibility (CAC) means that any person will be permitted to bring in

any amount of foreign currency in India. In this regime all the controls on the cross-border

movement of capital is removed. Thats why it is also known as floating rupee.

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CAC refers to the independence to convert local financial assets into foreign financial assets

at market determined rate of interest.

Full convertibility means no restrictions at all. Generally developing countries, which have

faced foreign exchange problems, put restrictions on the flow of capital to avoid the erosion

of their foreign exchange reserves. Because developing countries need that reserve to

maintain stability in the economy. But Indian forex reserve is robust now so thats why the

restrictions are being removed slowly and gradually.

After some last steps are completed any individual from India would be able to invest very

easily abroad in international market.

2.4 ADVANTAGES OF CURRENCY CONVERTIBILITY:

Convertibility of a currency has several advantages which are discussed below:

1. Encouragement to exports:

Exporters are motivated to increase their exports since there is possibility of making more

profits under currency convertibility conditions. As a result of convertibility on current

account, higher profits will be earned since market exchange rate will give higher returns as

compared to the officially fixed exchange rate. From the exports exporters can get more

rupees against foreign exchange (e.g. US dollars) earned from exports.

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 gives boost to import substitution.

3. Incentive to send remittances from abroad:

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Indian workers employed abroad & NRIs find it convenient to send remittances of foreign

exchange without hassle. This also encouraged illegal remittances like hawala money &

smuggling.

4. Self-adjusting Process in the Correction of Surplus or Deficits in Balance of Payments:-

In case, a country faces a deficit due to overvalued exchange rate, the currency of the

country will depreciate. This will encourage exports by lowering the prices & discourages

imports by raising their prices. In this manner the deficit or surplus in the BoP gets corrected

without the intervention of the government. 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.

5. Integration of World Economy:

Currency convertibility strengthen the integration of world economy. Under currency

convertibility access to foreign exchange is easy so it immensely helps the growth and capital

flows between the countries. Because of the expansion in trade and capital flows economic

9
growth in the economies will increase. In fact, currency convertibility is said to be a

prerequisite for the success of globalisation.

6. Financial sector becomes more efficient, disciplined and stronger.

2.5 DISADVANTAGES OF CURRENCY CONVERTIBITY

Rise To Inflation Currency convertibility can give rise to problems of inflation in domestic

economy. The market determined exchange rate is generally higher than the officially fixed

exchange rate. This leads to a rise in prices of essential imports which can results in a

situation of costpush inflation in an economy.5

Depreciation Of Domestic Currency If proper monitoring is not done then convertibility

can also result in the depreciation of the domestic currency. Undue depreciation of currency

can make people lose confidence in the currency itself. this can adversely affect the trade and

capital flows of a country.

Capital Movement Under CAC, a country is given the independence to transact in financial

assets with foreign countries without restrictions. This arrangement is to increase investment

activities in the economy. But there are also risks associated with it. Capital flight is one of

those risk. The shortterm capital flights termed as hot money transfers can destabilize an

economy unless precautionary or counter measures are taken to achieve stability.

Speculation Speculative activities may increase under free convertibility, making the

exchange rates highly volatile. Speculation can lead to depreciation of currencies & flight of

capital. This is proved by the experience of the South East Asian countries like Thailand,

Malaysia, in the year 1997-199, which experienced severe depreciation of currency & capital

flight.
5 http://www.knowledge2success.com/advantages-and-disadvantages-of-currency-
convertibility/ (last accessed 03.04.2017).

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India is moving very cautiously towards capital account convertibility due to various risks

which can create macroeconomic imbalance in the in the economy. Though the rupee is not

freely convertible on the capital account, in certain transactions full convertibility prevails.

According to Tarapore Committee 1999- If Fiscal deficit is below 3.5%, NPA is below 5%

and CRR is 3% than Full Capital Account convertibility can be a reality. Full account

convertibility will be good step but it should in line of actual condition of economy.

3. CURRENT ACCOUNT CONVERTIBILITY OF RUPEE:

Current account convertibility allows free inflows and outflows of currency i.e. to receive and

make trade related payments. After the economic liberalization in 1991, Government of India

announced partial convertibility of rupee from March 1st, 1992 in order to merge Indian

economy with the rest of the world. Under partial convertibility, 40% of the earnings were

convertible in rupee at official determined rates of exchange by the RBI and the government

and the remaining 60% of the exchange earnings were convertible at market determined rate

of exchange6.

Now, the government has made the rupee fully convertible on current account by ratifying

Article VIII of the Articles of the Agreement (IMF). Today, the exporters are allowed to

convert their entire foreign exchange earnings on current account transactions at the market

rate.

4. CAPITAL ACCOUNT CONVERTIBILITY OF RUPEE

As explained above, 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

6 http.//www.rbidocs.rbi.org.in/sec2/61694.doc

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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

Indias 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 any

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 rates of

exchange.

In simple language, capital account convertibility allows anyone 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.

4.1 PRECONDITIONS OF CAC IN INDIA

Tarapore committee suggested some preconditions which are necessary to bring full

convertibility of Indian rupee.

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1. FISCAL CONSOLIDATION- If CAC has to be brought in India then there should be

reduction in the Centres Gross Fiscal Deficit to GDP ratio with a reduction in the

states deficit and also a decrease in the quasi-fiscal deficit. The committee has

recommended for making a Consolidated Sinking Fund (CSF) to make fiscal system

more transparent and to prevent any crisis usually caused by borrowings. Committee

has recommended that any proceeds from disinvestments should be used for the

building of CSF.
2. MANDATED INFLATION RATE: Committee recommended that for the first three year

period, MIR should 3-5% on average. RBI should be empowered on the inflation

mandate approved by Parliament where RBI alone should be able to alter that

mandate where it can achieve the target with appropriate guidelines on changing the

mandate.
3. STRENGHTNG THE FINANCIAL SYSTEM: According to the committee report this was

the most important precondition for changing to CAC. Weaknesses in the financial

sector should be dealt early. Interest rates should be fully deregulated in the beginning

years and there should not be any formal and informal interest rate controls. The

average effective Cash Reserve Ratio should be decreased. Also serious measures

should be taken to bring down Non- Performing Assets.

