Convertibility of Rupee

The convertibility of a currency such as Rupee has different meanings in different times. In
existing standards, it means that the country’s currency becomes convertible in foreign
exchange and vice versa in the market. The definition should be seen in historical aspect of
foreign currency regulation in India. Almost at the same when India got independence, the
Foreign Exchange Regulation Act 1947 was enacted with the object of regulating certain
dealings in foreign exchange and the import and export of currency and bullion. The focus of
this act was on dealings in Foreign exchange and payments which directly affect foreign
exchange resources. This act was later replaced by the Foreign Exchange Regulation, Act,
1973, which we call FERA. Later FERA was laid to rest and its successor is now FEMA.
Those were the days of restriction on foreign exchange. No one could keep foreign exchange
without the knowledge and due permission of RBI. The exchange control consisted of
restrictions on the purchase and sale of foreign exchange by general public and payments to
and from non-residents. There were also restrictions on the import and export of Indian
currency, foreign currency and bullion. In those times, the exchange rates used to be different
than what they are today. Today we have a market determined exchange rate system, but
during those times, RBI used to dictate its Official Exchange Rate on which Indian currency
could be converted into foreign currency and vice versa. All transactions in foreign exchange
were governed by this official rate of exchange. This means that Rupee was inconvertible at
the market rate. An importer who wanted to import from abroad was supposed to buy dollars
at the RBI dictated rates. Similarly, an exporter who just got dollars was supposed to sell
them to RBI appointed Authorize agents at RBI decided rate. This was the inconvertibility of
Rupee. The major implications of these restrictions were: All foreign exchange earned and
received by any person in India were required to be sold to RBI authorised dealers. This
means that all foreign exchange earned or received could be converted and utilised only
according to the priorities fixed by the Government.

Partial Convertibility of Rupee on Current Account After the BoP crisis of 1990-91 and
change in the central Government, the LERMS was introduced as a first measure towards
making foreign exchange a free commodity. By LERMS, the exporters of goods and services
and those who are recipients of remittances from abroad could sell the part of their foreign
exchange receipts at market determined rates. Similarly, those who need to import goods and
services or undertake travel abroad could buy foreign exchange to meet such needs, at market
determined rates from the authorised dealers, subject to their transactions being eligible under
the liberalised exchange control system. But this was not for all exports and imports but in
respect of some priority imports and transactions, provisions were made in the scheme for
making available foreign exchange at the official rate by the Reserve Bank of India. Thus,
when LERMs was introduced, there were two exchange rates in India: Official Rate for select
items of exports and imports Market Rate for all others. The Government said that now
onwards, anyone who deals in current account means international trade of goods and
services will be able to convert them to Indian Rupees as follows: 40 % of the receipts at
Official rate 60% of the receipts at Market Rate This means that only part of the current
account receipts were made convertible at market rates and that is why it was called Partial
Convertibility of Rupee on Current Account. The imports of materials other than petroleum,
oil products, fertilizers, defence and life-saving drugs and equipment always had to be
effected against market determined rates. We see that practically, all the receipts of foreign
exchange were required to be surrendered to authorised dealers. The only difference was that
of the 60% of it could be converted at the free market rate quoted by authorised dealers. The
Partial convertibility of Rupee is known as Dual exchange system. At that time, India’s
current account was showing large deficit so it was risky to introduce the full convertibility of
Rupee. The major objective of the partial convertibility of Rupee was to “make the foreign
exchange available at a low price for essential imports so that the prices of the essentials are
not pushed up by the high market price of the foreign exchange”. Full convertibility of Rupee
on Current Account When Partial convertibility of Rupee on current account was introduced
1992, government had announced its intention to introduce the full convertibility on the
current account in 3 to 5 years. The full convertibility means no RBI dictated rates and there
is a unified market determined exchange rate regime. Encouraged with the success of the
