In this article we will discuss about:- 1. Current Account Convertibility of the Rupee 2. Capital Account Convertibility of the Rupee 3. Recommendations 4. Move towards Capital Account Convertibility.
Current Account Convertibility of the Rupee:
Under Article VIII, Sections 2, 3 and 4 of the IMF the member countries of the IMF are obliged to restore current account convertibility of their currencies.
This Article stipulates that the member countries should:
(a) Have no restrictions on current payments (capital account restrictions are allowed); and
(b) Avoid discriminatory currency practices (including multiple exchange rates).
Current account convertibility is defined as the freedom to buy and sell foreign exchange for the following international transactions:
(a) All payments due in connection with foreign trade, other current business, including services, and normal short-term banking and credit facilities;
(b) Payments due as interest on loans and as net income from other investments;
(c) Payments of moderate amount of amortization of loans or for depreciation of direct investments and
(d) Moderate remittances for family living expenses.
In his budget speech for 1992-1993, the Finance Minister of India announced the partial convertibility of rupee on the current account. This measure was a part of the policy of economic reforms and it was in line with the global trend towards currency convertibility. By 1994, 97 countries including India had acquired Article VIII status on the current account convertibility. Many more countries have joined them subsequently.
Under the Liberalised Exchange Rate Management System (LERMS) introduced in March 1992, 60 percent of all receipts under current transactions comprised of merchandise exports and invisible receipts could be converted at the free market rate quoted by the authorised dealers. In case of the remaining 40 percent of receipts, the rate applicable was the official rate of exchange.
This provision of 40 percent of total foreign exchange under the current account was meant to cover exclusively the government requirements and to enable the import of essential commodities. Moreover, the foreign exchange was also to be made available to meet 40 percent of the value of the advance licenses and special import licenses.
A major step in the direction of current account convertibility was adopted by India in March 1993, when the foreign exchange budget was abolished; the exchange rate was unified and; the transactions on trade account were freed from exchange control. The determination of exchange rate of the rupee was left to the market forces.
On February 1994, the RBI announced the liberalisation of exchange control regulations upto a specified limit relating to- (a) foreign currency accounts of exchange earners, (b) basic travel quota, (c) studies abroad, (d) gift remittances, (e) donations, and (f) payments due to certain services rendered by foreign parties. Some more relaxations on current account payments were announced by RBI on August 19, 1994 in respect of different schemes related to foreign currency non-resident accounts.
The rupee was made fully convertible on the current account of the balance of payments in August 1994. The Indian exporters to the Asian Clearing Union (ACU) countries and receiving export proceeds in rupee or in Asian Monetary Union (AMU) or in the currency of the participating country, were allowed to receive payments in any permitted currency through banking channels, provided it is offered by the overseas buyer in the ACU country.
The relaxations were made also in respect of the release of foreign exchange for foreign travel, interest income on Non-Resident Non-Repatriable (NRNR) rupee deposits and remittances to relatives abroad. The Reserve Bank of India announced some major relaxations in exchange control in January 1997. The monetary ceilings prescribed for remittance of foreign exchange for a wide range of purposes were removed and authorised dealers could now allow remittances for those purposes without prior clearance from the RBI.
Capital Account Convertibility of the Rupee:
Full convertibility of rupee was not introduced by the government as it was risky in the conditions of large deficit on current account faced by the country. Moreover, the intention was also to make the foreign exchange available at low prices for making essential imports.
The cautious approach in respect of full convertibility of rupee was fully justified in view of the Mexican crisis and subsequent East Asian crisis. The full convertibility of rupee required the capital account convertibility of rupee along with the current account convertibility.
Capital account convertibility implies the right to transact in financial assets with foreign countries without restrictions. When there is completely free capital account convertibility, an Indian can dispose of his assets in India and take the money out of the country without hindrance.
Although the rupee is not fully convertible on capital account, yet in respect of some elements, it had convertibility on capital account even earlier. For instance, capital account convertibility existed before for foreign investors and Non-Resident Indians for undertaking direct and portfolio investment in India.
In addition, Indian investments abroad upto U.S. $ 64 million were eligible for automatic approval by the RBI subject to certain conditions. No doubt, capital account convertibility can result in the large inflow of capital but, if the conditions are unfavourable in the home country, there is grave risk of capital flight from the home country, greater volatility in exchange rates and interest rates and wide fluctuations in exchange reserves. It is therefore prudent to undertake capital account convertibility only sometime after experimenting with the current account convertibility.
