Currency Convertibility, Current and Capital Account Convertibility, Liberalized Exchange Rate Management scheme,

 

Currency Convertibility:

Currency Convertibility refers to the ability to convert domestic currency into foreign currencies and vice versa to make payments for Balance of Payment transactions at market determined Exchange Rate.

Currency may be convertible on both current and capital accounts.

Current Account Convertibility of Currency: 

Current Account convertibility means that currency is convertible for the purposes of Current Account  ie, exports and imports of merchandise and invisibles only. 

Capital Account Currency of Currency: 

Capital account convertibility means convertibility on Capital Account. 

• Degree of BOP convertibility of any country depends on the level of economic development and degree of maturity of its financial markets. 
• So, Advanced Economies (AEs) are almost fully convertible while Emerging Market Economies (EMEs) are convertible to different degrees.

Advantages of Currency Convertibility:

• Market rate remains generally higher than the officially determined Exchange Rate. 
• Exporters receive more Rupees for the received Foreign Exchange from  exports  and hence increasing exports. 
• Being convertible there is easy access of foreign currency ,hence increasing trade .
• It acts as a self balancing mechanism to deal with BOP deficit.
• If BOP deficit is due to over-valued exchange rate, the currency depreciates as it is market driven which gives boost to exports by lowering their prices on the one hand and discourages imports by raising their prices on the other. 
• In case of surplus BOP, due to the under-valued exchange rate, the currency appreciates increasing the imports.
• Currency convertibility is prerequisite for the success of globalization giving boost to the inte­gration of the world economy. 

Convertibility of Indian Rupee:

In the seventies and eighties many countries switched over to the free convertibility of their currencies into foreign exchange.

 As a part of 1991-Economic reforms, Rupee was made partially convertible from March 1992 under the “Liberalised Exchange Rate Management scheme”

Liberalized Exchange Rate Management scheme (LERMS):

• 60 % of all receipts on current account could be converted freely into Rupees at market determined exchange rate quoted by authorised dealers, while 40 per cent of them was to be surrendered to Reserve Bank of India at the officially fixed exchange rate.
• These 40 per cent exchange receipts on current account was meant for meeting Government needs for foreign exchange and for financing imports of essential commodities. 
• This partial convertibility of Rupee on current account was adopted so that essential imports could be made available at lower exchange rate to ensure that their prices do not rise much. 
• Further, full convertibility of Rupees at that stage was considered to be risky in view of large deficit in balance of payments on current account. 
• In March’ 1994, Rupee was fully convertible at current account, However, on capital account Rupee remained nonconvertible.

Capital Account Convertibility of Rupee: 

Capital Account Convertibility is conversion of Indian financial assets into foreign financial assets and back, at an exchange rate fixed by the foreign exchange market and not by RBI.

The Tarapore Committee mentioned the following benefits of capital account convertibility to India:

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, and

4. Improvement of the financial system in the context of global competition.

Accordingly, the Tarapore Committee recommended for capital account convertibil­ity.

Preconditions for Capital Account Convertibility:

• Fiscal deficit should be 3.5 per cent.
• The Governments should fix the annual inflation target between 3 to 5 %
• Interest Rates should be deregulated, gross non-paying assets (NPAs) should be reduced to 5 per cent, the CRR should be reduced to 3 %.

Why Tarapore recommendations could not implemented:

• The difficulty with the Tarapore Committee recommendation was that it recommended Capital Account convertibility to be achieved in a 3 year period – 1998 to 2000.
• The period was too short and the pre-conditions and the macroeconomic indicators could not be achieved in such short period. 
• The Committee failed to appreciate the political instability in the country at that time, and the complete absence of political will and vision to carry forward the process of economic reforms and economic liberalisation.
• The outbreak of Asian financial crisis at this time was also responsible for shelving the recommendation of Tarapore Committee.

The second Tarapore Committee had drawn up a roadmap for 2011 as the target date for fuller capital convertibility of Rupee and mentioned that the conditions were quite favourable.

But economic events, especially global financial crisis of 2007-09,greatly affected the economic situation and hence recommendations could not be implemented.

Issues with Currency Convertibility:

• Market determined Exchange Rate is higher than the officially fixed exchange rate, prices of essential imports rise which may generate cost-push inflation in the economy. 
• If current account convertibility is not properly managed and monitored, market exchange rate may lead to the depreciation of domestic currency and speculations make it more volatile.
• Such situation can lead to situation of Capital Flight from the country as it happened in 1997-98 in case of South East Asian Tigers. 
• Empirical evidences suggests that free capital accounts were not necessary for the phenomenal growth recorded by countries in the diverse parts of the world. 
• All developed countries have adopted full convertibility, but the 2008 crises of USA and current turmoil of European Union has raised several questions while China has written its success story without full capital account convertibility.
• As Jagdish Bhagwati observes in his celebrated 1998 paper, “After all, China and Japan, different in politics and sociology as well as historical experience, have registered remarkable growth rates. Western Europe’s return to prosperity was also achieved without capital account convertibility.”
• Any deterioration in fiscal conditions, inflation management, balance of payments, or any other macroeconomic shock may cause a cessation or reversal of capital flows

What does the regime for capital account transactions look like today?:--

• There is virtually no restriction on Foreign Direct Investment (FDI). 
• Any foreign individual or firm or any other association of people can invest in any Indian company or set up an Indian company through FDI which essentially means long term engagement with influence on management. 
• FDI has a nexus with a whole lot of other issues including taxation, domestic investment climate, infrastructural support, ease of business and so on. 
• Reforms in such issues  will be far more that any liberalisation of capital flows into Indian financial markets.