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CHAPTER -1 CURRENCY CONVERTIBILITY

1.1 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
lenders 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 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.


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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.
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.
1.2 CONVERTIBILITY EVOLUTION OF THE CONCEPT
Historically, the banknote has followed a common or very similar pattern in the western nations.
Originally decentralized and issued from various independent banks, it was gradually brought
under state control and became a monopoly privilege of the central banks. In the process, the fact
that the banknote was merely a substitute for the real commodity money (gold and silver) was
gradually lost sight of. Under the gold standard, banknotes were payable in gold coins. The same
way under the silver standard, banknotes were payable in silver coins, and under a bi-metallic
standard, payable in either gold or silver coins, at the option of the debtor (the issuing bank).


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Under the gold exchange standard banks of issue were obliged to redeem their currencies in gold
bullion. Due to limited growth in the supply of gold reserves, during a time of great inflation of
the dollar supply, the United States eventually abandoned the gold exchange standard and thus
bullion convertibility in 1974 Under the contemporary international currency regimes, all
currencies inherent value derives from fiat, thus there is no longer any thing (gold or other
tangible store of value) for which paper notes can be redeemed. One currency can be converted
into another in open markets and through dealers. Some countries pass laws restricting the legal
exchange rates of their currencies, or requiring permits to exchange more than a certain amount.
Thus, those countries currencies are not fully convertible. Some countries currencies, such as
North Koreas won and Cubas national peso, cannot be converted.
Nations attempted to revive the gold standard following World War I, but it collapsed entirely
during the Great Depression of the 1930s. Some economists said adherence to the gold standard
had prevented monetary authorities from expanding the money supply rapidly enough to revive
economic activity. In any event, representatives of most of the worlds leading nations met at
Bretton Woods, New Hampshire, in 1944 to create a new international monetary system. Because
the United States at the time accounted for over half of the worlds manufacturing capacity and
held most of the worlds gold, the leaders decided to tie world currencies to the dollar, which, in
turn, they agreed should be convertible into gold at $35 per ounce.
Under the Bretton Woods system, central banks of countries other than the United States were
given the task of maintaining fixed exchange rates between their currencies and the dollar. They
did this by intervening in foreign exchange markets. If a countrys currency was too high relative
to the dollar, its central bank would sell its currency in exchange for dollars, driving down the
value of its currency. Conversely, if the value of a countrys money was too low, the country
would buy its own currency, thereby driving up the price.


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The Bretton Woods system lasted until 1971. By that time, inflation in the United States and a
growing American trade deficit were undermining the value of the dollar. Americans urged
Germany and Japan, both of which had favorable payments balances, to appreciate their
currencies. But those nations were reluctant to take that step, since raising the value of their
currencies would increase prices for their goods and hurt their exports. Finally, the United States
abandoned the fixed value of the dollar and allowed it to float that is, to fluctuate against
other currencies. The dollar promptly fell. World leaders sought to revive the Bretton Woods
system with the so-called Smithsonian Agreement in 1971, but the effort failed. By 1973, the
United States and other nations agreed to allow exchange rates to float.
Economists call the resulting system a managed float regime, meaning that even though
exchange rates for most currencies float, central banks still intervene to prevent sharp changes. As
in 1971, countries with large trade surpluses often sell their own currencies in an effort to prevent
them from appreciating (and thereby hurting exports). By the same token, countries with large
deficits often buy their own currencies in order to prevent depreciation, which raises domestic
prices. But there are limits to what can be accomplished through intervention, especially for
countries with large trade deficits. Eventually, a country that intervenes to support its currency
may deplete its international reserves, making it unable to continue buttressing the currency and
potentially leaving it unable to meet its international obligations.






