6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility 1/17 jurisonline.in/2010/06/full-convertibility-of-the-indian-rupee-an-analysis-of-the-feasibility/ Home Hall of Fame ICANN News Services in India Services in Singapore Submit Article JurisOnline.in From Legal Information to Knowledge Full Convertibility of the Indian Rupee : An analysis of the Feasibility by aashimajohur on June 13, 2010 The Prime Minister, Dr. Manmohan Singh in a speech at the Reserve Bank of India, Mumbai, on March 18, 2006 referred to the need to revisit the subject of capital account convertibility. To quote: “Given the changes that have taken place over the last two decades, there is merit in moving towards fuller capital account convertibility within a transparent framework…I will therefore request the Finance Minister and the Reserve Bank to revisit the subject and come out with a roadmap based on current realities”. Convertible currencies are defined as currencies that are readily bought, sold, and converted without the need for permission from a central bank or government entity. Most major currencies are fully convertible; that is, they can be traded freely without restriction and with no permission required. The easy convertibility of currency is a relatively recent development and is in part attributable to the growth of the international trading markets and the FOREX markets in particular. Historically, movement away from the gold exchange standard once in common usage has led to more and more convertible currencies becoming available on the market. Because the value of currencies is established in comparison to each other, rather than measured against a real commodity like gold or silver, the ready trade of currencies can offer investors an opportunity for profit. Fully convertible currency The U.S. dollar is an example of a fully convertible currency. There are no restrictions or limitations on the amount of dollars that can be traded on the international market, and the U.S. Government does not artificially impose a fixed value or minimum value on the dollar in international trade. For this reason, dollars are one of the major currencies traded in the FOREX market . Partially convertible currency The Indian rupee is only partially convertible due to the Indian Central Bank’s control over international investments flowing in and out of the country. While most domestic trade transactions are handled without any special requirements, there are still significant restrictions on international investing and special approval is often required in order to convert rupees into other currencies. Due to India’s strong financial position in the
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6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
Full Convertibility of the Indian Rupee : Ananalysis of the Feasibility
by aashimajohur on June 13, 2010
The Prime Minister, Dr. Manmohan Singh in a speech at the Reserve Bank of India, Mumbai, on March 18,
2006 referred to the need to revisit the subject of capital account convertibility. To quote:
“Given the changes that have taken place over the last two decades, there is merit in moving towards fuller
capital account convertibility within a transparent framework…I will therefore request the Finance Minister andthe Reserve Bank to revisit the subject and come out with a roadmap based on current realities”.
Convertible currencies are defined as currencies that are readily bought, sold, and converted without the need forpermission from a central bank or government entity. Most major currencies are fully convertible; that is, they
can be traded freely without restriction and with no permission required. The easy convertibility of currency is a
relatively recent development and is in part attributable to the growth of the international trading markets and the
FOREX markets in particular. Historically, movement away from the gold exchange standard once in common
usage has led to more and more convertible currencies becoming available on the market. Because the value of
currencies is established in comparison to each other, rather than measured against a real commodity like gold or
silver, the ready trade of currencies can offer investors an opportunity for profit.
Fully convertible currency
The U.S. dollar is an example of a fully convertible currency. There are no restrictions or limitations on the
amount of dollars that can be traded on the international market, and the U.S. Government does not artificiallyimpose a fixed value or minimum value on the dollar in international trade. For this reason, dollars are one of the
major currencies traded in the FOREX market.
Partially convertible currency
The Indian rupee is only partially convertible due to the Indian Central Bank’s control over international
investments flowing in and out of the country. While most domestic trade transactions are handled without any
special requirements, there are still significant restrictions on international investing and special approval is often
required in order to convert rupees into other currencies. Due to India’s strong financial position in the
6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
international community, there is discussion of allowing the Indian rupee to float freely on the market, altering it
from a partially convertible currency to a fully convertible one.
Nonconvertible currency
Almost all nations allow for some method of currency conversion; Cuba and North Korea are the exceptions.
They neither participate in the international FOREX market nor allow conversion of their currencies by
individuals or companies. As a result, these currencies are known as blocked currencies; the North Korean won
and the Cuban national peso cannot be accurately valued against other currencies and are only used for domestic
purposes and debts. Such nonconvertible currencies present a major obstruction to international trade for
companies who reside in these countries.
Convertibility is the quality of paper money substitutes which entitles the holder to redeem them on demand intomoney proper.
CONVERTIBILITY – EVOLUTION OF THE CONCEPT
Historically, the banknote has followed a common or very similar pattern in the western nations. Originallydecentralized and issued from various independent banks, it was gradually brought under state control and
became a monopoly privilege of the central banks. In the process, the fact that the banknote was merely asubstitute for the real commodity money (gold and silver) was gradually lost sight of. Under the gold standard,
banknotes were payable in gold coins. The same way under the silver standard, banknotes were payable in silvercoins, and under a bi-metallic standard, payable in either gold or silver coins, at the option of the debtor (theissuing bank).
