Currency Convertibility 4c31t

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L. S. RAHEJA COLLEGE OF ARTS & COMMERCE Internal Assessment: Project 40 Marks Name of the Student First name

Class

Division

Roll Number.

:

Father’s Name:

M COM PART I

Surname

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Subject: Economics of Global Trade & Finance

Topic for the Project:

Marks Awarded Signature DOCUMENTATION Internal Examiner (Out of 10 Marks) External Examiner (Out of 10 Marks) Presentation (Out of 10 Marks) Viva and Interaction (Out of 10 Marks)

TOTAL MARKS (Out of 40) 2

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 CONVERTIBILITY 2.1

COMPONENTS-GOODS

14

2.2

SERVICES

15

2.3

INCOME

18

CHAPTER III – CAPITAL CONVERTIBILITY 3.1

BASICS & APPLICATION

20

3.2

DIFFERENCE BETWEEN CAPITAL & CURRENT CONVERTIBILITY

21

3.3

PRINCIPLES GOVERNING CAPITAL CONVERTIBILITY

23

3.4

RESTRICTIONS ON CAPITAL 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?

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CHAPTER V – CONCLUSION CHAPTER VI - REFERNECE ( BIBLIOGRAPHY ) 3

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 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 nonresidents 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 7

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 Convertibility Current is defined as including the value of trade in merchandise, services, investment, income and unilateral transfers. Current convertibility, being essential to the development of multilateral trade, three approaches to current convertibility has been adapted by developing countries. These are the preannouncement, by-product, and front-loading approaches. Each approach is distinguished by the importance it attaches to convertibility relative to other economic objectives. Capital Convertibility Capital 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. 10

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 Convertibility, the government has made the rupee convertible on the current . 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 convertibility means that the home currency can be freely converted into foreign currencies for acquisition of capital assets abroad. Thus, implementation of the capital 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. 11

India`s Situation  India has full current convertibility.  Unfortunately, there are a few restrictions on capital convertibility, hence, India has partial capital convertibility.

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CURRENT CONVERTIBILITY Current 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 convertibility. As of now, convertibility of the rupee into foreign currencies is almost wholly free for current i.e. in case of transactions such as trade, travel and tourism, education abroad etc. Components of Current Covered in the current 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 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. 14



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 enger 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 of a resident enterprise or by an unincorporated site office that, if it meets certain criteria, is equivalent to a foreign .



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, 16

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. 17



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 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 convertibility?

Current 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 ?

Some steps have already been taken to facilitate the full capital convertibility in the country. Foreign exchange has been allowed to flow into Indian stock markets through ed institutional investors. In addition, many categories of the resident Indians have been allowed to open foreign currency s 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 21

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 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 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 convertibility.

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PRINCIPLES GOVERNING CAPITAL 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 In short  Includes all imports-exports, pension payments-both ways, remittances-to & fro  Indian scenario-fully convertible 23

 Freedom in respect of current international transactions

Capital 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

 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 ) IS IMPORTANT & WHAT ARE THE REASONS WHICH ARE IN FAVOUR OF SUCH A CONCEPT?  Reduction of black moneySuch a concept helps an economy to open up and make it transparent.

 Induces domestic competitionSuch 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 opportunitiesSuch a benefit goes hand in hand with increase in domestic competition.

 A catalyst for financial markets, institutional development, new technologies.

 Diversification 26

TARAPORE COMMITTEE APPOINTMENT

 The RBI has appointed a committee to set out the framework for fuller Capital 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. 27

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 outflowGood 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 inflowsSuch 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 savingsDomestic 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 fieldOnly 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 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 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 s.

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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 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 convertibility over the next five years and has laid down the roap 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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