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1.3 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 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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CHAPTER 2-RUPEE CONVERTIBILITY
2.1 WHAT IS RUPEE CONVERTABILITY?
Currency convertibility refers to the freedom to convert the domestic currency into other
internationally accepted currencies and vice versa at market determined rates of exchange.Rupee
convertibility means the systemwhere any amount of rupee can be converted into any other
currencywithout any question asked about thepurpose for which the foreign exchangeis to be
used. Though impressionisticreports suggest that the rupee isalready convertible in the
unofficialmarkets, this is an fact not the case. Free convertibility refers to officiallysanctioned
market mechanism forcurrency conversion.
Non-convertibility can generally be defined with reference to transaction for whichforeign
exchange cannot be legally purchased (e.g. import of consumer goods etc),or transactions which
are controlled and approved on a case by case basis (likeregulated imports etc). A move towards
free convertibility implies a reduction in thenumber / volume of the above types of transaction.
Convertibility can be related as the extent to which a country's regulations allow free flow
of money into and outside the country. For instance, in the case of India till 1990, one had to get
permission from the Government or RBI as the case may be to procure foreign currency, say US
Dollars, for any purpose. Be it import of raw material, travel abroad, procuring books or paying
fees for a ward who pursues higher studies abroad. Similarly, any exporter who exports goods or
services and brings foreign currency into the country has to surrender the foreign exchange to RBI
and get it converted at a rate pre-determined by RBI.
After liberalization began in 1991, the government eased the movement of foreign
currency on trade account. I.e. exporters and importers were allowed to buy and sell foreign
currency, as long as the items that they are exporting and importing were not in the banned list.


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They need not get permission on a CASE TO CASE basis as was prevalent in the earlier regime.
This was the first concrete step the economy took towards making our currency convertible on
trade account.
In the next two to three years, government liberalized the flow of foreign exchange to
include items like amount of foreign currency that can be procured for purposes like travel
abroad, studying abroad, engaging the services of foreign consultants etc. This set the first step
towards getting our currency convertible on the current account. What it means is that people are
allowed to have access to foreign currency for buying a whole range of consumable products and
services. These relaxations coincided with the liberalization on the industry and commerce front -
which is why we have Honda City cars, Mars chocolate bars and Bacardi in India. There was also
simultaneous relaxation on the restriction on the funds that foreign investors can bring into India
to invest in companies and the stock market in the country.
2.2 HISTORY OF RUPEE CONVERTABILITY
The exchange rate regime in India has transited gradually from the fixed exchange rate regime in
the pre-1991 period to the flexible exchange rate regime in the post-1991 period.
Rupee was historically linked with the UK pond sterling. However, till 1971
Indian rupee was linked with the US dollar to meet the requirement of IMF membership. To
provide greater stability to rupee India started fixing the value of rupee in terms of basket of
currency since 1975. In the aftermath of BOP crisis, in 1992 Liberalized Exchange Rate
Management System (LERMS) was introduced whereby exporters were required to surrender
40% of their foreign exchange earnings at the officially determined rate. The rest could be
converted at market determined rate. The importers, on the other hand, had to procure all their
foreign exchange requirements at the official rate. LERMS were replaced by Unified Exchange


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Rate in 1993 and rupee was made convertible on the current account in August 1994. Since then
there is gradual move towards capital account convertibility in India.
In 1997 a committee under stewardship of S.S.Tarapore submitted its report on 'Capital
Account Convertibility' which provided the initial roadmap for the liberalisation of capital
account transactions.Taking the lessons from international experience, committee recommended a
set of preconditions to be achieved prior to liberalisation of capital account. It was the time when
banking sector reforms were also instigated on the proposition of Narasimhan committee.
To facilitate foreign exchange transactions India has replaced more restrictive act of
FERA, 1974 by more facilitating approach in the form of FEMA, 2000.Till now, all the rules
pertaining to foreign exchange are governed by FEMA. All the current account transactions are
permitted under FEMA and no prior permission of RBI is required for any such transactions,
while there remain restrictions on capital account. Under FEMA some capital account
transactions are completely permitted, some are totally prohibited while some are allowed within
a fixed ceiling. Sectoral rules have also been shaped and enforced with FEMA rules.
On the success of the measures adopted, the issue of capital account liberalisation was re-
examined by Tarapore committee II. Setup in year 2006 it was an extension of the previous
committee. The committee on the capital account convertibility has suggested five year time
frame (2006 to 2011) for movement towards fuller convertibility in India. During this period the
country needs to strengthen macroeconomic framework and bring in place sound financial system
and markets and prudential regulatory and supervisory architecture by meeting FRBM targets,
greater autonomy and transparency to the RBI in conduct of monetary policy, reducing the share
of government in the capital of public sector banks, maintaining the current account deficit
Following the East Asian crisis, even the most ardent votaries of CAC in the World Bank
and the IMF realised that the dangers of going in for CAC without adequate preparation could be


