CURRENCY CONVERTIBILITY

CURRENCY AS SUBSTITUTE
Currency, or money can be defined as a unit of purchasing power. It is a medium of exchange, a substitute for goods or services. It doesn't have to be the coins or bills with which you're probably most familiar. In fact, through the ages, everything from large stone wheels, knives, slabs of salt, and even human beings have been used as money. Anything that people agree represents value is currency. Eg: if you have one barrel of wheat, and you want a cow, without currency you have to find someone who not only has a cow, but also wants a barrel of wheat and will agree to the trade.

Let's say your neighbor fits the bill -- he has a cow and wants a barrel of wheat. What if a barrel of wheat isn't worth an entire cow? Your neighbor can't exactly make change by giving you part of a cow. Now, if you live in a place where round, stamped coins are widely considered to have a certain value and can be exchanged for other things, then you just have to find someone who needs wheat. That person will take the wheat in exchange for an agreed-upon amount of coins, which you can later use to buy a cow from someone else.

WHY CURRENCY CONVERTIBILITY

The Cost of Money
National currencies are vitally important to the way modern economies operate. They allow us to consistently express the value of an item across borders of countries, oceans, and cultures. We need exchange rates because one nation's currency is not always accepted in another. Eg: We walk into a store in Japan and buy a loaf of bread with Swiss francs??? First, we have to go to a bank and buy some Japanese yen with your Swiss francs. An exchange rate is simply the cost of one form of currency in another form of currency. In other words, if you exchange 1 Swiss franc for 80 Japanese yen, you really just purchased a different form of money.

DEFINATION
The ease with which a country's currency can be converted into gold or another currency. Convertibility is extremely important for international commerce. When a currency in inconvertible, it poses a risk and barrier to trade with foreigners who have no need for the domestic currency.

Investopedia explains Currency Convertibility

Government restrictions can often result in a currency with a low convertibility. For example, a government with low reserves of hard foreign currency often restrict currency convertibility because the government would not be in a position to intervene in the foreign exchange market (i.e. revalue, devalue) to support their own currency if and when necessary. An international monetary system has been in existence since monies have been traded, its analyses have been traditionally started from the late 19th century when the gold standard began

The Gold Exchange Standard

An international conference at Bretton Woods, New Hampshire, in 1944 at the close of World War II transformed the international monetary system into one based on mutual cooperation and freely convertible currencies. By this each country had to fix the value of its currency in terms of gold. This established the "par" value of each currency. The U.S. $ was the main currency in the system and $1 was equated in value to 1/35 oz. of gold. By this all currencies were linked in a system of fixed exchange rates

GOLD STANDARDS

Currencies are valued in terms of a gold equivalent known as the mint parity price (an ounce of gold was worth $ 20.67 in terms of the U.S. dollar over the gold standard period) in gold standard. Each currency is defined in terms of its gold value hence all currencies are linked together in a system of fixed exchange rates. Gold was used as a monetary standard because it is an internationally-recognized homogeneous commodity that is easily storable, portable, and divisible into standardized units, such as ounces. Since gold is costly to produce, it possesses another important attribute governments cannot easily increase its supply.

TYPES OF CURRENCY CONVERTIBILITY

Current account convertibility
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.

Capital account convertibility (or a floating exchange rate)

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. It refers to the removal of restraints on international flows on a country's capital account, enabling full currency convertibility and opening of the financial system. Capital account convertibility is considered to be one of the major features of a developed economy. It helps attract foreign investment. It offers foreign investors a lot of comfort as they can re-convert local currency into foreign currency anytime they want to and take their money away.

CAPITAL AND CURRENT ACCOUNT CONVERTIBILITY IN PRETEXT TO INDIAN ECONOMY

The Committee, chaired by former RBI governor S S Tarapore, was set up by the Reserve Bank of India in consultation with the Government of India 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 and global integration. Reserve Bank of India, and will have the following terms of reference: Undertake a review of the extant regulations that straddle current and capital accounts, especially items in one account that have implication for the other account, and iron out inconsistencies in such regulations. Examine existing repatriation/surrender requirements in the context of current account convertibility and management of capital account. Identify areas where streamlining and simplification of procedure is possible and remove the operational impediments, especially in respect of the ease with which transactions at the level of authorized entities are conducted, so as to make liberalization more meaningful. Ensure that guidelines and regulations are consistent with regulatory intent. Review the delegation of powers on foreign exchange regulations between Central Office and Regional offices of the RBI and examine, selectively, the efficacy in the functioning of the delegation of powers by RBI to Authorised Dealers (banks). Consider any other matter of relevance to the above.