Under the gold exchange standard banks of issue were obliged to redeem their currencies in gold bullion. Due tolimited growth in the supply of gold reserves, during a time of great inflation of the dollar supply, the UnitedStates eventually abandoned the gold exchange standard and thus bullion convertibility in 1974 Under the
contemporary international currency regimes, all currencies’ inherent value derives from fiat, thus there is nolonger any thing (gold or other tangible store of value) for which paper notes can be redeemed. One currency
can be converted into another in open markets and through dealers. Some countries pass laws restricting thelegal exchange rates of their currencies, or requiring permits to exchange more than a certain amount. Thus, those
countries’ currencies are not fully convertible. Some countries’ currencies, such as North Korea’s won andCuba’s national peso, cannot be converted.
Nations attempted to revive the gold standard following World War I, but it collapsed entirely during the Great
Depression of the 1930s. Some economists said adherence to the gold standard had prevented monetaryauthorities from expanding the money supply rapidly enough to revive economic activity. In any event,representatives of most of the world’s leading nations met at Bretton Woods, New Hampshire, in 1944 to create
a new international monetary system. Because the United States at the time accounted for over half of theworld’s manufacturing capacity and held most of the world’s gold, the leaders decided to tie world currencies to
the dollar, which, in turn, they agreed should be convertible into gold at $35 per ounce.
Under the Bretton Woods system, central banks of countries other than the United States were given the task ofmaintaining fixed exchange rates between their currencies and the dollar. They did this by intervening in foreign
exchange markets. If a country’s currency was too high relative to the dollar, its central bank would sell itscurrency in exchange for dollars, driving down the value of its currency. Conversely, if the value of a country’s
6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
money was too low, the country would buy its own currency, thereby driving up the price.
The Bretton Woods system lasted until 1971. By that time, inflation in the United States and a growing American
trade deficit were undermining the value of the dollar. Americans urged Germany and Japan, both of which hadfavorable payments balances, to appreciate their currencies. But those nations were reluctant to take that step,
since raising the value of their currencies would increase prices for their goods and hurt their exports. Finally, theUnited States abandoned the fixed value of the dollar and allowed it to “float” — that is, to fluctuate against other
currencies. The dollar promptly fell. World leaders sought to revive the Bretton Woods system with the so-calledSmithsonian Agreement in 1971, but the effort failed. By 1973, the United States and other nations agreed to
allow exchange rates to float.
Economists call the resulting system a “managed float regime,” meaning that even though exchange rates for mostcurrencies float, central banks still intervene to prevent sharp changes. As in 1971, countries with large trade
surpluses often sell their own currencies in an effort to prevent them from appreciating (and thereby hurtingexports). By the same token, countries with large deficits often buy their own currencies in order to preventdepreciation, which raises domestic prices. But there are limits to what can be accomplished through
intervention, especially for countries with large trade deficits. Eventually, a country that intervenes to support itscurrency may deplete its international reserves, making it unable to continue buttressing the currency and
potentially leaving it unable to meet its international obligations.
FIXED AND FLOATING EXCHANGE RATES
Exchange Rate systems are classified on the basis of the flexibility that the monetary authorities show towardsfluctuations in the exchange rates and have been traditionally divided into 2 categories, namely:
• systems with a fixed exchange rate• systems with a flexible exchange rate.
In the former system the exchange rate is usually a political decision, in the latter the prices are determined by the
market forces, in accordance with demand and supply. These systems are often referred to as Fixed Peg(sometimes also described as “hard peg”) and Floating systems. But as usual, between these two extreme
positions there exists also an intermediate range of different systems with limited flexibility, usually referred to as“soft pegs”.
Fixed Exchange Rate
A country’s decision to tie the value of its currency to another country’s currency, gold (or another commodity),
or a basket of currencies.
A fixed exchange rate is usually used to stabilize the value of a currency, against the currency it is pegged to. This
makes trade and investments between the two countries easier and more predictable, and is especially useful for
small economies where external trade forms a large part of their GDP.
It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the
currency pegged to it. In addition, according to the Mundell-Fleming model, with perfect capital mobility, a fixed
exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomicstability.
6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
Fixing value of the domestic currency relative to that of a low-inflation country is one approach central banks
have used to pursue price stability. The advantage of an exchange rate target is its clarity, which makes it easily
understood by the public. In practice, it obliges the central bank to limit money creation to levels comparable tothose of the country to whose currency it is pegged. When credibly maintained, an exchange rate target can
lower inflation expectations to the level prevailing in the anchor country. Experiences with fixed exchange rates,
however, point to a number of drawbacks. A country that fixes its exchange rate surrenders control of its
domestic monetary policy.
A fixed currency exchange rate is one that is set by a government, usually through a central bank. A currency is
pegged to another currency at a certain rate. For example, the Chinese yuan might be fixed to the U.S. dollar,
meaning that its exchange rate is held within a range, depending on the U.S. dollar. Some countries fix theircurrencies to the Japanese yen or the euro. In other cases, a fixed currency may be pegged to a basket of
currencies.
