Currency Convertibility and its Impact on B.O.P

Convertibility

Convertibility essentially means the ability of residents and non-residents to exchange domestic currency for foreign currency, without limit, whatever be the purpose of the transactions.

ClassificationRupee Convertibility

Current Account Convertibi lity

Capital Account Convertibi lity

Current Account It refers to currency convertibility required in the case of transactions relating to exchange of goods and services, money transfers and all those transactions that are classified in the current account.

In Short, Current account includes all transactions, which give rise to or use of our National income

Current Account Transactions1. All imports and exports of merchandise 2. Invisible Exports and Imports (sale/purchase of services 3. Inward private remittances (to & fro) 4. Pension payments (to & fro) 5. Government Grants (both ways)

Convertibility on Current AccountIndia is fully convertible on the current account A full convertibility means movement of funds in & out of India without any restrictions & permissions. Provides full freedom to both residents and non-residents to trade in goods/services. RBI has placed a cap in creation of a capital asset In India, most current account transactions have been freed from controls over the years.

Contd 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.

Rangarajan Committee Recommendations1. Liberalization of current account transactions leading to current account convertibility 2. a compositional shift in capital flows away from debt- to nondebt-creating flows 3. strict regulation of external commercial borrowings, especially short-term debt 4. discouraging volatile elements of flows from nonresident Indians 5. gradual liberalization of outflows 6. disintermediation of the government in the flow of external assistance 7. Introducing a market-determined exchange rate regime

Rangarajan CommitteeImplementationsStep-1:Dual exchange rate systemLiberalised Exchange Rate Management System involving dual exchange rate system was instituted in March 1992 The dual exchange rate system was essentially a transitional stage leading to the ultimate convergence of the dual rates made effective from March 1, 1993 Two rates of exchange: Official rate of exchange & Market rate of exchange 60% of the export earnings could be converted at the free market determined rate. (which was around Rs.28) The balance 40% of the earnings should be sold to RBI through authorised dealers at the official rate of exchange. (generally higher at Rs.32)

Step-2:Full convertibility of the current account This unification of exchange rates brought about the era of market determined exchange rate regime of rupee, based on demand and supply in the forex market. Liberalize the access to foreign exchange for all current business transactions including travel, education, medical expenses, etc. Under Article VIII of the IMFs Articles of Agreement in August 1994.

Path that lead to Current Account ConvertibilityAfter 2000

From 1992 to 2000

Liberalizati on began in 1991

Till 1990

Current Situation on Current Account India is fully convertible on the current account Provides full freedom to both residents and non-residents to trade in goods/services. RBI has placed a cap in creation of a capital asset

Capital Account Capital Account consist of short term and long term capital transactions As per FEMA "capital account transaction" means a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India of persons resident outside India

Capital Account Transactions1. Direct Foreign Investments (both inward & outward) 2. Investment in securities (both inward & outward) 3. Other Investments (both inward & outward) 4. Government Loans (both inward & outward) 5. Short-term investments (both inward & outward)

Capital Account TransactionCapital Account transactions are classified as :1.Portfolio investment involves trade in securities like stocks, bonds, bank loans, derivatives, etc. 2.Direct investment involves purchase of real estate, production facilities, or equity investment. 3.Other investment involves holdings in loans, bank accounts and currencies

Capital Account Convertibility The freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. In other words, it means allowing Indians to purchase both the physical and financial assets abroad and vice-versa. In simple language, CAC allows anyone to freely move from local currency into foreign currency and back. It is associated with changes of ownership in foreign/domestic financial assets and liabilities.

Currently Restriction on Capital Account are1. There are limit to company borrowing abroad 2. Restriction on foreigner investing in India. 3. Restriction on amount that FII can hold. 4. Purchasing a company is allowed but limit exit on the amount that can be send. 5. Global Diversification of household portfolio is practically nonexistent.

