There would be no limit on inflow or outflow of capital for various purposes including investments, remittances, or asset purchases/sales. During the times when the financial markets of an economy are doing good , a country may receive huge foreign investment. For example when the federal reserve Bank of America gave a sign that they are going increase the interest rates the foreign Institutional investors who invested their dollars in Indian stock market had withdrawn their investment from India which adversely impacted the rupee value. When currency reforms were enacted at the end of the 20th century, the rupee was made partially convertible for goods, services, and merchandise only. During the mid-1990s, the rupee was fully made current account convertible for all trading activities, remittances, and indivisibles.
Thus, partial convertibility of rupee on current account meant a dual exchange rate system. Further, full convertibility of rupees at that stage was considered to be risky in view of large deficit in balance of payments on current account. Referred to as ‘Capital Asset Liberation’ in foreign countries, it implies free exchangeability of currency at lower rates and an unrestricted mobility of capital. Capital account convertibility allows freedom to convert local financial assets into foreign financial assets and vice-versa. As of today, one can still bring in foreign capital or take out local money for these purposes, but there are ceilings imposed by the government that need approvals.
About Capital Account Convertibility:
By virtue of this control all the foreign exchange earned was to be sold to authorized dealer and if we want to purchase foreign exchange we have to seek permission of central bank. The main purpose behind this was to utilize the foreign exchange earned by the residents as per the priorities fixed by the government. These controls were necessary at that time as India was underdeveloped country and its exports were limited to agricultural product and raw material and it used to import only consumable goods.
Under this system, which remained in operation for a period of one year, 60 per cent of the exchange earnings were convertible in rupees at market determined exchange rate and the remaining 40 per cent earnings were convertible in rupees at the officially determined exchange rate. The term convertibility of a currency indicates that it can be freely converted into any other currency. Convertibility can also be identified as the removal of quantitative restrictions on trade and payments on current account.
- This was called mandated inflation target — and give foil freedom to RBI to use monetary weapons to achieve the inflation target.
- India is expected to become a truly global economy in the near future, and it will need a fuller integration into the world economic system.
- During mid-1990s, the rupee was made fully convertible for current account for all trading activities, remittances and indivisibles.
- However, there are still barriers to full convertibility in India, such as developing a more comprehensive infrastructure for regulating financial markets.
- When currency reforms were enacted at the end of the 20th century, the rupee was made partially convertible for goods, services, and merchandise only.
Four indicators should be used for evaluating adequacy of foreign exchange reserves to safeguard against any contingency. Plus, a minimum net foreign asset to currency ratio of 40 per cent should be prescribed by law in the RBI Act. The correct answer is Freely permitting the conversion of rupee to other currencies and vice versa. Making the INR into a fully convertible currency comes with both advantages and disadvantages. The correct answer is Freely permitting the conversion of the rupee to other major currencies and vice versa. For this, interest rates should be folly deregulated, gross non-paying assets (NPAs) should be reduced to 5 per cent, the average effective CRR should be reduced to 3 per cent and weak banks should either be liquidated or be merged with other strong banks.
Convertibility of rupee implies (a) being able to convert rupee notes into gold
Having a nonconvertible currency makes it harder for a government to participate in the international market because these transactions generally take longer to execute. As it allows converting any foreign receipt into Indian rupees at market determined rates there may be chance that domestic economy will be flooded with foreign exchange which in long run may damage the financial health of an economy. After liberal economic reforms were introduced in 1991, many significant developments occurred that impacted the way forex transactions and businesses were conducted.
It allows the foreign investors to easily move in and move out from an economy. But now India is a fast developing country and one of the most preferred countries for investment by foreigners. So government has allowed convertibility of rupee in phased manner on current account transactions.
UPSC Civil Services Examination, Previous Year Questions (PYQs)
Recently RBIs governor Raguram Rajan, in an interview has suggested moving towards full capital account convertibility in short numbers of years. Mr. G Padmanabhan, Executive Director of the Reserve Bank of India (RBI), has suggested that India should move towards making the rupee more convertible for capital transactions by foreign investors. According to him keeping any restriction for too long could prove self defying. As even after partial convertibility of rupee foreign exchange value of rupee remained stable, this laid down a base for the full convertibility on current account. Hence, from March 1993, rupee was made convertible for all trade in merchandise. In March’ 1994, even indivisibles and remittances from abroad were allowed to be freely convertible into rupees at market determined exchange rate.
