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 th e Reserve Bank ofIndia, Mumbai, on March 18, 2006 referred to the need to revisit the subject ofcapital 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 est ablished 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 international community , there is discussion ofallowing the Indian rupee to float freely on the market, altering it from a partially convertible currency to a fully convertible one.
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 meritin moving towards fuller capital account convertibility within a transparentframework…I will therefore request the Finance Minister and the Reserve Bank torevisit the subject and come out with a roadmap based on current realities‖.
Convertible currencies are defined as currencies that are readily bought, sold, andconverted without the need for permission from a central bank or governmententity. Most major currencies are fully convertible; that is, they can be tradedfreely without restriction and with no permission required. The easy convertibilityof currency is a relatively recent development and is in part attributable to thegrowth of the international trading markets and the FOREX markets in particular.Historically, movement away from the gold exchange standard once in commonusage has led to more and more convertible currencies becoming available on themarket. 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 tradeof currencies can offer investors an opportunity for profit.
Fully convertible currencyThe U.S. dollar is an example of a fully convertible currency. There are norestrictions or limitations on the amount of dollars that can be traded on theinternational market, and the U.S. Government does not artificially impose a fixedvalue or minimum value on the dollar in international trade. For this reason, dollarsare 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. Whilemost domestic trade transactions are handled without any special requirements,there are still significant restrictions on international investing and special approvalis often required in order to convert rupees into other currencies. Due to India‘sstrong financial position in the international community, there is discussion of allowing the Indian rupee to float freely on the market, altering it from a partiallyconvertible currency to a fully convertible one.
Almost all nations allow for some method of currency conversion; Cuba and NorthKorea are the exceptions. They neither participate in the international FOREXmarket nor allow conversion of their currencies by individuals or companies. As a
result, these currencies are known as blocked currencies; the North Korean wonand the Cuban national peso cannot be accurately valued against other currenciesand are only used for domestic purposes and debts. Such nonconvertible currenciespresent a major obstruction to international trade for companies who reside in thesecountries.
Convertibility is the quality of paper money substitutes which entitles the holder toredeem them on demand into money proper.
CONVERTIBILITY – EVOLUTION OF THE CONCEPT
Historically, the banknote has followed a common or very similar pattern in thewestern nations. Originally decentralized and issued from various independentbanks, it was gradually brought under state control and became a monopolyprivilege of the central banks. In the process, the fact that the banknote was merelya substitute for the real commodity money (gold and silver) was gradually lostsight of. Under the gold standard, banknotes were payable in gold coins. The sameway under the silver standard, banknotes were payable in silver coins, and under abi-metallic standard, payable in either gold or silver coins, at the option of thedebtor (the issuing bank).
Under the gold exchange standard banks of issue were obliged to redeem theircurrencies in gold bullion. Due to limited growth in the supply of gold reserves,during a time of great inflation of the dollar supply, the United States eventuallyabandoned the gold exchange standard and thus bullion convertibility in 1974Under the contemporary international currency regimes, all currencies‘ inherentvalue derives from fiat, thus there is no longer any thing (gold or other tangiblestore of value) for which paper notes can be redeemed. One currency can beconverted into another in open markets and through dealers. Some countries passlaws restricting the legal exchange rates of their currencies, or requiring permits to
exchange more than a certain amount. Thus, those countries‘ currencies are notfully 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 itcollapsed entirely during the Great Depression of the 1930s. Some economists saidadherence to the gold standard had prevented monetary authorities 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, NewHampshire, in 1944 to create a new international monetary system. Because theUnited States at the time accounted for over half of the world‘s manufacturingcapacity and held most of the world‘s gold, the leaders decided to tie worldcurrencies to the dollar, which, in turn, they agreed should be convertible into goldat $35 per ounce.
Under the Bretton Woods system, central banks of countries other than the UnitedStates were given the task of maintaining fixed exchange rates between theircurrencies and the dollar. They did this by intervening in foreign exchangemarkets. If a country‘s currency was too high relative to the dollar, its central bank would sell its currency in exchange for dollars, driving down the value of itscurrency. Conversely, if the value of a country‘s 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 UnitedStates and a growing American trade deficit were undermining the value of thedollar. Americans urged Germany and Japan, both of which had favorablepayments balances, to appreciate their currencies. But those nations were reluctantto take that step, since raising the value of their currencies would increase pricesfor their goods and hurt their exports. Finally, the United States abandoned thefixed value of the dollar and allowed it to ―float‖ — that is, to fluctuate againstother currencies. The dollar promptly fell. World leaders sought to revive the
Bretton Woods system with the so-called Smithsonian Agreement in 1971, but theeffort failed. By 1973, the United States and other nations agreed to allowexchange rates to float.
