Convertibility
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This document discusses the concept of currency convertibility. It defines convertibility as the ability to freely exchange a country's domestic currency for foreign currencies at market-determined exchange rates, without restrictions. It outlines the benefits of convertibility, such as facilitating international trade and capital flows. However, it also notes potential risks like currency volatility and capital flight if a currency is not properly managed after becoming convertible. The document then provides context on India's moves towards partial and eventual full convertibility of the rupee since independence.
Convertibility
- 1. Dr. Mohamed Kutty Kakkakunnan Associate Professor P G Dept. of Commerce N A M College Kallikkandy Kannur –Kerala - India
- 2. INTRODUCTION For the rapid growth of world trade and capital flows between countries convertibility of currency is desirable. Without free and unrestricted convertibility of currencies foreign exchange trade and capital flows between countries cannot take place smoothly To achieve higher rate of economic growth and thereby to improve living standards through greater trade and capital flows, the need for convertibility of currencies of different nations has been greatly felt.
- 3. The concept of convertibility formerly referred (in the era of the gold standard and some time thereafter) to the right to convert a currency into Gold at a given rate of exchange Nowadays it means the ability of residents and non- residents to exchange freely domestic currency for foreign currency without limit, whatever is the purpose of the transactions Convertibility can apply to currencies of countries that have fixed or flexible rate regimes
- 4. It is the ease with which a country's currency can be converted into gold or another currency The quality that allows money or other financial instruments to be converted into other liquid stores of value It is the ability of citizens to exchange a currency without restrictions or controls It also refers to the extent to which a foreign financial security such as a foreign currency or convertible loan can be exchanged for some other currency or financial asset
- 5. • The currency of a country can be freely converted into foreign exchange at market determined rate of exchange or the rate is determined by market forces (demand & supply) • Convertibility of rupee means that those who have foreign exchange can get them converted into rupees and vice-versa at the market determined rate of exchange. • Under convertibility of a currency there are authorized dealers of foreign exchange which constitute foreign exchange market. • Those who have foreign currency may sell it and those who need may buy at market rates.
- 6. Currencies that can be freely converted and globally traded are known as HARD or SAFE –HEAVEN or STRONG CURRENCY Serve as reliable and stable store of value. Long-term stability of purchasing power, associated country’s fiscal and political conditions and outlook and policy of the central bank issuing the currency Currencies whose value fluctuate widely and depreciate often, are known as soft currencies Associated country’s political and fiscal conditions and outlook, the central banks policy make a country's currency soft /hard
- 7. Fiat money A currency established as money by government regulation or law. Latin word ‘fiat’ means “let it be done” or “it shall be”. It is used in the sense of an order or decree. First used in China around 1000 AD Commodity money crated from a good, often a precious metal- gold or sliver, having uses other than as a medium of exchange Representative Money represents a claim on such a good (gold, silver)
- 8. SOFT AND HARD CONVERTIBILITY Soft convertibility entails the ability to freely exchange currencies at market determined exchange rate while the hard convertibility entails the right to freely exchange currencies at a given exchange rate The key distinction is here who bears the exchange risk: under soft convertibility the holders of currency do, while under the hard convertibility the country issuing the currency does
- 9. CAPITAL ACCOUNT CONVERTIBILITY AND CURRENT ACCOUNT CONVERTIBILITY CAC refers to the freedom to convert local financial assets into foreign financial assets and vice-versa, at market determined rates of exchange (Tarapore Committee, 1997) It is the freedom to convert Rupee into foreign currency and back for capital transactions It is associated with changes of ownership in foreign domestic financial assets and liabilities and embodies the creation and liquidation of claims on or by the rest of the world It is an inevitable step in development and thus cannot be avoided
- 10. Capital Account Convertibility in India • Capital account is made up of both the short- term and long-term capital transactions such as investments in financial and non-financial assets • The Capital Transaction may be Capital outflow or capital inflow • Capital account convertibility (CAC) or a floating exchange rate means the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange • Capital account convertibility allows anyone to freely move from local currency into foreign currency and back
- 11. • Capital Account Convertibility (CAC) is the freedom to convert local financial assets into foreign financial assets at market determined exchange rates. • Referred to as ‘Capital Asset Liberation’ in foreign countries, it implies free exchangeability of currency at lower rates and an unrestricted mobility of capital • India, at present has partial capital account convertibility with certain limits and caps on FDI • In India there are conflicting views regarding whether to move towards full convertibility of capital account or not • CAC and SS Tarapore Committee
- 12. • CAC is related with flows of portfolio capital, FDI flows, flows of borrowed funds and dividends and interest payable on them. • Under CAC, a currency is freely convertible into foreign currency and vice-versa at market determined exchange rate • 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 can get them freely converted into rupees without taking any permission from the government