The main criticism of a fixed exchange rate is that flexible exchange rates serve to automatically adjust the
balance of trade. When a trade deficit occurs, there will be increased demand for the foreign (rather than
domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in
turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the tradedeficit. Under fixed exchange rates, this automatic re-balancing does not occur.
The belief that the fixed exchange rate regime brings with it stability is only partly true, since speculative attacks
tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system ismaintained mainly through capital control. A fixed exchange rate regime should be viewed as a tool in capital
control.
For instance, China has allowed free exchange for current account transactions since December 1, 1996. Ofmore than 40 categories of capital account, about 20 of them are convertible. These convertible accounts are
mainly related to foreign direct investment. Because of capital control, even the renminbi is not under the
managed floating exchange rate regime, but free to float, and so it is somewhat unnecessary for foreigners topurchase renminbi.
Floating Exchange Rate
A floating currency is one that is more influenced by the market. Supply and demand sets the exchange rate. For
example, if more people want to buy euros, and sell dollars to do so, the value of the euro rises in response,
while the value of the dollar — relative to the Euro falls in forex trading.
In the modern world, the majority of the world’s currencies are floating. Central banks often participate in the
markets to attempt to influence exchange rates, but such interventions are becoming less effective and less
important as the markets have become larger and less naive. Such currencies include the most widely traded
currencies: the United States dollar, the euro, the Japanese yen, the British pound, the Swiss franc and theAustralian dollar.
The Canadian dollar most closely resembles the ideal floating currency as the Canadian central bank has not
interfered with its price since it officially stopped doing so in 1998. The US dollar runs a close second with verylittle changes in its foreign reserves; by contrast, Japan and the UK intervene to a greater extent. From 1946 to
the early 1970s, the Bretton Woods system made fixed currencies the norm; however, in 1971, the United
6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
States government abandoned the gold standard, so that the US dollar was no longer a fixed currency, and most
of the world’s currencies followed suit.
It is not possible for a developing country to maintain the stability in the rate of exchange for its currency in the
exchange market. There are two options open for them-
1. Let the exchange rate be allowed to fluctuate in the open market according to the market conditions, or
2. An equilibrium rate may be fixed to be adopted and attempts should be made to maintain it as far as possible.
If there is a fundamental change in the circumstances, the rate should be changed accordingly. The rate of
exchange under the first alternative is know as fluctuating rate of exchange and under second alternative, it is
called flexible rate of exchange. In the modern economic conditions, the flexible rate of exchange system is moreappropriate as it does not hamper the foreign trade.
Global Scenario
Trends in Global Exchange Rate Regimes
1991 1999 2002
No. Countries Percentage No. Countries Percentage No. Countries PercentageHard Peg 25 15,72% 45 24,32% 49 25,93%
Intermediate 98 61,64% 63 34,05% 58 30,69%
Free Float 36 22,64% 77 41,62% 82 43,39%
Totals 159 100,00% 185 100,00% 189 100,00%
There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed
exchange rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of
shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis.However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty.
This may not necessarily be true, considering the results of countries that attempt to keep the prices of their
currency “strong” or “high” relative to others, such as the UK or the Southeast Asia countries before the Asiancurrency crisis.
The debate of making a choice between fixed and floating exchange rate regimes is set forth by the Mundell-
Fleming model, which argues that an economy cannot simultaneously maintain a fixed exchange rate, free capitalmovement, and an independent monetary policy. It can choose any two for control, and leave third to the market
forces.
In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency.Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A
central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a
price “ceiling” and “floor”. Management by the central bank may take the form of buying or selling large lots in
order to provide price support or resistance, or, in the case of some national currencies, there may be legalpenalties for trading outside these bounds.
A free floating exchange rate increases foreign exchange volatility. There are economists who think that this could
cause serious problems, especially in emerging economies. These economies have a financial sector with one ormore of following conditions:
• high liability dollarization
6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
When liabilities are denominated in foreign currencies while assets are in the local currency, unexpected
depreciations of the exchange rate deteriorate bank and corporate balance sheets and threaten the stability of the
domestic financial system.
For this reason emerging countries appear to face greater fear of floating, as they have much smaller variations of
the nominal exchange rate, yet face bigger shocks and interest rate and reserve movements. This is the
consequence of frequent free floating countries’ reaction to exchange rate movements with monetary policyand/or intervention in the foreign exchange market.
CURRENT AND CAPITAL ACCOUNT TRANSACTIONS
Current Account Transactions
Section 2(j) defines a Current Account Transaction as a transaction and without prejudice to the generality of the
foregoing such transaction includes-1. Payments due in connection with foreign trade, other current business, services and short term banking and
credit facilities in the ordinary course of business,
2. Payments due as interest on loans and as net income from investments
3. Remittances for living expenses of parents, spouse and children residing abroad, and4. Expenses in connection with foreign travel, education and medical care of parents, spouse and children.
Any person can sell or draw foreign exchange to or from authorized person if such sale or drawal is a current
account transaction. Reasonable restriction on current account transactions can be imposed by CentralGovernment in public interest, in consultation with RBI.