Economists call the resulting system a ―managed float regime,‖ meaning that eventhough exchange rates for most currencies float, central banks still intervene toprevent sharp changes. As in 1971, countries with large trade surpluses often selltheir own currencies in an effort to prevent them from appreciating (and therebyhurting exports). By the same token, countries with large deficits often buy theirown currencies in order to prevent depreciation, which raises domestic prices. But
there are limits to what can be accomplished through intervention, especially forcountries with large trade deficits. Eventually, a country that intervenes to supportits currency may deplete its international reserves, making it unable to continuebuttressing the currency and potentially leaving it unable to meet its internationalobligations.
Exchange Rate systems are classified on the basis of the flexibility that themonetary authorities show towards fluctuations in the exchange rates and havebeen 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 latterthe prices are determined by the market forces, in accordance with demand andsupply. These systems are often referred to as Fixed Peg (sometimes also describedas ―hard peg‖) and Floating systems. But as usual, between these two extremepositions there exists also an intermediate range of different systems with limitedflexibility, 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, againstthe currency it is pegged to. This makes trade and investments between the twocountries easier and more predictable, and is especially useful for small economieswhere external trade forms a large part of their GDP.
It can also be used as a means to control inflation. However, as the reference valuerises and falls, so does the currency pegged to it. In addition, according to the
Mundell-Fleming model, with perfect capital mobility, a fixed exchange rateprevents a government from using domestic monetary policy in order to achievemacroeconomic stability.
Fixing value of the domestic currency relative to that of a low-inflation country isone 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 thepublic. In practice, it obliges the central bank to limit money creation to levelscomparable to those of the country to whose currency it is pegged. When crediblymaintained, 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 surrenderscontrol of its domestic monetary policy.
A fixed currency exchange rate is one that is set by a government, usually througha central bank. A currency is pegged to another currency at a certain rate. Forexample, 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 countriesfix their currencies to the Japanese yen or the euro. In other cases, a fixed currencymay 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 beincreased demand for the foreign (rather than domestic) currency which will pushup the price of the foreign currency in terms of the domestic currency. That in turnmakes the price of foreign goods less attractive to the domestic market and thuspushes down the trade deficit. 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 partlytrue, since speculative attacks tend to target currencies with fixed exchange rateregimes, and in fact, the stability of the economic system is maintained mainly
through capital control. A fixed exchange rate regime should be viewed as a tool incapital control.
For instance, China has allowed free exchange for current account transactionssince December 1, 1996. Of more than 40 categories of capital account, about 20of them are convertible. These convertible accounts are mainly related to foreigndirect investment. Because of capital control, even the renminbi is not under themanaged floating exchange rate regime, but free to float, and so it is somewhatunnecessary for foreigners to purchase renminbi.
Floating Exchange Rate
A floating currency is one that is more influenced by the market. Supply anddemand sets the exchange rate. For example, if more people want to buy euros, andsell dollars to do so, the value of the euro rises in response, while the value of thedollar — relative to the Euro falls in forex trading.
In the modern world, the majority of the world‘s currencies are floating. Centralbanks often participate in the markets to attempt to influence exchange rates, butsuch interventions are becoming less effective and less important as the markets
have become larger and less naive. Such currencies include the most widely tradedcurrencies: the United States dollar, the euro, the Japanese yen, the British pound,the Swiss franc and the Australian dollar.
The Canadian dollar most closely resembles the ideal floating currency as theCanadian central bank has not interfered with its price since it officially stoppeddoing so in 1998. The US dollar runs a close second with very little changes in its
foreign reserves; by contrast, Japan and the UK intervene to a greater extent. From1946 to the early 1970s, the Bretton Woods system made fixed currencies thenorm; however, in 1971, the United States government abandoned the goldstandard, so that the US dollar was no longer a fixed currency, and most of theworld‘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 forthem-1. Let the exchange rate be allowed to fluctuate in the open market according to themarket conditions, or2. An equilibrium rate may be fixed to be adopted and attempts should be made tomaintain 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 fluctuatingrate 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 Regimes1991 1999 2002No. Countries Percentage No. Countries Percentage No. Countries Percentage
There are economists who think that, in most circumstances, floating exchangerates are preferable to fixed exchange rates. As floating exchange ratesautomatically adjust, they enable a country to dampen the impact of shocks andforeign 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 Asiacountries before the Asian currency crisis.