The full convertibility of currency, including also capital account convertibility, should be introduced only after some preconditions are met:
(i) There should be domestic macro-economic stability.
(ii) The domestic enterprises should have reasonable degree of competitiveness.
(iii) The country should have trade-oriented development strategy and adequate incentives for export growth.
(iv) The country should have an appropriate industrial policy and a favourable investment climate.
(v) The country should have comfortable current account position.
(vi) The country should have adequate foreign exchange reserves.
The full convertibility of currency has the following chief merits:
(i) The convertibility or floating of rupee would indicate the true value of it.
(ii) If the free market rate were higher than the official rate of exchange, the profitability of exports would increase. As a result, the exporters would be induced to raise exports.
(iii) In case the exportable products have high import-content, to that extent, a higher market-determined rate of exchange can reduce profitability of exports. In such a situation, the import substitution would receive a boost not only in respect of exportable products but also in other imported products.
(iv) A higher exchange rate of rupee can stimulate the remittances by the Non-Resident Indians (NRIs).
(v) As a result of full convertibility of rupee, the illegal remittance would not remain attractive and, consequently, larger remittances from abroad would take place through proper channel.
(vi) If, along with convertibility, there is liberalisation of import of gold, there would be an effective deterrent to the smuggling of gold.
(vii) The fully convertible currency can result in automatic self-balancing of total foreign receipts and payments.
(viii) Full convertibility of rupee will enable the Indian investors to hold internationally diversified investment portfolio.
Full convertibility of rupee has some demerits:
(i) If difficulty arises in keeping the current account balance under control, the free market exchange rate is likely to rise steeply.
(ii) If full convertibility causes appreciation of rupee, the possibility of reduction in exports cannot be ruled out.
(iii) If there is appreciation of rupee, consequent upon its free convertibility, the imports are likely to increase and have adverse effect on BOP deficit.
(iv) If the full convertibility causes depreciation of rupee, the import prices are likely to increase. As a result, the inflationary pressures can get intensified.
(v) Full convertibility of rupee can greatly strengthen the speculative tendencies and consequent instability in the whole system.
Recommendations of Committee on Capital Account Convertibility:
On February 28, 1997, the RBI instituted the Committee on Capital Account Convertibility (CAC) under the chairmanship of S.S. Tarapore for making a review of international experience related to capital account convertibility; to specify preconditions for the introduction of full CAC; to specify the sequence and time frame in which measures suggested by the committee are to be adopted and; to suggest domestic policy measures and changes in institutional framework in accordance with the specified sequence. This Committee submitted its Report on May 30, 1997.
The main recommendations of the Committee were as follows:
(a) The implementation of CAC should be spread over a period of three years (1997-98 to 1999-2000). This implementation should be sequenced with the progress towards the attainment of the preconditions/signposts stipulated for the relevant year. The implementation of measures should be accelerated or decelerated depending upon the assessment made by the authorities.
(b) The crucial preconditions /signposts for CAC in India are fiscal consolidation, a mandated target of inflation and the strengthening of the financial system. In respect of fiscal consolidation, Committee specified that centre’s gross fiscal deficit to GDP ratio should be brought down from 4.5 percent in 1997-98 to 4.2 percent in 1998-99 and further to 3.5 percent in 1999-2000, along with a reduction in the states’ deficit and quasi fiscal deficit. About the mandated inflation rate, the Committee suggested that it should be on an average 3.5 percent rate over the three-year period.
The inflation mandate should be approved by the Parliament, and the Parliament should alone be competent to make an alteration in the mandate under clear cut and transparent guidelines about the circumstances in which change in target could be made. About the strengthening of financial system, the Committee specified that the interest rates should be fully deregulated in 1997-1998. There should be no formal or informal controls on interest rates.
The average effective Cash Reserve Ratio (CRR), which was 9.3 percent in 1997-98, should be reduced to 3.0 percent in 1999-2000. The gross Non-Performing Assets (NPAs) should be drastically reduced from the tentative estimate of 13.7 percent of total advances in March 1997 to 5.0 percent in 1999-2000. In addition, a few important macro-economic indicators, viz. exchange rate policy, the balance of payments and the adequacy of foreign exchange reserves should be assessed on the on-going basis.
(c) As regards to the international experience, the Committee found that the countries that had strong fundamentals were less vulnerable to back tracking and the re-imposition of control.
