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1 INTRODUCTION Each country has its own currency through which both national and international transactions are performed. All the international business transactions involve an exchange of one currency for another. For example, if any Indian firm borrows funds from international financial market in US dollars for short or long term then at maturity the same would be refunded in particular agreed currency along with accrued interest on borrowed money. It means that the borrowed foreign currency brought in the country will be converted into Indian currency, and when borrowed fund are paid to the lender then the home currency will be converted into foreign lenders currency. Thus, the currency units of a country involve an exchange of one currency for another. The price of one currency in terms of other currency is known as exchange rate. The foreign exchange markets of a country provide the mechanism of exchanging different currencies with one and another, and thus, facilitating transfer of purchasing power from one country to another. With the multiple growths of international trade and finance all over the world, trading in foreign currencies has grown tremendously over the past several decades. Since the exchange rates are continuously changing, so the firms are exposed to the risk of exchange rate movements. As a result the assets or liability or cash flows of a firm which are denominated in foreign currencies undergo a change in value over a period of time due to variation in exchange rates. This variability in the value of assets or liabilities or cash flows is referred to exchange rate risk. Since the fixed exchange rate system has been fallen in the early 1970s, specifically in developed countries, the currency risk has become substantial for many business firms. As a result, these firms are increasingly turning to various risk hedging products like foreign currency futures, foreign currency forwards, foreign currency options, and foreign currency swaps.

Convertibility essentially means the ability of residents and non-residents to exchange domestic currency for foreign currency, without limit, whatever is the purpose of the transactions. Externally inconvertible currencies may be of rather limited value to their holder. An exported item from a developing country to the USSR, for example, may be paid for in rubles or the currency of a country that has ratified Article VIII. The proceeds may be used to purchase goods anywhere. In considering possible import suppliers, therefore, a developing country will have some interest in directing its importers to those countries that will have some interest in directing its importers to those countries whose inconvertible currencies are in large supply. This is, of course, a case of trade discrimination that is condemned by traditional theory. This means that goods are not being purchased from the cheapest source. Recent economic writing has, however, reopened the question in view of the continued existence of inconvertible currencies. Where it is profitable on the export side to trade with countries maintaining inconvertible currencies, and the government wishes to encourage imports from those countries to offset its credit balances, it will utilize its exchange distribution mechanism to limit the availability of convertible exchange where there are alternative suppliers of the same type of goods in inconvertible currency countries.


Historically, the banknote has followed a common or very similar pattern in the western nations. Originally decentralized 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 a substitute 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 silver coins, and under a bi-metallic standard, payable in either gold or silver coins, at the option of the debtor (the issuing bank).

Under the gold exchange standard banks of issue were obliged to redeem their currencies 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 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 no longer 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 the legal 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 Koreas won and Cubas 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 monetary authorities from expanding the money supply rapidly enough to revive economic activity. In any event, representatives of most of the worlds 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 the worlds manufacturing capacity and held most of the worlds 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 of maintaining fixed exchange rates between their currencies and the dollar. They did this by intervening in foreign exchange markets. If a countrys currency was too high relative to the dollar, its central bank would sell its currency in exchange for dollars, driving down the

value of its currency. Conversely, if the value of a countrys 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 had favorable 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, the United 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-called Smithsonian 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 most currencies 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 hurting exports). By the same token, countries with large deficits often buy their own currencies in order to prevent depreciation, 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 its currency may deplete its international reserves, making it unable to continue buttressing the currency and potentially leaving it unable to meet its international obligations.


1: Fully convertible currency. 2: Partially convertible currency. 3: Non convertible currency. Convertibility of a currency determines the ability of an individual, corporate or government to convert its local currency to another currency or vice versa with or without central bank/government intervention. Based on the above restrictions or free and readily conversion features currencies are classified as:

Fully Convertible - When there are no restrictions or limitations on the amount of currency that can be traded on the international market and the government does not artificially impose a fixed value or minimum value on the currency in international trade. The US dollar is an example of a fully convertible currency and for this reason, US dollars are one of the major currencies traded in the FOREX market.

Partially Convertible - Central Banks control international investments flowing in and out of the country, while most domestic trade transactions are handled without any special requirements, there are significant restrictions on international investing and special approval is often required in order to convert into other currencies. The Indian Rupee is an example of a partially convertible currency.