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catastrophic. Since then the received wisdom has been to move slowly but cautiously towards
CAC with priority being accorded to fiscal consolidation and financial sector reform above all
else.
Indian companies were allowed to raise funds by way of equities (shares) or debts. The
fancy terms like Global Depository Receipts (GDRs), Euro Convertible Bonds (ECBs), Foreign
currency syndicated loans became household jargons of Indian investors. Listing in NASDAQ or
NYSE became new found status symbols for Indian companies. However, Indian companies or
individuals still had to get permission on a case to case basis for investing abroad.
In 2000, the forex policy was further relaxed that allowed companies to acquire other
companies abroad without having to go through the rigmarole of getting permission on a case to
case basis. Further, Indian debt based mutual funds were also allowed to invest in AAA rated
government /corporate bonds abroad. This got further relaxed with Indians being allowed to hold
a portion of their foreign exchange earnings as foreign currency, subject to a limit in the recent
monetary policy in October 2002.
2.3 TYPES OF RUPEE CONVERTIBILITY





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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.
To begin with lets 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


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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.
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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CHAPTER-3 CURRENT ACCOUNT CONVERTIBILITY
3.1 INTRODUCTION
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.
APPLICATION
In most traditional theories of international trade, the reasoning for capital account convertibility
was so that foreign investors could invest without barriers. Prior to its implementation, foreign
investment was hindered by uneven exchange rates due to corrupt officials, local businessmen
had no convenient way to handle large cash transactions, and national banks were disassociated
from fiscal exchange policy and incurred high costs in supplying hard-currency loans for those
few local companies that wished to do business abroad.
Due to the low exchange rates and lower costs associated with Third World nations, this was
expected to spur domestic capital, which would lead to welfare gains, and in turn lead to higher
GDP growth. The tradeoff for such growth was seen as a lack of sustainable internal GNP growth
and a decrease in domestic capital investments.
[7]

When CAC is used with the proper restraints, this is exactly what happens. The entire outsourcing
movement with jobs and factories going overseas is a direct result of the foreign investmentaspect
of CAC. The Tarapore Committee's recommendation of tying liquid assets to static assets (i.e.,
investing in long term government bonds, etc.) was seen by many economists as directly
responsible for stabilizing the idea of capital account liberalization.


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3.2 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.
I. 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.
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.






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II .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 servicesincluding those related to health and educationacquired
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 othersmilitary and embassy personnel and
non resident workersare 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.

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.



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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, 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
rightssuch as trademarks, copyrights, patents, processes, techniques, designs, manufacturing
rights, franchises, etc. and (ii) the use, through licensing agreements, of produced originals or
prototypessuch as manuscripts, films, etc.



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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.

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 servicessuch as those
associated with libraries, museumsand 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.

II. 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).

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


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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.
3. CURRENT TRANSFERS
Current transfers are distinguished from capital transfers, which are included in the capital and
financial account in concordance with the SNA treatment of transfers. Transfers are the offsets
to changes, which take place between residents and nonresidents, in ownership of real
resources or financial items and, whether the changes are voluntary or compulsory, do not
involve a quid pro quo in economic value.
Current transfers consist of all transfers that do not involve (i) transfers of ownership of fixed
assets; (ii) transfers of funds linked to, or conditional upon, acquisition or disposal of fixed
assets; (iii) forgiveness, without any counterparts being received in return, of liabilities by
creditors. All of these are capital transfers.
Current transfers include those of general government (e.g., current international cooperation
between different governments, payments of current taxes on income and wealth, etc.), and
other transfers (e.g., workers remittances, premiumsless service charges, and claims on
non-life insurance). A full discussion of the distinction between current transfers and capital
transfers.








