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 28th 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.
