What is currency convertibility?

Currency convertibility means “the freedom to convert one currency into other internationally
accepted currencies”. There are two popular categories of currency convertibility, namely :
• Convertibility for current international transactions; and
• Convertibility for international capital movements.
Currency convertibility implies the absence of exchange controls or restrictions on foreign
exchange transactions.

What is meant by Current Account Convertibility:

Current account convertibility is popularly defined as the freedom to buy or sell foreign
exchange for :-
a. The international transactions consisting of payments due in connection with
foreign trade, other current businesses including services and normal short-term
banking and credit facilities
b. Payments due as interest on loans and as net income from other investments
c. Payment of moderate amounts of amortisation of loans for depreciation of
direct investments
d. Moderate remittances for family living expenses
e. Authorised Dealers may also provide exchange facilities to their customers
without prior approval of the RBI beyond specified indicative limits, provided,
they are satisfied about the bonafides of the application such as, business travel,
participation in overseas conferences/seminars, studies/ study tours abroad,
medical treatment/check-up and specialised apprenticeship training.
What is meant by Capital Account Convertibility?
Tarapore Committee on Capital Account Convertibility appointed in February, 1997 defines
Capital Account Convertibility as the “freedom to convert local financial assets into foreign
financial assets and vice versa at market determined rates of exchange”. In other terms we can
say Capital Account Convertibility (CAC) means that the home currency can be freely
converted into foreign currencies for acquisition of capital assets abroad and vice versa.

Background of Capital Account Convertibility :

Foreign exchange transactions are broadly classified into two types: current account transactions
and capital account transactions. In the early nineties, India’s foreign exchange reserves were so
low that these were hardly enough to pay for a few weeks of imports. To overcome this crisis
situation, Indian Government had to pledge a part of its gold reserves to the Bank of England to
obtain foreign exchange. However, after reforms were initiated and there was some
improvement on FOREX front in 1994, transactions on the current account were made fully
convertible and foreign exchange was made freely available for such transactions. But capital
account transactions were not fully convertible. The rationale behind this was clear.that India
wanted to conserve precious foreign exchange and protect the rupee from volatile fluctuations.
By late nineties situation further improved, a committee on capital account convertibility was
setup in February, 1997 by the Reserve Bank of India (RBI) under the chairmanship of former
RBI deputy governor S.S. Tarapore to "lay the road map" to capital account convertibility. The
committee recommended that full capital account convertibility be brought in only after certain
preconditions were satisfied. These included low inflation, financial sector reforms, a flexible
exchange rate policy and a stringent fiscal policy. However, the report was not accepted due to
Asian Crisis.
The five-member committee has recommended a three-year time frame for complete
convertibility by 1999-2000. The highlights of the report including the preconditions to be
achieved for the full float of money are as follows:-
Pre-Conditions Set By Tarapore Committee :
• Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5 per cent in
1997-98 to 3.5% in 1999-2000.
• A consolidated sinking fund has to be set up to meet government's debt repayment
needs; to be financed by increased in RBI's profit transfer to the govt. and disinvestment
proceeds.
• Inflation rate should remain between an average 3-5 per cent for the 3-year period
1997-2000
• Gross NPAs of the public sector banking system needs to be brought down from the
present 13.7% to 5% by 2000. At the same time, average effective CRR needs to be
brought down from the current 9.3% to 3%.
• RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a
neutral Real Effective Exchange Rate RBI should be transparent about the changes in
REER.
• External sector policies should be designed to increase current receipts to GDP ratio
and bring down the debt servicing ratio from 25% to 20%.
• Four indicators should be used for evaluating adequacy of foreign exchange reserves
to safeguard against any contingency. Plus, a minimum net foreign asset to currency
ratio of 40 per cent should be prescribed by law in the RBI Act.
• Phased liberalisation of capital controls

The Committee's recommendations for a phased liberalization of controls on capital

outflows over the three year period which have been set out in detail in a tabular form in
Chapter 4 of the Report, inter alia, include:-

(i) Indian Joint Venture/Wholly Owned Subsidiaries (JVs/WOSs) should be allowed to

invest up to US $ 50 million in ventures abroad at the level of the Authorised Dealers
(ADs) in phase 1 with transparent and comprehensive guidelines set out by the RBI. The
existing requirement of repatriation of the amount of investment by way of dividend
etc., within a period of 5 years may be removed. Furthermore, JVs/WOs could be
allowed to be set up by any party and not be restricted to only exporters/exchange
earners.

ii) Exporters/exchange earners may be allowed 100 per cent retention of earnings in
Exchange Earners Foreign Currency (EEFC) accounts with complete flexibility in
operation of these accounts including cheque writing facility in Phase I.

iii) Individual residents may be allowed to invest in assets in financial market abroad up
to $ 25,000 in Phase I with progressive increase to US $ 50,000 in Phase II and US$
100,000 in Phase III. Similar limits may be allowed for non-residents out of their non-
repatriable assets in India.
 iv) SEBI registered Indian investors may be allowed to set funds for investments abroad
subject to overall limits of $ 500 million in Phase I, $ 1 billion in Phase II and $ 2 billion
in Phase III.

