TILAK RAJ CHADHA INSTITUTE OF MANAGEMENT & TECHNOLOGY , YAMUNA NAGAR -135001
( AFFILIATED TO KURUKSHETRA UNIVERSITY . KURUKSHETRA )
A SEMINAR REPORT ON
FULL RUPEE CONVERTABILITYGOOD, BAD OR UGLY?
GUIDED BY : Ms. Amanjeet kaur (Asst. Professor)
SUBMITTED BY :
THEORITICAL FRAMEWORK
CONSTRUCT : RELEVANCE OF FULL RUPEES CONVERTABILITY INDEPENDENT VARIABLE : Govt. Programe & policies regarding full convertabilty of rupees DEPENDENT VARIABLE : Econmomic Status of country Foreign Market Condition
CONTENTS
WHAT DOES FULL CONVERTIBILITY OF RUPEES MEAN? FULL CONVERTIBILITY OF THE INDIAN RUPEE CONVERTIBILITY – EVOLUTION OF THE CONCEPT FIXED AND FLOATING EXCHANGE RATES GLOBAL SCENARIO CURRENT ACCOUNT TRANSACTIONS CAPITAL ACCOUNT TRANSACTIONS FULL RUPEE CONVERTIBILITY: GOOD, BAD OR UGLY? RUPEE AS A CONVERTIBLE CURRENCY AND ITS IMPLICATIONS ADVANTAGES DISADVANTAGES INTEREST RATE – A DANGEROUS WEAPON CONCLUSION
INTRODUCTION FULL RUPEE CONVERTIBILITY MEANING
In foreign exchange, ability to exchange money for other currencies or for gold without government restriction. Also said of a currency that foreign residents will accept as payment for goods or services. Convertibility is the quality of money which is officially backed by government reserves of a precious metal, usually by the gold standard. Under convertibility, currency is seen as more reliable and less prone to exchange-rate fluctuations (though gold, of course, also changes in value). The Bretton Woods Institutions were set up partially to allow countries to peg their currencies to the US dollar instead of their own gold reserves; the U.S. eventually abandoned the gold standard, and thus convertibility, in 1971. It can also refer to the convertibility of one currency into another. Some countries pass laws restricting the legal exchange rates or requiring permits to exchange more than a certain amount. Thus, those countries' currencies are not fully convertible. Officially, the Indian rupee has a market determined exchange rate. However, the RBI trades actively in the INR/USD currency market to impact effective exchange rates. Thus, the currency regime in place for the Indian rupee with respect to the US dollar is a de facto controlled exchange rate. This is sometimes called a dirty or managed float. Other rates such as the INR/EUR and INR/JPY have volatilities that are typical of floating exchange rates. It should be noted, however, that unlike China, successive administrations (through RBI, the central bank) have not followed a policy of pegging the INR to a specific foreign currency at a particular exchange rate. RBI
intervention in currency markets is solely to deliver low volatility in the exchange rates, and not to take a view on the rate or direction of the Indian rupee in relation to other currencies.
FULL CONVERTIBILITY OF THE INDIAN RUPEE
The Prime Minister, Dr. Manmohan Singh in a speech at the Reserve Bank of India, Mumbai, on March 18, 2006 referred to the need to revisit the subject of capital account convertibility. To quote: “Given the changes that have taken place over the last two decades, there is merit in moving towards fuller capital account convertibility within a transparent framework…I will therefore request the Finance Minister and the Reserve Bank to revisit the subject and come out with a roadmap based on current realities”. Convertible currencies are defined as currencies that are readily bought, sold, and converted without the need for permission from a central bank or government entity. Most major currencies are fully convertible; that is, they can be traded freely without restriction and with no permission required. The easy convertibility of currency is a relatively recent development and is in part attributable to the growth of the international trading markets and the FOREX markets in particular. Historically, movement away from the gold exchange standard once in common usage has led to more and more convertible currencies becoming available on the market. Because the value of currencies is established in comparison to each other, rather than measured against a real commodity like gold or silver, the ready trade of currencies can offer investors an opportunity for profit.
FULLY CONVERTIBLE CURRENCY
The U.S. dollar is an example of a fully convertible currency. There are no restrictions or limitations on the amount of dollars that can be traded on the international market, and the U.S. Government does not artificially impose a fixed value or minimum value on the
dollar in international trade. For this reason, dollars are one of the major currencies traded in the FOREX market.
PARTIALLY CONVERTIBLE CURRENCY
The Indian rupee is only partially convertible due to the Indian Central Bank’s control over international investments flowing in and out of the country. While most domestic trade transactions are handled without any special requirements, there are still significant restrictions on international investing and special approval is often required in order to convert rupees into other currencies. Due to India’s strong financial position in the international community, there is discussion of allowing the Indian rupee to float freely on the market, altering it from a partially convertible currency to a fully convertible one.
