CONVERTIBILITY OF CURRENCY : EASY ACCESS TO FOREX

 Vashistha Ray

Convertibility of currency (Rupee) implies freedom to convert our currency into foreign currency at market exchange rate without limit and government permission. It means our freedom to buy foreign currency in any amount at market-exchange rate .it also implies our freedom to sell Indian rupee against foreign exchange. Under convertibility of currency, those who have foreign currencies can get them converted into Indian rupee and vice-versa at market rate of exchange.

                Convertibility of currency is necessary to promote foreign trade and capital flours among nations. Without convertibility of currency, foreign trade and capital flows can not take place among different countries of the world. It is also required t o promote tourism and movement of people across globe.

EXCHANGE CONTROL

Exchange control implies lack of freedom to convert our currency into foreign currency at market rate of exchange. It means restriction or prohibition on acquiring foreign exchange without government permission. Under exchange control, people are not allowed or allowed in a limited way to buy foreign currency at market exchange rate, what so ever the purpose may be.

                India pursued a policy of exchange control for a longer period of time, despite the fact that India had been one of the founding members of the IMF which aims to remove exchange control and promote multi-lateral payment system.

                In Pre-reform period (before 1991) the government exercised exchange control using FERA provisions and imposing restrictions as foreign trade and capital flows. Imports were controlled and imports of “unnecessary” goods were not allowed. All external payments had to be made through the authorized dealers of RBI and exports earnings had to be surrendered to RBI to obtain rupee in return.

                Exchange control was exercised by the government in order to prevent the wasteful uses of foreign currencies and put them to the purchase/ import of capital goods (plants & machines) from other countries, So that the production capacity of our economy could be augmented.

                However, the policy of exchange control made importers, exporters and general people miserable. Restriction  on imports deprived the citizen of the country of a variety of goods and services. Exporters had to give up their earned foreign currency to government at a very low value in exchange for rupee. And, the general people could not make frequent trips to foreign countries for want of foreign exchange.

PARTIAL CONVERTIBILITY OF THE RUPEE ON CURRENT A/C

During 1992-93, the Government of India introduced dual exchange rate system. Under this system:

(a)    The GOI accepted the existence of two exchange rates in the country- the official rate of exchange (which was controlled) and the market rate of exchange (which was free to move and fluctuate according to market conditions).

(b)   All foreign exchange earned either through exports or through remittances were allowed to be converted is the following manner.

-          60 percent of the export earning could be converted at the free market determined rate: and this amount could be freely used for current A/c transaction and payments (i.e for import of goods, remittances, trade etc.)

-          40 percent of the export earning should be sold to RBI through authorized dealers at the official rate of exchange; this amount of foreign exchange would be made available by RBI for financing preferred and bulk imports, such as plant & machinery.

The Introduction of dual exchange rate system paved the way for the partial convertibility of rupee. This enabled the exports to convert at least 60% of their export earning at the market rate of exchange which was much higher than the official exchange rate.

                Before the introduction of dual exchange rate system, all export earnings were required to be converted into rupee at official rate of exchange which was very low.

FULL CONVERTIBILITY OF THE RUPEE ON CURRENT A/C

The partial convertibility of the rupee boosted India’s exports and our foreign currency reserve increased from $5.8 billion to  $25.2 billion between 1990-91 and 1994-95.

                However, the incentive was not sufficient to promote exports and increase foreign exchange reserve to a significant degree. The existence of the partial convertibility of the rupee hurt exporters and Indians working abroad who had to surrender 40 percent of their earnings at the official rate which was lower that market rate.

                It was to remove this defect, the then Finance Minister Dr.Manmohan Singh announced full convertibility of rupee on trade account in March 1993 while presenting the budget for 1993-94.

                Full convertibility of Rupee on trade account implies that now Indian exporters and people working abroad could convert their 100 percent earning at market rate of exchange. It also means that these earning could be freely used for import payments. Importers could also convert Indian rupee in any quantity into foreign currency to make import payments without government permission.

                Full convertibility of rupee on trade A/c was a solid step towards full convertibility of the rupee on current A/c , which was announced by the GOI on 28^th Feb 1994. With the full convertibility of Indian Rupee on current A/c, now rupee has become fully convertible into foreign currencies for all current transactions such as export, import, foreign travel, education, medical expenses and remittances etc.

CONVERTIBILITY OF RUPEE ON CAPITAL A/C

Current A/c consists of all transactions of current nature such as export and imports of goods and services, foreign travel, education, medical expenses and remittances. Capital A/c consists of all financial transactions of long-term nature among countries of the world. It includes external lending or borrowing, inflows and outflows of FDI/FPI, NRI deposits etc. freedom to convert rupee into foreign currencies and vice-versa at market rate of exchange for these purpose is called convertibility of rupee on capital A/c.

                Thus, under capital A/c convertibility, those who bring in foreign capital to lend or invest in Indian market (FDI/FPI) can freely convert their currencies into Indian rupee. Likewise, interest, return or dividend earned through these investment can be converted back into foreign currencies and sent back to foreign countries. Indian people, institutions and firms can also freely convert Indian rupee into foreign currencies in order to invest or level in foreign countries.