Nonconvertible - Neither participate in the international FOREX market nor allow conversion of these currencies by individuals or companies. As a result, these currencies are known as blocked currencies. e.g.: North Korean Won and the Cuban Peso


2.1 WHAT IS RUPEE CONVERTABILITY? Currency convertibility refers to the freedom to convert the domestic currency into other internationally accepted currencies and vice versa at market determined rates of exchange.Rupee convertibility means the systemwhere any amount of rupee can be converted into any other currencywithout any question asked about thepurpose for which the foreign exchangeis to be used. Though impressionisticreports suggest that the rupee isalready convertible in the unofficialmarkets, this is an fact not the case. Free convertibility refers to officiallysanctioned market mechanism forcurrency conversion. Non-convertibility can generally be defined with reference to transaction for whichforeign exchange cannot be legally purchased (e.g. import of consumer goods etc),or transactions which are controlled and approved on a case by case basis (likeregulated imports etc). A move towards free convertibility implies a reduction in thenumber / volume of the above types of transaction. Convertibility can be related as the extent to which a country's regulations allow free flow of money into and outside the country. For instance, in the case of India till 1990, one had to get permission from the Government or RBI as the case may be to procure foreign currency, say US Dollars, for any purpose. Be it import of raw material, travel abroad, procuring books or paying fees for a ward who pursues higher studies abroad. Similarly, any exporter who exports goods or services and brings foreign currency into the country has to surrender the foreign exchange to RBI and get it converted at a rate pre-determined by RBI. After liberalization began in 1991, the government eased the movement of foreign currency on trade account. I.e. exporters and importers were allowed to buy and sell foreign currency, as long as the items that they are exporting and importing were not in the banned list.

They need not get permission on a CASE TO CASE basis as was prevalent in the earlier regime. This was the first concrete step the economy took towards making our currency convertible on trade account. In the next two to three years, government liberalized the flow of foreign exchange to include items like amount of foreign currency that can be procured for purposes like travel abroad, studying abroad, engaging the services of foreign consultants etc. This set the first step towards getting our currency convertible on the current account. What it means is that people are allowed to have access to foreign currency for buying a whole range of consumable products and services. These relaxations coincided with the liberalization on the industry and commerce front which is why we have Honda City cars, Mars chocolate bars and Bacardi in India. There was also simultaneous relaxation on the restriction on the funds that foreign investors can bring into India to invest in companies and the stock market in the country.

2.2 HISTORY OF RUPEE CONVERTABILITY The exchange rate regime in India has transited gradually from the fixed exchange rate regime in the pre-1991 period to the flexible exchange rate regime in the post-1991 period. Rupee was historically linked with the UK pond sterling. However, till 1971 Indian rupee was linked with the US dollar to meet the requirement of IMF membership. To provide greater stability to rupee India started fixing the value of rupee in terms of basket of currency since 1975. In the aftermath of BOP crisis, in 1992 Liberalized Exchange Rate Management System (LERMS) was introduced whereby exporters were required to surrender 40% of their foreign exchange earnings at the officially determined rate. The rest could be converted at market determined rate. The importers, on the other hand, had to procure all their foreign exchange requirements at the official rate. LERMS were replaced by Unified Exchange

Rate in 1993 and rupee was made convertible on the current account in August 1994. Since then there is gradual move towards capital account convertibility in India. In 1997 a committee under stewardship of S.S.Tarapore submitted its report on 'Capital Account Convertibility' which provided the initial roadmap for the liberalisation of capital account transactions.Taking the lessons from international experience, committee recommended a set of preconditions to be achieved prior to liberalisation of capital account. It was the time when banking sector reforms were also instigated on the proposition of Narasimhan committee. To facilitate foreign exchange transactions India has replaced more restrictive act of FERA, 1974 by more facilitating approach in the form of FEMA, 2000.Till now, all the rules pertaining to foreign exchange are governed by FEMA. All the current account transactions are permitted under FEMA and no prior permission of RBI is required for any such transactions, while there remain restrictions on capital account. Under FEMA some capital account transactions are completely permitted, some are totally prohibited while some are allowed within a fixed ceiling. Sectoral rules have also been shaped and enforced with FEMA rules. On the success of the measures adopted, the issue of capital account liberalisation was reexamined by Tarapore committee II. Setup in year 2006 it was an extension of the previous committee. The committee on the capital account convertibility has suggested five year time frame (2006 to 2011) for movement towards fuller convertibility in India. During this period the country needs to strengthen macroeconomic framework and bring in place sound financial system and markets and prudential regulatory and supervisory architecture by meeting FRBM targets, greater autonomy and transparency to the RBI in conduct of monetary policy, reducing the share of government in the capital of public sector banks, maintaining the current account deficit Following the East Asian crisis, even the most ardent votaries of CAC in the World Bank and the IMF realised that the dangers of going in for CAC without adequate preparation could be

catastrophic. Since then the received wisdom has been to move slowly but cautiously towards CAC with priority being accorded to fiscal consolidation and financial sector reform above all else. Indian companies were allowed to raise funds by way of equities (shares) or debts. The fancy terms like Global Depository Receipts (GDRs), Euro Convertible Bonds (ECBs), Foreign currency syndicated loans became household jargons of Indian investors. Listing in NASDAQ or NYSE became new found status symbols for Indian companies. However, Indian companies or individuals still had to get permission on a case to case basis for investing abroad. In 2000, the forex policy was further relaxed that allowed companies to acquire other companies abroad without having to go through the rigmarole of getting permission on a case to case basis. Further, Indian debt based mutual funds were also allowed to invest in AAA rated government /corporate bonds abroad. This got further relaxed with Indians being allowed to hold a portion of their foreign exchange earnings as foreign currency, subject to a limit in the recent monetary policy in October 2002. 2.3 TYPES OF RUPEE CONVERTIBILITY

