Convertibility of Rupee in India on Current Account and on Capital Account
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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:
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
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.
Following were some important recommendations of this committee:
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.
For Practice watch videos: CBSE UGC NET in Hindi: https://goo.gl/1NvyMk
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Research Aptitude: https://goo.gl/TgyqyK
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Higher Education: https://goo.gl/3dSkPn
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Best Coaching for CBSE UGC NET 8 July 2018 https://goo.gl/i34Npu Complete Course for CBSE UGC NET Paper 1
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
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.
For Practice watch videos: CBSE UGC NET in Hindi: https://goo.gl/1NvyMk
Teaching Aptitude: https://goo.gl/UF2ojY
Research Aptitude: https://goo.gl/TgyqyK
ICT- Computer Aptitude :https://goo.gl/7smZNu
Higher Education: https://goo.gl/3dSkPn
If any one wants to get PDFs by Navclasses then click here: https://www.facebook.com/groups/navclasses/files/
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