PPT ON CURRENCY CONVERTIBILITY

PRESENTED BY:SHREYA BANSAL; 43

MEANING OF CURRENCY CONVERTIBILTY Currency convertibility refers to the freedom to convert the

domestic currency into other internationally accepted currencies and vice versa.

The report on Fuller Capital Account Convertibility (FCAC) defines convertibility as, the freedom to convert local financial assets into foreign financial assets and vice versa.

TYPES OF CONVERTIBLE CURRENCIES

types

Fully convertible currency

Partially convertible currency

Non-convertible currency

CONVERTIBILITY OF RUPEE

Rupee convertibility means the system where any amount of rupee can be converted into any other currency without any question asked about the purpose for which the foreign exchange is to be used.

The need to convert domestic currency into foreign currency or to convert foreign currency into domestic currency arises for two reasons:

1. For transaction arising due to exports, imports, tourism, medical expenses, education, currency gifted overseas. These transaction are called current account transactions.

2. For transaction arising due to foreign direct investment (FDI) into a country or outside the country, to borrow overseas, and to lend overseas. These transactions are called capital account transactions.

CURRENT ACCOUNT CONVERTIBILITY Current account convertibility refers to freedom in respect of payments and

transfers for current international transactions. In other words, if Indians are allowed

to buy only foreign goods and services but restrictions remain on the purchase of

assets abroad, it is only current account convertibility. As of now, convertibility of the

rupee into foreign currencies is almost wholly free for current account i.e. in case of

transactions such as trade, travel and tourism, education abroad etc.

The Government of India introduced a system of Partial Rupee

Convertibility (PCR) (Current Account Convertibility) on February 29,1992. PCR is

designed to provide a powerful boost to export as well as to achieve as efficient

import substitution. It is designed to reduce the scope for bureaucratic controls,

which contribute to delays and inefficiency. Government liberalized the flow of

foreign exchange to include items like amount of foreign currency that can be

procured for purpose like travel abroad, studying abroad etc. What it means that

people are allowed to have access to foreign currency for buying a whole range of

consumables products and services.

COMPONENTS OF CURRENT ACCOUNT CONVERTIBILITY

1. Goods and services

2. Income

3. unilateral transfers

RANGARAJAN COMMITTEE REPORTThe chief recommendations as explained by Gopinath are:

1. Introduction of a market determined exchange rate regime.

2. Liberalization of current account transactions and introduction of current account

convertibility.

3. Shifting of capital flows away from debt creating to non-debt creating flows.

4. Strict regulation of external commercial borrowing especially short-term debt.

5. Giving full freedom to outflows associated inflows, such as repayment of principal

taken in foreign currency , payment of interest, dividend to overseas investors , and

sale proceeds from sale of assets held in India.

In august 1994,India accepted article VIII of the articles of agreement of the IMF. This

required a country to introduce convertibility on the current account. In June 2000, a

new act called Foreign exchange management act (FEMA) was implemented and the

existing act called foreign exchange regulation act (1973) ceased. FEMA was

implement to ensure current account convertibility.

CAPITAL ACCOUNT CONVERTIBILITY (CAC)

The concept of Capital Account Convertibility was coined by RBI and CAC is now almost synonymous with the SS Tarapore Committee.

capital account is made up of both the short-term and long-term capital transactions. The Capital Transaction may be Capital outflow or capital inflow.

Capital account convertibility (CAC) or a floating exchange rate means the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. This means that capital account convertibility allows anyone to freely move from local currency into foreign currency and back.

convertibility on the capital account is usually introduced after a certain period of introducing the Current account convertibility. The most important effect of introducing the capital account convertibility is that it encourages the inflow of the foreign capital, because under certain conditions, the foreign investors are enabled to repatriate their investments, wherever they want.

BASIC STATEMENTS OF CAPITAL ACCOUNT CONVERTIBILITY All types of liquid capital assets must be able to be exchanged

freely between any two nations with standardized exchange rates.

The amounts must be significant amount( in excess of $5,00,000)

Capital inflows should be invested in semi-liquid assets to prevent excessive outflow.

Institutional investors should not use capital account convertibility to manipulate exchange rates.

Excessive inflows and outflows should be buffered by national banks to provide collateral.

IMPACT OF CAC After fully convertibility is adopted by India , it will lead to acceptance of Indian rupee

currency all over the world.

In case of two convertible currencies, forward exchange rates reflect interest rate

differentials between these two currencies.

Thus, it can be said that the forward exchange rate for the higher interest rate currency

would depreciate so as to neutralize the interest rate difference.

However, sometimes there can be opportunities when forward rates do not fully neutralize

interest rate differentials.

In such situations, arbitrageurs get into the act and forward exchange rates quickly adjust

to eliminate the possibility of risk-less profits.

Capital account convertibility is likely to bring depth & large volumes in long-term INR

currency swap markets.

Thus for better market determination of INR exchange rates, the INR should be

convertible.

TARAPORE COMMITTEE ON CAPITAL ACCOUNT CONVERTIBILITY

The Committee on Capital Account Convertibility (CAC) or Tarapore Committee was

constituted by the Reserve Bank of India for suggesting a roadmap on full convertibility of

Rupee on Capital Account. The committee submitted its report in May 1997.