Current Account Convertibility Current account is defined as including the value of trade in merchandise, services, investment, income and unilateral transfers. Current account convertibility, being essential to the development of multilateral trade, three approaches to current account convertibility has been adapted by developing countries. These are the pre-announcement, by-product, and front-loading approaches. Each approach is distinguished by the importance it attaches to convertibility relative to other economic objectives. Capital Account Convertibility Capital account includes transactions of financial assets. Its convertibility refers to the freedom to convert local financial assets into foreign assets in any form and vice versa at market-determined rates of exchange. Capital controls normally restrict or prohibit cross-border movement of capital. Thus, controls on capital movements include prohibitions: need for prior approval; authorization and notification; multiple currency practices; discriminatory taxes; and reserve requirements or interest penalties imposed by the authorities that regulate the conclusion or execution of transactions. The coverage of the regulations would apply to receipts as well as payments and to actions initiated by non-residents and residents. To begin with lets understand the concept of currency convertibility. Currency convertibility may be defined as the freedom to convert one currency into other internationally accepted currencies. Thus in a CAG regime the country places no exchange controls or restrictions on foreign exchange transactions. There are two forms of convertibility convertibility for current international transactions and the convertibility for international capital movements. While India is still to opt for full Capital Account Convertibility, the government has made the rupee convertible on the current account. This implies that companies and resident

Indians can make and receive payments for import/export of goods and services and be able to access foreign currency for travel, education, medical or other designated purposes. Though there is no formal definition of CAC, the Tarapore Committee provides some clarity in this regard as it defines the same as - the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. In other words, Capital account convertibility means that the home currency can be freely converted into foreign currencies for acquisition of capital assets abroad. Thus, implementation of the capital account convertibility regime will allow Indian residents to invest, disinvest or transact in any property or assets/liability of any country, convert one currency to another or move funds anywhere in the world, solely guided by discretion of the concern individual or company & not restricted by law. India`s Situation India has full current account convertibility. Unfortunately, there are a few restrictions on capital account convertibility, hence, India has partial capital 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.

APPLICATION In most traditional theories of international trade, the reasoning for capital account convertibility was so that foreign investors could invest without barriers. Prior to its implementation, foreign investment was hindered by uneven exchange rates due to corrupt officials, local businessmen had no convenient way to handle large cash transactions, and national banks were disassociated from fiscal exchange policy and incurred high costs in supplying hard-currency loans for those few local companies that wished to do business abroad. Due to the low exchange rates and lower costs associated with Third World nations, this was expected to spur domestic capital, which would lead to welfare gains, and in turn lead to higher GDP growth. The tradeoff for such growth was seen as a lack of sustainable internal GNP growth and a decrease in domestic capital investments.[7] When CAC is used with the proper restraints, this is exactly what happens. The entire outsourcing movement with jobs and factories going overseas is a direct result of the foreign investmentaspect

of CAC. The Tarapore Committee's recommendation of tying liquid assets to static assets (i.e., investing in long term government bonds, etc.) was seen by many economists as directly responsible for stabilizing the idea of capital account liberalization. 3.2 COMPONENTS OF CURRENT ACCOUNT

Covered in the current account are all transactions (other than those in financial items) that involve economic values and occur between resident non-resident entities. Also covered are offsets to current economic values provided or acquired without a quid pro quo. Specifically, the major classifications are goods and services, income, and current transfers. I. Goods

General merchandise covers most movable goods that residents export to or import from non residents. Goods for processing covers exports (or, in the compiling economy, imports) of goods crossing the frontier for processing abroad and subsequent re-import (or, in the compiling economy, export) of the goods, which are valued on a gross basis before and after processing. The treatment of this item in the goods account is an exception to the change of ownership principle. Repairs on goods covers repair activity on goods provided to or received from non residents on ships, aircraft, etc. repairs are valued at the prices (fees paid or received) of the repairs and not at the gross values of the goods before and after repairs are made. Goods procured in ports by carriers covers all goods (such as fuels, provisions, stores, and supplies) that resident/nonresident carriers (air, shipping, etc.) procure abroad or in the compiling economy. The classification does not cover auxiliary services (towing, maintenance, etc.), which are covered under transportation.

Nonmonetary gold covers exports and imports of all gold not held as reserve assets (monetary gold) by the authorities. Nonmonetary gold is treated the same as any other commodity and, when feasible, is subdivided into gold held as a store of value and other (industrial) gold.


Transportation covers most of the services that are performed by residents for nonresidents (and vice versa) and that were included in shipment and other transportation in the fourth edition of the Manual.