The debate of making a choice between fixed and floating exchange rate regimes isset forth by the Mundell-Fleming model, which argues that an economy cannot
simultaneously maintain a fixed exchange rate, free capital movement, and anindependent monetary policy. It can choose any two for control, and leave third tothe 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 floatingcurrencies 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 andlower bound, a price ―ceiling‖ and ―floor‖. Management by the central bank maytake the form of buying or selling large lots in order to provide price support orresistance, or, in the case of some national currencies, there may be legal penaltiesfor trading outside these bounds.
A free floating exchange rate increases foreign exchange volatility. There areeconomists who think that this could cause serious problems, especially in
emerging economies. These economies have a financial sector with one or more of following conditions:• high liability dollarization • financial fragility • strong balance sheet effects
When liabilities are denominated in foreign currencies while assets are in the localcurrency, unexpected depreciations of the exchange rate deteriorate bank andcorporate balance sheets and threaten the stability of the domestic financial system.
For this reason emerging countries appear to face greater fear of floating, as theyhave much smaller variations of the nominal exchange rate, yet face bigger shocksand interest rate and reserve movements. This is the consequence of frequent freefloating 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 withoutprejudice to the generality of the foregoing such transaction includes-1. Payments due in connection with foreign trade, other current business, servicesand short term banking and credit facilities in the ordinary course of business,2. Payments due as interest on loans and as net income from investments3. Remittances for living expenses of parents, spouse and children residing abroad,and
4. 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 suchsale or drawal is a current account transaction. Reasonable restriction on current
account transactions can be imposed by Central Government in public interest, inconsultation with RBI.
Capital Account Transactions
Section 2(e) of the Foreign Exchange Management Act, 1999 defines a CapitalAccount Transaction as a transaction which alters the assets or liabilities, includingcontingent liabilities, outside India of persons resident in India or assets orliabilities in India, and includes transactions referred to in sub-section (3) of Section 6.
Following Capital Account Transactions are prohibited as per Foreign ExchangeManagement (Permissible Capital Account Transactions) Regulations, 2000 – Transactions not permitted in FEMA - Capital account transactions not permittedin the FEMA Act, Rules or Regulations. In other words, all capital accounttransactions are prohibited, unless specifically permitted. In current accounttransactions the position is reverse, that is all current transactions are permittedunless specifically prohibited.Investment in certain sectors – Foreign investment in India in any company, firmor 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 either by the Central Government or StateGovernment in consideration of surrender of land by the owner without monetaryconsideration. The TDR is transferable in part or whole.
In practice, the distinction between current and capital account transactions is notalways clear-cut. There are transactions which straddle the current and capitalaccount. Illustratively, payments for imports are a current account item but to theextent these are on credit terms, a capital liability emerges and with increase intrade payments, trade finance would balloon and the resultant vulnerability shouldcarefully be kept in view in moving forward to FCAC. Contrarily, extending creditto 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 regimethan resident individuals. Till recently, resident individuals faced a virtual ban oncapital 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 immovableproperty situated outside India, except as provided in the Act.
According to Section 6(4), a person resident may hold, own, transfer or invest inforeign currency, foreign security or any immovable property situated outsideIndia, if such currency, security or property was acquired, held or owned by suchperson when he was resident outside India or inherited from a person who wasresident 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 accounttransactions under the Liberalised Remittance Scheme. Initially it was USD 25,000when introduced in 2003, which was increased to USD 50,000 on 20-12-2006, thento USD 100,000 on 8-5-2007 and now to USD 200,000.
There is justification for some liberalisation in the rules governing residentindividuals investing abroad for the purpose of asset diversification. Theexperience thus far shows that there has not been much difficulty with the presentorder of limits for such outflows. It would be desirable to consider a gradualliberalisation for resident corporates/business entities, banks, non-banks andindividuals. The issue of liberalisation of capital outflows for individuals is astrong confidence building measure, but such opening up has to be well calibratedas there are fears of waves of outflows. The general experience is that as the capitalaccount 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 abilityto conduct transactions of local financial assets into foreign financial assets freely
and at market determined exchange rates. It is sometimes referred to as CapitalAsset Liberation.