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CHAPTER 4- CAPITAL ACCOUNT CONVERTIBILITY
4.1 INTRODUCTION
Currency convertibility refers to the freedom to convert the domestic currency into other
internationally accepted currencies and vice versa. Convertibility in that sense is the obverse of
controls or restrictions on currency transactions. While current account convertibility refers to
freedom in respect of payments and transfers for current international transactions, capital
account convertibility (CAC) would mean freedom of currency conversion in relation to capital
transactions in terms of inflows and outflows. Article VIII of the
International Monetary Fund (IMF) puts an obligation on a member to avoid imposing restrictions
on the making of payments and transfers for current international transactions. Members may
cooperate for the purpose of making the exchange control regulations of members more effective.
Article VI (3),
however, allows members to exercise such controls as are necessary to regulate international
capital movements, but not so as to restrict payments for current transactions or which would
unduly delay transfers of funds in settlement of commitments.

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



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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.

4.2 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.
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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4.3 PROGRESS THROUGH CAPITAL ACCOUNT CONVERTIBILITY
A hybrid between control and liberalisation of the capital account, has served country well for
nearly a decade. India has witnessed a significant surge in cross border capital flows through
CAC. The strong capital movements to India in the recent period reflect the momentum in
following:
A) PROGRESS AT COUNTRY LEVEL
(1) End of Balance of Payment (BoP) crisis: In 1991 India was struggling with the crisis in its
balance of payments. Importing was essential for the country while the government's conservative
approach towards exports pushed country into severe balance of payment deficit.Capital account
liberalisation has been the strongest medium in curbing such crisis. There was an ongoing trade
deficit from the year 1990-91, but a positive capital account has provided cushion against all odds
and overall balance of payments are in surplus.
(2) Plenty of Foreign Currency Reserves:India has envisaged a plentiful surge in its reserves. The
liberalisation of capital account has helped country in recovering from reserve shortage. The
doting supply of dollars to Reserve Bank exchequer is a healthy sign for economy, as reserves can
be utilised during the times of adversity. The reserve position is shown in the graph:



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(3) Efficiency in Financial System: Capital Account Convertibility is incomplete without fiscal
consolidation, sound policies and financial prudence. RBI and Government of India have been
very conservative and watchful during whole process of liberalisation. This has improved total
financial performance of economy. Banks today have greater access to additional capital (foreign
borrowing), autonomy in operations (easening of control by RBI) and intensive competition
(opening of private and foreign banks and Non Banking Finance Corporations). There is larger
room for financial efficacy, specialisation and innovation in financial system.
(4) Development of Securities Market: Gush of Foreign Institutional Investment (FII) has helped
in multifold enlargement of security market. The market capitalisation of BSE and NSE has
significantly risen. Derivates, bonds, commodities now constitute the major trading instruments
besides equity shares. Sensex (above 20,000) and Nifty (above 6,000) touched new heights due to
huge investment in the listed stocks. The position of BSE Sensex is shown in the graph:

(5) Worldwide Presence and Friendly Relations with Trading Counterparts: Flow of investment
is a distinctive medium of developing global relationships. Indian MNCs and service
organisations are conducting business operations in almost 140 countries across the globe. India is
19th largest exporting country in the world according to 2011 estimates. Indian IT services,