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4.2 THE BENEFITS OF CAPITAL ACCOUNT CONVERTIBILITY

Full convertibility of Indian rupee will affect everyone in the country but is remotely

understable by even few. In this regime all obstacles to free flow of money will be removed

and goods and services will be able to move freely.

Some advantages of full convertibility:

1. In fully convertible regime foreigners would be able to invest in Indian stock markets,

buy up companies and properties without any restrictions unlike present time.
2. Indian people and companies would be able to import anything they prefer like shares of

foreign companies, property abroad and also can transfer money without going to Hawala

business.
3. Indians who have not paid their taxes or repaid their loans taken from Indian banks will

be able to freely transfer their money to foreign countries outside the jurisdiction of the

Indian authority.
4. There will be availability of large funds to help domestic resources which would increase

economic growth.
5. There will be easy access to international financial market and there would be reduction

in cost of capital.
6. Improvement of the financial system will be there in the context of global competition.

Tarapore Committee recommended some advantages that will occur if full convertibility is

adopted:

1. 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 RBI or Government approval to go in for external commercial borrowings within

certain limits, etc.

2. 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.

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3. Indian banks would be allowed to borrow from overseas markets for short-term and long-

term upto 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.

4. All-India financial institutions which fulfill certain regulatory and prudential

requirements would be allowed to participate in foreign exchange market along with

authorised dealers (ADs) who are, at present, banks. In a later stage, certain select NBFCs

would also be permitted to act as ADs in foreign exchange market.

5. 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.

4.3 DISADVANTAGES OF FULL CONVERTIBILITY IN CAPITAL

Full convertibility in Indian scenario is an illusory concept. In this regime, all the obstacles to

the free flow of the money will be removed and because of that goods and services will be

able to flow freely. Government will not be able to control these flows directly. Indirect

controls can be implemented by changing interest rates and taxes but the effectiveness of

those measures in uncertain.

1. Since market determined exchange rate is generally higher than the officially fixed

exchange rate, prices of essential imports rise which may generate cost-push inflation in

the economy.
2. If current account convertibility is not managed properly then it can cause the

depreciation of domestic currency. If the currency depreciates drastically and the

confidence is shaken then no one will accept Indian rupee in their transactions. Trade

and capital will be affected drastically.

3. Full convertibility has adverse consequences against Indian domestic producers of raw

materials and machineries, as they have to compete with foreign suppliers like Chinese

who deliberately lower their exchange rate for their currencies thus making their goods

15
 low in price. Most of the people still in India are dependent on agriculture and SMES.

They would be ruled out in the competition with their counterparts.

4. The freedom for Indias rich to buy companies and property abroad may lead to massive

diversion of funds from investments in the home economy of India to investments

abroad. This would amount to export of jobs to foreign countries creating more and

more unemployment at home. Japan is an example of this situation. Japanese companies

are transferring funds to China for investments to take advantage of Chinese low wage

rate and low exchange rate of Yuan, thus creating unemployment at home.
5. Full Convertibility can result in the flooding of the domestic markets with imports,

particularly non-essential ones.

6. Rupee will be under the control of currency speculators. It is very much possible for the

speculators to buy massive amount of Rupee to drive up its exchange rate and then they

can suddenly sell all to gain enormous profit. That will drive rupee to a very low depth

suddenly.

5. CONCLUSION

Capital account convertibility is one of the hallmarks of developed economies. It is a relief

for foreign investors since they are aware that anytime they change their mind they will be

able to re-convert local currency back into foreign currency and take their money but it not

the same for investors from developing countries like India. Many countries in 80s went for

full convertibility in capital without realizing that free movement of capital leaves economic

open to sudden huge inflows and outflows, which can be potentially destabilizing. Unless

16
there are strong institutions in the economy to deal with those flows countries could not cope

up with that destabilisation as shown by East Asian crisis in the late nineties. Therefore,

going for CAC without taking enough measures can be devastating for an economy. specially

for an economy like India, which is a developing country.

Therefore, full capital account convertibility should only be adopted in India if all the pre-

requisites are fulfilled, otherwise it can be devastating for the economy and it can push

economy in a very big financial problem which would be very difficult to manage. India

should keep in mind the outcomes which developing countries like Indonesia, Korea,

Thailand etc. faced by implementing full CAC without taking proper care in adopting it.

BIBLIOGRAPHY

STATUTES

1. Foreign Exchange Management Act, 1999

2. Article VIII of the Articles of the Agreement (IMF)

BOOKS

1. Ravi Puliani and Mahesh Puliani, Foreign Exchange Management Act Rules.
2. Taxmanns Foreign Exchange Laws Ready Reckoner(2009)

WEB SOURCES

1. http.//www.rbidocs.rbi.org.in/sec2/61694.doc
2. http://www.knowledge2success.com/advantages-and-disadvantages-of-currency-
convertibility/ (last accessed 03.04.2017).

17
3. http://www.caclubindia.com/articles/convertibility-of-indian-rupee-1945.asp, (last
accessed 05.04.2017).

4. http://www.investorwords.com/1241/currency_convertibility.html (last accessed

05.04.2017).
5. http://www.yourarticlelibrary.com/economics/foreign-exchange/currency-
convertibility-advantage-benefits-and-preconditions-for-capital-account-
convertibility/38177/ (last accessed 05.04.2017).

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