- Rupee convertibility refers to the ability to freely exchange the Indian rupee for other foreign currencies or assets without significant restrictions or controls imposed by the Reserve Bank of India (RBI) or the government.
- In March’ 1994, even indivisibles and remittances from abroad were allowed to be freely convertible into rupees at market determined exchange rate.
- However, Indians still require regulatory approval if they want to invest an amount above a pre-determined threshold in overseas assets.
- It allows for the conversion of rupees into other currencies at market rates, enhancing international trade and investment.
- The growing international interest in the Indian rupee is evident from the development of offshore rupee markets in locations like Dubai, London, New York, and Singapore.
- At present, there are limits on investment by foreign financial investors and also caps on FDI ceiling in most sectors, for example, 74% in banking and communication, 49% in insurance, 0% in retail, etc.
Advantages and Disadvantages of a Fully Convertible Rupee
The growing international interest in the Indian rupee is evident from the development of offshore rupee markets in locations like Dubai, London, New York, and Singapore. Trading of the INR is still far lower than other currencies such as the euro. As of September 2024, INR contracts traded against the dollar an average of 11,825 times per day in 2024, compared to 198,027 contracts converted from Euro to USD. (a) Capital account convertibility exists for foreign convertibility of rupee implies investors and Non-Resident Indians (NRIs) for undertaking direct and portfolio investment in India.
At the same time, average effective CRR needs to be brought down from the current 9.3% to 3%. The Indian rupee is a different currency from the Pakistani rupee (used in the Republic of Pakistan) and the Nepalese rupee (used in the Federal Democratic Republic of Nepal). (ii) The Governments should fix the annual inflation target below 4 per cent. This was called mandated inflation target — and give foil freedom to RBI to use monetary weapons to achieve the inflation target. The Government should also set up a Consolidated Sinking Fund (CSF) to reduce Government debt.
Convertibility establishes a system where the market place determines the rate of exchange through the free interplay of demand and supply forces. A currency with current account convertibility can be converted to any foreign currency at existing market rates for trade purposes for any amount. This allows for easy financial transactions for the export and import of goods and services. Reserve Bank of India appointed the second Tarapore committee to set out the framework for fuller Capital Account Convertibility.
Post Independence India
As of today, the Indian rupee is partly convertible, which means that although there is a lot of freedom to exchange local and foreign currency at market rates, a few important restrictions remain for higher amounts and these still need approvals. The regulators also pitch in from time-to-time to keep the exchange rates within permissible limits, instead of keeping INR as a completely free-floating currency left to the market dynamics. In the case of extreme volatility in rupee exchange rates, the RBI swings into action by purchasing/selling U.S. dollars (kept as foreign reserve) to stabilize the rupee.
A fully convertible rupee would improve employment and consumer opportunities, help Indian businesses raise foreign capital, and allow India to become a global economic player. However, this would also come with increased volatility, the risk of businesses becoming burdened by foreign debt, and reduced competitiveness in the global export market. However, Indians still require regulatory approval if they want to invest an amount above a pre-determined threshold in overseas assets.
Another important merit of currency convertibility lies in its self-balancing mechanism. When balance of payments is in deficit due to over-valued exchange rate, under currency convertibility, the currency of the country depreciates which gives boost to exports by lowering their prices on the one hand and discourages imports by raising their prices on the other. Currency convertibility is an important part of global commerce because it opens up trade with other countries. Having a convertible currency allows a government to pay for goods and services in a currency other than its own.
India’s currency, the rupee, is not yet a fully convertible currency, meaning there are still restrictions that make it difficult to buy or sell in the foreign exchange (forex) market. However, there have been talks of making the rupee (INR) fully convertible and setting up an onshore INR market. Capital account convertibility refers to a liberalization of a country’s capital transactions such as loans and investment, both short term and long term as well as speculative capital flows. The Tarapore Committee’s recommendations (in 1997 and 2006), including reducing fiscal deficits, inflation rates, and banking non-performing assets, should be pursued as a primary step towards internationalisation of rupee.
Also, advocating for the rupee to become an official currency in international organizations would raise its profile and acceptance. However, Indians still require regulatory approvals if they want to invest an amount above a pre-determined threshold level for the purpose of investments or purchasing assets overseas. Similarly, incoming foreign investments in certain sectors (like insurance or retail) are capped at a specific percentage and require regulatory approvals for higher limits.