Capital Account Transactions
Section 2(e) of the Foreign Exchange Management Act, 1999 defines a Capital Account Transaction as a
transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident inIndia or assets or liabilities in India, and includes transactions referred to in sub-section (3) of Section 6.
Following Capital Account Transactions are prohibited as per Foreign Exchange Management (Permissible
Capital Account Transactions) Regulations, 2000 –
Transactions not permitted in FEMA - Capital account transactions not permitted in the FEMA Act, Rules or
Regulations. In other words, all capital account transactions are prohibited, unless specifically permitted. In
current account transactions the position is reverse, that is all current transactions are permitted unless specificallyprohibited.
Investment in certain sectors – Foreign investment in India in any company, firm or proprietary concern engaged
or proposing to engage in the following business is completely prohibited:
• Chit Fund
• Nidhi Company
• Agricultural or plantation activities
• Real Estate business or construction of farmhouses
• Trading in Transferable Development Rights (certificates issued in respect of land acquired for public purposes
6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
either by the Central Government or State Government in consideration of surrender of land by the ownerwithout monetary consideration. The TDR is transferable in part or whole.
In practice, the distinction between current and capital account transactions is not always clear-cut. There are
transactions which straddle the current and capital account. Illustratively, payments for imports are a current
account item but to the extent these are on credit terms, a capital liability emerges and with increase in trade
payments, trade finance would balloon and the resultant vulnerability should carefully be kept in view in moving
forward to FCAC. Contrarily, extending credit to exports is tantamount to capital outflows.
As regards residents, the capital restrictions are clearly more stringent than for non-residents. Furthermore,
resident corporates face a relatively more liberal regime than resident individuals. Till recently, resident individuals
faced a virtual ban on capital outflow but a small relaxation has been undertaken in the recent period.
Section 4 of FEMA provides that no person resident of India shall acquire, hold, own, possess or transfer any
foreign exchange, foreign security or any immovable property situated outside India, except as provided in the
Act.
According to Section 6(4), a person resident may hold, own, transfer or invest in foreign currency, foreign
security or any immovable property situated outside India, if such currency, security or property was acquired,
held or owned by such person when he was resident outside India or inherited from a person who was resident
outside India.
In addition to various remittances provided, a resident individual can remit upto USD 200,000 per financial year
for permitted capital account and current account transactions under the Liberalised Remittance Scheme. Initially
it was USD 25,000 when introduced in 2003, which was increased to USD 50,000 on 20-12-2006, then toUSD 100,000 on 8-5-2007 and now to USD 200,000.
There is justification for some liberalisation in the rules governing resident individuals investing abroad for the
purpose of asset diversification. The experience thus far shows that there has not been much difficulty with the
present order of limits for such outflows. It would be desirable to consider a gradual liberalisation for resident
corporates/business entities, banks, non-banks and individuals. The issue of liberalisation of capital outflows for
individuals is a strong confidence building measure, but such opening up has to be well calibrated as there arefears of waves of outflows. The general experience is that as the capital account is liberalised for resident
outflows, the net inflows do not decrease, provided the macroeconomic framework is stable.
CAPITAL ACCOUNT CONVERTIBILITY
Capital Account Convertibility is a monetary policy that centers around the ability to conduct transactions of local
financial assets into foreign financial assets freely and at market determined exchange rates. It is sometimes
referred to as Capital Asset Liberation.
It is basically a policy that allows the easy exchange of local currency (cash) for foreign currency at low rates.
This is so local merchants can easily conduct transnational business without needing foreign currency exchanges
to handle small transactions. Capital Account Convertibility is mostly a guideline to changes of ownership in
foreign or domestic financial assets and liabilities. Tangentially, it covers and extends the framework of the
creation and liquidation of claims on, or by the rest of the world, on local asset and currency markets.
It is basically a policy that allows the easy exchange of local currency (cash) for foreign currency at low rates.
6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
This is so local merchants can easily conduct transnational business without needing foreign currency exchangesto handle small transactions. CAC is mostly a guideline to changes of ownership in foreign or domestic financial
assets and liabilities. Tangentially, it covers and extends the framework of the creation and liquidation of claims
on, or by the rest of the world, on local asset and currency markets.
Capital Account Convertibility has 5 basic statements designed as points of action:
1. All types of liquid capital assets must be able to be exchanged freely, between any two nations, with
standardized exchange rates.2. The amounts must be a significant amount (in excess of $500,000).
3. Capital inflows should be invested in semi-liquid assets, to prevent churning and excessive outflow.
4. Institutional investors should not use Capital Account Convertibility to manipulate fiscal policy or exchange
rates.