v) Banks may be allowed much more liberal limits in regard to borrowings from abroad
and deployment of funds outside India. Borrowings (short and long term) may be subject
to an overall limit of 50 per cent of unimpaired Tier 1 capital in Phase 1, 75 per cent in
Phase II and 100 per cent in Phase III with a sub-limit for short term borrowing. in case
of deployment of funds abroad, the requirement of section 25 of Banking Regulation Act
and the prudential norms for open position and gap limits would apply.

vi) Foreign direct and portfolio investment and disinvestment should be governed by
comprehensive and transparent guidelines, and prior RBI approval at various stages may
be dispensed with subject to reporting by ADs. All non-residents may be treated on part
purposes of such investments.

vii) In order to develop and enable the integration of forex, money and securities market,
all participants on the spot market should be permitted to operate in the forward markets;
FIIs, non-residents and non-resident banks may be allowed forward cover to the extent
of their assets in India; all India Financial Institutions (FIs) fulfilling requisite criteria
should be allowed to become full-fledged ADs; currency futures may be introduced with
screen based trading and efficient settlement system; participation in money markets
may be widened, market segmentation removed and interest rates deregulated; the RBI
should withdraw from the primary market in Government securities; the role of primary
and satellite dealers should be increased; fiscal incentives should be provided for
individuals investing in Government securities; the Government should set up its own
office of public debt.

viii) There is a strong case for liberalising the overall policy regime on gold; Banks and
FIs fulfilling well defined criteria may be allowed to participate in gold markets in India
and abroad and deal in gold products.
The assumption of the committee was that these pre-conditions would take care of possible
problems created by unseen flight of capital. Given a sound fiscal and financial set-up, the flight
of capital was unlikely to be large, particularly in the short run, as capital would be invested and
not all of it would be in a liquid form.

Present Status :

Major Pre-Conditions by Tarapore Status as on March 2006

Committee
1 Reduction in gross fiscal deficit to 3.5% The present fiscal deficit is still at 4.1% (above the
by 1999-2000 level of 3.5%). However, estimates for the next
fiscal year are pegged at 3.8%
2. The inflation rate for 3 years should be an Inflation at present is around 4.00%.
average 3% to 5%
3. Forex reserves should at least be enough The present forex reserves are enough to cover more
to cover 6 months import cover than one year’s imports.
4. Gross NPAs to be brought down to 5% by Gross NPA for the banking sector is still marginally
1999-2000 higher than 5%
5. CRR to be reduced to 3% by 1999-2000 CRR is still at 5.00%
6. Interest Rate to be fully deregulated All interest rates, except Saving Fund interest rates,
have already been deregulated.

The process of opening up the Indian economy has proceeded in steady steps.
• First, the exchange rate regime was allowed to be determined by market forces as
against the fixed exchange rate linked to a basket of currencies.
• Second, this was followed by the convertibility of the Indian rupee for current
account transactions with India accepting the obligations under Article VIII of the IMF
in August 1994.
• Third, capital account convertibility has proceeded at a steady pace. RBI views
capital account convertibility as a process rather than as an event.
• Fourth, the distinct improvement in the external sector has enabled a progressive
liberalisation of the exchange and payments regime in India. Reflecting the changed
approach to foreign exchange restrictions, the restrictive Foreign Exchange Regulation
Act (FERA), 1973 has been replaced by the Foreign Exchange Management Act, 1999.

Thus, at present in India we have a restricted capital account convertibility. Indian entities (i.e.
individuals, companies or otherwise) are allowed to invest or acquire assets outside India or a
foreign entity remit funds for investment or acquisition of assets with specified ‘cap” on such
investments and for specific purpose. A full convertibility will allow free movement of funds in
and out of India without any restrictions on purpose and amount. Thus, after full convertibility is
allowed, residents in India will be able to transfer money abroad and receive from other entities
across the world. However, government will certainly make rules and regulations to ensure
these do not lead to money laundering or funding for illegal activities.

Prime Minister Manmohan Singh on 18th March 2006 said that the country's economic position
internally and externally had become 'far more comfortable' and it was worth looking into greater
capital account convertibility. In a speech at the Reserve Bank of India (RBI) in the country's
financial hub Mumbai, Prime Minister Manmohan Singh said he would ask the Finance Minister
and RBI to come out with a roadmap to greater convertibility 'based on current realities'. PM
also said "Given the changes that have taken place over the last two decades, there is merit in
moving towards fuller capital account convertibility within a transparent framework," Singh said.
RBI in its circular issued in March, 2006 has laid down that economic reforms in India have
accelerated growth, enhanced stability and strengthened both external and financial sectors. Our
trade as well as financial sector is already considerably integrated with the global economy.
India's cautious approach towards opening of the capital account and viewing capital account
liberalisation as a process contingent upon certain preconditions has stood India in good stead.
Given the changes that have taken place over the last two decades, however, there is merit in
moving towards fuller capital account convertibility within a transparent framework. There is,
thus, a need to revisit the subject and come out with a roadmap towards fuller Capital Account
Convertibility based on current realities. In consultation with the Government of India, the
Reserve Bank of India has appointed a committee to set out the framework for fuller Capital
Account Convertibility.

