Currency Convertibility and Rupee Convertibility: Key Points – UPSC Economy Notes

Currency convertibility refers to the ease with which a currency can be exchanged for another currency or converted into other forms of assets without restrictions or limitations. In the context of India, rupee convertibility specifically refers to the ability to freely exchange the Indian rupee for other currencies on the global market. This concept holds significant importance in international trade, investment, and economic policy, as it affects the flow of capital in and out of a country. The key points surrounding currency and rupee convertibility include their impact on economic stability, foreign exchange reserves, trade competitiveness, and the overall integration of a country’s economy into the global financial system. Additionally, discussions around convertibility often involve considerations of monetary policy, exchange rate management, and the balance of payments. As countries navigate the complexities of global finance, understanding and managing currency convertibility remains a crucial aspect of economic governance and development strategies.

Currency Convertibility and Rupee Convertibility: Key Points

1. Currency Convertibility:
   • Currency convertibility grants freedom to currency holders to convert them freely into other currencies at prevailing market rates and vice versa.
   • It can be permitted on both current and capital account transactions, either in a limited manner or more liberally.
2. Advantages of Convertibility:
   • Full convertibility is not often granted, but countries allowing a broader scope are considered to have stronger and more resilient economies.
   • Convertibility facilitates trade, travel, investment, loans, and various economic transactions.
3. Rupee Convertibility Timeline:
   • Until 1992, the RBI regulated the external value of the Indian rupee.
   • Devaluation of the rupee occurred in 1991 as a step towards convertibility.
   • Partial Convertibility of Rupee (PCR) was introduced in 1992, with 40% of foreign exchange earnings traded at the official rate and 60% at market-determined rates.
   • Full convertibility on the trade account was achieved in 1993, extended to the current account in 1994.
4. International Commitments:
   • India assumed obligations under Article VIII of the International Monetary Fund (IMF) when it adopted current account convertibility.
   • Full convertibility measures helped gain international investors’ confidence in the Indian economy.
5. Capital Account Liberalization:
   • On the capital account, measures included permitting foreign institutional investments, allowing Indian companies to raise resources in international capital markets, and liberalizing norms for foreign direct investments.
6. Impact on Capital Flows:
   • The change in the external economic policy environment led to a significant increase in capital flows.
   • Foreign direct investments were encouraged, especially in consumer durables, infrastructure, and other projects.
7. Risk Factors:
   • Current account convertibility is considered relatively risk-free as it doesn’t involve external debt.
8. Purposes of Current Account Convertibility:
   • Involves freedom to convert domestic currency into foreign currency and vice versa for purposes such as exports and imports of goods, services, remittances (including factor incomes), and travel.

Understanding the process of rupee convertibility and the transition towards greater convertibility plays a crucial role in assessing India’s economic policies and their impact on international trade and capital flows.

Capital Account Convertibility: Key Points

1. Definition:
   • Capital Account Convertibility is a significant structural reform that involves allowing Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI) into India.
   • It also encompasses permitting capital outflows from India for Indian entities to invest abroad.
   • Additionally, Indian entities gain the ability to borrow from foreign countries.
2. Challenges and Sequencing:
   • Implementing capital account convertibility is a challenge and requires careful sequencing based on the economy’s ability to absorb it.
   • The process needs to be structured and phased in a manner that aligns with the country’s economic capacity.
3. FDI and FPI Impact:
   • Capital account convertibility allows for a more liberal inflow of FDI and FPI, contributing to increased foreign investments in India.
   • It signifies a shift toward a more open and globally integrated financial system.
4. Outward Investments:
   • Indian entities are granted the freedom to invest abroad, encouraging global diversification of investments and participation in international markets.
5. Borrowing from Foreign Countries:
   • Capital account convertibility enables Indian entities to borrow funds directly from foreign countries, expanding the financing options available to them.
6. Multi-Brand Retail Example:
   • The implementation of capital account convertibility can be seen in specific sectors, such as multi-brand retail.
   • For instance, allowing 51% FDI in multi-brand retail in India since 2012 required government approval, showcasing a structural reform with a direct impact on a significant portion of the population.
7. Sequencing with Economic Reforms:
   • The introduction of capital account convertibility may be sequenced based on the progress and acceptance of economic reforms.
   • In the example mentioned, the decision to allow greater FDI in multi-brand retail came approximately 20 years after the initiation of broader economic reforms, indicating a measured and phased approach.