5. Excessive inflows and outflows should be buffered by national banks to provide collateral.
The status of capital account convertibility in India for various non-residents is as follows: for foreign corporates,
and foreign institutions, there is a reasonable amount of convertibility; for non-resident Indians (NRIs) there isapproximately an equal amount of convertibility, but one accompanied by severe procedural and regulatory
impediments. For non-resident individuals other than NRIs, there is near-zero convertibility. Movement towards
an Fuller Capital Account Convertibility implies that all non-residents (corporates and individuals) should be
treated equally. This would mean the removal of the tax benefits presently accorded to NRIs via special bank
deposit schemes for NRIs, viz., Non-Resident External Rupee Account [NR(E)RA] and Foreign Currency
Non-Resident (Banks) Scheme [FCNR(B)]. Non-residents, other than NRIs, should be allowed to open
FCNR(B) and NR(E)RA accounts without tax benefits, subject to Know Your Customer (KYC) and FinancialAction Task Force (FATF) norms. In the case of the present NRI schemes for various types of investments,
other than deposits, there are a number of procedural impediments and these should be examined by the
Government and the RBI.
A person resident in India is permitted to open, hold and maintain with an Authorized Dealer in India a Foreign
Currency Account known as Exchange Earner’s Foreign Currency (EEFC) Account subject to the terms and
conditions of the Exchange Earner’s Foreign Currency Account Scheme specified. Further, all categories offoreign exchange earners are allowed to credit up to 100 per cent of their foreign exchange earnings, as specified
in the paragraph 1 (A) of the Schedule, to their EEFC Account.
All categories of foreign exchange earners are allowed to credit up to 100 per cent of their foreign exchange
earnings, as specified in the paragraph 1 (A) of the Schedule, to their EEFC Account. As such, it will be in order
for the Authorised Dealers to allow
SEZ developers to open, hold and maintain EEFC Account and to credit up to 100 per cent of their foreign
exchange earnings, as specified in the paragraph 1 (A) of the Schedule.
Any person resident in India,
i) may take outside India (other than to Nepal and Bhutan) currency notes of Government of India and Reserve
Bank of India notes up to an amount not exceeding Rs.7,500 (Rupees seven thousand five hundred only) per
person; and
ii) who had gone out of India on a temporary visit, may bring into India at the time of his return from any place
outside India (other than from Nepal and Bhutan), currency notes of Government of India and Reserve Bank of
India notes up to an amount not exceeding Rs.7,500 (Rupees seven thousand five hundred only) per person.
6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
According to Regulation 7 of the Foreign Exchange Management (Foreign Currency Accounts by a Person
Resident in India) Regulations, 2000,
(i) A citizen of a foreign State, resident in India, being an employee of a foreign company or a citizen of India,
employed by a foreign company outside India and in either case on deputation to the office /branch /subsidiary
/joint venture in India of such foreign company may open, hold and maintain a foreign currency account with a
bank outside India and receive the whole salary payable to him for the services rendered to the
office/branch/subsidiary/joint venture in India of such foreign company, by credit to such account, provided that
income-tax chargeable under the Income-tax Act,1961 is paid on the entire salary as accrued in India.
(ii) A citizen of a foreign State resident in India being in employment with a company incorporated in India may
open, hold and maintain a foreign currency account with a bank outside India and remit the whole salary received
in India in Indian Rupees, to such account, for the services rendered to such an Indian company, provided that
income-tax chargeable under the Income-tax Act, 1961 is paid on the entire salary accrued in India.
It would be desirable to consider a gradual liberalisation for resident corporates/business entities, banks, non-
banks and individuals. The issue of liberalisation of capital outflows for individuals is a strong confidence buildingmeasure, but such opening up has to be well calibrated as there are fears of waves of outflows. The general
experience is that as the capital account is liberalised for resident outflows, the net inflows do not decrease,
provided the macroeconomic framework is stable.
As India progressively moves on the path of convertibility, the issue of investments being channeled through a
particular country so as to obtain tax benefits would come to the fore as investments through other channels get
discriminated against. Such discriminatory tax treaties are not consistent with an increasing liberalisation of thecapital account as distortions inevitably emerge, possibly raising the cost of capital to the host country. With
global integration of capital markets, tax policies should be harmonised. It would, therefore, be desirable that the
Government undertakes a review of tax policies and tax treaties.
A hierarchy of preferences may need to be set out on capital inflows. In terms of type of flows, allowing greater
flexibility for rupee denominated debt which would be preferable to foreign currency debt, medium and long term
debt in preference to short-term debt, and direct investment to portfolio flows. There are reports of large flows
of private equity capital, all of which may not be captured in the data (this issue needs to be reviewed by theRBI). There is a need to monitor the amount of short-term borrowings and banking capital, both of which have
been shown to be problematic during the crisis in East Asia and in other EMEs.
Greater focus may be needed on regulatory and supervisory issues in banking to strengthen the entire risk
management framework. Preference should be given to control volatility in cross-border capital flows in
prudential policy measures. Given the importance that the commercial banks occupy in the Indian financial
system, the banking system should be the focal point for appropriate prudential policy measures.
RUPEE AS A CONVERTIBLE CURRENCY AND ITS IMPLICATIONS
The recent decision of the government to have full convertibility of the Indian Rupee which will affect everyone in
the country but is remotely understandable by a few, is one such important decision, which is designed to please
the international financial institutions and the 10 percent of the population of India who are either rich or of upper
middle class.