LERMS, the government introduced the full convertibility of Rupee in Trade account(means
only merchandise trade no service trade)from March 1993 onwards. With this the dual
exchange rate system got automatically abolished and LERMS was now based upon the open
market exchange. The full convertibility of Rupee was followed by stability in the Rupee
Rate in the next many months coming up. The above full convertibility was introduced on
Trade account. The Government wanted to introduce the Full convertibility of Rupee on
Current account (means invisible also included). In August 1994, the Government of India
declared full convertibility of Rupee on Current account with announcing some relaxations as
per requirements of the Article VIII of the IMF. These were: Repatriation of the income
earned by the NRIs and overseas corporate bodies of NRIs in a Phased manner in 3 years
period. The ceiling for providing foreign exchange for foreign tours, education, medical
treatment, gifts and services was made just an indicative. Above this ceiling, foreign
exchange could be obtained for payments, while making a reference to RBI. While the
Principal amount on the NRNR (Non Resident Non Repatriable) Accounts was non
repatriable, the interest was made repatriable. Capital Account Convertibility Please note that
the concept of Capital Account Convertibility was coined by RBI and CAC is now almost
synonymous with the SS Tarapore Committee. Capital account is made up of both the short-
term and long-term capital transactions such as investments in financial and non-financial
assets. The Capital Transaction may be Capital outflow or capital inflow. Capital account
convertibility (CAC) or a floating exchange rate means the freedom to convert local financial
assets into foreign financial assets and vice versa at market determined rates of exchange.This
means that capital account convertibility allows anyone to freely move from local currency
into foreign currency and back. Convertibility on the capital account is usually introduced
after a certain period of introducing the Current account convertibility. The most important
effect of introducing the capital account convertibility is that it encourages the inflow of the
foreign capital, because under certain conditions, the foreign investors are enabled to
repatriate their investments, wherever they want. But the risk is that it may accelerate the
flight of the capital from the country if things are unfavourable. For example, an Indian can
sell property here and take the Capital outside. This is why; it is generally introduced after
experimenting with the convertibility on current account. Presently, India has current account
convertibility. This means one can import and export goods or receive or make payments for
services rendered. However, investments and borrowings are restricted. Tarapore Committee
on Capital Account Convertibility CAC is considered to be one of the major features of a
developed economy. CAC helps attract foreign investment and offers foreign investors a lot
of comfort as they can re-convert local currency into foreign currency anytime they want to
and take their money away. Capital account convertibility also makes it easier for domestic
companies to tap foreign markets. But, jumping into capital account convertibility game
without considering the downside of the step can harm the economy. The Committee on
Capital Account Convertibility (CAC) or Tarapore Committee was constituted by the
Reserve Bank of India for suggesting a roadmap on full convertibility of Rupee on Capital
Account. The committee submitted its report in May 1997. The committee observed that
there is no clear definition of CAC. The CAC as per the standards – refers to the freedom to
convert the local financial assets into foreign financial assets or vice versa at the market
determined rates of exchange. Here is what this committee observed: The Capital Control
must stay here.Capital controls can be useful in insulating the economy of the country from
the volatile capital flows during the transitional periods and also in providing time to the
authorities, so that they can pursue discretionary domestic policies to strengthen the initial
conditions. The Capital Account Convertibility, if the Government wants, can be introduced
for a 3 year period viz. 1997-98, 1998-99 and 1999-2000. However, there are some pre
conditions as follows: First bring you Gross fiscal deficit to GDP ratio from 4.5 per cent in
1997-98 to 3.5% in 1999-2000. Create a consolidated sinking fund which can meet the
government’s debt repayment needs. It can be financed by increased in RBI’s profit transfer
to the govt. and disinvestment proceeds. Bring the Inflation rate between an average 3-5 per
cent for the 3-year period 1997-2000. Bring down the Gross NPAs of the public sector
banking system 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.
