Indian economy was under strict foreign exchange control system in the first four decades of planning. As part of the liberalisation of the Indian economy the Government of India (GOI) started dismantling the foreign exchange control system from 1991-92 onwards.
Partial Convertibility of the Rupee:
In 1991-92 the GOI adopted a dual exchange rate system under which the official rate of exchange was controlled and the market rate (or the black-market rate) of exchange was free to move or fluctuate according to forces of supply and demand.
All of India’s foreign exchange remittances—earned through export of goods or services or through inward remittances—were allowed to be converted in the following manner:
1. 60% of the export earnings could be converted at the market determined rate; this amount could be used freely for current account transactions and payments (i.e., for import of goods, for travel and for remittances abroad).
2. The balance 40% of the earnings should be sold to RBI through authorised dealers at the official rate of exchange; this amount of foreign exchange would be made available by RBI for financing preferred imports, bulk imports, etc.
The system of dual exchange rate of the rupee enabled the exporters to convert (at least) 60% of their export earnings at the market rate of exchange which was much higher than the official exchange rate. The GOI expected that this would provide adequate incentive to exporters and increase foreign exchange earnings.
Full Convertibility of the Rupee:
The existence of the dual exchange rate, however, hurts exporters and Indians working abroad who had to surrender 40% of their earnings at the official rate which was lower than the market rate of exchange. In order to remove this defect, the GOI announced full convertibility of the rupee on trade account. This measure enabled Indian exporters and Indian workers abroad convert 100% of their foreign exchange earnings at the market rates.
As the next step, the GOI announced the convertibility of the rupee on the current account, that is, liberalise the access to foreign exchange for all current business transactions including travel, education, medical expenses, etc. The basic objective of the GOI was to eliminate reliance upon illegal channels for such legitimate transactions. Full current account convertibility of the Rupee is in operation since the middle of 1990s.
This move was justified by India’s unprecedented success in the international sector, viz., spectacular rise in forex reserves, increase in exports, stagnation of imports in dollar terms and improvements in balance of payments on current account.
Meaning of Current Account Convertibility:
All current transactions of India with other countries—in respect of trade (merchandise), services such as education, travel, medical expenses, etc. and ‘invisibles’ such as remittances—are fully met through full convertibility of the Rupee into other currencies. The Rupee can be used to buy other currencies and other countries can buy Indian rupee without limit.
Meaning of Capital Account Convertibility (CAC):
Under CAC any Indian or Indian company is free to convert Indian financial assets into foreign financial assets and reconvert foreign financial assets into rupees at the prevailing market rate of exchange. This means that CAC removes all the restrains on international flows on India’s capital account.
Basic Difference between the Two Systems:
In case of current account convertibility, it is important to have a transaction involving payment or receipt of one currency against another currency (in respect of importing and exporting of goods, buying and selling of services, inward or outward remittances, etc.). In case of capital account convertibility, a currency can be converted into any other currency even without any transaction.
The RBI appointed in 1997 the Committee on Capital Account Convertibility with Mr. S. S. Tarapore as its Chairperson. The Tarapore Committee defined CAC as “the freedom to convert local financial assets into foreign financial assets and vice versa at market-determined rates of exchange.” CAC would permit anyone to move freely from local currency into foreign currency and back.
The basic purpose of CAC is to woo foreign investors by sharing an easy market to move in and move out and to send a strong message that Indian economy is strong and vibrant enough, and that India has sufficient forex reserves to meet any flight of capital from the country—whatever may be its extent.
Benefits of CAC:
The potential benefits from the scheme are:
1. Availability of large funds to supplement domestic resources and thereby promote faster economic growth.
2. Improved access to international financial markets and reduction of the cost of capital.
3. Incentive for Indians to acquire and hold international securities and assets.
4. Improvement (strengthening) of the financial system in the context of global competition.
Main Provisions Under the System of CAC:
(a) Indian companies would be allowed to issue foreign currency denominated bonds to local investors, to invest in such bonds and deposits to issue Global Depository Receipts (GDRs) without RBI or GOI approval and to go for external commercial borrowings subject to certain limits.
(b) Indian residents would be permitted to have foreign currency denominated deposits with banks in India, to make transfers of financial capital to other countries within certain limits, and to take loans from non-relatives and others up to a ceiling of $1 million.
(c) Indian banks would be permitted to borrow from overseas markets for short-term and long-term up to certain limits, to invest in overseas money markets, to accept deposits and extend loans denominated in foreign currency. Such facilities would also be available to non- bank financial institutions and financial intermediaries like insurance companies, investment companies and mutual funds.
(d) All India financial institutions which fulfill certain regulatory and prudential requirements would be allowed to participate in foreign exchange market along with banks which are the only Authorised Dealers (ADs) now. At a later stage, certain select Non-Bank Financial Companies (NBFCs) would also be permitted to act as Ads in foreign exchange markets.
(e) Banks and financial institutions would be permitted to operate in domestic and international markets. They would be allowed to buy and sell gold freely and offer gold denominated deposits and loans.
Preconditions for CAC:
According to the Tarapore Committee four preconditions have to be fulfilled to ensure full currency convertibility:
(i) Reducing Fiscal Deficit:
Fiscal deficit should be reduced to 3.5% of GDP.
(ii) Reducing Public Debt:
The GOI should also set up a Consolidated Sinking Fund (CSF) to reduce its debt.
(iii) Fixing Inflation Target:
The GOI should fix the annual inflation target between 3% to 5%. This is called mandated inflation target. The GOI should also give full freedom to the RBI to use monetary weapons to achieve the inflation target.
(iv) Strengthening the Indian Financial Sector:
For this, four conditions are to be satisfied:
(a) Full deregulation of interest rates,
(b) Reduction of gross Non-Performing Assets (NPAs) to 5%,
(c) Reduction of average effective CRR to 3% and
(d) Liquidation of weak banks or their merger with other strong banks.
Apart from these, the Tarapore Committee also recommended that:
(a) The RBI should fix an exchange rate band of 5% around real effective exchange rate and should intervene only when the Real Effective Exchange Rate (REER) is outside the band.
(b) The size of the current account deficit should be within manageable limits and the debt service ratio should be gradually reduced from the present 25% to 20% of the export earnings.
(c) To meet import bill and to service external debt, forex reserves should be adequate and range between $22 billion and $32 billion.
(d) The GOI should remove all restrictions on the movement of gold.
Dangers of CAC:
There are certain dangers associated with CAC:
(i) Contagion Effect:
The Asian financial crisis of 1997 makes it abundantly clear that financial crisis from one country may be easily transmitted to other countries having convertible currencies. Any adverse development in overseas market will affect India’s economy equally adversely—as was amply shown in the recent world recession of 2008-09.
A convertible currency shows greater fluctuation than an inconvertible one and thus gives greater scope for destabilising speculation. This creates uncertainty and reduces the volume of trade.
(iii) Outflow of Funds:
Indians will have a tendency to buy more assets abroad and India may become a debtor nation like the USA since it may develop a tendency to spend beyond its means.
(iv) No Ceiling on External Debt:
Finally, there will be no ceiling on India’s external debt since the GOI—knowing well that rupee can now be used for debt serving—will borrow without limits.
On balance it seems full convertibility of the rupee—both on current account and capital account—is a welcome measure. This is necessary to achieve closer integration of the Indian economy with the global economy.