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Convertibility of Currency in India

26-NOV-2015 15:19

    After the collapse of Breton Woods’s system in 1971, the various countries switched over to the floating foreign exchange rate system. Under the floating or flexible exchange rate system, exchange rates between different national currencies are allowed to be determined through market demand for and supply of the same.

    Convertibility of Rupee:

    For the first time, the Union Budget for 1992-93 has made the Indian rupee partially convertible. This was an inevitable move for the expeditious integration of Indian economy with that of the world In order to face the serious current account deficit in the balance of payments, the Government of India introduced the partial convertibility of rupee from March 1. 1992.

    Under this system, which remained in operation for a period of one year, 60 per cent of the exchange earnings were convertible in rupees at market determined exchange rate and the remaining 40 per cent earnings were convertible in rupees at the officially determined exchange rate. The term convertibility of a currency indicates that it can be freely converted into any other currency. Convertibility can also be identified as the removal of quantitative restrictions on trade and payments on current account. Convertibility establishes a system where the market place determines the rate of exchange through the free interplay of demand and supply forces.

    Current Account Convertibility: Meaning

    Current account convertibility is the next phase for attaining full convertibility of rupee. Current account convertibility relates to the removal of restrictions on payments relating to the international exchange of goals, services and factor incomes, while capital account convertibility refers to a similar liberalization of a country’s capital transactions such as loans and investment, both short term and long term.

    Current account convertibility has been defined as the freedom to buy or sell foreign exchange for the following international transactions:

    (a) All payments due in connection with foreign trade, other current business, 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) Payments of moderate amount of amortization of loans or for depreciation of direct investment; and

    (d) Moderate remittances for family living expenses.

    Capital Account Convertibility: Meaning

    Capital account convertibility refers to a liberalization of a country’s capital transactions such as loans and investment, both short term and long term as well as speculative capital flows.

    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 any other currency without any transaction.

    Current Status of Capital Account Convertibility

    (a) Capital account convertibility exists for foreign investors and Non-Resident Indians (NRIs) for undertaking direct and portfolio investment in India.

    (b) Indian investment abroad up to US $ 4 million is eligible for automatic approval by the RBI subject to certain conditions.

    (c) In September 1995, the RBI appointed a special committee to process all applications involving Indian direct foreign investment abroad beyond US $ 4 million or those not qualifying for fast track clearance.

    Tara-pore Committee’s Second Report on Capital Account Convertibility (July 2006):

    With the growing strength of balance of payments in the post-1991 period and with external sector remaining robust and gaining strength every year and the relative macro economic stability with high growth providing a conducive environment relaxation of capital controls, RBI, in pursuance of the announcement the Prime Minister constituted a committee on March 20, 2006 with Mr. S.S. Tarapore as its chairman for setting out a roadways towards fuller capital account convertibility. The committee submitted its Report to the RBI on July 31, 2006.

    Advantages of Currency Convertibility

    • Export promotion: 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.
    • Incentive 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.
    • 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.
    • A self – Balancing Ability: 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.
    • Integration of World Economy: Currency convertibility gives the chance to Indian economy to interact with the rest 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 Globalisation.

    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.

    5. Freedom to convert local financial assets into foreign ones at market-determined exchange rates

    6. Leads to free exchange of currency at lower rates and an unrestricted mobility of capital

    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 2% per cent of GDP. The Government should also set up a Consolidated Sinking Fund (CSF) to reduce Government debt.

    (ii) The Governments should fix the annual inflation target below 4 per cent. This was called mandated inflation target — and give foil 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 folly deregulated, gross non-paying assets (NPAs) should be reduced to 5 per cent, the average effective CRR should be reduced to 3 per cent and weak banks should either be liquidated or be merged with other strong banks.

    Conclusion:

    It can be conclude that the India has all time high foreign exchange reserve of $340bn, inflation within the control, moderate fiscal deficit and highest growth rate in the whole world, so it’s the requirement of the time that we allow full capital account convertibility to cash the benefits of Globalisation.

    DISCLAIMER: JPL and its affiliates shall have no liability for any views, thoughts and comments expressed on this article.

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