Introduction

Convertibility of rupee: means the rupee can

be freely converted into dollars, pounds sterling, yen, deutsche mark etc & vice versa at the rates of exchange determined by demand & supply forces and government regulations.

 In India, foreign exchange transactions in dollars, pounds, or any other currency are broadly classified into two accounts. Current account transactions. Capital account transactions.

A brief description about current and capital account convertibility.

Current account transactions

Current account transactions includes all transactions which gives rise to or use up national income. It mainly consists of: Merchandise exports & imports. Invisible exports & imports.

Examples of current account transactions. Import foreign products. Import insurance services. Export steel. Export software. Send money abroad to a child attending college in foreign country.

Convertibility aspect.
Today, India has current account convertibility in the sense that you are free to buy foreign exchange for the purpose of importing goods & services. In other words, the rupee is convertible in the current account.

Capital account transactions.

It consists of Short term capital transactions. Long term capital transactions

Examples: capital inflows. If an Indian company takes a loan from an American bank. If a UK company invests in a factory in India, this is classified as foreign direct investment(FDI). When foreigners buy shares in Indian companies, their investment shows up as portfolios on the capital account.

Capital outflows: Its where, Indian households and companies invest in global assets and global portfolios invest in Indian assets.

Convertibility aspect
Today, the rupee is not fully convertible in the capital account, as there exists restrictions on money, that comes into India to buy assets or that goes out of India to acquire assets abroad.

What will full CAC do?...

With full capital account convertibility, there will be no restrictions for foreigners seeking to buy Indian assets. Conversely, there will no restrictions for Indian households or companies taking rupee out or bringing foreign exchange for doing global diversification.

Capital account convertibility is desirable because of following reasons. Reduction in cost of capital. Diversify portfolios internationally. Induces competition against Indian finance. Reduced size of black economy.

Reduced cost of capital.

It is good for India, if foreigners come to India and invest in Indian assets- this makes more capital available for Indias development. As it helps in reducing the cost of capital. As when steel imports become easier, steel becomes cheaper in India. Similarly, when capital inflows in India are made easier, capital becomes cheaper in India. More projects become viable at a lower cost of capital.

Diversify portfolios internationally

Its good for India, if Indian households are globally diversified in their portfolios, this reduces risk and stabilizes the economy. This means that, even when conditions are bad in India, globally diversified households will be buoyed by off shore assets, will be able to spend more and thus prop up the Indian economy.

Induces competition against Indian finance

Convertibility induces competition against Indian finance. Currently, Indian finance is a monopoly in intermediating the savings of Indian households for the investment plans of Indian firms. With convertibility, Indian savings will have the choice of moving to off shore venues and firms will have the choice of financing the projects off shore.

Reduced risk of black economy

If India tries to have control over the capital account, it will be rather easy to evade through various unscrupulous means. In Practice, huge amount of capital are moving across the borders anyway. It is better for India, if these transactions happen in white money. Pushing for convertibility is about reducing the size of the lack economy. This will improve law & order, tax compliance and corporate governance.

Essential conditions for convertibility of rupee.

Comfortable current account position. Maintenance of domestic economic stability. Adequate foreign exchange reserves. Restrictions on inessential imports as long as the foreign exchange position is not very comfortable. An appropriate industrial policy & a conductive investment climate. An outward oriented development strategy and sufficient incentives for export growth

Committees constituted by RBI

Tarapore committee Rangarajan committiee

TARAPORE COMMITTIEE

 It submitted it report in July 2006. Reviewing the existing macro-economic variables, the committee detailed a broad framework in form of 3 phases ranging from FY 2006-07 to 2010-11. The targets are related primarily to fiscal reform and budget management. These are:

Specific targets given by Tarapore II

Reducing govt. stakes in the public sector banks. Greater autonomy and transparency in the conduct of monetary policy Current account deficit /GDP ratio should be maintained under 3% Adequate foreign reserves not from the view point of Import but also liquidity risk related to capital flows

Introduction To Rangarajan committee

The Government in June 2006, had constituted a Committee to prepare a strategy of Financial Inclusion. The Ten Member Committee, was constituted under the Chairmanship of Dr. C. Rangarajan, Chairman of the Economic Advisory Council to the Prime Minister.

 Liberalization of current account transactions leading to current account convertibility a compositional shift in capital flows away from debtto non-debt-creating flows strict regulation of external commercial borrowings, especially short-term debt discouraging volatile elements of flows from nonresident Indians gradual liberalization of outflows disintermediation of the government in the flow of external assistance Introducing a market-determined exchange rate regime

Benefits of Full Convertibility

Free flows of money in a FCR means foreigners would be able to invest in the Indian stock markets, buy up companies and property including land. FCR for the Indian rich is that they can import as they like and buy properties abroad. The Indian companies will be able to import both raw materials and machineries or set up foreign establishments at will. Attractiveness of the country as a safe destination for short-term investments.

Disadvantages of Full Convertibility

Rupee will be under the control of currency speculators. Convertibility of Rupee will give pleasure to the 10 percent of Indian people who are either rich or upper middle class, traders in the stock market, speculators, bankers, and accountants. The rest 90 percent of the people will be adversely affected with loss of employments in the manufacturing sector and bankruptcy in the agricultural sector