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handicrafts, cuisine and jewellery are world famous and contribute to major chunk of revenue
from international operations. It all has become reality with the financial liberalisation.
India is the founder member of WTO, IMF and World Bank. It is a member of BRICS and
G-20 at WTO trade negotiations. Government has entered into multilateral trade agreements and
tax avoidance treaties with the trading counterparts. Immigration norms have also been untangled.
All this has given a global presence to the country and friendly relations too are in progress.
B) PROGRESS AT CORPORATE LEVEL
1) Indian corporate sector is inundated with broader access to low cost capital through External
Commercial Borrowings. In addition, companies have the prospect of expanding theircapital base
through issue of American Depository Receipts, Global Depository Receipts and corporate bonds.
2) Diversification of risk and economies of scale through business performance in different
realms.
3)Increase in profit after tax through intercontinental operations (manufacturing, sales, services
and Intellectual Property Rights).
4) Gains in technology through joint ventures, international license and import of technology
from the specialised manufacturer.
5)Access to worldwide pool of intellectuals, managers, technical personnel etc and their
specialised knowledge and skills.
C) PROGRESS AT CUSTOMER LEVEL
Indian customers have gained in plenteous ways, and are getting superior quality, competitive
prices and added features in the goods available in the market. They have a bundle of offerings in
every sector from fast moving consumer goods (FMCGs) to automobiles, furniture to food, health


23

clubs to telecommunication, clothes to electronics and so on. This has amplified the price wars
and there has been an eminent improvement in customer services and customer information
through 24/7 help lines andWorld Wide Web technology.
4.4 CAPITAL ACCOUNT CONVERTIBILITY AND MENACE
It is a discernible fact that a number of empirical studies do not find evidence that greater
openness of capital account and higher flows of capital lead to advanced growth (Prasad et al
2000). Some economists believe that the opening up of capital account is the last mile
connectivity to the globalised world; to others it symbolise a shortcut to economic ruination.
India's most recent negative experiences with the capital account liberalisation are as follows:
(1) Depreciating Rupee: With the liberalisation of capital account large amount of money is
flowing in and out of the economy. Subsequently rupee has become highly volatile and slipped to
its all time low (1$=57.33). India's imports are greater than its exports and former has further
declined due to financial crisis in Euro zone. Reserve Bank is not able to peg rupee at harmless
levels, consequently imports have become too expensive and the risk of widening trade deficit is
obvious. Reserve Bank has to buy or sell dollars in substantial amount to maintain the value of
rupee at reasonable levels. Weakening rupee has also created problems in setting appropriate
interest rates. Graph shows the value of Indian rupee pegged to US dollar.







24




It is clear from the graph that in August 2011, value of 1 USD was INR 44 and by June
2012 this value has become 57 rupee, the lowest value ever.
(2) Volatility in Stock Markets:International financing and investment shifts from country to
country in search of higher speculative returns. Stock markets have undergone this phenomenon
rapidly. In good times of the economy (good rating, healthy IIP, high GDP, political stability)
foreign institutional investors are on buying spree, but in bad times FII quickly lose their
confidence in market and there is an abnormal selling. Investors experience huge losses some
become bankrupt too. Given in the graph drasticups and downs in stock market indicators:
Source: BSE
(3) Debilitating Impact on Inflation: Capital convertibility has lead to exchange rate volatility of
the Rupee resulting in macroeconomic instability caused through the risk of rapid and large
capital outflows as well as inflows. When capital flows are large money supply increases and RBI
comes up with tightening of monetary policy. Also, India imports approximately 75% of its crude


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requirements. Given the fact that the oil prices have been well above theUSD 90 per barrel and
extremely volatile, this hasfurther widened the trade deficit of India and hasresulted in soaring
energy prices. This has upset theeconomy and has a debilitating impact on inflationwithin India.
Such speculative capital flows havemade domestic monetary policy virtually ineffective.
(4) Asset Liability Mismatch of Banks: Inglobal experience with convertibility, banking
envisages to be another weaker link. Banks are facingan inequality between their assets and
liabilities.Banks generally refuse to lend a company which hasa debt equity ratio of more than 2.
Indian bankspresently have high debt because of cheap borrowingthrough ECBs. Moreover high
interest rate in marketon borrowings has led to slump in demand of loansand advances. Decline in
loans and advances on theasset side of balance sheet has increased the pressureto sustain the same
maturity period for deposits andthe asset liability management has come under strain.
(5)Flow of Black Money through Participatory Notes (P-Notes): SEBI allowed issue of P-Notes
to FII in 2006. Concerns have been raised on the secrecy afforded to investors through P-Notes.
Different types of foreign entities are eligible for the issue of P-Notes but the identity of the actual
investor may be mysterious to the regulatory bodies. Therefore some of the money invested in the
market through P-Notes may be unaccounted wealth of affluent Indians hidden beneath the
pretext of FII investment. Such funds could be tainted and linked with unlawful activities like
corruption and smuggling. Hedge funds too may use P-Notes and sub accounts of FII to operate in
stock market. Reserve Bank stance is towards prohibition of P-Notes.
(6)Does not serve the Purpose of Real Sectors: Capital Account Convertibility (CAC)
primarilybenefitindustrialists and financial capitalists who invest in stock market for speculative
gains. It is mainly pursued to please international organisations (IMF, WB, and WTO) and foreign
investors. It hasn't addressed the real problems of the country like poverty, unemployment,
income inequalities, infrastructure bottlenecks and many more.


