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Convertibility of Rupee

The document discusses the convertibility of the Indian rupee, including current account convertibility and capital account convertibility. It provides details on: 1) India adopting a dual exchange rate system in 1991-92 with an official controlled rate and a market fluctuating rate. 2) Current account convertibility allowing full conversion of rupees for trade, services, remittances with other countries. 3) Capital account convertibility removing restrictions on flows of Indian financial assets overseas and foreign assets into India.

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Sonam Kus
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82 views3 pages

Convertibility of Rupee

The document discusses the convertibility of the Indian rupee, including current account convertibility and capital account convertibility. It provides details on: 1) India adopting a dual exchange rate system in 1991-92 with an official controlled rate and a market fluctuating rate. 2) Current account convertibility allowing full conversion of rupees for trade, services, remittances with other countries. 3) Capital account convertibility removing restrictions on flows of Indian financial assets overseas and foreign assets into India.

Uploaded by

Sonam Kus
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Convertibility of rupee; Current account

convertibility, Capital Account


Convertibility
Convertibility of rupee

In 1991-92 the GOI adopted a dual exchange rate system under which the official rate
of exchange was controlled and the market rate (or the black-market rate) of exchange
was free to move or fluctuate according to forces of supply and demand.

Current account convertibility

All current transactions of India with other countries in respect of trade (merchandise),
services such as education, travel, medical expenses, etc. and ‘invisibles’ such as
remittances are fully met through full convertibility of the Rupee into other currencies.
The Rupee can be used to buy other currencies and other countries can buy Indian
rupee without limit.

Capital Account Convertibility

Under CAC any Indian or Indian company is free to convert Indian financial assets into
foreign financial assets and reconvert foreign financial assets into rupees at the
prevailing market rate of exchange. This means that CAC removes all the restrains on
international flows on India’s capital account.

Benefits of CAC:

The potential benefits from the scheme are:

1. Availability of large funds to supplement domestic resources and thereby


promote faster economic growth.
2. Improved access to international financial markets and reduction of the cost of
capital.
3. Incentive for Indians to acquire and hold international securities and assets.
4. Improvement (strengthening) of the financial system in the context of global
competition.

Main Provisions Under the System of CAC:

(a) Indian companies would be allowed to issue foreign currency denominated bonds to
local investors, to invest in such bonds and deposits to issue Global Depository
Receipts (GDRs) without RBI or GOI approval and to go for external commercial
borrowings subject to certain limits.
(b) Indian residents would be permitted to have foreign currency denominated deposits
with banks in India, to make transfers of financial capital to other countries within certain
limits, and to take loans from non-relatives and others up to a ceiling of $1 million.

(c) Indian banks would be permitted to borrow from overseas markets for short-term
and long-term up to certain limits, to invest in overseas money markets, to accept
deposits and extend loans denominated in foreign currency. Such facilities would also
be available to non- bank financial institutions and financial intermediaries like insurance
companies, investment companies and mutual funds.

(d) All India financial institutions which fulfill certain regulatory and prudential require-
ments would be allowed to participate in foreign exchange market along with banks
which are the only Authorised Dealers (ADs) now. At a later stage, certain select Non-
Bank Financial Companies (NBFCs) would also be permitted to act as Ads in foreign
exchange markets.

(e) Banks and financial institutions would be permitted to operate in domestic and
international markets. They would be allowed to buy and sell gold freely and offer gold
denominated deposits and loans.

Preconditions for CAC:

According to the Tarapore Committee four preconditions have to be fulfilled to ensure


full currency convertibility:

(i) Reducing Fiscal Deficit:

Fiscal deficit should be reduced to 3.5% of GDP.

(ii) Reducing Public Debt:

The GOI should also set up a Consolidated Sinking Fund (CSF) to reduce its debt.

(iii) Fixing Inflation Target:

The GOI should fix the annual inflation target between 3% to 5%. This is called
mandated inflation target. The GOI should also give full freedom to the RBI to use
monetary weapons to achieve the inflation target.

(iv) Strengthening the Indian Financial Sector:

For this, four conditions are to be satisfied:

(a) Full deregulation of interest rates,

(b) Reduction of gross Non-Performing Assets (NPAs) to 5%,


(c) Reduction of average effective CRR to 3% and

(d) Liquidation of weak banks or their merger with other strong banks.

Apart from these, the Tarapore Committee also recommended that:

(a) The RBI should fix an exchange rate band of 5% around real effective exchange rate
and should intervene only when the Real Effective Exchange Rate (REER) is outside
the band.

(b) The size of the current account deficit should be within manageable limits and the
debt service ratio should be gradually reduced from the present 25% to 20% of the
export earnings.

(c) To meet import bill and to service external debt, forex reserves should be adequate
and range between $22 billion and $32 billion.

(d) The GOI should remove all restrictions on the movement of gold.

Disadvantages of CAC:

(i) Contagion Effect:

The Asian financial crisis of 1997 makes it abundantly clear that financial crisis from one
country may be easily transmitted to other countries having convertible currencies. Any
adverse development in overseas market will affect India’s economy equally adversely
as was amply shown in the recent world recession of 2008-09.

(ii) Speculation:

A convertible currency shows greater fluctuation than an inconvertible one and thus
gives greater scope for destabilising speculation. This creates uncertainty and reduces
the volume of trade.

(iii) Outflow of Funds:

Indians will have a tendency to buy more assets abroad and India may become a debtor
nation like the USA since it may develop a tendency to spend beyond its means.

(iv) No Ceiling on External Debt:

Finally, there will be no ceiling on India’s external debt since the GOI knowing well that
rupee can now be used for debt serving will borrow without limits.

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