CURRENCY CONVERTIBILITY :
Floating of a currency is a pre-requisite to convertibility of a currency. While floating deals
with the method used to establish the value of the currency, convertibility deals with the
operational ease with which domestic currency is allowed to be converted into foreign
currency. Convertibility therefore represents procedural simplification of foreign exchange
transactions for persons dealing in a currency.
Although the INR was floated, which means market demand / supply factors would
determine the exchange rate, the transactions constituting the demand / supply continued
to be controlled by the RBI. Most transactions required licences or permits from RBI.
Effectively, the RBI controlled the elements forming the demand / supply for the foreign
currencies. If the exchange rate determined by the market was to truly represent the
economy, then it was essential to free the transactions constituting the demand and supply
for foreign currencies.
Foreign Exchange transactions arising in an economy can be broadly classified as :
1. Export and Import of goods and services.
2. Personal remittances.
3. Investments and Redemptions.
4. Borrowing and Lending.
All the above transactions pertaining to an economy over a given period are captured in
the Balance of Payments Account (BOP) for the country. All the above transactions get
recorded in either the Current or the Capital Accounts in the BOP The concept of
convertibility is thus viewed at two levels Current account Convertibility and Capital
Account Convertibility (CAC).
CURRENT ACCOUNT CONVERTIBILITY :
In August 1994, the 1NR was made convertible on current account tranaetiofls. This
means that all impediments such as licensing etc. were removed in so far as foreign
exchange transactions involved purchase / sale of foreign currencies for permitted imports
and exports of goods and services. Convertibility does not mean unlimited ability to
convert domestic currency. Limits were placed on conversion allowed for several
categories of activities. Eg: Currently, each resident individual is permitted to purchase
foreign currencies only to the extent of USD 10000 per calendar year for international
tourism described as Basic Travel Quota.
The Current Account of the Balance of Payments represents the cash / ready transactions
which have an immediate impact on the demand – supply equilibrium. Making the 1NR
convertible on Current Account thus implies that not only is the currency valued by the
market but the factors contributing to the rate determination are also decontrolled thereby
ensuring that the exchange rate truly represents the economic status of the currency.
CAPITAL ACCOUNT CONVERTIBILITY (CAC) :
In 1997, a committee headed by Mr S.S. Tarapore, the Deputy Governor of Rf, was
constituted to recommend step-wise implementation of capital account convertibility
(CAC). The recommendations of this committee could not be implemented because of
international developments such as the South East Asian Crisis, currency failures in Brazil
and Russia and events such as 11th September, 2001 in the US.
While there is no formal definition of Capital Account Convertibility, the committee under
the chairmanship of Mr S.S. Tarapore defined CAC as the freedom to convert local
financial assets into foreign financial assets and vice – a – versa at market determined
rates of exchange. It is associated with changes of ownership in foreign / domestic
financial assets and liabilities in the form of Receivables and Payables and involves the
creation and liquidation of claims on, or by, non-resident entities.
The critical preconditions specified by the committee in the ‘road-map for introducing CAC
Control of inflation within targeted levels.
Strengthening of the Financial System.
Maintenance of domestic economic stability.
Adequate foreign exchange reserves.
Restrictions on inessential imports.
Comfortable current account position.
An appropriate industrial policy and a friendly investment climate