Travel covers goods and servicesincluding those related to health and educationacquired from an economy by non resident travelers (including excursionists) for business and personal purposes during their visits (of less than one year) in that economy. Travel excludes international passenger services, which are included in transportation. Students and medical patients are treated as travelers, regardless of the length of stay. Certain othersmilitary and embassy personnel and non resident workersare not regarded as travelers. However, expenditures by non resident workers are included in travel, while those of military and embassy personnel are included in government services.

Communications services cover communications transactions between residents and nonresidents. Such services comprise postal, courier, and telecommunications services .

Construction services covers construction and installation project work that is, on a temporary basis, performed abroad/ or in Extra territorial enclaves by resident/non resident enterprises and associated personnel. Such work does not include that undertaken by a foreign affiliate of a

resident enterprise or by an unincorporated site office that, if it meets certain criteria, is equivalent to a foreign affiliate.

Insurance services covers the provision of insurance to non residents by resident insurance enterprises and vice versa. This item comprises services provided for freight insurance (on goods exported and imported), services provided for other types of direct insurance (including life and non-life), and services provided for reinsurance.

Financial services (other than those related to insurance enterprises and pension funds) covers financial intermediation services and auxiliary services conducted between residents and nonresidents. Included are commissions and fees for letters of credit, lines of credit, financial leasing services, foreign exchange transactions, consumer and business credit services, brokerage services, underwriting services, arrangements for various forms of hedging instruments, etc. Auxiliary services include financial market operational and regulatory services, security custody services, etc.

Computer and information services covers resident/non-resident transactions related to hardware consultancy, software implementation, information services (data processing, data base, news agency), and maintenance and repair of computers and related equipment.

Royalties and license fees covers receipts (exports) and payments (imports) of residents and nonresidents for (i) the authorized use of intangible non produced, nonfinancial assets and proprietary rightssuch as trademarks, copyrights, patents, processes, techniques, designs, manufacturing rights, franchises, etc. and (ii) the use, through licensing agreements, of produced originals or prototypessuch as manuscripts, films, etc.

Other business services provided by residents to nonresidents and vice versa covers merchandising and other trade-related services; operational leasing services; and miscellaneous business, professional, and technical services.

Personal, cultural, and recreational services covers (i) audiovisual and related services and (ii) other cultural services provided by residents to non-residents and vice versa. Included under (i) are services associated with the production of motion pictures on films or video tape, radio and television programs, and musical recordings. (Examples of these services are rentals and fees received by actors, producers, etc. for productions and for distribution rights sold to the media.) Included under (ii) are other personal, cultural, and recreational servicessuch as those associated with libraries, museumsand other cultural and sporting activities.

Government services i.e. covers all services (such as expenditures of embassies and consulates) associated with government sectors or international and regional organizations and not classified under other items. 2. Income

Compensation of employees covers wages, salaries, and other benefits, in cash or in kind, and includes those of border, seasonal, and other non-resident workers (e.g., local staff of embassies).

Investment income covers receipts and payments of income associated, respectively, with residents holdings of external financial assets and with residents liabilities to nonresidents. Investment income consists of direct investment income, portfolio investment income, and other investment income. The direct investment component is divided into income on equity (dividends, branch profits, and reinvested earnings) and income on debt (interest); portfolio

investment income is divided into income on equity (dividends) and income on debt (interest); other investment income covers interest earned on other capital (loans, etc.) and, in principle, imputed income to households from net equity in life insurance reserves and in pension funds. 3. Current transfers Current transfers are distinguished from capital transfers, which are included in the capital and financial account in concordance with the SNA treatment of transfers. Transfers are the offsets to changes, which take place between residents and nonresidents, in ownership of real resources or financial items and, whether the changes are voluntary or compulsory, do not involve a quid pro quo in economic value. Current transfers consist of all transfers that do not involve (i) transfers of ownership of fixed assets; (ii) transfers of funds linked to, or conditional upon, acquisition or disposal of fixed assets; (iii) forgiveness, without any counterparts being received in return, of liabilities by creditors. All of these are capital transfers. Current transfers include those of general government (e.g., current international cooperation between different governments, payments of current taxes on income and wealth, etc.), and other transfers (e.g., workers remittances, premiumsless service charges, and claims on non-life insurance). A full discussion of the distinction between current transfers and capital transfers.



Currency convertibility refers to the freedom to convert the domestic currency into other internationally accepted currencies and vice versa. Convertibility in that sense is the obverse of controls or restrictions on currency transactions. While current account convertibility refers to freedom in respect of payments and transfers for current international transactions, capital account convertibility (CAC) would mean freedom of currency conversion in relation to capital transactions in terms of inflows and outflows. Article VIII of the International Monetary Fund (IMF) puts an obligation on a member to avoid imposing restrictions on the making of payments and transfers for current international transactions. Members may cooperate for the purpose of making the exchange control regulations of members more effective. Article VI (3), however, allows members to exercise such controls as are necessary to regulate international capital movements, but not so as to restrict payments for current transactions or which would unduly delay transfers of funds in settlement of commitments.