The Committee consists of the following:

i. Shri S.S Tarapore Chairman
ii. Dr. Surjit S. Bhalla Member
iii. Shri M.G Bhide Member
iv. Dr. R.H. Patil Member
v. Shri A.V Rajwade Member
vi. Dr. Ajit Ranade Member

The terms of reference of the Committee will be:

i. To review the experience of various measures of capital account liberalisation in India,

ii. To examine implications of fuller capital account convertibility on monetary and
exchange rate management, financial markets and financial system,
iii. To study the implications of dollarisation in India of domestic assets and liabilities
and internationalisation of the Indian rupee,
iv. To provide a comprehensive medium-term operational framework, with sequencing
and timing, for fuller capital account convertibility taking into account the above
implications and progress in revenue and fiscal deficit of both centre and states,
v. To survey regulatory framework in countries which have advanced towards fuller
capital account convertibility,
vi. To suggest appropriate policy measures and prudential safe- guards to ensure
monetary and financial stability, and
vii. To make such other recommendations as the Committee may deem relevant to the
subject.
Technical work is being initiated in the Reserve Bank of India. The Committee will commence
its work from May 1, 2006 and it is expected to submit its report by July 31, 2006. The
Committee will adopt its own procedures and meet as often as necessary. The Reserve Bank of
India will provide Secretariat to the Committee.

FACTORS WHICH ARE CRITICAL / OF CONCERN IN ADOPTING CAPITAL

ACCOUNT CONVERTIBILITY:
There are number of issues which are of concern for adopting capital account convertibility.
• The impact of allowing unlimited access to short-term external commercial
borrowing for meeting working capital and other domestic requirements. In respect of
short-term external commercial borrowings, there is already a strong international
consensus that emerging markets should keep such borrowings relatively small in
relation to their total external debt or reserves. Many of the financial crises in the 1990s
occurred because the short-term debt was excessive. When times were good, such debt
was easily accessible. The position, however, changed dramatically in times of external
pressure. All creditors who could redeem the debt did so within a very short period,
causing extreme domestic financial vulnerability. The occurrence of such a possibility
 has to be avoided, and we would do well to continue with our policy of keeping access
to short-term debt limited as a conscious policy at all times – good and bad.

• Providing unrestricted freedom to domestic residents to convert their domestic

bank deposits and idle assets (such as, real estate), in response to market developments
or exchange rate expectations. The day-to-day movement in exchange rates is
determined by "flows" of funds, i.e. by demand and supply of spot or forward
transactions in the market. Now, suppose the exchange rate is depreciating unduly
sharply (for whatever reasons) and is expected to continue to do so for the near future.
Now, further suppose that domestic residents, therefore, that they should convert a part
or whole of their stock of domestic assets from domestic currency to foreign currency.
This will be financially desirable as the domestic value of their converted assets is
expected to increase because of anticipated depreciation. And, if a large number of
residents so decide simultaneously within a short period of time, as they may, this
expectation would become self-fulfilling. A severe external crisis is then unavoidable.
• Although at present our reserves are high and exchange rate movements are, by
and large, orderly. However, there can be events like Kargil ware or Pokhran Test,
which creates external uncertainty, Domestic stock of bank deposits in rupees in India is
presently close to US $ 290 billion, nearly three and a half times our total reserves. At
the time of Kargil or Pokhran or the oil crises, the multiple of domestic deposits over
reserves was in fact several times higher than now. One can imagine what would have
had happened to our external situation, if within a very short period, domestic residents
decided to rush to their neighbourhood banks and convert a significant part of these
deposits into sterling, euro or dollar. No emerging market exchange rate system can
cope with this kind of contingency. This may be an unlikely possibility today, but it
must be factored in while deciding on a long term policy of free convertibility of "stock"
of domestic assets. Incidentally, this kind of eventuality is less likely to occur in respect
of industrial countries with international currencies such as Euro or Dollar, which are
held by banks, corporates, and other entities as part of their long-term global asset
portfolio (as distinguished from emerging market currencies in which banks and other
intermediaries normally take a daily long or short position for purposes of currency
trade).

Impact of Capital Account Convertibility

After full convertibility is adopted by India, it will lead to acceptance of Indian Rupee currency
all over the world.
In case of two convertible currencies, Forward Exchange Rates reflect interest rate differentials
between these two currencies. Thus, we can say that the Forward Exchange Rate for the higher
interest rate currency would depreciate so as to neutralize the interest rate difference. However,
sometimes there can be opportunities when forward rates do not fully neutralize interest rate
differentials. In such situations, arbitrageurs get into the act and forward exchange rates quickly
adjust to eliminate the possibility of risk-less profits.
Capital account convertibility is likely to bring depth and large volumes in long-term INR
currency swap markets. Thus for a better market determination of INR exchange rates, the INR
should be convertible.

Last updated on 21/03/2006