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External Sector Handout 4b GS

Currency convertibility allows a country's currency to be exchanged freely for foreign currency at market rates, facilitating trade and capital flows. In India, the rupee became fully convertible on the current account in 1994, while capital account convertibility remains partial due to various economic challenges. The benefits of capital account convertibility include access to international markets and improved economic growth, but concerns exist regarding currency stability and potential capital flight.

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6 views2 pages

External Sector Handout 4b GS

Currency convertibility allows a country's currency to be exchanged freely for foreign currency at market rates, facilitating trade and capital flows. In India, the rupee became fully convertible on the current account in 1994, while capital account convertibility remains partial due to various economic challenges. The benefits of capital account convertibility include access to international markets and improved economic growth, but concerns exist regarding currency stability and potential capital flight.

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jamshikasim3
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We take content rights seriously. If you suspect this is your content, claim it here.
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Currency Convertibility

By convertibility of a currency we mean currency of a country can be freely converted into foreign
exchange and vice-versa at market determined rate of exchange.

For the rapid growth of world trade and capital flows between the countries convertibility of
currency is desirable.

Without free and unrestricted convertibility of currencies into foreign exchange trade and capital
flows between countries cannot take place smoothly.

Current Account convertibility

Current account convertibility refers to the freedom to convert domestic currency into foreign
currency and vice-versa for current account purposes like- exports, imports, remittances, foreign
travel etc.

Current account convertibility in India


As a part of new economic reforms initiated in 1991 Rupee was made partly convertible from march
1992 under the “Liberalized Exchange Rate Management (LERM)” scheme.

In this scheme 60% of all receipts on current account could be converted freely into rupees at
market determined exchange rate while 40% was to be surrendered to RBI at the officially fixed
exchange rate. Thus partial convertibility of rupee on current account meant a dual exchange rate
system.

From march 1993 rupee was made convertible for all trade in merchandise.

From march 1994 rupee was made fully convertible even for invisible transactions. Thus rupee
became fully convertible on current account.

Capital Account convertibility of Rupee

The Reserve Bank of India [RBI] in 1997 appointed the committee on capital account convertibility
with Mr. S.S. Tarapore (former deputy governor of RBI) as its chairman.

The Tarapore committee defined capital account convertibility as the freedom to convert local
financial assets into foreign financial assets and vice-versa at market determined rate of exchange.

In simple words capital account convertibility means converting domestic currency into foreign
exchange and vice-versa for capital account purposes [e.g. foreign investments , external loans etc.],
freely and at market determined rate of exchange.

VAJIRAM & RAVI Page 1


The purpose of capital account convertibility is to give foreign investors an easy market to move in
and move out and to send a strong message that Indian economy is strong enough and that India
has sufficient FOREX reserves to meet any flight of capital from the country.

Benefits of Capital Account Convertibility

1. Availability of large funds to supplement domestic resources and thereby promote economic
growth.
2. Improved access to international financial markets and reduction in cost of capital.
3. Incentive for Indians to acquire and hold international securities and assets.
4. Improvement of the financial system in the context of global competition.

Preconditions for Capital Account Convertibility


1. Fiscal deficit should be reduced to 3.5% of GDP.
2. The government should fix annual inflation target between 3-5%. This was called mandated
inflation target. RBI should be given full freedom to use monetary weapons to achieve the
inflation target.
3. Indian financial sector should be strengthened – interest rates should be fully deregulated, gross
NPA should be reduced to 5 %, weak banks should either be liquidated or be merged with other
strong banks

Because of Asian financial crisis [1997] and political instability during those years these
recommendations could not be implemented.
Second Tarapore committee was set up in 2006 and it gave a roadmap for adopting full capital
account convertibility by 2011. Because of global financial crisis of 2007-09 the recommendations
could not be implemented.

At present rupee is fully convertible on the current account but is only partially convertible on the
capital account.

Concerns related to full capital account convertibility


1. If currency convertibility is not properly managed and monitored, market exchange rate may
lead to depreciation of domestic currency. If currency depreciates heavily the confidence in it is
shaken and no one will accept it in its transactions.
2. Convertibility of currency sometimes makes it highly volatile and unstable. It shakes the
confidence and capital flight from the country can take place as it happened in Asian financial
crisis 1997 in countries like Thailand, Malaysia, Indonesia, and Singapore etc.

VAJIRAM & RAVI Page 2

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