It is basically a policy that allows the easy exchange of local currency (cash) forforeign currency at low rates. This is so local merchants can easily conducttransnational business without needing foreign currency exchanges to handle smalltransactions. Capital Account Convertibility is mostly a guideline to changes of
ownership in foreign or domestic financial assets and liabilities. Tangentially, itcovers and extends the framework of the creation and liquidation of claims on, orby 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. This is so local merchants can easily conducttransnational business without needing foreign currency exchanges to handle smalltransactions. CAC is mostly a guideline to changes of ownership in foreign ordomestic financial assets and liabilities. Tangentially, it covers and extends theframework 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, betweenany 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 andexcessive outflow.4. Institutional investors should not use Capital Account Convertibility tomanipulate fiscal policy or exchange rates.5. Excessive inflows and outflows should be buffered by national banks to providecollateral.
The status of capital account convertibility in India for various non-residents is asfollows: for foreign corporates, and foreign institutions, there is a reasonableamount of convertibility; for non-resident Indians (NRIs) there is approximately anequal amount of convertibility, but one accompanied by severe procedural andregulatory impediments. For non-resident individuals other than NRIs, there isnear-zero convertibility. Movement towards an Fuller Capital AccountConvertibility implies that all non-residents (corporates and individuals) should betreated equally. This would mean the removal of the tax benefits presentlyaccorded to NRIs via special bank deposit schemes for NRIs, viz., Non-ResidentExternal 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 YourCustomer (KYC) and Financial Action 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 bythe Government and the RBI.
A person resident in India is permitted to open, hold and maintain with anAuthorized Dealer in India a Foreign Currency Account known as ExchangeEarner‘s Foreign Currency (EEFC) Account subject to the terms and conditions of the Exchange Earner‘s Foreign Currency Account Scheme specified. Further, allcategories 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 theSchedule, to their EEFC Account.
All categories of foreign exchange earners are allowed to credit up to 100 per centof their foreign exchange earnings, as specified in the paragraph 1 (A) of theSchedule, to their EEFC Account. As such, it will be in order for the AuthorizedDealers to allowSEZ developers to open, hold and maintain EEFC Account and to credit up to 100per 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 notexceeding Rs.7,500 (Rupees seven thousand five hundred only) per person; andii) who had gone out of India on a temporary visit, may bring into India at the timeof 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 anamount not exceeding Rs.7,500 (Rupees seven thousand five hundred only) per
person.According to Regulation 7 of the Foreign Exchange Management (ForeignCurrency Accounts by a Person Resident in India) Regulations, 2000,(i) A citizen of a foreign State, resident in India, being an employee of a foreigncompany or a citizen of India, employed by a foreign company outside India and ineither case on deputation to the office /branch /subsidiary /joint venture in India of such foreign company may open, hold and maintain a foreign currency accountwith a bank outside India and receive the whole salary payable to him for theservices rendered to the office/branch/subsidiary/joint venture in India of such
foreign company, by credit to such account, provided that income-tax chargeableunder 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 acompany incorporated in India may open, hold and maintain a foreign currencyaccount with a bank outside India and remit the whole salary received in India inIndian Rupees, to such account, for the services rendered to such an Indian
company, provided that income-tax chargeable under the Income-tax Act, 1961 ispaid on the entire salary accrued in India.
It would be desirable to consider a gradual liberalisation for residentcorporates/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 wavesof outflows. The general experience is that as the capital account is liberalised forresident outflows, the net inflows do not decrease, provided the macroeconomicframework is stable.
As India progressively moves on the path of convertibility, the issue of investmentsbeing channeled through a particular country so as to obtain tax benefits wouldcome to the fore as investments through other channels get discriminated against.Such discriminatory tax treaties are not consistent with an increasing liberalisation
of the capital account as distortions inevitably emerge, possibly raising the cost of capital to the host country. With global integration of capital markets, tax policiesshould be harmonised. It would, therefore, be desirable that the Governmentundertakes 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 wouldbe preferable to foreign currency debt, medium and long term debt in preference toshort-term debt, and direct investment to portfolio flows. There are reports of largeflows of private equity capital, all of which may not be captured in the data (thisissue needs to be reviewed by the RBI). There is a need to monitor the amount of short-term borrowings and banking capital, both of which have been shown to beproblematic during the crisis in East Asia and in other EMEs.