The report made 40 recommendations of which 19 recommendations were fully

implemented by the RBI & 15 were partly implemented.

The CAC Committee recommended the implementation of Capital Account Convertibility

for a 3 year period viz. 1997-98, 1998-99 and 1999-2000

parameter target

Gross fiscal deficit as a percentage of GDP 1997-98:4.5%1998-99:4%1999-00:3%

Gross NPAs of public sector banks 1997-98:12%1998-99:9%1999-00:5%

Inflation range during 1997-00 3 to 5%

CONT…

But this committee had laid down some pre conditions as follows:

1. Gross fiscal deficit to GDP ratio has to come down from a budgeted

4.5 per cent in 1997-98 to 3% in 1999-2000.

2. A consolidated sinking fund has to be set up to meet government's

debt repayment needs; to be financed by increased in RBI's profit

transfer to the govt.

3. Inflation rate should remain between an average 3-5 per cent for the

3-year period 1997-2000.

4. Gross NPAs of the public sector banking system needs to be brought

down from the present 13.7% to 5% by 2000. At the same time,

average effective CRR needs to be brought down from the current

9.3% to 3%

5. RBI should have a Monitoring Exchange Rate Band of plus minus 5%

around a neutral Real Effective Exchange Rate RBI should be

transparent about the changes in REER

CONT…

6. External sector policies should be designed to increase current

receipts to GDP ratio and bring down the debt servicing ratio from

25% to 20%

7. Four indicators should be used for evaluating adequacy of foreign

exchange reserves to safeguard against any contingency. Plus, a

minimum net foreign asset to currency ratio of 40 per cent should

be prescribed by law in the RBI Act.

Since, the RBI aceepted only 34 of the 40 recommendations made by

the report; some restrictions on convertibility still remained. Even in

the case of residents, the implementation of recommendations by

the RBI lead to greater freedom to resident corporate, and less to

resident individuals. These were addressed in the FCAC

report ,2006.

THE SECOND TARAPORE COMMITTEE ON CAPITAL ACCOUNT CONVERTIBILITY

Reserve Bank of India appointed the second Tarapore committee to set out the

framework for fuller Capital Account Convertibility. The committee was

established by RBI in consultation with the Government to revisit the subject of

fuller capital account convertibility in the context of the progress in economic

reforms, the stability of the external and financial sectors, accelerated growth.

The report of this committee was made by RBI on 1st September 2006. In this

report, the committee suggested 3 phases of adopting the full convertibility of

rupee in capital account.

First Phase in 2006-7

Second phase in 2007-09

Third Phase by 2011

CONT…

Following were some important recommendations of this committee:

1. The ceiling for External Commercial Borrowings (ECB) should be raised for automatic approval.

2. NRI should be allowed to invest in capital markets

3. NRI deposits should be given tax benefits.

4. Improvement of the Banking regulation.

5. FII (Foreign Institutional Investors) should be prohibited from investing fresh money raised to participatory notes.

6. Existing PN holders should be given an exit route to phase out completely the PN notes.

PROS OF CAC It allows domestic residents to invest abroad and have a globally diversified

investment portfolio, this reduces risk and stabilizes the economy. A globally diversified equity portfolio has roughly half the risk of an Indian equity portfolio.

Capital Account Convertibility becomes a reality. The reason is on account of current restrictions imposed on movement of their funds. As the remittances made by NRI’s are subject to numerous restrictions which will be eased considerably once Capital Account Convertibility is incorporated.

It also opens the gate for international savings to be invested in India. It is good for India if foreigners invest in Indian assets — this makes more capital available for India’s development. That is, it reduces the cost of capital

Huge amounts of capital are moving across the border anyway. It is better for India if these transactions happen in white money. Convertibility would reduce the size of the black economy, and improve law and order, tax compliance and corporate governance.

Most importantly convertibility induces competition against Indian finance. Currently, finance is a monopoly in mobilizing the savings of Indian households for the investment plans of Indian firms.

CONS OF CAC The possibility of misallocation of capital inflows. Such capital

inflows may fund low-quality domestic investments, like investments in the stock markets or real estates, and factories, which leads to more creation and utilization, and increased level of employment. This also reduces the potential of the country to increase exports and thus creates external imbalances.

capital account can lead to “the export of domestic savings” (the rich can convert their savings into dollars or pounds in foreign banks or even assets in foreign countries), which for capital scarce developing countries would curb domestic investment.

No evidence linking improved growth to CAC.

DIFFERENCE BETWEEN CAPITAL ACCOUNT CONVERTABILITY AND CRRENT ACCOUNT CONVERTIBILITY

BASIS CURRENT ACCOUNT CONVERTIBILITY

CAPITAL ACCOUNT CONVERTIBILITY

MEANING Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. In other words, it allows residents to make and receive trade-related payments — receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services

the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange

CONVERTIBILITY Partial convertible Fully convertible

ESTABLISHED established with the acceptance of the obligations under Article VIII of the IMF's Articles of Agreement in August 1994.

Coined by RBI of India in 1997 by the Tarapore committee.