It is essential to judge a policy by examining both the costs and benefits of it. The government is talking about the
6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
illusory benefits of this convertibility, which will basically remove all obstacle to the free flow of money and as a
result goods and services also can move freely. The government, in a fully convertible regime, will not be able to
control these flows directly. Indirect controls will be implemented by changing interest rates and taxes but the
effectiveness of this control according to the international experiences is uncertain.
Advantages
The benefits of free flows of money in a fully convertible regime means foreigners would be able to invest in theIndian stock markets, buy up companies and property including land (unless there are restrictions). Indian people
and companies can import anything they would like, buy shares of foreign companies and property in foreign
lands and can transfer money as they please without going through the Hawala business. Indians who have not
paid their taxes or repaid their loans taken from the Indian banks will be free to transfer their money to foreign
countries outside the jurisdiction of the Indian authority.
The expected benefits for India would depend on the attractiveness of the country as a safe destination for short-
term investments. Long-term investments do not depend on convertibility. China has no convertibility, instead afixed exchange rate for the last 12 years. Yet, China is the most important destination for long-term foreign
investments. Thus, discussions about the full convertibility should be about the desirability of short-term
investments and their implications.
Short term investments i.e., foreign investments in shares and bonds of the Indian companies and Indian
government depend on the demonstration of profit of the Indian companies and the continuous good health of the
Indian economy in terms of low budget deficits, low balance of payments deficits, low level of governmentborrowings and low level of non-performing loan in the Indian banking system. From these points of view India
cannot be a very attractive destination as the health of the economy despite of the propaganda of the Indian
government is very weak with huge government debt, revenue deficits, Rs.150,000 Crores of uncollected taxes
and Rs.120,000 Crores of unpaid loans in the banks, increasing price of petroleum and increasing balance of
payments deficits of the country. With 80 percent of people live on less than 2 dollars a day, and 70 percent of
the people live on less than 1 dollar a day, profitable market in India is also very small. If the Indian companies
working under these constraints cannot demonstrate good and continuous profit, short-term investments will flyout very easily if there is any sign of economic downturn when there is a fully convertible Rupee. The result will
be further increase in the balance of payments deficits and fall of the exchange rate of Rupee, which will provoke
Indians to take their money out of India.
Another advantage of full convertibility of Rupee for the Indian rich is that they can import as they like and buy
properties abroad as they were allowed to do so during the days of British Raj. It has certain advantages for the
Indian companies who will be able to import both raw materials and machineries or set up foreign establishments
at will.
Disadvantages
Full convertibility also has adverse consequences for the India’s domestic producers of these raw materials and
machineries, as they have to compete against foreign suppliers who like Chinese may have deliberate low rate of
exchange for their currencies thus making their goods low in price. Foreign suppliers also can be supported by all
kinds of subsidies by their government so as to make their prices very low. Agricultural exports from Europe,
USA, Thailand, and Australia can ruin India’s own agriculture.
6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
There are many such historical examples in India. Within 20 years between 1860 and 1880, India’s domestic
manufacturing industries were wiped out by free trade and convertible Rupee during the days of British Raj.
Indian farmers during those days could not cultivate their lands, as the imported food products were cheaper
than whatever they could produce. Demonstration of wealth by the Nawabs and Maharajas of India in Paris and
London during the days of British Raj has not done any good for starving millions of India but was responsible
for massive misuse of India’s foreign currency reserve created by the sweat and blood of the India’s poor in
those days. Full convertibility of Rupee and free trade may bring back those dark days.
The freedom for India’s rich to buy companies and property abroad may lead to massive diversion of funds from
investments in the home economy of India to investments abroad. This would amount to export of jobs to foreign
countries creating more and more unemployment at home. Japan in recent years suffers from this phenomenon,
where increasingly Japanese companies are transferring funds to China for investments, taking advantage of the
very low wage rate and low exchange rate of Yuan, thus creating unemployment at home. Although China has
massive surplus in the balance of payments, huge reserve of dollars and gigantic flows of foreign investments, a
non-convertible Yuan and controls on transfer of money have kept China’s exchange rate low enough so thatChinese goods can capture the markets of every important country of the world.
The most dangerous consequence of convertibility is that Rupee will be under the control of currency
speculators. A fully convertible regime for the Rupee will certainly include participation of Rupee in the
international currency market and in the ‘future market’ of Rupee, the playground for the international
speculators. It is very much possible for the speculators to buy massive amount of Rupee to drive up its
exchange rate and then they can suddenly sell all to gain enormous profit. That will drive down Rupee to a very
low depth suddenly. If the Reserve Bank of India wants to protect Rupee in such a situation, within a few daysIndia will have no foreign exchange left in reserve and the country will go bankrupt.
1997 Asian Financial Crisis – The Tom Yum Goong crisis
The Asian Financial Crisis was a period of financial crisis that gripped much of Asia beginning in July 1997, and
raised fears of a worldwide economic meltdown due to financial contagion.