Inflows and outflows of capital Borrowing from or lending abroad. Sales and purchases of securities abroad. Capital Foreign Direct Investments Short term and Long term Investments Government Loans


Ultimate aim for such a concept is foreign investors could invest in other countries without barriers.

This has led to many factories going overseas thus creating innumerable job opportunities.

CAC should be used with proper restraints.


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, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts etc.

Is India ready to switch to full convertibility of rupee on capital account?

Some steps have already been taken to facilitate the full capital account convertibility in the country. Foreign exchange has been allowed to flow into Indian stock markets through registered institutional investors. In addition, many categories of the resident Indians have been allowed to open foreign currency accounts abroad. Indian companies have also been making overseas acquisitions for which they have been given access to foreign currency resources.

It would, however, be wrong to presume that full convertibility on the capital account would result in lifting of all the restrictions. Even the developed countries like the USA block foreign investment in some of the sectors. Despite the government decision in this regard, it has not been easy for the non-resident Indians to acquire property and real estate in the country. The government of India, though has allowed Direct Foreign Investment (FDI) in most of the fields, yet certain caps have been put by the government on the FDI in some of the sectors.. Benefits would be in terms of more flow of foreign capital into the economy, resulting in higher investment and the resultant growth rate. Further, the financial and capital markets would bring more profits to the domestic investors. The economy must be nearer to the global standards in the matter of fiscal deficit, inflation rate, interest rates, foreign exchange reserves, etc. It is said that the economy can be said to be ripe for capital account convertibility only if interest rates are low and de-regulated and the inflation rate in the three consecutive years had been around three per cent. Considering the above prerequisites it appears that the Indian economy is not yet prepared for switching over to the capital account convertibility.

Current Account In short Includes all imports-exports, pension payments-both ways, remittances-to & fro Indian scenario-fully convertible Freedom in respect of current international transactions

Capital account convertibility In short

Inflows outflows of capital, borrowing or lending from abroad, sale and purchase of securities.

Indian scenario-partially convertible.


CAC has 5 basic statements designed as points of action All types of liquid capital assets must be able to be exchanged freely, between any two nations in the world, with standardized exchange rates.

The amounts must be a significant amount (in excess of $500,000). Capital inflows should be invested in semi-liquid assets, to prevent churning and excessive outflow.

Institutional investors should not use CAC to manipulate fiscal policy or exchange rates. Excessive inflows and outflows should be buffered by national banks to provide collateral.


Limits to companies borrowing abroad. Restrictions exist on Indians sending money abroad that does not have to do with importing goods and services.

Restriction on foreigners investing in India Restriction on amount that FII can hold. Purchasing a company is permissible but a limit exists on the amount that can be sent.


A hybrid between control and liberalisation of the capital account, has served country well for nearly a decade. India has witnessed a significant surge in cross border capital flows through CAC. The strong capital movements to India in the recent period reflect the momentum in following: A) Progress At Country Level (1) End of Balance of Payment (BoP) crisis: In 1991 India was struggling with the crisis in its balance of payments. Importing was essential for the country while the government's conservative approach towards exports pushed country into severe balance of payment deficit.Capital account liberalisation has been the strongest medium in curbing such crisis. There was an ongoing trade deficit from the year 1990-91, but a positive capital account has provided cushion against all odds and overall balance of payments are in surplus. (2) Plenty of Foreign Currency Reserves:India has envisaged a plentiful surge in its reserves. The liberalisation of capital account has helped country in recovering from reserve shortage. The doting supply of dollars to Reserve Bank exchequer is a healthy sign for economy, as reserves can be utilised during the times of adversity. The reserve position is shown in the graph:

(3) Efficiency in Financial System: Capital Account Convertibility is incomplete without fiscal consolidation, sound policies and financial prudence. RBI and Government of India have been very conservative and watchful during whole process of liberalisation. This has improved total financial performance of economy. Banks today have greater access to additional capital (foreign borrowing), autonomy in operations (easening of control by RBI) and intensive competition (opening of private and foreign banks and Non Banking Finance Corporations). There is larger room for financial efficacy, specialisation and innovation in financial system. (4) Development of Securities Market: Gush of Foreign Institutional Investment (FII) has helped in multifold enlargement of security market. The market capitalisation of BSE and NSE has significantly risen. Derivates, bonds, commodities now constitute the major trading instruments besides equity shares. Sensex (above 20,000) and Nifty (above 6,000) touched new heights due to huge investment in the listed stocks. The position of BSE Sensex is shown in the graph:

(5) Worldwide Presence and Friendly Relations with Trading Counterparts: Flow of investment is a distinctive medium of developing global relationships. Indian MNCs and service organisations are conducting business operations in almost 140 countries across the globe. India is 19th largest exporting country in the world according to 2011 estimates. Indian IT services,

handicrafts, cuisine and jewellery are world famous and contribute to major chunk of revenue from international operations. It all has become reality with the financial liberalisation. India is the founder member of WTO, IMF and World Bank. It is a member of BRICS and G-20 at WTO trade negotiations. Government has entered into multilateral trade agreements and tax avoidance treaties with the trading counterparts. Immigration norms have also been untangled. All this has given a global presence to the country and friendly relations too are in progress. B) PROGRESS AT CORPORATE LEVEL 1) Indian corporate sector is inundated with broader access to low cost capital through External Commercial Borrowings. In addition, companies have the prospect of expanding theircapital base through issue of American Depository Receipts, Global Depository Receipts and corporate bonds. 2) Diversification of risk and economies of scale through business performance in different realms. 3)Increase in profit after tax through intercontinental operations (manufacturing, sales, services and Intellectual Property Rights). 4) Gains in technology through joint ventures, international license and import of technology from the specialised manufacturer. 5)Access to worldwide pool of intellectuals, managers, technical personnel etc and their specialised knowledge and skills. C) PROGRESS AT CUSTOMER LEVEL Indian customers have gained in plenteous ways, and are getting superior quality, competitive prices and added features in the goods available in the market. They have a bundle of offerings in every sector from fast moving consumer goods (FMCGs) to automobiles, furniture to food, health

clubs to telecommunication, clothes to electronics and so on. This has amplified the price wars and there has been an eminent improvement in customer services and customer information through 24/7 help lines andWorld Wide Web technology.


It is a discernible fact that a number of empirical studies do not find evidence that greater openness of capital account and higher flows of capital lead to advanced growth (Prasad et al 2000). Some economists believe that the opening up of capital account is the last mile connectivity to the globalised world; to others it symbolise a shortcut to economic ruination. India's most recent negative experiences with the capital account liberalisation are as follows: (1) Depreciating Rupee: With the liberalisation of capital account large amount of money is flowing in and out of the economy. Subsequently rupee has become highly volatile and slipped to its all time low (1$=57.33). India's imports are greater than its exports and former has further declined due to financial crisis in Euro zone. Reserve Bank is not able to peg rupee at harmless levels, consequently imports have become too expensive and the risk of widening trade deficit is obvious. Reserve Bank has to buy or sell dollars in substantial amount to maintain the value of rupee at reasonable levels. Weakening rupee has also created problems in setting appropriate interest rates. Graph shows the value of Indian rupee pegged to US dollar.

It is clear from the graph that in August 2011, value of 1 USD was INR 44 and by June 2012 this value has become 57 rupee, the lowest value ever. (2) Volatility in Stock Markets:International financing and investment shifts from country to country in search of higher speculative returns. Stock markets have undergone this phenomenon rapidly. In good times of the economy (good rating, healthy IIP, high GDP, political stability) foreign institutional investors are on buying spree, but in bad times FII quickly lose their confidence in market and there is an abnormal selling. Investors experience huge losses some

become bankrupt too. Given in the graph drasticups and downs in stock market indicators:

Source: BSE (3) Debilitating Impact on Inflation: Capital convertibility has lead to exchange rate volatility of the Rupee resulting in macroeconomic instability caused through the risk of rapid and large capital outflows as well as inflows. When capital flows are large money supply increases and RBI comes up with tightening of monetary policy. Also, India imports approximately 75% of its crude requirements. Given the fact that the oil prices have been well above theUSD 90 per barrel and extremely volatile, this hasfurther widened the trade deficit of India and hasresulted in soaring energy prices. This has upset theeconomy and has a debilitating impact on inflationwithin India. Such speculative capital flows havemade domestic monetary policy virtually ineffective. (4) Asset Liability Mismatch of Banks: Inglobal experience with convertibility, banking envisages to be another weaker link. Banks are facingan inequality between their assets and liabilities.Banks generally refuse to lend a company which hasa debt equity ratio of more than 2.

Indian bankspresently have high debt because of cheap borrowingthrough ECBs. Moreover high interest rate in marketon borrowings has led to slump in demand of loansand advances. Decline in loans and advances on theasset side of balance sheet has increased the pressureto sustain the same maturity period for deposits andthe asset liability management has come under strain. (5)Flow of Black Money through Participatory Notes (P-Notes): SEBI allowed issue of PNotes to FII in 2006. Concerns have been raised on the secrecy afforded to investors through PNotes. Different types of foreign entities are eligible for the issue of P-Notes but the identity of the actual investor may be mysterious to the regulatory bodies. Therefore some of the money invested in the market through P-Notes may be unaccounted wealth of affluent Indians hidden beneath the pretext of FII investment. Such funds could be tainted and linked with unlawful activities like corruption and smuggling. Hedge funds too may use P-Notes and sub accounts of FII to operate in stock market. Reserve Bank stance is towards prohibition of P-Notes. (6)Does not serve the Purpose of Real Sectors: Capital Account Convertibility (CAC) primarilybenefitindustrialists and financial capitalists who invest in stock market for speculative gains. It is mainly pursued to please international organisations (IMF, WB, and WTO) and foreign investors. It hasn't addressed the real problems of the country like poverty, unemployment, income inequalities, infrastructure bottlenecks and many more. The irony is that burden is borne by the common man under a crisis, which has become an actuality these days. This comes up in the form of sharper reduction in subsidies, less budgetary allocations for social welfare programmes, high taxes and high inflation. The foreign speculators and domestic players walk out of the market by converting their assets into cash and insulate themselves from losses in such during economic problems.