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. We see that the Tarapore committee came up with some not from this world
recommendations. It was not a good idea to ignore the prerequisites so CAC was not
translated into reality. However, some partial convertibility of Rupee on Capital Account was
introduced later. Today we have Partial convertibility of Rupee on Capital Account. The
Second Tarapore Committee on Capital Account Convertibility Reserve Bank of India
appointed the second Tarapore committee to set out the framework for fuller Capital Account
Convertibility. The committee was established by RBI in consultation with the Government
to revisit the subject of fuller capital account convertibility in the context of the progress in
economic reforms, the stability of the external and financial sectors, accelerated growth and
global integration. The report of this committee was made public by RBI on 1st September
2006. In this report, the committee suggested 3 phases of adopting the full convertibility of
rupee in capital account. First Phase in 2006-7 Second phase in 2007-09 Third Phase by
2011. Following were some important recommendations of this committee: The ceiling for
External Commercial Borrowings (ECB) should be raised for automatic approval. NRI
should be allowed to invest in capital markets NRI deposits should be given tax benefits.
Improvement of the Banking regulation. FII (Foreign Institutional Investors) should be
prohibited from investing fresh money raised to participatory notes. Existing PN holders
should be given an exit route to phase out completely the PN notes. It means at present the
rupee are fully convertible on the current account, but only partially convertible on the capital
account. Is there any role of RBI in Foreign Exchange or not? Officially, the Indian rupee has
a market-determined exchange rate. So, the way via which RBI affects the exchange rates in
India is “Trade”. RBI is very active in currency market and is capable to impact effective
exchange rates effectively by its volume of lifting and releasing the foreign currency from
and to the market. The impact of RBI on trade is so much that currency regime in India is de
facto controlled. That is why we sometimes call it “managed float“. Here we should note that
the objective of RBI to intervene in the currency markets is to ensure low volatility in
exchange rates, and not to influence the direction of the Indian rupee in relation to other
currencies. Further, RBI has one more arm in its arsenal called “capital controls” in addition
to intervention through active trading in currency markets. What are Capital Controls?
Through Capital controls, the RBI controls the foreign capital inflows in the form of loans
and equity in India. The current account flows arise out of transactions in goods& services
are permanent in nature whereas capital account flows are dynamic in nature and are can be
reversed at any time. That is why a close eye on capital flows is needed. The Capital Inflows
would include the foreign borrowings by Indian corporates and businesses, NRI deposits and
portfolio flows from institutional investors into the stock markets, Loans to government and
short-term trade credit. The foreign Capital inflows bring cheaper resources to finance the
economy but the dark side is that they pose risks to value of the country’s currency. They can
put the liquidity management also in trouble. Because when huge dollars flow, they would
need to be bought by Central bank and in turn Central bank would pumps local currency. If
there is an abrupt reverse flow of capital, it would put the country into vulnerable condition.
Are we moving towards full Capital Account Convertibility? Though there are certain risks
associated with full capital account convertibility, we cannot avoid it for longer period as it
may become counter-productive. As the country is becoming more globalised it will be
difficult to maintain closed capital accounts. Capital account restrictions may create
opportunities for traders to circumvent rules through under-pricing or over-pricing of trade
transactions and corporates could use transfer pricing mechanism. But how early are we
moving to full capital account convertibility depend on various pre-conditions like low and
sustained current account deficit, fiscal-consolidation, controlled inflation, low level of
NPAs, resilient financial markets, prudent supervision of financial institutions etc. Already
India is making progress on these fronts. The progress can be measured by the attainment of
the specific goals mentioned by the two Tarapore committees. The present low level prices of
oil and large net invisibles are helping the country moving towards low level of CAD but it
needs to be sustained. On inflation front, though we made some progress but it is always an
area of suspect. There are other areas where the country is needed to make progress like
reduction of NPAs, development of resilient financial system etc. India cannot escape the
full convertibility of capital account as its economy grows further and becomes global in
dimension. The country cannot afford to remain isolated for a longer period of time