- 13. • Dividends, interest, capital gains earned on direct investment can be converted into foreign currencies at market determined exchange rate between these currencies and repatriate them • Capital convertibility is risky, makes foreign exchange rate more volatile. It is introduced only some time after the introduction of convertibility on current account when exchange rate is relatively stable, deficit in balance of payments is well under control and enough foreign exchange reserves are available with the Central Bank
- 16. • Investors can diversify their portfolio internationally thereby decreasing their vulnerability to domestic shocks • Companies can go global by investing abroad. It should encourage Indian entrepreneurs to seek a global presence • CAC would bring in its wake international competition. This in turn would propel the economy to a higher level of efficiency
- 17. The Benefits of Capital Account Convertibility (Tarapore Committee) 1. Availability of large funds to supplement domestic resources and thereby promote economic growth. 2. Improved access to international financial markets and reduction in cost of capital 3. Incentive for Indians to acquire and hold international securities and assets 4. Improvement of the financial system in the context of global competition
- 18. Demerits • Since market determined exchange rate is generally higher than the previous officially fixed exchange rate, prices of essential imports rise which may generate cost-push inflation in the economy • If not properly managed and monitored, market exchange rate may lead to the depreciation of domestic currency. If a currency depreciates heavily, the confidence in it is shaken and no one will accept it in its transactions. As a result, trade and capital flows in the country are adversely affected. • Convertibility of a currency sometimes makes it highly volatile
- 19. Demerits contd… • Operations by speculators make it more volatile and unstable and adversely affect confidence in the currency and capital flight Eg:-South East Asian economies like Thailand, Malaysia, Indonesia, Singapore and South Korea - 1997-98 • Capital flight adversely affect economic growth and depreciation of currency discourage further inflow
- 21. ADVANTAGES OF CURRENCY CONVERTIBILITY 1.Encouragement to exports increasing profitability. 2. Encouragement to import substitution 3. Incentive to send remittances from abroad: 4. A self – balancing mechanism to correct BOP 5. Specialization in accordance with comparative advantage 6. Integration of World Economy
- 22. Convertibility of Indian Rupee At the time of independence the Foreign Exchange Regulation Act 1947 (FERA) was enacted with the object of regulating certain dealings in foreign exchange and the import and export of currency and bullion The focus of this act was on dealings in Foreign exchange and payments which directly affect foreign exchange resources. This act was later replaced by the Foreign Exchange Regulation, Act, 1973, which we call FERA. Later FERA was laid to rest and its successor is now FEMA
- 23. Those were the days of restriction on foreign exchange No one could keep foreign exchange without the knowledge and due permission of RBI The exchange control consisted of restrictions on the purchase and sale of foreign exchange by general public and payments to and from non-residents There were also restrictions on the import and export of Indian currency, foreign currency and bullion In those times, the exchange rates used to be different than what they are today.
- 24. In the olden days, RBI used to dictate its Official Exchange Rate on which Indian currency could be converted into foreign currency and vice versa All transactions in foreign exchange were governed by this official rate of exchange Means that Rupee was inconvertible at the market rate An importer who wanted to import from abroad was supposed to buy dollars at the RBI dictated rates An exporter who got dollars was supposed to sell them to RBI appointed Authorize agents at RBI decided rate This was the inconvertibility of Rupee
- 25. • MAJOR implications of these restrictions were: – Exchange rate was controlled by RBI – All foreign exchange received by any person in India had to sell to RBI authorized dealers at the rate fixed by RBI. • The main purpose of the control was to utilize the foreign exchange earned by the residents as per the priorities fixed by the government • Controls were necessary at that time as India was underdeveloped country and its exports were limited to agricultural product and raw material and it used to import only consumable goods
- 26. Now India is a fast developing country and one of the most preferred countries for investment by foreigners India needs foreign exchange to grow further Government has allowed convertibility of Rupee in phased manner on current account transactions But full convertibility of currency for capital account transactions is still a distant dream At present, Rupee is both convertible on capital account (partial) and current account
- 27. Full Convertibility of Rupee on Current Account • In 1992, Government announced intention to introduce the full convertibility on the current account in 3 to 5 years • Full convertibility means no RBI dictated rates and a unified market determined exchange rate regime • Encouraged with the success of the LERMS, the government introduced the full convertibility of Rupee in Trade account (means only merchandise trade no service trade) from March 1993 onwards • With this the dual exchange rate system got automatically abolished and LERMS was now based upon the open market exchange • The full convertibility of Rupee was followed by stability in the Rupee Rate in the next many months coming up
- 28. • In August 1994, declared full convertibility of Rupee on Current account with announcing some relaxations as per requirements of the Article VIII of the IMF These were: • Repatriation of the income earned by the NRIs and overseas corporate bodies of NRIs in a Phased manner in 3 years period • Ceiling for providing foreign exchange for foreign tours, education, medical treatment, gifts and services was made just an indicative • Above this ceiling, foreign exchange could be obtained for payments, while making a reference to RBI • Principal amount on the NRNR (Non Resident Non Repatriable) Accounts was non repatriable, the interest was made repatriable
- 29. ADVANTAGES OF CURRENCY CONVERTIBILITY 1. Encouragement to exports 2. Encourages import substitution 3. Incentive to remittances from abroad 4. Reduction in Malpractices 5. A self – balancing mechanism