In the process of capital account liberalisation, Indian economy has been able to attract reasonable foreign investment without any major shocks. The benefits that have been derived with an open capital account have induced the growth and development of India's financial markets and external sector. Due to some or other reasons from inside and outside macroeconomic instability has lingered in the economy and things are not going well. Inflation rate is high from the year 2009onwards. The average yearly inflation was 10.9% in 2009 and 11.7% in 2010. In 2011 the rate of inflation stood at 9.6%. Between the periods it rose to double digits too. RBI has revised monetary policy during the different time periods. Cash Reserve Ratio (CRR) was revised 13 times in the time frame of 2 years which is a benchmark in itself. Despite continuous efforts RBI is not able to tame inflation and it is still modest at the level of 8% according to latest estimates. The depreciation in the value of rupee to the level of 1 USD=57.33 INR has also raised serious questions and concern on the conduct and policies of Reserve Bank and Government of India. Global rating agencies Standard & Poor (s & P) and Fitch have revised India's rating from 'Stable' to 'Negative'. S&P has released a report strongly criticising the Government's inability to move ahead with economic reforms and referred to cracks in ruling coalition that they were holding up progress. Fitch has censured and added the general elections due in early 2014 could see politically driven pressure to loosen fiscal policy, which could further weaken India's public finance related to peers. The ratings and statement of S&Pand Fitch raise the risk of Indian bonds slipping into junk category, hurting the country's

image as an investment destination. The cost of overseas borrowing for Indian companies could also go up. The story is not yet over. Equity market is plummeting week after week because FII are on selling fling. Sensex is currently trading lower than 17,000 and Nifty near 5,000. Investor sentiments are down. Individual portfolios are making losses. Volatility and panic are the latest buzz words for the 'Dalal Street'. Food inflation is constantly maintaining its double digit levels causing a decline in domestic savings with banks. IIP has fallen to the level of 3.5% from 8.1% of the previous year. GDP growth in 2012- 13 is estimated at the aching level of 6.5% while fiscal deficit is at 5.9%. Reserve Bank's Governor D.Subbarao said 'fiscal deficit in 1991 was 7% and it is ruling at 5.9% in 2012.' Is it an alarming signal? Because, India was going through its meagre times in 1991 and latest GDP estimates too are worrisome. There are additional doubts about Government's ability to trim subsidy level to cut fiscal deficit, which could further increase the prices of essential commodities. A new retro tax GAAR (General Anti Avoidance Rule) is also proposed to be enacted in budget for fiscal 2013. GAAR aims to target tax evaders, partly by stopping Indian companies and investors from routing investments through Mauritius or other tax havens for the sole purpose of avoiding taxes. It has sparked an outcry among foreign investors. Thus the recent global turmoil, volatile capital flows and economic instability have considerably heightened the uncertainty surrounding the outlook for India, complicating the conduct of monetary policy and external management. The intensified pressures have necessitated stepped up operations in terms of capital account management and more active liquidity management with all instruments at command of Reserve Bank. Therefore in this scenario, it is suggested that India should adopt a go slow approach in moves to liberalise capital account. Instead, it is important for the country to be ready to deal with potentially large and volatile

outflows along with spillovers. In this context, there is a need of manoeuvre for Reserve Bank to deal with present serious matters by deployment of monetary policy instruments, buying and selling operations of forex, complemented by prudential restrictions and measures for capital account management. 5.2 TARAPORE COMMITTEE APPOINTMENT

The RBI has appointed a committee to set out the framework for fuller Capital Account Convertibility

To revisit the subject of FCAC in the context of progress in economic reforms, the stability of the external and financial sectors, accelerated growth and global integration.

Suggestions of the committee:

1. Reduction in gross fiscal deficit as a percentage of GDP 2. A certain level of rate of inflation for a certain period 3. A fully de-regulated interest rate structure. 4. A reduction of non-performing assets as a percentage of total advances.

Such factors were the pre-requisites towards attainment of FCAC. Unfortunately the performance was below satisfactory as none of the conditions could be met. For Example: Gross fiscal deficit did not show a reducing trend and it did not reduce as expected. Interest rates could not be completely deregulated. Non-performing assets did not reduce as expected.

