Currency Convertibility

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e-mail :[email protected], [email protected] Tel. : 26609320 Website : www.lsraheja.org.in SADHANA EDUCATION SOCIETY’S L. S. RAHEJA COLLEGE OF ARTS AND COMMERCE RE-ACCREDITED BY NAAC WITH ‘A’ GRADE Juhu Road, Santacruz (West), Mumbai – 400 054. DECLARATION BY THE STUDENT I, _____________________________________________________student of M Com Part-I Roll Number __________hereby declare that the project for the Paper _________________. “- _________________________________________________________________ ________” submitted by me for Semester –I during the academic year 2012-13, is based on actual work carried out by me under the guidance and supervision of _______________________. I further state that this work is original and not submitted anywhere else for any examination. Signature of Student 1

Transcript of Currency Convertibility

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e-mail :[email protected], [email protected] Tel. : 26609320 Website : www.lsraheja.org.in

SADHANA EDUCATION SOCIETY’S

L. S. RAHEJA COLLEGE OF ARTS AND COMMERCE RE-ACCREDITED BY NAAC WITH ‘A’ GRADE

Juhu Road, Santacruz (West), Mumbai – 400 054.

DECLARATION BY THE STUDENT

I, _____________________________________________________student of M Com Part-I

Roll Number __________hereby declare that the project for the Paper _________________.

“_________________________________________________________________________”

submitted by me for Semester –I during the academic year 2012-13, is based on actual work

carried out by me under the guidance and supervision of _______________________. I further

state that this work is original and not submitted anywhere else for any examination.

Signature of Student

EVALUATION CERTIFICATE

This is to certify that the undersigned have assessed and evaluated the project on

“_________________________________________________________________________”

submitted by ___________________________________________Student of M Com Part-I.

This project is original to the best of our knowledge and has been accepted for Internal

Assessment.

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Internal Examiner External Examiner Principal

L. S. RAHEJA COLLEGE OF ARTS & COMMERCE

Internal Assessment: Project 40 Marks

Name of the Student Class Division RollNumber.

First name :

Father’s Name:

Surname :

M COM

PART I

Subject: Economics of Global Trade & Finance

Topic for the Project:

Marks Awarded Signature

DOCUMENTATIONInternal Examiner (Out of 10 Marks)External Examiner (Out of 10 Marks) Presentation (Out of 10 Marks)

Viva and Interaction (Out of 10 Marks)

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TOTAL MARKS (Out of 40)

CONTENTS

Sr. No. PARTICULARS Page No.

CHAPTER I – INTRODUCTION

1.1 INTRODUCTION 4

1.2 TYPES OF CURRENCY CONVERTIBILITY 7

1.3 RUPEE CONVERTIBILITY 9

CHAPTER II –CURRENT ACCOUNT CONVERTIBILITY

2.1 COMPONENTS-GOODS 14

2.2 SERVICES 15

2.3 INCOME 18

CHAPTER III – CAPITAL ACCOUNT CONVERTIBILITY

3.1 BASICS & APPLICATION 20

3.2 DIFFERENCE BETWEEN CAPITAL & CURRENT ACCOUNT CONVERTIBILITY

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3.3 PRINCIPLES GOVERNING CAPITAL ACCOUNT CONVERTIBILITY

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3.4 RESTRICTIONS ON CAPITAL ACCOUNT CONVERTIBILITY

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CHAPTER IV – BURNING ISSUE

4.1 WHY IS FCAC IMPORTANT & WHAT ARE THE REASONS FAVOURING SUCH A CONCEPT?

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4.2 TARAPORE COMMITTEE APPOINTMENT 27

4.3 HOW DOES CAPITAL A/C CONVERTIBILITY AFFECT US? 32

CHAPTER V – CONCLUSION

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CHAPTER VI - REFERNECE ( BIBLIOGRAPHY )

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 lender’s 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

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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.

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Convertibility: why?

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.

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TYPES OF CURRENCY CONVERTIBILITY :

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

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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

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RUPEE CONVERTIBILITY

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Current

Account

Convertibility

RupeeConvertibility

Capital Accoun

t Convertibility

Classification

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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.

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To begin with let’s 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.

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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.

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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.

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.

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1. Goods and services

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.

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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.

Services

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 services—including those related to health and education

—acquired 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 others—military and embassy personnel and non

resident workers—are 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.

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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,

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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 non-residents for (i) the authorized use of intangible non produced,

nonfinancial assets and proprietary rights—such as trademarks, copyrights, patents,

processes, techniques, designs, manufacturing rights, franchises, etc. and (ii) the

use, through licensing agreements, of produced originals or prototypes—such 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.

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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 services—such as

those associated with libraries, museums—and 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).

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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.

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CAPITAL ACCOUNT CONVERTIBILITY

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

APPLICATION:

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.

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How is CAC different from 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.

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

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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. 

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PRINCIPLES GOVERNING CAPITAL ACCOUNT

CONVERTIBILITY

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.

Current Account

In short

Includes all imports-exports, pension payments-both ways, remittances-to &

fro

Indian scenario-fully convertible

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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.

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RESTRICTIONS ON CAPITAL ACCOUNT

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.

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WHY IS FCAC(FULL CONVERTIBILITY ON CAPITAL ACCOUNT)

IS IMPORTANT & WHAT ARE THE REASONS WHICH ARE IN

FAVOUR OF SUCH A CONCEPT?

Reduction of black money-

Such a concept helps an economy to open up and make it

transparent.

Induces domestic competition-

Such a concept would open the market to foreign investment as

restriction would be relaxed and domestic competitors would have to

be on their toes to keep up.

Increases job opportunities-

Such a benefit goes hand in hand with increase in domestic

competition.

A catalyst for financial markets, institutional development, new

technologies.

Diversification

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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.

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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.

What are the dangers of CAC? Or points in favour of restrictions?

1. Huge Inflow & Enormous outflow-

Good years get good inflow of capital and vice versa as per herd

behavior by which the investors tend to follow the movement of other investors so

if one moves out the other also does the same.

Eg: South Asian Countries received more than 150US$ by the first half of 1997

starting from 1996,but in the second half due to the threat of a crisis lost 102US$.

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2. Misallocation of capital inflows-

Such capital inflows may tend to use up the funds for low quality

domestic investments like investments in the stock markets real estates & prevent

from investing in building up industries & factories which gives better job

opportunities. Also exports suffer and thus create external imbalances.

3.Export of domestic savings-

Domestic savings would be invested in foreign banks thus leading to

savings being dragged away from the country. And in times of crisis, domestic

savings and foreign investments would also move out thus making the country

helpless in trying times.

4.Creation of unequal playing field-

Only the rich can borrow from foreign banks while the farmers face the

axe from such banks as well as domestic banks as domestic ones also tend to

increase their interest rates and reduce subsidies in order to keep up with the

foreign banks.

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2012 FDI Reforms

FDI in insurance sector up now to 49% from 26%.

FDI in single retail sector available upto 100%

FDI in multi retail sector available upto 51%

FDI in housing sector available upto 51%

The basic point highlighted here is that restrictions are getting relaxed and the Govt

is showing some hope towards FCAC although there are many pre requisites left to

be accomplished.

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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

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HOW DOES CAPITAL A/C CONVERTIBILITY AFFECT US?

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.

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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.

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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.

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CONCLUSION

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.

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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.

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BIBLIOGRAPHY

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

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