Capital account convertibility represents a crucial aspect of economic liberalization, facilitating increased participation in the global financial landscape and supporting both inward and outward capital flows. The careful sequencing and management of this process are vital for its successful implementation and impact on the economy.

Full Convertibility: Key Considerations

1. Definition:
   • Full convertibility refers to the freedom to convert the domestic currency (rupee) into foreign currency and vice versa without significant restrictions for both current and capital account transactions.
2. Current and Capital Account Purposes:
   • It entails allowing close to 100% Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI) in various sectors, excluding security-related areas, on the capital account.
   • There should be a liberal regime for capital outflows, permitting Indians to invest and borrow from overseas with minimal constraints.
3. Least Restrictions:
   • Full convertibility implies minimizing restrictions on both current and capital account transactions, creating an environment where financial flows in and out of the country face few limitations.
4. Global Practice:
   • While full convertibility is not practiced anywhere globally, many advanced countries aspire to achieve it, recognizing the benefits of a more open and flexible financial system.
5. Current Indian Scenario:
   • India currently has a significant degree of capital account convertibility, allowing foreigners and Non-Resident Indians (NRIs) to invest in India and repatriate profits related to FDI, portfolio investment, and NRI bank deposits.
   • However, certain restrictions still exist for Indian residents and corporates regarding overseas investments, and RBI permission may be required for specific purposes.
6. Dimensions of Full Convertibility:
   • Liberalization of financial flows both into and out of the country.
   • Expanded purposes for convertibility, such as allowing FDI in retail and potentially broader sectors.
   • Higher or no caps on existing foreign investment regimes.
   • A shift toward automatic approval routes rather than requiring explicit permission.
   • Greater liberalization of outflows from India, providing Indians with more freedom to move their funds abroad.
7. Relaxations with Fuller Convertibility:
   • The fuller the convertibility, the more extensive the relaxations, leading to increased flexibility in economic transactions.

Achieving full convertibility represents a progressive step toward creating a more open and globally integrated financial system. While challenges and considerations exist, the pursuit of fuller convertibility aligns with the broader goals of economic liberalization and globalization.

Benefits of Full Convertibility:

1. Attracting Foreign Funds:
   • Full convertibility ensures free entry and exit of foreign funds, making India an attractive destination for Foreign Direct Investment (FDI) and other financial resources, particularly for infrastructure development.
2. Cost-Competitiveness for Businesses:
   • Established Indian businesses gain access to cheaper foreign funds, enhancing their international cost competitiveness.
3. Lower Borrowing Costs for Banks:
   • Indian banks can borrow foreign funds at lower rates, enabling them to offer loans at reduced interest rates to small and medium enterprises that may face challenges borrowing directly from the international capital market.
4. Global Expansion for Indian Companies:
   • Indian companies can use foreign funds to acquire firms abroad, contributing to the development of more Indian Multinational Corporations (MNCs).
5. Macroeconomic Discipline:
   • Full convertibility exerts macroeconomic discipline on the economy, fostering responsible financial management.
6. Diversification for Investors:
   • Ordinary Indian investors can diversify their asset portfolios by investing abroad, helping balance inflows and outflows and preventing issues like the appreciation of the rupee or the “Dutch disease.”
7. Availability of FDI Advantages:
   • All advantages associated with Foreign Direct Investment, including technology transfer, increased investment, and enhanced trade opportunities, become accessible.