Limits to Partial CAC Limits specified by the Reserve Bank of India:1.Private visit abroad is $10,000: of which only $5,000 can be in cash 2.Business travel, the yearly limit is $25,000 3.Gift or donate up to $5,000 in a year. 4.Going abroad for employment, or are going for studies abroad: the limit in both these cases is $100,000 5.Investment into foreign stock markets up to the extent of $25,000 in a year.

TARAPORE COMMITTEE-I

Members of the CommitteeHead of Committee: S. S. Tarapore Surjit S. Bhalla Ajit Ranade A. V. Rajwade R. H. Patil M. G. Bhide

i. To review the experience of various measures of capital account liberalization in India,

The Terms Of Reference Of The Committee

ii. To examine implications of fuller capital account convertibility on monetary and exchange rate management, financial markets and financial system, iii. To study the implications of dollarization in India of domestic assets and liabilities and internationalization of the Indian rupee, iv. To survey regulatory framework in countries which have advanced towards fuller capital account convertibility, v. To suggest appropriate policy measures and prudential safeguards to ensure monetary and financial stability, and vi. To make such other recommendations as the Committee may deem relevant to the subject.

Tarapore Committee-I Recommendations Direct Investment in Ventures abroad by Indian Corporate ECB (External Commercial Borrowing) Ceiling Direct and Portfolio Investment and Foreign Disinvestment should be Governed by Comprehensive and Transparent Guidelines Banks may be allowed to Borrow from Overseas Markets SEBI Registered Indian Investors may be allowed to set up Funds for Investment Overseas

Contd Currency Futures may be Introduced Participation in Money Markets may be Widened RBI should withdraw from Primary Market in Government Securities Banks and Financial Institutes should be allowed to Participate in Gold Markets in India and abroad and Deal in Gold Products

Preconditions Of The Tarapore Committee-I Major Pre-Conditions by Report Status as on July 2009Tarapore Committee 1. Reduction in gross fiscal deficit to 3.5% by 1999-2000 2. The inflation rate for 3 years should be an average 3% to 5% 3. Forex reserves should at least be enough to cover 6 months import cover 4. Gross NPAs to be brought down to 5% by 1999-2000 5. CRR to be reduced to 3% by 1999-2000 6. Interest Rate to be fully deregulated The present fiscal deficit is at 6.8% Inflation at present is around 4.00%. The present forex reserves are enough to cover more than one years imports. Gross NPA for the banking sector is around 3% CRR is at 5.00% All interest rates, except Saving Fund interest rates, have already been deregulated.

TARAPORE COMMITTEE-II

Tarapore Committee IIRevisiting The Subject Of CACPrime Minister Manmohan Singh 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 frameworkI will therefore request the Finance Minister and the Reserve Bank to revisit the subject and come out with a roadmap based on current realities.

Tarapore Committee IIRecommendations Meeting Fiscal Responsibility and Budget Management targets Shifting from present measures of fiscal deficit to public sector borrowing requirement. Segregating government debt management and monetary policy operations Imparting greater autonomy and transparency in the conduct of monetary policy Reduction in the share of government / RBI in the capital of public sector banks.

Capital Controls in India India maintains an extensive capital control regime Controls have been quantity-based rather than markets based Oriented towards limiting the countrys external debt Controls remain on the external exposure of pension funds, insurance companies etc. The external assets of banks are closely monitored Stricter controls on short term rather than long term inflows

What Will Full Capital Account Convertibility Do? Reduction in Cost of Capital Help in Diversifying Portfolio Internationally Improve the efficiency of the financial sector through greater competition Reduce Size of Black Economy

Issues to FCAC Capital Flight Credit and liquidity risks Risk of regulatory arbitrage include new dimensions Increased cross-border transactions will augment the dimensions of risks that Indian financial institutions face in their domestic markets

Pre-Requisites These include: 1.Comfortable Current Account Position. 2.Maintenance of Domestic Economic Stability. 3.Adequate Foreign Exchange Reserve. 4.Restriction on inessential Import. 5.An Appropriate Industrial Policy.

The Road Ahead India proceeds gradually towards CAC Reform of Indian financial system is a precondition Banking sector reform is required on a grand scale

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