Currency Convertibility: Current and Capital
Recent Panama papers leak has again rekindled the old question, whether countries should go for Capital account convertibility?
To understand the answer to this, let’s first understand the concept of convertibility
Current Account Convertibility / Currency Convertibility
By convertibility of a currency we mean currency of a country can be freely converted into foreign exchange at market determined rate of exchange that is, exchange rate as determined by demand for and supply of a currency.
Capital Account Convertibility
By capital account convertibility we mean that in respect of capital flows, that is, flows of portfolio capital, direct investment flows, flows of borrowed funds and dividends and interest payable on them, a currency is freely convertible into foreign exchange and vice-versa at market determined exchange rate.
Thus, by convertibility of rupee on capital account means those who bring in foreign exchange for purchasing stocks, bonds in Indian stock markets or for direct investment in power projects, highways steel plants etc. can get them freely converted into rupees without taking any permission from the government.
Likewise, the dividends, capital gains, interest received on purchased stock, equity etc. profits earned on direct investment get the rupees converted into US dollars, Pound Sterlings at market determined exchange rate between these currencies and repatriate them.
Why Capital Account Convertibility is needed?
- The most obvious argument is that all developed countries are capital account convertible; hence this is an inevitable destiny of the developing countries in their path to development.
- Free global capital flows bring about better and more efficient allocation of the global pool of savings to the more productive uses. From the developing country’s viewpoint, free access to global capital markets increases available investible resources which augments domestic savings, reduces marginal cost of capital, and accelerates investment and growth.
- Open capital accounts facilitate portfolio diversification by investors in developed as well as developing countries.
- Because the feasibility of capital account convertibility rests on sound macroeconomic policy, it creates a sort of commitment for the country concerned to ensure better macroeconomic management, lest it is punished by the investors.
The Tarapore Committee mentioned the following benefits of capital account convertibility to India:
- Availability of large funds to supplement domestic resources and thereby promote economic growth.
- Improved access to international financial markets and reduction in cost of capital.
- Incentive for Indians to acquire and hold international securities and assets, and
- Improvement of the financial system in the context of global competition.
Accordingly, the Tarapore Committee recommended the adoption of capital account convertibility.
Under the system of capital account convertibility proposed by this committee the following features are worth mentioning:
(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 Deposit Receipts (GDRs) without RBI or Government approval to go in for external commercial borrowings within certain limits, etc.
(b) Indian residents would be permitted to have foreign currency denominated deposits with banks in India, to make financial capital transfers to other countries within certain limits, to take loans from non-relatives and others upto a ceiling of $ 1 million, etc.
(c) Indian banks would be allowed to borrow from overseas markets for short-term and long-term upto certain limits, to invest in overseas money markets, to accept deposits and extend loans denominated in foreign currency. Such facilities would be available to financial institutions and financial intermediaries also.
(d) All-India financial institutions which fulfill certain regulatory and prudential requirements would be allowed to participate in foreign exchange market along with authorised dealers (ADs) who are, at present, banks. In a later stage, certain select NBFCs would also be permitted to act as ADs in foreign exchange market.
(e) Banks and financial institutions would be allowed to operate in domestic and international markets and they would also be allowed to buy and sell gold freely and offer gold denominated deposits and loans.
Preconditions for Capital Account Convertibility:
The Tarapore Committee recommended that, before adopting capital account convertibility (CAC), India should fulfill three crucial pre-conditions:
(i) Fiscal deficit should be reduced to 3.5 per cent. The Government should also set up a Consolidated Sinking Fund (CSF) to reduce Government debt.
(ii) The Governments should fix the annual inflation target between 3 to 5 per cent. This was called mandated inflation target — and give foil freedom to RBI to use monetary weapons to achieve the inflation target.
(iii) The Indian financial sector should be strengthened. For this, interest rates should be folly deregulated, gross non-paying assets (NPAs) should be reduced to 5 per cent, the average effective CRR should be reduced to 3 per cent and weak banks should either be liquidated or be merged with other strong banks.
Apart from this thee essential pre-conditions, the Tarapore Committee also recommended that:
(a) RBI should have a monitoring exchange rate band of 5 per cent around Real Effective Exchange Rate (REER) and should intervene only when the RER 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 per cent to 20 per cent of the export earnings.
(c) The Government should remove all restrictions on the movement of gold.
It was generally agreed that foil convertibility of the rupee, both on current account and capital account was a welcome measure and is necessary for closer integration of the Indian economy with the global economy.
very nice article..
However there are drawbacks as well of adopting convertibility
Current account convertibility may lead to cost push inflation, domestic currency depreciation and can hamper capital inflow, the very basic purpose of convertibility.
Capital account convertibility may lead to instability of Rupee, can affect domestic companies taking loans from outside when foreign currency appreciates against rupee