The Committee observed that most countries considered strong balance of payments fiscal consolidation and strengthening of financial system as the necessary prerequisites for the success of capital account convertibility. In the countries studied by the Committee, there was the removal of restrictions on inflows and related outflows by the non-residents and residents.
It was followed by the removal of restrictions on outflows by the residents. Among the latter, corporates and non-corporates in those countries received generally the preferential treatment. They were followed by banks and individuals. In the transition to CAC, most of these countries maintained or had to impose some controls on capital inflows.
(d) The Committee made several recommendations for preparing the financial system for CAC. These included the removal of market imperfections, uniform treatment of non-resident and resident liabilities for purposes of reserve requirements, improvement of risk management, more stringent capital adequacy and prudential standards, greater autonomy of commercial banks and financial institutions and an effective supervisory system.
(e) The CAC Committee made recommendations about the timing and sequencing of a series of measures phased over 1997-2000 period.
The recommendations are:
(i) For resident corporate/business, the measures suggestion included- liberalization of measures in respect of issue of foreign currency denominated bonds (rupee settlements), transfer of financial capital abroad, loans from non-residents, opening of offices abroad, direct investments abroad, repatriation of dividends and the use of foreign exchange by the exporters and the foreign exchange earners, long-term External Commercial Borrowing (ECB) to be kept outside ceiling, queuing for the implementation of ceiling for avoiding crowding out of the small borrowers by the larger ones and the same recommendation for FCCB/FRNs as for the ECB.
(ii) In the case of resident banks, the CAC Committee recommended liberalisation in the matters of bank’s borrowing from overseas market, use of funds and repayments, acceptance of deposits and extension of loans in foreign currencies, investment in overseas markets, fund based/non-fund based facilities to Indian joint ventures and buyers’ credit acceptance for financing importers purchases from India.
(iii) In respect of non-resident banks, the recommendations included allowing of forward cover in Rupee Account, cancelling/re-booking, enhanced overdraft limit and limited investment.
(iv) Overseas investments by SEBI registered Indian investors including Mutual Funds and short- term borrowing by the All India Financial Institutions within limits.
(v) Removal of maturity restrictions on FII investments in debt instruments and investment in rupee debt securities to be subjected to a separate ceiling and not ECB ceiling.
(vi) In the case of resident individuals, the recommendations included the allowing of foreign currency denominated deposits, foreign capital transfer and liberalisation of repatriation norms.
(vii) In regard to non-residents, the Committee suggested that capital transfers from non-repatriable assets held in India should be allowed subject to an appropriate ceiling.
(viii) Forward market, along with its derivatives and futures should be allowed.
(ix) The CAC Committee recommended that there should be participation in the international commodity market.
(x) There should be deregulation of deposit rates with the removal of minimum period restrictions.
(xi) There should be level playing field for all banks, financial institutions and non-bank financial institutions regarding reserve requirements and prudential norms.
(xii) There should be development of Treasury bill market and access to financial institutions in it.
(xiii) The primary and satellite dealers should be allowed more prominent roles.
(xiv) There should be the setting up of Office of Public Debt to handle part of issue of dated securities and treasury bills.
(xv) There should be the development of gold market with participations of banks, and financial institutions, gold denominated deposits and loans, and gold derivatives.
(xvi) The requirement of prior approval of the RBI should be replaced with subsequent reporting. Such requirement should be dispensed with in case of disinvestment in a number of cases concerning investments by both residents and non-residents.
Move towards Capital Account Convertibility:
In pursuance of the recommendations of the CAC Committee a series of measures were adopted during 1998-2003 period. These were followed up with more measures during 1998-2002 for further liberalisation on the capital account.
In continuation of the phased programme of capital account convertibility, the following measures were adopted in 2002-03:
(i) Removal of the existing limit of U.S. $ 20.000 for remittance under ESOP scheme.
(ii) Discontinuation of limits on trade-related loans and advances by EEFC account holders. Such transactions will, however, continue to be reported to the RBI.
(iii) General permission to retain ADR/GDR proceeds, abroad for future foreign exchange requirements.
(iv) Permission to corporates, that have set up their offices and branches abroad, to acquire immovable property overseas for their business/ staff residential purposes.
(v) Permission to listed Indian companies to invest abroad in companies listed in recognised overseas stock exchanges, and having at least 10 percent shareholding in a company listed on a recognised stock exchange in India on January 1 of the year of investment. Such investments should not exceed 25 percent of the Indian company’s net worth on the date of the last audited balance sheet.