Greater focus may be needed on regulatory and supervisory issues in banking tostrengthen the entire risk management framework. Preference should be given tocontrol volatility in cross-border capital flows in prudential policy measures. Giventhe importance that the commercial banks occupy in the Indian financial system,the banking system should be the focal point for appropriate prudential policymeasures.
RUPEE AS A CONVERTIBLE CURRENCY AND ITS IMPLICATIONS
The recent decision of the government to have full convertibility of the IndianRupee which will affect everyone in the country but is remotely understandable bya 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 eitherrich or of upper middle class.
It is essential to judge a policy by examining both the costs and benefits of it. Thegovernment is talking about the illusory benefits of this convertibility, which will
basically remove all obstacle to the free flow of money and as a result goods andservices also can move freely. The government, in a fully convertible regime, willnot be able to control these flows directly. Indirect controls will be implemented bychanging interest rates and taxes but the effectiveness of this control according tothe international experiences is uncertain.
Advantages
The benefits of free flows of money in a fully convertible regime means foreignerswould be able to invest in the Indian stock markets, buy up companies and
property including land (unless there are restrictions). Indian people and companiescan import anything they would like, buy shares of foreign companies and propertyin foreign lands and can transfer money as they please without going through theHawala business. Indians who have not paid their taxes or repaid their loans takenfrom the Indian banks will be free to transfer their money to foreign countriesoutside the jurisdiction of the Indian authority.
The expected benefits for India would depend on the attractiveness of the countryas a safe destination for short-term investments. Long-term investments do notdepend on convertibility. China has no convertibility, instead a fixed exchange rate
for the last 12 years. Yet, China is the most important destination for long-termforeign investments. Thus, discussions about the full convertibility should be aboutthe desirability of short-term investments and their implications.
Short term investments i.e., foreign investments in shares and bonds of the Indiancompanies and Indian government depend on the demonstration of profit of theIndian companies and the continuous good health of the Indian economy in termsof 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 veryweak with huge government debt, revenue deficits, Rs.150,000 Crores of uncollected taxes and Rs.120,000 Crores of unpaid loans in the banks, increasingprice 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 thepeople 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 fly out very easily if there is anysign of economic downturn when there is a fully convertible Rupee. The result willbe further increase in the balance of payments deficits and fall of the exchange rateof 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 theycan import as they like and buy properties abroad as they were allowed to do soduring the days of British Raj. It has certain advantages for the Indian companieswho will be able to import both raw materials and machineries or set up foreignestablishments at will.
Disadvantages
Full convertibility also has adverse consequences for the India‘s domesticproducers of these raw materials and machineries, as they have to compete against
foreign suppliers who like Chinese may have deliberate low rate of exchange fortheir currencies thus making their goods low in price. Foreign suppliers also can besupported by all kinds of subsidies by their government so as to make their pricesvery low. Agricultural exports from Europe, USA, Thailand, and Australia can ruinIndia‘s own agriculture.
There are many such historical examples in India. Within 20 years between 1860and 1880, India‘s domestic manufacturing industries were wiped out by free tradeand convertible Rupee during the days of British Raj. Indian farmers during thosedays could not cultivate their lands, as the imported food products were cheaper
than whatever they could produce. Demonstration of wealth by the Nawabs andMaharajas of India in Paris and London during the days of British Raj has not doneany 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 thosedark days.
The freedom for India‘s rich to buy companies and property abroad may lead tomassive diversion of funds from investments in the home economy of India toinvestments abroad. This would amount to export of jobs to foreign countries
creating more and more unemployment at home. Japan in recent years suffers fromthis phenomenon, where increasingly Japanese companies are transferring funds toChina for investments, taking advantage of the very low wage rate and lowexchange rate of Yuan, thus creating unemployment at home. Although China hasmassive surplus in the balance of payments, huge reserve of dollars and giganticflows of foreign investments, a non-convertible Yuan and controls on transfer of
money have kept China‘s exchange rate low enough so that Chinese goods cancapture the markets of every important country of the world.
The most dangerous consequence of convertibility is that Rupee will be under thecontrol of currency speculators. A fully convertible regime for the Rupee will
certainly include participation of Rupee in the international currency market and inthe ‗future market‘ of Rupee, the playground for the international speculators. It isvery much possible for the speculators to buy massive amount of Rupee to drive upits exchange rate and then they can suddenly sell all to gain enormous profit. Thatwill drive down Rupee to a very low depth suddenly. If the Reserve Bank of Indiawants to protect Rupee in such a situation, within a few days India will have noforeign 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 meltdowndue to financial contagion.
