Current Account Convertibility

Currency Convertibility

• Currency convertibility refers to the freedom of currency holders to convert their domestic currency into foreign currencies and vice versa at the prevailing market exchange rate.
• For example, if the Indian Rupee is convertible, a person holding rupees can exchange them for foreign currencies such as the US Dollar, Euro or Pound.

Types of Currency Convertibility

All transactions between India and the rest of the world are broadly recorded under the Current Account and the Capital Account. Accordingly, currency convertibility is of two types:

• Current Account Convertibility
• Capital Account Convertibility

Current Account Convertibility

• Current Account Convertibility means the freedom to convert rupees into foreign currency, or foreign currency into rupees, for current account transactions such as:
  • Import and export of goods
  • Import and export of services
  • Travel and education expenses
  • Interest and dividend payments
  • Remittances and other current transfers
• Example: An Indian importer needs US dollars to pay an American company for imported machinery.
• As part of the economic reforms initiated in 1991, the Indian Rupee was made fully convertible at current account in 1994.

Evolution of Current Account Convertibility

• Before 1992: The exchange rate of the Indian Rupee was largely officially determined and managed by the RBI, rather than being determined primarily by market forces.
• 1991: During the Balance of Payments crisis, the rupee underwent a two step downward adjustment in July 1991. This was followed by reforms aimed at moving towards a more market determined exchange rate system.
• 1992: Partial Convertibility under LERMS: The Liberalised Exchange Rate Management System (LERMS) was introduced in March 1992. Under the LERMS, 40 per cent of exchange earnings had to be surrendered at an official rate determined by the Reserve Bank, which in turn was obliged to sell foreign exchange only for import of certain essential commodities such as oil, fertiliser and life saving drugs besides the Government’s debt servicing. The balance 60 per cent of exchange earnings was to be converted at rates determined by the market.
  • 40% of Foreign Exchange Earnings → Official Exchange Rate
  • 60% of Foreign Exchange Earnings → Market Determined Exchange Rate
  • Thus, the rupee became partially convertible under the 40:60 arrangement.
• 1993: Unified Market Determined Exchange Rate: The dual exchange rate system was abolished from 1 March 1993. A unified single market-determined exchange rate system based on the demand for and supply of foreign exchange replaced the LERMS effective March 1, 1993.
• 1994: Current Account Convertibility: In 1994, India accepted Article VIII of the Articles of Agreement of the International Monetary Fund (IMF) making INR fully convertible on the current account.

Capital Account Convertibility

• Capital Account Convertibility is the ability or freedom to convert domestic currency for capital account transactions. The Tarapore Committee (2006), for instance, defined capital account convertibility as the “freedom to convert local financial assets into foreign financial assets and vice versa.”
• Capital Account Convertibility means freedom to convert domestic currency into foreign currency and vice versa for capital account transactions, such as:
  • Foreign Direct Investment
  • Portfolio Investment
  • Purchase of foreign shares and securities
  • Foreign borrowing and lending
  • Purchase of assets abroad
• Example: If an Indian resident converts rupees into dollars to purchase shares of a US company, it involves a capital account transaction.
• India does not have full capital account convertibility.
• The RBI does not allow the rupee to be freely converted into foreign currencies for all capital account transactions. There are certain rules and limits on how much money can be invested, borrowed or transferred across countries. Therefore, the Indian Rupee is said to be partially convertible on the capital account.