(vi) Permission to mutual funds to invest abroad in companies, listed on overseas stock exchanges and having at least 10 percent shareholding in a company listed on a recognised stock exchange in India on January 1 of the year of investment. The overall cap for investment abroad by mutual funds has been increased to U.S. $ 1 billion.
(vii) Permission to individuals to invest abroad in companies, listed on overseas stock exchanges and having at least 10 percent shareholding in a company listed on a recognised stock exchange in India on January 1 of the year of investment.
(viii) Permission to the authorised dealers to allow remittance, with regard to transfer of assets in India up to U.S. $ 1 million out of balances held in NRO accounts/sale proceeds of assets, subject to Indian taxes.
In the subsequent years also, the liberalisation policy measures in these directions continue to be undertaken.
For setting put a roadmap towards fuller capital account convertibility, the Reserve Bank of India constituted a Committee headed by S.S. Tarapore in March 2006. It submitted its Report on July 31, 2006.
In view of the risks involved in the fuller convertibility of the Rupee, the Committee emphasized upon the phased programme of relaxing the capital controls. The time frame for the movement towards fuller convertibility involved three phases- Phase I (2006-07), Phase II (2007-09) and Phase III (2009-11).
The Tarapore Committee (II) recommended that certain indicators/targets should be met in respect of the Fiscal Reforms and Budget Management (FRBM); shift from the present measure of fiscal deficit to a measure of Public Sector Borrowing Requirement (PSBR); segregation of government debt management and monetary policy operations through the setting up of the office of Public Debt and independent of the RBI; imparting greater transparency in the conduct of monetary policy and a set of reforms in banking sector including a single banking legislation and reduction in the share of government/RBI in the capital of public sector banks; keeping the current account deficit to GDP ratio under 3 percent; and formulation of appropriate indicators of adequacy of reserves to cover not only import requirements but also liquidity risks associated with present types of capital flows, short term debt obligations and broader measures including solvency.
After laying down the roadmap, the Committee recommended some significant measures such as:
(i) The raising of the overall external commercial borrowing (ECB) ceiling for automatic approval gradually;
(ii) Keeping ECBs of over 10 year maturity in Phase I and over 7-year maturity in Phase II and outside the ceiling and removing end-use restrictions in Phase I;
(iii) Monitoring import-linked short-term borrowings in a comprehensive manner and reviewing the per transaction limit of US $ 20 million;
(iv) Raising the limits for outflows on account of corporate investment abroad in phases from 200 percent of net worth to 400 per cent of net worth;
(v) Providing Exchange Earners Foreign Currency Account Holders access to foreign currency current/saving accounts with cheque facility and interest bearing term deposits;
(vi) Prohibiting FIIs from investing fresh money raised through Participatory Notes (PN), after providing existing PN-holders an exit route so as to phase them out completely within one year, allowing non-resident corporates (and non-residents) to invest in the Indian stock markets through SEBI-registered duties including mutual funds and portfolio management schemes who will be individually responsible for fulfilling Know Your Customer (KYC) and Financial Action Taken Force (FATF) norms;
(vii) Permitting institutions/corporates other than multilateral ones to raise Rupee bonds (with an option to convert into foreign exchange) subject to an overall ceiling which should be raised gradually;
(viii) Linking the limits for borrowing overseas to paid-up capital and free reserves, and not to unimpaired Tier I capital, as at present, raising it substantially to 50 percent in Phase I, 75 percent in Phase II and 100 percent in Phase II;
(ix) Abolishing the various stipulations on individual fund limits and the proportion in relation to net asset value;
(x) Raising the overall ceilings from the present level of US $2 billion to US $ 3 billion in Phase I, to US $ 4 billion in Phase II and to US $ 5 billion in Phase III;
(xi) Raising the annual limit of remittance abroad by individuals from existing US $ 25,000 per calendar year to US $ 50,000 in Phase I, US $ 100,000 in Phase II and US $ 200,000 in Phase III;
(xii) Allowing non-residents (other than NRIs) access to Foreign Currency Non-Resident [FCNR (B)] and Non-Resident (External) Rupee Account [NR(E)RA] schemes.
The government followed this phased roadmap during the last few years. However, the global recession during 2008-09 caused a temporary roadblock in achieving fuller convertibility of Rupee on capital account. In this regard, it must be recognised that gradual and restrained move in that direction greatly reduced the severity of recession upon India.