Here is an essay on ‘Currency Convertibility’ for class 9, 10, 11 and 12. Find paragraphs, long and short essays on ‘Currency Convertibility’ especially written for school and college students.

A currency is said to be convertible in the true sense if it is accepted throughout the world in both types of transactions:

(a) Transactions in current account,

(b) Transactions in capital account.


The US dollar is a fully convertible currency. So is the German mark, English pound and Japanese yen. The status of a country’s currency in the international market depends on its BOP positions. If a country’s BOP position is comfortable, the rest of the world has confidence in the country’s currency.

But if a country is a perennial debtor to rest of the world due to growing deficit in its BOP, the rest of the world loses confidence in its currency and the derived demand for its currency falls and the currency depreciates.

A fully convertible currency is also called a hard currency and an in convertible currency is called a soft currency. If a currency is convertible only on current account, it is called a partially convertible currency. Up to July 1994, Indian rupee was an inconvertible currency.

The rupee was devalued in 2 steps by 18% in July 1991 and in March 1992 there was a move to a dual exchange rate, one controlled by RBI and another determined by the market. In March 1993, the dual exchange rate system was unified and, in August 1994, the rupee was made convertible on current account.


Meaning of Current Account (Partial) Convertibility:

Current Account convertibility of the rupee implies removal of all restrictions relating to purchase and sale for current transactions for goods and services. In the case of current account convertibility, it is necessary to satisfy the IMF that restrictions on the current account have been virtually removed and that if there are any payment restrictions, the units are sufficiently liberal.

One-Sided Capital Account Convertibility:

At present there is a significant element of capital account convertibility for non-resident Indi­ans but little or no convertibility for Indian residents. Non-residents, by and large, enjoy the freedom to take capital out of the country without any hindrance.


This relates to foreign direct investors—MNG who set up production units in India, foreign institutional investors who invest in the Indian stock market and non-resident Indians who make remittances to India. Again, corporations are allowed to raise equity and make loans from abroad.

There are, however, very stringent restrictions or management of capital out of India by residents. In other words, there is, by and large, a significant element of capital account convertibility for non-residents but hardly any convertibility for Indian residents.

Ineffectiveness of Countries over Capital Movements in an era of Financial Globalisation:

Countries impose capital controls in the hope that they would insulate themselves from shocks from capital flows. With an increase in globalisation of international economy, even if we do not allow CAC, cross-border integration of financial markets renders capital controls totally porous.

Some of the costs of capital controls are not easily visible as they create distortions and inefficiencies in domestic system. Since India has already moved to current account convert­ibility, the porosity of controls has been accentuated as capital agreements can take on the guise of current transactions.

Meaning of Capital Account (Full) Convertibility:

For a long time the rupee is convertible on the capital account for the non-residents. Actions are to be taken permitting greater capital outflows from India.

For making the rupee fully convertible at least eight should be mentioned:

(i) Individuals are to be allowed to hold financial assets abroad.


(ii) The regulations for joint ventures abroad should be liberalised.

(iii) Banks should be permitted to borrow and invest in overseas markets.

(iv) Indian investors should be given permission to invest abroad.

(v) The joint-stock companies should be allowed to issue foreign currency denominated bonds, provide easier access for GDRs (Global Depository Receipts) and ECBs (Euro Cur­rency Bonds) and permit establishment of offices abroad.


(vi) Exporters are to be allowed to retain 100% of their export earnings in foreign currency accounts.

(vii) The procedures for non-resident direct investment and portfolio investment should be eased to facilitate inflows.

(viii) All participants in the spot exchange market should be allowed to participate in the forward exchange market.

The Tarapore Committee on CAC suggested that individual residents should be allowed to undertake financial transfers up to US $25,000 per annum. Indian mutual funds should be allowed to invest a total of US $500 million abroad. Indian banks should be able to increase their earnings by investing a part of their resources abroad and Indian companies should be freely able to set up joint ventures abroad if they find it remunerative.



To benefit fully from the CAC the corporate sector has to develop adequate skills for handling foreign exchange risks. When borrowing in foreign currencies. Indian companies have to take a conscious view of the relative strength of various currencies and, as such, the currency risk should be carefully assessed. While the opening up of the external sector would, no doubt, give Indian companies more avenues for borrowing.

They should not borrow exorbitantly from foreign countries. The corporate sector has much to gain and also much to lose in the way it handles the greater freedom to raise resources from the global financial market. This is the essence of CAC for the corporate sector.

CAC has the following advantages—First, since more capital would be available in the country, the cost of capital would fall. Secondly, just as there are gains from international trade, i.e. exports and imports, there are gains from trading in financial assets, i.e. gains from a free inflow and outflow of capital.

Thirdly, with increased competition, the differences among fi­nancial intermediates will gradually disappear and, as such, the system would be more effi­cient. Fourthly, tax levels would come down to international levels, thereby reducing erosion and capital outflow.

Fifthly, with lower rates of interest, the cost of government borrowing will come down and this will reduce fiscal deficit. Lastly, there will be a stronger discipline on domestic policies. CAC would lead to more efficient use of resources and ensure that macroeconomic policies are sound and contribute to sustained growth.