5.3 INDIAS PERFORMANCE AGAINST THE PRE-CONDITIONS The previous discussion clearly indicates the following: On the fiscal front, India has performed poorly. The fiscal deficit/GDP ratio has not been contained within the prescribed limit. Concurrently, domestic liabilities/GDP ratio has been continuously rising Average inflation rate has stayed higher than the recommended band Debt-servicing ratio has not at all responded to the recommendation Average effective CRR has remained much higher than the floor However, the gross NPA ratio of public sector banks has come down remarkably Indias external sector has registered positive performance. The exports/GDP ratio and import/GDP ratio have gone up. CAD/GDP ratio has been contained within the 2-3% band on a continuous basis. Thus Tarapore Committees recommendations have mostly not been implemented, sincethe prescribed conditions were not met. Time-frame wise, it is clear that the committeessuggestions and recommendations were premature by at least 10 years, if not more.


As most of us know, resident Indians cannot move their money abroad freely. That is, one has to operate within the limits specified by the Reserve Bank of India and obtain permission from RBI for anything concerning foreign currency.

For example, the annual limit for the amount you are allowed to carry on a private visit abroad is $10,000: of which only $5,000 can be in cash. For business travel, the yearly limit is $25,000. Similarly, you can gift or donate up to $5,000 in a year.

The RBI limit raises the limit if you are going abroad for employment, or are emigrating to another country, or are going for studies abroad: the limit in both these cases is $100,000.

You are also allowed to invest into foreign stock markets up to the extent of $25,000 in a year.

For the average Indian, these 'limits' seem generous and might not affect him at all. But for heavy spenders and those with visions of buying a house abroad or a Van Gogh painting, it will mean a lot. . .

But with the markets opening up further with the advent of capital account convertibility, one would be able to look forward to more and better goods and services.

And how will it affect Non-Resident Indians?

Capital account convertibility may NRIs as it will help remove all shackles on movement of their funds.

Currently, NRIs have to produce a whole lot of documents and certificates if they want to buy a house in India (for which the lock-in period is 10 years, meaning they can't take their money back overseas if they sell the house after having owned it for less than 10 years), or send money to India from their overseas accounts.


There are certain prerequisites for introduction of capital account full convertibility. The Economy must be nearer to the global standards in the matter of fiscal deficit, inflation rate, interest rates, foreign exchange reserves, etc. It is said that the economy can be said to be ripe for capital account convertibility only if interest rates are low and de-regulated and the inflation rate in the three consecutive years had been around three per cent. In addition, fiscal deficit should be low at around 3 per cent and foreign exchange reserves should be reasonably high. Further, the economy has to be in good shape, as full convertibility would result in bringing in the instabilities and fluctuations of the outside world into the economy, as it gets more connected to the outside world. Further, imperfections in the economy, like the urban-rural dichotomy and difference in the growth rates in various sectors like agriculture and industries, as well as services, must be removed. But post-CAC, they are expected to deal with multi-currency transactions. The risks involved are: Currency Risk: Effect of currency appreciation/depreciation Counterparty Credit Risk Transfer Risk: Generated from tracking financial position of all economies involved Legal Risk.

It is still doubtful whether the state-protected banks would be able to ward the risks off.India also falls short of most of the criteria suggested by the first Tarapore Committee.The 3-year phasing plan of CAC as conceived in 1997 has not been fully effective even11 years down the line. Without the pre-conditions strongly in place, no country cansafely adopt CAC (as mentioned

earlier, capital controls are virtually irreversible so far asinternational investor confidence is concerned).Two crucial questions arise during evaluation of Indias readiness to adopt fullconvertibility: First, are the indicators which conform to the levels suggested by theCommittee sustainable in future, or are significant deviations from current levels to beexpected, say 10 years down the line? Second, when, if at all, the non-conforming criteriaare expected to converge to the recommended level or band? Considering the above prerequisites it appears that the Indian economy is not yet prepared for switching over to the capital account convertibility. The only requisites which have been met are reasonably high level of foreign exchange reserves, mostly deregulated interest rates and relatively good condition of the economy as a whole. In most of the other areas there is lot more to be done. Interest rates as well as the inflation rate are higher than the required levels. Further, the imperfections of the economy are glaring as the services and industrial sectors are booming, but the agricultural sector which employs over 65 per cent of the total work force, is growing at a much lower rate of 2 to 3 per cent per annum.


India has been relentlessly moving on the path towards liberalization, opening up its markets and loosening its controls over many economic matters so as to integrate with the global economy.

Despite the opposition to globalization from some quarters, India has been quite watchful in its approach to embracing global economy. The issue of capital account convertibility is one such where the nation has tread very cautiously.

A high-level committee to look into this matter, appointed by the Reserve Bank of India recommended that India move to fuller capital account convertibility over the next five years and has laid down the roadmap for the move.

Various pre requisites need to be fulfilled:

Reduction in gross fiscal deficit as a percentage of GDP A certain level of rate of inflation for a certain period A fully de-regulated interest rate structure. A reduction of non-performing assets as a percentage of total advances.

Such steps will help India match with the global standards and these steps would also pave the way for Full Capital Convertibility.


Recent Development in International Currency Market by: Lucjan T. Orlowski www.investopedia.com www.hindubusinessline.com www.ias.org www.phindia.com www.rbi.org