The crisis started in Thailand with the financial collapse of the Thai baht caused bythe 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 overextensionthat 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 inprivate debt
A similar situation took place in South Korea, Malaysia and Indonesia, all withtheir then convertible currency. Malaysia has survived by imposing fixed exchangerate, exchange control, and making Malaysian dollar nonconvertible. Both Indiaand China were unaffected because their economies at that time were closed andtheir 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 thespeculators. However, Britain with 400 tons of gold in the Bank of England couldnot go bankrupt. There is no guarantee that a similar situation will not occur forIndia. India has no massive gold reserve; in 1991 it had to submit its gold reserveto the Bank of England to get loan from the IMF. Thus, it will certainly gobankrupt if there is any speculative attack on Rupee.
Convertibility also implies that the government of India will lose all controls overthe economy. In a regime with convertible currency and as a result a flexibleexchange rate, fiscal policy of the government, i.e., various taxes and publicexpenditure to stimulate the economy, will be neutralized by adverse monetaryflows out of the country. Only monetary policy i.e., interest rate and money supplyby 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 the country, instead,increases the money supply to stimulate the economy it can cause inflation andeventually unemployment will go up as well because of possible bankruptcy of theprivate companies as a result of high inflation. The argument of Keynes that if there are underemployed resources in the economy increased money supply
resultant from increased government spending cannot cause inflation is not validfor a dual economy like India where the 10 percent of the population live in adifferent 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 beinflation, speculative movements 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-terminvestments will fly out of the country. There would be a free fall of the Rupee inthe international currency market. As a result the economy may go bankruptwithout any foreign exchange. The result can be collapse of the private companiesleaving 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, butthe exporters will be unable to sell their products abroad because of higher price of Indian exports as a result of higher exchange rate of Rupee. High exchange rate of
Rupee also mean lower price of imported products. As a result both manufacturersand farmers will suffer from enhanced competitions from the manufacturedproducts from the East and South East Asia and farm products from USA, Europe,Australia and Thailand.
Thus, interest rate is a dangerous weapon to depend upon. If a country wants to useit extensively the economy will go up and down creating havoc for the people. In
1988 Nigel Lawson, the then Chancellor of Exchequer of Britain used lowerinterest rate to stimulate the economy creating speculative bubble for a few yearsuntil 1991, then he had to increase the interest rate to a very high level to protectthe British pound from the speculators causing serious depression of the economyand high unemployment. The policy of the Federal Reserve of the U.S during thepresidency of Carter had the same experience. Recently Thailand, South Korea,Argentina, and Chile have suffered in the same way.
If the interest rate is determined by the market, as it should be in a convertiblecurrency regime with unrestricted flows of money, India government will not haveany control over the economy to give it a direction. The only instrument that maybe available is the public expenditure policy. The government can stimulate theeconomy by increasing public expenditure, which may have uncertainconsequences for the fate of Indian Rupee. Due to increased public expenditure,
rate of growth of the economy and employment may go up, but at the same timethere will be increased deficits in the balance of payments. Increased rate of growth may invite short-term investments and international speculators will buymore Rupee. However, increased budget deficit will cause increased deficits in thebalance of payments, which will soon drive out short-term investments andspeculators will start selling Rupee. The exact consequence will depend upon howfast the economy can grow and whether the reduced exchange rate will stimulatethe export earnings strong enough to keep the growth growing. The experience of South Korea with a convertible currency from 1996 to 1998 showed thatconvertibility leads to bankruptcy due to speculative attacks against the currency in
the international currency market. Argentina and Chile have similar experiencesrecently.
USA during the days of Reagan and Clinton has avoided the consequences becauseUSA is immune from effects of balance of payments deficits. Value of the U.Sdollar does not depend on the balance of payments deficits of USA but on thevalue of international trade in petroleum, as dollar is the sole currency forpetroleum trading in the world. Also, dollar is the currency in which othercountries keep their reserve of foreign exchange. As India not USA, the experienceof USA cannot give any guide for the Indian policy makers.
India should learn from China. China has no convertibility of Yuan, instead thereare extensive controls on financial, and commodity flows in or out of the country.Foreign companies cannot have 100 percent ownership; they must have partnershipwith Chinese state owned companies. Foreign companies cannot repatriate profit,as they like; they must bring new technology, they must export most of theirproducts. China imports what it needs, although theoretically it is a member of the
World Trade Organization. China does not allow short-term investments, but it isthe most attractive destination for the long-term foreign investments.