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The irony is that burden is borne by the common man under a crisis, which has become an
actuality these days. This comes up in the form of sharper reduction in subsidies, less budgetary
allocations for social welfare programmes, high taxes and high inflation. The foreign speculators
and domestic players walk out of the market by converting their assets into cash and insulate
themselves from losses in such during economic problems.






















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CHAPTER-5 BURNING ISSUES
5.1 CHALLENGES OF CAPITAL ACCOUNT CONVERTIBILITY AND THEIR
MANAGEMENT
In the process of capital account liberalisation, Indian economy has been able to attract reasonable
foreign investment without any major shocks. The benefits that have been derived with an open
capital account have induced the growth and development of India's financial markets and
external sector. Due to some or other reasons from inside and outside macroeconomic instability
has lingered in the economy and things are not going well.
Inflation rate is high from the year 2009onwards. The average yearly inflation was 10.9%
in 2009 and 11.7% in 2010. In 2011 the rate of inflation stood at 9.6%. Between the periods it
rose to double digits too. RBI has revised monetary policy during the different time periods. Cash
Reserve Ratio (CRR) was revised 13 times in the time frame of 2 years which is a benchmark in
itself. Despite continuous efforts RBI is not able to tame inflation and it is still modest at the level
of 8% according to latest estimates. The depreciation in the value of rupee to the level of 1
USD=57.33 INR has also raised serious questions and concern on the conduct and policies of
Reserve Bank and Government of India. Global rating agencies Standard & Poor (s & P) and
Fitch have revised India's rating from 'Stable' to 'Negative'. S&P has released a report strongly
criticising the Government's inability to move ahead with economic reforms and referred to
cracks in ruling coalition that they were holding up progress. Fitch has censured and added the
general elections due in early 2014 could see politically driven pressure to loosen fiscal policy,
which could further weaken India's public finance related to peers. The ratings and statement of
S&Pand Fitch raise the risk of Indian bonds slipping into junk category, hurting the country's
image as an investment destination. The cost of overseas borrowing for Indian companies could
also go up.


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The story is not yet over. Equity market is plummeting week after week because FII are on
selling fling. Sensex is currently trading lower than 17,000 and Nifty near 5,000. Investor
sentiments are down. Individual portfolios are making losses. Volatility and panic are the latest
buzz words for the 'Dalal Street'.
Food inflation is constantly maintaining its double digit levels causing a decline in
domestic savings with banks. IIP has fallen to the level of 3.5% from 8.1% of the previous year.
GDP growth in 2012- 13 is estimated at the aching level of 6.5% while fiscal deficit is at 5.9%.
Reserve Bank's Governor D.Subbarao said 'fiscal deficit in 1991 was 7% and it is ruling at 5.9%
in 2012.' Is it an alarming signal? Because, India was going through its meagre times in 1991 and
latest GDP estimates too are worrisome. There are additional doubts about Government's ability
to trim subsidy level to cut fiscal deficit, which could further increase the prices of essential
commodities. A new retro tax GAAR (General Anti Avoidance Rule) is also proposed to be
enacted in budget for fiscal 2013. GAAR aims to target tax evaders, partly by stopping Indian
companies and investors from routing investments through Mauritius or other tax havens for the
sole purpose of avoiding taxes. It has sparked an outcry among foreign investors.
Thus the recent global turmoil, volatile capital flows and economic instability have
considerably heightened the uncertainty surrounding the outlook for India, complicating the
conduct of monetary policy and external management. The intensified pressures have necessitated
stepped up operations in terms of capital account management and more active liquidity
management with all instruments at command of Reserve Bank. Therefore in this scenario, it is
suggested that India should adopt a go slow approach in moves to liberalise capital account.
Instead, it is important for the country to be ready to deal with potentially large and volatile
outflows along with spillovers. In this context, there is a need of manoeuvre for Reserve Bank to
deal with present serious matters by deployment of monetary policy instruments, buying and