Concerns and Prerequisites:

1. Calibrated Approach:
   • History, including the Asian financial crisis (1997) and the global financial crisis (2008), suggests that the adoption of fuller convertibility should be calibrated to avoid destabilizing effects.
2. Impact on Domestic Interests:
   • Domestic interests may be negatively impacted, leading to unemployment in certain sectors, such as FDI in retail.
3. Currency Volatility:
   • The rupee, not being a globally strong currency, may face volatility, as witnessed in 2018, affecting the stability of the economy.
4. National Security Concerns:
   • Increased FDI in defense may raise concerns related to national security.

Prerequisites for Fuller Convertibility (Tarapore Committee, 1997):

1. Minimal Fiscal Deficit:
   • Ensure a minimal fiscal deficit to maintain economic stability.
2. Adequate Forex Reserves:
   • Maintain sufficient foreign exchange reserves to support the currency and manage economic shocks.
3. Low Non-Performing Assets (NPAs):
   • Keep Non-Performing Assets of banks at a minimum to ensure financial health.
4. Moderate Inflation and Interest Rates:
   • Maintain moderate inflation and interest rates to support economic stability.

Conclusion:

• Before progressing toward fuller convertibility, it is crucial to meet these conditions to minimize potential adverse effects on the economy. The Tarapore Committee’s recommendations provide a framework for a cautious and well-planned approach.

Tarapore Committee on Capital Account Convertibility (CAC):

The Committee on Capital Account Convertibility, commonly known as the Tarapore Committee, was constituted by the Reserve Bank of India (RBI) in 1997. This expert committee was tasked with studying the feasibility of implementing capital account convertibility in India. The primary objectives of the committee were as follows:

1. Study Economies with Convertibility:
   • Examine economies that had already implemented capital account convertibility to gain insights into the process and its impact.
2. Recommend Measures and Time Frame:
   • Provide recommendations on the measures to be undertaken for capital account convertibility and suggest a time frame for its implementation.
3. Suggest Changes in Domestic Financial Policy:
   • Propose changes in the domestic financial policy that would contribute to achieving full capital account convertibility.
4. Assess Benefits, Preconditions, and Risks:
   • Evaluate the benefits, preconditions, and risks associated with the adoption of capital account convertibility.

Key Findings and Recommendations:

1. Appropriate Timing:
   • The committee concluded that the time was right for India to take steps toward capital account convertibility. However, it emphasized that these steps should only be taken when certain prerequisites were met.
2. Phased Adoption:
   • The adoption of capital account convertibility should be phased, and the transition from one phase to the next should occur only when specific preconditions are fulfilled.
3. Prerequisites:
   • The committee identified several prerequisites for capital account convertibility, including the reduction of fiscal deficit, maintaining inflation in the 3-5 percent range, and implementing financial sector reforms. These reforms included addressing non-performing assets (NPAs) in the banking system.
4. Caution as a Double-Edged Sword:
   • The committee emphasized that capital account convertibility could be a double-edged sword and should be approached with caution. It recommended careful consideration and adherence to prerequisites to avoid potential risks.
5. Phasing Transition:
   • The transition from one phase to another should be made incrementally, with a focus on achieving the necessary conditions before progressing further.

Conclusion:

• The Tarapore Committee’s report provided a comprehensive analysis of the feasibility, benefits, and risks associated with capital account convertibility. It highlighted the importance of careful planning, phased implementation, and meeting specific prerequisites to ensure a smooth and successful transition. The recommendations served as a valuable guide for policymakers considering capital account convertibility in India.

Second Tarapore Committee 2006:

The Second Tarapore Committee, officially known as the Committee on Fuller Capital Account Convertibility, was established by the Reserve Bank of India (RBI) in 2006. The primary purpose of this committee was to assess the status of capital account convertibility in India and provide recommendations for potential changes in the future. The committee focused on examining the feasibility, risks, and necessary precautions associated with further opening up convertibility.