The crisis started in Thailand with the financial collapse of the Thai baht caused by the decision of the Thai
government to float the baht, cutting its peg to the USD, after exhaustive efforts to support it in the face of a
severe financial overextension that was in part real estate driven. At the time, Thailand had acquired a burden of
foreign debt that made the country effectively bankrupt even before the collapse of its currency. As the crisis
spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and other asset
prices, and a precipitous rise in private debt
A similar situation took place in South Korea, Malaysia and Indonesia, all with their then convertible currency.Malaysia has survived by imposing fixed exchange rate, exchange control, and making Malaysian dollar
nonconvertible. Both India and China were unaffected because their economies at that time were closed and
their currencies were non-convertible.
Similarly, the British pound suffered in 1992 when the British government lost its entire dollar holding to save the
pound, which was under attack from the speculators. However, Britain with 400 tons of gold in the Bank of
England could not go bankrupt. There is no guarantee that a similar situation will not occur for India. India has no
massive gold reserve; in 1991 it had to submit its gold reserve to the Bank of England to get loan from the IMF.Thus, it will certainly go bankrupt if there is any speculative attack on Rupee.
6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
Convertibility also implies that the government of India will lose all controls over the economy. In a regime with
convertible currency and as a result a flexible exchange rate, fiscal policy of the government, i.e., various taxes
and public expenditure to stimulate the economy, will be neutralized by adverse monetary flows out of the
country. Only monetary policy i.e., interest rate and money supply by the Reserve Bank of India, may work to
some extent.
Money supply as experience suggests can work only on the negative direction; i.e., if the country reduces the
money supply inflation can be controlled at the cost of reduced investments and increased unemployment. If thecountry, instead, increases the money supply to stimulate the economy it can cause inflation and eventually
unemployment will go up as well because of possible bankruptcy of the private companies as a result of highinflation. The argument of Keynes that if there are underemployed resources in the economy increased moneysupply resultant from increased government spending cannot cause inflation is not valid for a dual economy like
India where the 10 percent of the population live in a different planet from the other 90 percent of the population.
Interest Rate – A Dangerous Weapon
Interest rate is a dangerous instrument. If the government reduces it, there will be inflation, speculativemovements in the market and disincentives for the savers, which would reduce future investments.
Reduced interest rate for a convertible Rupee will reduce the exchange rate of the Rupee. The currency
speculators will start selling Rupee and short-term investments will fly out of the country. There would be a freefall of the Rupee in the international currency market. As a result the economy may go bankrupt without any
foreign exchange. The result can be collapse of the private companies leaving millions of people unemployed.
If the government increases the interest rate exchange rate of Rupee will go up. Short-term investment will flood
the market, speculators will buy more Rupee, but the exporters will be unable to sell their products abroadbecause of higher price of Indian exports as a result of higher exchange rate of Rupee. High exchange rate ofRupee also mean lower price of imported products. As a result both manufacturers and farmers will suffer from
enhanced competitions from the manufactured products from the East and South East Asia and farm productsfrom USA, Europe, Australia and Thailand.
Thus, interest rate is a dangerous weapon to depend upon. If a country wants to use it extensively the economywill go up and down creating havoc for the people. In 1988 Nigel Lawson, the then Chancellor of Exchequer of
Britain used lower interest rate to stimulate the economy creating speculative bubble for a few years until 1991,then he had to increase the interest rate to a very high level to protect the British pound from the speculatorscausing serious depression of the economy and high unemployment. The policy of the Federal Reserve of the
U.S during the presidency of Carter had the same experience. Recently Thailand, South Korea, Argentina, andChile have suffered in the same way.
If the interest rate is determined by the market, as it should be in a convertible currency regime with unrestrictedflows of money, India government will not have any control over the economy to give it a direction. The only
instrument that may be available is the public expenditure policy. The government can stimulate the economy byincreasing public expenditure, which may have uncertain consequences for the fate of Indian Rupee. Due toincreased public expenditure, rate of growth of the economy and employment may go up, but at the same time
there will be increased deficits in the balance of payments. Increased rate of growth may invite short-terminvestments and international speculators will buy more Rupee. However, increased budget deficit will cause
increased deficits in the balance of payments, which will soon drive out short-term investments and speculators
6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
will start selling Rupee. The exact consequence will depend upon how fast the economy can grow and whetherthe reduced exchange rate will stimulate the export earnings strong enough to keep the growth growing. The
experience of South Korea with a convertible currency from 1996 to 1998 showed that convertibility leads tobankruptcy due to speculative attacks against the currency in the international currency market. Argentina andChile have similar experiences recently.
USA during the days of Reagan and Clinton has avoided the consequences because USA is immune from effectsof balance of payments deficits. Value of the U.S dollar does not depend on the balance of payments deficits of
USA but on the value of international trade in petroleum, as dollar is the sole currency for petroleum trading inthe world. Also, dollar is the currency in which other countries keep their reserve of foreign exchange. As India
not USA, the experience of USA cannot give any guide for the Indian policy makers.