Chinese Yuan does not take part in the international foreign exchange market andthus, protected from the currency speculators. China has reduced the exchange rate
of Yuan by 40 percent in 1984 and kept it fixed only to increase it by only 2percent in 2005 when it has gigantic reserve of US dollars and massive tradesurplus with the rest of the world. Very low exchange rate of Yuan is one of themost important reasons why China has managed to capture the markets of everyimportant countries of the world.
CONCLUSION
The rupee exchange rate is neither completely free-floating nor fixed, but is―managed‖ by the Reserve Bank of India 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 ataround 44 to the dollar. But with investor sentiment so hot on India and moneypouring in from abroad — international investors have bought more than $7.5billion 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 foreigncurrencies just to keep the rupee stable. When inflation shot up to over 6% inApril, Bank officials appeared to decide — they never comment explicitly on suchmatters — 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 whoare either rich or upper middle class, traders in the stock market, speculators,bankers, and accountants. The rest 90 percent of the people will be adverselyaffected with loss of employments in the manufacturing sector and bankruptcy inthe agricultural sector and total economic uncertainly.
During the days of the British Raj, Rupee was convertible, India had very largesurplus in the balance of payments. India‘s share in the world trade was muchhigher than what it is today. However, millions of Indians used to starve to death
from time to time; millions of acres of land were left uncultivated by the bankruptfarmers; there were hardly any industry except for a few textile mills, only 15percent of the population had any education at all. Yet at the same time, one couldbuy Rolls Royce and Scotch whisky in Bombay and Calcutta; Jinnah could buy hisapartment in Bond Street of London; Maharaja of Patiala could build palace inParis. We are returning back to those days through the acts of an un-elected (onlyselected for the upper hose of the parliament) Prime Minister Man Mohan Singh
whose loyalty is not to the people of India but to the international financialinstitutions.
In any democratic country for any serious matter like turning the Rupee into aconvertible currency there must be referendums. There were referendums in each
and every European country when they wanted to create the European monetarysystem whereby each European currency would be aligned to each other to create acommon currency Euro. Although India claims to be a democracy, Indian policymakers try their best to avoid the public opinion, even the parliament. Major issueslike India‘s membership of the World Trade Organization, abolition of the plannedeconomy and privatization of public assets, free trade, and now the convertibilityof Rupee should be debated in the parliament and people of India should beallowed 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 therupee to strengthen over the past few months, India is showing it‘s prepared to playmuch more fairly in the global market. India is seen as a more or less unambiguousally to the U.S.
Of course, the Reserve Bank could still intervene to push India‘s rupee lower again. But both the anonymous government official warning of rupee-related joblosses and investors see the rupee continuing to rise in the coming months. If thathappens expect to hear a lot more bleating from India‘s exporters — and not aword of complaint from India‘s trading partners around the world.
Capital account convertibility is considered to be one of the major features of adeveloped economy. It helps attract foreign investment. It offers foreign investors alot of comfort as they can re-convert local currency into foreign currency anytimethey want to and take their money away.
At the same time, capital account convertibility makes it easier for domesticcompanies to tap foreign markets. At the moment, India has current accountconvertibility. This means one can import and export goods or receive or make
payments for services rendered. However, investments and borrowings arerestricted.
But economists say that jumping into capital account convertibility game withoutconsidering the downside of the step could harm the economy. The East Asianeconomic crisis is cited as an example by those opposed to capital accountconvertibility.
Even the World Bank has said that embracing capital account convertibilitywithout adequate preparation could be catastrophic. But India is now on firmground given its strong financial sector reform and fiscal consolidation, and cannow slowly but steadily move towards fuller capital account convertibility.
REFERENCES
BOOKS
1. Taxmann‘s Foreign Exchange Laws Ready R eckoner (2009)2. Ravi Puliani and Mahesh Puliani: Foreign Exchange Management Act, Rules,Regulations, RBI Cirlulars with Allied Acts and Rules, Bharat Law House Pvt.Ltd. (2005)
A convertible currency is defined as being a specific currency that trades freely in
the foreign exchange market, with the price of the currency determined by the
influential forces of demand and supply. Nations that allow for a currency to befully convertible, are those with a stronger financial position, and have ample
foreign currency reserves. There are a handful of developing nations that permit