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selling operations of forex, complemented by prudential restrictions and measures for capital
account management.
5.2 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.
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.






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5.3 INDIAS PERFORMANCE AGAINST THE PRE-CONDITIONS
The previous discussion clearly indicates the following:
On the fiscal front, India has performed poorly. The fiscal deficit/GDP ratio has not been
contained within the prescribed limit. Concurrently, domestic liabilities/GDP ratio has
been continuously rising
Average inflation rate has stayed higher than the recommended band
Debt-servicing ratio has not at all responded to the recommendation
Average effective CRR has remained much higher than the floor
However, the gross NPA ratio of public sector banks has come down remarkably
Indias external sector has registered positive performance. The exports/GDP ratio and
import/GDP ratio have gone up. CAD/GDP ratio has been contained within the 2-3% band
on a continuous basis.
Thus Tarapore Committees recommendations have mostly not been implemented, sincethe
prescribed conditions were not met. Time-frame wise, it is clear that the committeessuggestions
and recommendations were premature by at least 10 years, if not more.
5.4 SUITABILITY OF FULL CONVERTIBILITY IN INDIA
There are certain prerequisites for introduction of capital account full convertibility. 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.
In addition, fiscal deficit should be low at around 3 per cent and foreign exchange reserves
should be reasonably high. Further, the economy has to be in good shape, as full convertibility


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would result in bringing in the instabilities and fluctuations of the outside world into the
economy, as it gets more connected to the outside world. Further, imperfections in the economy,
like the urban-rural dichotomy and difference in the growth rates in various sectors like
agriculture and industries, as well as services, must be removed.
But post-CAC, they are expected to deal with multi-currency transactions.
The risks involved are:
Currency Risk: Effect of currency appreciation/depreciation
Counterparty Credit Risk
Transfer Risk: Generated from tracking financial position of all economies involved
Legal Risk.
It is still doubtful whether the state-protected banks would be able to ward the risks off.India also
falls short of most of the criteria suggested by the first Tarapore Committee.The 3-year phasing
plan of CAC as conceived in 1997 has not been fully effective even11 years down the line.
Without the pre-conditions strongly in place, no country cansafely adopt CAC (as mentioned
earlier, capital controls are virtually irreversible so far asinternational investor confidence is
concerned).Two crucial questions arise during evaluation of Indias readiness to adopt
fullconvertibility: First, are the indicators which conform to the levels suggested by theCommittee
sustainable in future, or are significant deviations from current levels to beexpected, say 10 years
down the line? Second, when, if at all, the non-conforming criteriaare expected to converge to the
recommended level or band?
Considering the above prerequisites it appears that the Indian economy is not yet prepared
for switching over to the capital account convertibility. The only requisites which have been met
are reasonably high level of foreign exchange reserves, mostly deregulated interest rates and


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relatively good condition of the economy as a whole. In most of the other areas there is lot more
to be done. Interest rates as well as the inflation rate are higher than the required levels. Further,
the imperfections of the economy are glaring as the services and industrial sectors are booming,
but the agricultural sector which employs over 65 per cent of the total work force, is growing at a
much lower rate of 2 to 3 per cent per annum.















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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.
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