Explain Currency Convertibility

CURRENCY CONVERTIBILITY :

Floating of a currency is a pre-requisite to convertibility of a currency. While floating deals

with the method used to establish the value of the currency, convertibility deals with the

operational ease with which domestic currency is allowed to be converted into foreign

currency. Convertibility therefore represents procedural simplification of foreign exchange

transactions for persons dealing in a currency.

Although the INR was floated, which means market demand / supply factors would

determine the exchange rate, the transactions constituting the demand / supply continued

to be controlled by the RBI. Most transactions required licences or permits from RBI.

Effectively, the RBI controlled the elements forming the demand / supply for the foreign

currencies. If the exchange rate determined by the market was to truly represent the

economy, then it was essential to free the transactions constituting the demand and supply

for foreign currencies.

Foreign Exchange transactions arising in an economy can be broadly classified as :

1. Export and Import of goods and services.

2. Personal remittances.

3. Investments and Redemptions.

4. Borrowing and Lending.

All the above transactions pertaining to an economy over a given period are captured in

the Balance of Payments Account (BOP) for the country. All the above transactions get

recorded in either the Current or the Capital Accounts in the BOP The concept of

convertibility is thus viewed at two levels Current account Convertibility and Capital

Account Convertibility (CAC).

CURRENT ACCOUNT CONVERTIBILITY :

In August 1994, the 1NR was made convertible on current account tranaetiofls. This

means that all impediments such as licensing etc. were removed in so far as foreign

exchange transactions involved purchase / sale of foreign currencies for permitted imports

and exports of goods and services. Convertibility does not mean unlimited ability to

convert domestic currency. Limits were placed on conversion allowed for several

categories of activities. Eg: Currently, each resident individual is permitted to purchase

foreign currencies only to the extent of USD 10000 per calendar year for international

tourism described as Basic Travel Quota.

The Current Account of the Balance of Payments represents the cash / ready transactions

which have an immediate impact on the demand – supply equilibrium. Making the 1NR

convertible on Current Account thus implies that not only is the currency valued by the

market but the factors contributing to the rate determination are also decontrolled thereby

ensuring that the exchange rate truly represents the economic status of the currency.

CAPITAL ACCOUNT CONVERTIBILITY (CAC) :

In 1997, a committee headed by Mr S.S. Tarapore, the Deputy Governor of Rf, was

constituted to recommend step-wise implementation of capital account convertibility

(CAC). The recommendations of this committee could not be implemented because of

international developments such as the South East Asian Crisis, currency failures in Brazil

and Russia and events such as 11th September, 2001 in the US.

While there is no formal definition of Capital Account Convertibility, the committee under

the chairmanship of Mr S.S. Tarapore defined CAC as the freedom to convert local

financial assets into foreign financial assets and vice – a – versa at market determined

rates of exchange. It is associated with changes of ownership in foreign / domestic

financial assets and liabilities in the form of Receivables and Payables and involves the

creation and liquidation of claims on, or by, non-resident entities.

The critical preconditions specified by the committee in the ‘road-map for introducing CAC

were :

 Fiscal consolidation.

 Control of inflation within targeted levels.

 Strengthening of the Financial System.

 Maintenance of domestic economic stability.

 Adequate foreign exchange reserves.

 Restrictions on inessential imports.

 Comfortable current account position.

 An appropriate industrial policy and a friendly investment climate