HOW DOES CAPITAL A/C CONVERTIBILITY AFFECT AN INDIAN OR NRI?

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.

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.

EXTERNAL AND INTERNAL CONVERTIBILITY

When all holdings of the currency by non-residents are freely exchangeable into any foreign (non- resident) currency at exchange rates within the official margins than that currency is said to be externally convertible. All payments that residents of the country are authorized to make to non-residents may be made in any externally convertible currency that residents can buy in foreign exchange markets. And if there are no restrictions on the ability of a country to use their holdings of domestic currency to acquire any foreign currency and hold it, or transfer it to any nonresident for any purpose, that countrys currency is said to be internally convertible. Thus external convertibility is the partial convertibility and total convertibility is the sum of external and internal convertibility.

CURRENCY CONVERSION RULES

Reporting currency conversion rules differ depending on whether the exchange rate relationship between a transaction and reporting currency is variable or fixed. When there is a variable relationship, the exchange rate between the two currencies fluctuates. When there is a fixed relationship, the exchange rate between the two currencies remains constant, having been fixed at a specific point in time. Note: As of January 1, 1999, the national currencies of countries who are members of the European Monetary Union (EMU) will become another denomination of the Euro, the pan-European currency. Fixed exchange rates will be used between the Euro and each EMU currency.

CURRENCY CONVERSION RULES

Transaction Currency Same as Primary Currency
The following diagram illustrates the conversion business rules that apply when the transaction currency is the same as the primary currency and a variable rate relationship exists between the transaction and reporting currencies:

AN EXAMPLE TO SUPPORT THE ABOVE SLIDES

You receive an invoice for 1,000.00 Australian dollars (AUD) from an Australian supplier. Your organization uses spot rates to account for the invoice in your primary set of books, which is maintained in Canadian dollars (CAD). You use corporate exchange rates to convert amounts to U.S. dollars (USD) for reporting purposes. Summary of related information: Transaction currency: AUD Primary currency: CAD Reporting Currency: USD Spot exchange rate (AUD to CAD): 0.9181 Corporate exchange rate (AUD to USD): 0.6409

This is how the invoice will be converted:

Transaction amount: Primary amount: (0.9181 * 1,000.00 AUD) Reporting amount: (0.6409 * 1,000.00 AUD)

1,000.00 AUD 918.10 CAD 640.90 USD

CURRENCY CONVERSION RULES

The following diagram illustrates the conversion business rules that apply when the transaction currency is different from both the primary currency and the reporting currency, a variable rate relationship exists between the transaction and reporting currencies, and you specify a transaction-to-primary currency conversion rate when you enter the transaction:

AN EXAMPLE TO SUPPORT THE ABOVE SLIDE

You receive an invoice for 1,000.00 Australian dollars (AUD) from an Australian supplier. Your contract with the supplier was originally negotiated using prices in Canadian dollars. The exchange rate used at the time of the agreement was 0.8950 (1 Australian dollar = 0.8950 Canadian dollars). This is also the rate specified on the invoice. Your organization uses corporate exchange rates to convert amounts to U.S. dollars for reporting purposes.
Summary of related information: Transaction currency: Primary currency: Reporting Currency: User-specified rate (AUD to CAD): Corporate exchange rate (CAD to USD): AUD CAD USD 0.8950 0.6974

This is how the invoice will be converted:

Transaction amount: Primary amount: (0.8950 * 1,000.00 AUD) Reporting amount: (0.6974 * 895.00 CAD)

1,000.00 AUD 895.00 CAD 624.17 USD

CURRENCY CONVERSION RULES

The following diagram illustrates the conversion business rules that apply when the transaction currency is the same as the reporting currency:

AN EXAMPLE TO SUPPORT THE ABOVE SLIDE

In February 1999, after the transition period to the Euro begins, you receive an invoice for 1,000 Belgian francs (BEF). Your primary set of books is still maintained in your national currency units (Belgian francs), and you are preparing to convert your operations and financial accounting to the Euro. For this reason, you have created a reporting set of books with a reporting functional currency of Euro and assigned it to your primary set of books. Summary of related information:
Transaction currency (EMU): Primary currency (EMU): Reporting Currency: Fixed conversion factor (EUR to BEF): Transaction amount: Reporting amount: (1000 BEF / 40.7048) BEF BEF EUR 40.7048 1,000 BEF 24.57 EUR

This is how the invoice will be converted:

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