For making CAC a success the following preconditions are to be fulfilled:

(i) The gross fiscal deficit of the Centre is to be reduced from 5% to 3.5% of GDP.

(ii) The inflation rate has to be brought down to an average of 5% per annum.

(iii) The cash resolve ratio (CRR) has to be brought down to 3% from 4.5% while non- performing assets (NPA) to be reduced from 12% to 5%.

By making the RBI an autonomous organisation it will be possible to strengthen its ability to focus on achieving an inflation target The RBI has to fix an acceptable rate of inflation consistent with the IMF directive. At the same time, other macroeconomic policies are to be so formulated and implemented that the inflation rate does not rise.


A question is whether India Would be able to handle large capital inflows without adverse effects on the economy. It needs to be explained that, in India, there is an ex-ante monetisation of the fiscal deficit and, to the extent the inflows are large, the government borrowing programme would be put through without such monetisation.

The RBI can also undertake open market operations. In addition, the reserve requirements on non-resident deposit liabilities can be raised to moderate the inflows. As such, the adverse effects of large inflows, as experienced in certain other countries, would not pose a problem in India. Moreover, the essence of CAC is the liberalisation of outflows for residents and it is in this area that right action would provide the right signal that the country is moving towards CAC.

With the foreign exchange reserves at over US $65 billion, the time is aperture to undertake the first phase of measures on capital outflows for residents. The government has already announced certain measures liberalizing investment in joint ventures abroad up to 50% of the proceeds of GDRs, and further liberalisation of joint ventures abroad would be appropriate.

Liberalizing on banking capital flows, Indian investments (including mutual funds) abroad and financial capital transfers by Indian individual residents would be salutary measures in the present context. The move to CAC would impose a pressure on the financial system and it will be necessary for banks and non-bank financial entities to operate more efficiently to be able to meet the forces of international competition.

Interest rates should be fully deregulated and there should be total transparency to ensure that there are no formal or informal interest rate controls. The lending rate controls have already been abolished for cooperatives and regional rural banks—and there have been no adverse effects; and a similar lifting of controls for commercial banks would not be detrimental.


Foreign Exchange Resources and External Debt:

In the context of CAC the traditional assessment of adequacy of the foreign exchange reserves— i.e. relating to its imports—is no longer, by itself, a sufficient criterion. So other criteria should be taken into account such as debt service payments, leads and lags, short-term debt and port­folio stock and domestic currency.

Such liabilities such as short term debt and portfolio stock are at present equivalent to 70% of the level of reserves and this should be lowered to 60% and, in the interim any incremental short term debt and portfolio abilities should be accompanied at least by an equivalent increase in reserves.

However, it is felt that the present level of reserves is not unduly high, given the extent of short-term debt and portfolio flows. So if these short term liabilities were to flow out of India we would lose 70% of our reserves, leaving us with an inadequate balance of reserves to take care of our needs. The larger the short-term flows, the larger the need for reserves.


In India, up to 1956, a foreign securities-to-currency ratio of 40% was prescribed by law. It is unfortunate that this salutary statutory stipulation was abrogated and this opened up the floodgates for automatic monetisation of fiscal deficit. A minimum net foreign exchange as- sets-to-currency ratio of 40% should be prescribed by the law.

At the present time, this ratio is a little less than 70% and the policy prescription of the Committee is that actual ratio currently? Should be maintained. With large capital flows there can be an unsustainable appreciation of the rupee and, when the market assessment is that the appreciation is unsustainable, there can be sudden outflows and an uncontrollable spiral of depreciation of the currency.

The committee has, therefore, recommended that it would be desirable to evolve a system under which any correction of the real effective exchange rate (REER), which may be necessary, is brought about smoothly to avoid any sudden volatility in the exchange market. Ultimately, the RBI would need unfettered freedom to formulate an exchange rate policy but it would need to set out the type of policy it follows.

The objective of a stable REER is one such policy, but the RBI could follow some other broad policy. But, whatever be the exchange rate policy for credibility the broad parameters of the policy need to be clearly spelt out. Furthermore, if the extent of intervention is made known contemporaneously, the need for intervention would be minimised.

Now, what if the present situation changes and foreign capital flows out of India? As these outflows take place there would be a tightening of liquidity, interest rates would rise and stock prices would fall. This would, in a sense, force the Indian authorities to undertake correction of Indian macroeconomic policies. Such a situation Indian interest rates and stock prices would be attractive and Indians holding foreign financial assets abroad would find it attractive to invest in India.

This is precisely what happened in 1991-92. Under CAC, these responses would he faster and it is not as if Indian holding of assets abroad is all that bad an idea. Cynics could argue that Indian residents would join the bandwagon and also exodus from India.

This is unlikely as the liquidity conditions and stock prices would impose a heavy burden on such flows. There is also the question of non-resident Indians with inconvertible rupee assets. Since foreign exchange is not in short supply, such controls would become redundant.

The world is becoming a global village. We may have fears of integrating with the interna­tional economy but there is no way that we can stop the world from integrating with us. Which means that the choice is one between an orderly move to CAC or a de facto CAC imposed by the rest of the world. The choice is quite clear and we should endeavour to have an orderly move to CAC.