BENEFITS: -

Convertibility of rupee on capital A/c removes all barriers on international flow of capital. Inflow and outflow of capital becomes rapid and frequent. The benefits of CAC can be listed as below:-

i.                     Availability of large funds to supplement domestic resources and there by promote economic growth.

ii.                   Improved access to international financial markets and reduction in cost of capital.

iii.                  Incentives for Indians to acquire and hold foreign securities & Assets.

PROBLEMS: - 

i.                     Convertibility of a currency makes it highly volatile. Further, operates by speculators make it more volatile. When a currency depreciates due to speculative activity, the confidence in the economy is shaken and this is capital flight from the country. Inflow of capital is also discouraged as due to depreciation of the currency profitability of investment in the economy is also adversely affected.

ii.                   Since market rate of exchange is higher than official exchange rate, imports of essential commodities become costlier.

iii.                  The real benefits of CAC in terms of more inflow of capital occur when currency is appreciated. But appreciation of currency leads of erosion in competitiveness of Indian exports, resulting in wider CAD.

CAPITAL ACCOUNT CONVERTIBILITY (CAC) : TARAPORE COMMITTEE (1997)

When the convertibility of the rupee on the current accou8nt was successful and when RBI accumulated over $25 billion forex reserves it was ready to take the next of India appointed in 1997 the Committee on capital account convertibility with Mr. S.S. Tarapore, former Deputy Governor of RBI, as its chairman. The Tarapore Committee defined CAC as “the freedom to convert local financial assets with foreign financial assets and vice-versa at market determined rates of exchange”.

PRECONDITIONS FOR CAC

                The Tarapore Committee recommended that, before adopting CAC, India should fulfill three crucial preconditions :

(i)                  Fiscal deficit should be reduced to 3.5 percent. The Government should also set up a consolidated sinking fund (CSF) to reduce Government debt.

(ii)                The Government should fix the annual inflation target between 3 and 5 percent – this was called mandated inflation target – and give ful 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 fully deregulated, gross non-paying assets (NPAs) should be reduced to 5 percent, the average effective CRR  should be reduced to 3 percent and weak banks should either be liquidated or be merged with other strong banks

A part from these three essential pre-conditions, the Tarapore Committee also recommended that :

(a)    RBI should have a monitoring exchange rate band of 5 percent around Real Effective Exchange Rate (REER) and should intervene only when the 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 percent to 20 percent of the export earnings ;

(c)    To meet import and debt service payments forex reserves should be adequate and range between $ 22 billion and $ 32 billion ; and

(d)   The Government should remove all restrictions on the movement of gold.

The major difficulty with the Tarapore Committee recommendation was that it would like the CAC 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 a short period.

        Basically, 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 liberalization. The outbreak of Asian financial crisis at this time was also responsible for shelving the recommendation of Tarapore Committee.

SECOND TARAPORE COMMITTEE ON FULLER CAPITAL ACCOUNT CONVERTIBILITY

                RBI constituted the “Committee on fuller Capital Account convertibility” with S.S Tarapore again as chairman. The Tarapore Committee submitted its report in September 2006 (more commonly called the Second Tarapore Report or Tarapore II).

RECOMMENDATIONS

                As a fresh move, the Tarapore II has made many important recommendations.

                The Tarapore II contends that capital outflows by residents, corporate and banks are a strong confidence building measure but at the same time the Committee asserts that net inflows should not drop. In this connection, the Tarapore II has suggested that :

(a)    The distinction between non-resident Indians (NRIs) and foreigners be narrowed down;

(b)   Foreign corporate to be allowed to invest in Indian equity and debt; this will  help to deepen the Indian stock market ;

(c)    Multilateral institutions and corporate to be allowed to raise Rupee Bonds in India subject to overall upward mobile ceiling ;

(d)   Liberal external commercial borrowings to be  permitted by corporate (i) with the removal of cap on 10 year loans and (ii) raising the automatic approval of such loans to $ 1 billion by 2011;

(e)    Import-linked short term loans should be monitored in a comprehensive manner; however, the over-all limit of external commercial borrowings (ECB) should be gradually raised but keeping (i) the cap 4 18 billion, and (ii) automatic approval limit of up to $ 500 million for an entity for the year 2006-07.

These suggestions were accepted and were being implemented by the RBI and Finance Ministry. However, Tarapore II has made two radical suggestions, which may be accepted by RBI but may be rejected by the Finance Ministry. They are:

Ban Participatory Notes (PNs)

Discriminating Treaties Should Go

Even nine years after the submission of Tarapore II committee report, capital account convertibility is yet to see the light of the day. We have only partial convertibility of Rupee on capital account. However, with the RBI Governor Raghuram Rajan and minister of finance for states Jayant Sinha advocating for its early implementation, a new hope has been rekindled. Is India really ready for integrating herself with the rest of the world through CAC?

Vashistha Ray.