Key Recommendations:

1. Gradual Move Towards Convertibility:
   • The committee recommended a gradual transition over the next five years to make the Indian rupee more freely convertible. The objective was to realize the country’s maximum economic potential.
2. Importance of Foreign Capital Inflows:
   • Recognizing the significant investment needs of the country and the insufficient domestic savings, the committee emphasized the imperative nature of foreign capital inflows.
3. Phased Approach to Convertibility:
   • The shift towards fuller convertibility should be phased, ensuring a systematic and cautious progression.
4. Regulatory Improvements:
   • Before making the rupee more freely tradeable, the committee stressed the importance of improving regulatory and supervisory standards across the banking system.
5. Participatory Notes and Direct Investment Routes:
   • The committee recommended banning participatory notes as a mode of investment in Indian equities. It also suggested easing direct investment routes for foreigners.
6. Parity for Foreign Individual Investors:
   • Foreign individual investors were recommended to be brought at par with non-resident Indian investors, implying equal treatment.
7. Liberalization of Overseas Borrowings:
   • Restrictions on overseas borrowings by Indian firms and banks were suggested to be eased to facilitate greater financial flexibility.
8. Increased Limits on Outbound Remittances:
   • The committee proposed increasing limits on outbound remittances by Indian citizens, allowing more flexibility in moving funds abroad.
9. Fiscal Deficit Control:
   • Emphasizing the importance of fiscal discipline, the committee recommended bringing the fiscal deficit under control to safeguard the vulnerability of India’s economy to external shocks.
10. Formation of Monetary Policy Committee (MPC):
    • The committee proposed the formation of a Monetary Policy Committee (MPC), which has been established and is operational.

Capital Account Convertibility Relaxations:

• Over time, several relaxations have been implemented in the context of capital account convertibility, including liberalizing foreign direct investment, issuing Masala bonds abroad, enhancing overseas investment limits for Indian companies, and allowing Indian citizens to invest up to $2,50,000 per year in foreign markets.
• Additionally, the Union Budget 2019-20 proposed the issuance of sovereign bonds abroad, further reflecting a gradual move towards greater capital account convertibility.

The recommendations and subsequent developments highlighted the importance of careful and phased measures to ensure a smooth transition towards fuller capital account convertibility in India.

FAQs

Q: What is currency convertibility?

A: Currency convertibility refers to the ease with which a country’s currency can be exchanged for another currency or converted into other assets, typically without restrictions or limitations imposed by the government or central bank.

Q: What is rupee convertibility?

A: Rupee convertibility specifically pertains to the Indian rupee and denotes the ability to freely exchange the Indian currency for other foreign currencies or assets without significant restrictions or controls imposed by the Reserve Bank of India (RBI) or the government.

Q: What are the benefits of currency convertibility?

• Enhanced international trade: Increased currency convertibility facilitates smoother international transactions, leading to improved trade relations and economic growth.
• Foreign investment inflows: Investors are more likely to invest in a country with freely convertible currency as it provides them with confidence and ease of repatriation of funds.
• Financial market integration: Currency convertibility fosters integration with global financial markets, promoting capital flows, and enhancing economic stability.

Q: What are the challenges associated with currency convertibility?

• Exchange rate volatility: Freely convertible currencies may be subject to fluctuations in exchange rates, which can affect trade balances and economic stability.
• Speculative attacks: Unrestricted currency convertibility can make a currency vulnerable to speculative attacks and capital flight during times of economic uncertainty.
• Policy constraints: Some governments may be hesitant to fully embrace currency convertibility due to concerns about losing control over monetary policy and exchange rates.

Q: What is India’s stance on rupee convertibility?

• Partial convertibility: Historically, India has maintained a stance of partial convertibility, allowing limited convertibility for current account transactions while imposing restrictions on capital account transactions.
• Gradual liberalization: The Indian government and RBI have pursued a policy of gradual liberalization of rupee convertibility, taking measured steps to relax restrictions and promote greater integration with global financial markets while managing associated risks.
• Economic considerations: India’s approach to rupee convertibility is influenced by various economic factors such as inflation, balance of payments, foreign exchange reserves, and external debt levels.

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