India should learn from China. China has no convertibility of Yuan, instead there are extensive controls onfinancial, and commodity flows in or out of the country. Foreign companies cannot have 100 percent ownership;
they must have partnership with Chinese state owned companies. Foreign companies cannot repatriate profit, asthey like; they must bring new technology, they must export most of their products. China imports what it needs,
although theoretically it is a member of the World Trade Organization. China does not allow short-terminvestments, but it is the most attractive destination for the long-term foreign investments.
Chinese Yuan does not take part in the international foreign exchange market and thus, protected from the
currency speculators. China has reduced the exchange rate of Yuan by 40 percent in 1984 and kept it fixed onlyto increase it by only 2 percent in 2005 when it has gigantic reserve of US dollars and massive trade surplus with
the rest of the world. Very low exchange rate of Yuan is one of the most important reasons why China hasmanaged to capture the markets of every important countries of the world.
CONCLUSION
The rupee exchange rate is neither completely free-floating nor fixed, but is “managed” by the Reserve Bank ofIndia through buying and selling other currencies. Up until April, the Reserve Bank was buying lots of U.S.
dollars — perhaps as much as $24 billion in the previous six months — to keep the rupee at around 44 to thedollar. But with investor sentiment so hot on India and money pouring in from abroad — international investors
have bought more than $7.5 billion worth of Indian stocks so far this year, compared to $8 billion in all of 2006— the Reserve Bank found itself having to spend more and more on foreign currencies just to keep the rupee
stable. When inflation shot up to over 6% in April, Bank officials appeared to decide — they never commentexplicitly on such matters — to stop buying dollars. The result was, over the next couple of months, astrengthening of the rupee to close to 40 to $1.
Convertibility of Rupee will give pleasure to the 10 percent of Indian people who are either rich or upper middleclass, traders in the stock market, speculators, bankers, and accountants. The rest 90 percent of the people will
be adversely affected with loss of employments in the manufacturing sector and bankruptcy in the agriculturalsector and total economic uncertainly.
During the days of the British Raj, Rupee was convertible, India had very large surplus in the balance of
payments. India’s share in the world trade was much higher than what it is today. However, millions of Indiansused to starve to death from time to time; millions of acres of land were left uncultivated by the bankrupt farmers;
there were hardly any industry except for a few textile mills, only 15 percent of the population had any educationat all. Yet at the same time, one could buy Rolls Royce and Scotch whisky in Bombay and Calcutta; Jinnah
6/23/12 Full Convertibility of the Indian Rupee : An analysis of the Feasibility
could buy his apartment in Bond Street of London; Maharaja of Patiala could build palace in Paris. We are
returning back to those days through the acts of an un-elected (only selected for the upper hose of theparliament) Prime Minister Man Mohan Singh whose loyalty is not to the people of India but to the internationalfinancial institutions.
In any democratic country for any serious matter like turning the Rupee into a convertible currency there must bereferendums. There were referendums in each and every European country when they wanted to create the
European monetary system whereby each European currency would be aligned to each other to create acommon currency Euro. Although India claims to be a democracy, Indian policy makers try their best to avoid
the public opinion, even the parliament. Major issues like India’s membership of the World Trade Organization,abolition of the planned economy and privatization of public assets, free trade, and now the convertibility ofRupee should be debated in the parliament and people of India should be allowed to give their verdict in
referendums if India wants to be a true democracy.
The strengthening rupee may also send an even more important signal: India is not China. It helps of course that
India’s trade surplus with the U.S. last year was just $11.7 billion compared to China’s whopping $232.5 billion.But by allowing the rupee to strengthen over the past few months, India is showing it’s prepared to play much
more fairly in the global market. India is seen as a more or less unambiguous ally to the U.S.
Of course, the Reserve Bank could still intervene to push India’s rupee lower again. But both the anonymousgovernment official warning of rupee-related job losses and investors see the rupee continuing to rise in the
coming months. If that happens expect to hear a lot more bleating from India’s exporters — and not a word ofcomplaint from India’s trading partners around the world.
Capital account convertibility is considered to be one of the major features of a developed economy. It helpsattract foreign investment. It offers foreign investors a lot of comfort as they can re-convert local currency intoforeign currency anytime they want to and take their money away.
At the same time, capital account convertibility makes it easier for domestic companies to tap foreign markets.At the moment, India has current account convertibility. This means one can import and export goods or receive
or make payments for services rendered. However, investments and borrowings are restricted.
But economists say that jumping into capital account convertibility game without considering the downside of the
step could harm the economy. The East Asian economic crisis is cited as an example by those opposed tocapital account convertibility.
Even the World Bank has said that embracing capital account convertibility without adequate preparation could
be catastrophic. But India is now on firm ground given its strong financial sector reform and fiscal consolidation,and can now slowly but steadily move towards fuller capital account convertibility.
2. Ravi Puliani and Mahesh Puliani: Foreign Exchange Management Act, Rules, Regulations, RBI Cirlulars withAllied Acts and Rules, Bharat Law House Pvt. Ltd. (2005)
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