NON-CONVERTIBLE CURRENCY
Almost all nations allow for some method of currency conversion; Cuba and North Korea are the exceptions. They neither participate in the international FOREX market nor allow conversion of their currencies by individuals or companies. As a result, these currencies are known as blocked currencies; the North Korean won and the Cuban national peso cannot be accurately valued against other currencies and are only used for domestic purposes and debts. Such nonconvertible currencies present a major obstruction to international trade for companies who reside in these countries. Convertibility is the quality of paper money substitutes which entitles the holder to redeem them on demand into money proper.
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). 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 Korea’s won and Cuba’s 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 world’s 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 world’s manufacturing capacity and held most of the world’s 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 country’s 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 country’s money was too low, the country would buy its own currency, thereby driving up the price. 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.
FIXED AND FLOATING EXCHANGE RATES
Exchange Rate systems are classified on the basis of the flexibility that the monetary authorities show towards fluctuations in the exchange rates and have been traditionally divided into 2 categories, namely: • systems with a fixed exchange rate • systems with a flexible exchange rate. In the former system the exchange rate is usually a political decision, in the latter the prices are determined by the market forces, in accordance with demand and supply. These systems are often referred to as Fixed Peg (sometimes also described as “hard peg”) and Floating systems. But as usual, between these two extreme positions there exists also an intermediate range of different systems with limited flexibility, usually referred to as “soft pegs”.
FIXED EXCHANGE RATE
A country’s decision to tie the value of its currency to another country’s currency, gold (or another commodity), or a basket of currencies.A fixed exchange rate is usually used to stabilize the value of a currency, against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable, and is especially useful for small economies where external trade forms a large part of their GDP. It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the MundellFleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. Fixing value of the domestic currency relative to that of a low-inflation country is one approach central banks have used to pursue price stability. The advantage of an exchange rate target is its clarity, which makes it easily understood by the public. In practice, it obliges the central bank to limit money creation to levels comparable to those of the country to whose currency it is pegged. When credibly maintained, an exchange rate target can lower inflation expectations to the level prevailing in the anchor country. Experiences with fixed exchange rates, however, point to a number of drawbacks. A country that fixes its exchange rate surrenders control of its domestic monetary policy. A fixed currency exchange rate is one that is set by a government, usually through a central bank. A currency is pegged to another currency at a certain rate. For example, the Chinese yuan might be fixed to the U.S. dollar, meaning that its exchange rate is held within a range, depending on the U.S. dollar. Some countries fix their currencies to the Japanese yen or the euro. In other cases, a fixed currency may be pegged to a basket of currencies.
For instance, China has allowed free exchange for current account transactions since December 1, 1996. Of more than 40 categories of capital account, about 20 of them are convertible. These convertible accounts are mainly related to foreign direct investment. Because of capital control, even the renminbi is not under the managed floating exchange rate regime, but free to float, and so it is somewhat unnecessary for foreigners to purchase renminbi.
FLOATING EXCHANGE RATE
A floating currency is one that is more influenced by the market. Supply and demand sets the exchange rate. For example, if more people want to buy euros, and sell dollars to do so, the value of the euro rises in response, while the value of the dollar — relative to the Euro falls in forex trading. The Canadian dollar most closely resembles the ideal floating currency as the Canadian central bank has not interfered with its price since it officially stopped doing so in 1998. The US dollar runs a close second with very little changes in its foreign reserves; by contrast, Japan and the UK intervene to a greater extent. From 1946 to the early 1970s, the Bretton Woods system made fixed currencies the norm; however, in 1971, the United States government abandoned the gold standard, so that the US dollar was no longer a fixed currency, and most of the world’s currencies followed suit.It is not possible for a developing country to maintain the stability in the rate of exchange for its currency in the exchange market.There are two options open for them1. Let the exchange rate be allowed to fluctuate in the open market according to the market conditions, or 2. An equilibrium rate may be fixed to be adopted and attempts should be made to maintain it as far as possible. If there is a fundamental change in the circumstances, the rate should be changed accordingly. The rate of exchange under the first alternative is know as fluctuating rate of exchange and under second alternative, it is called flexible rate of exchange. In the
modern economic conditions, the flexible rate of exchange system is more appropriate as it does not hamper the foreign trade.
GLOBAL SCENARIO
There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency “strong” or “high” relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis. The debate of making a choice between fixed and floating exchange rate regimes is set forth by the Mundell-Fleming model, which argues that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave third to the market forces. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price “ceiling” and “floor”. Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.A free floating exchange rate increases foreign exchange volatility. There are economists who think that this could cause serious problems, especially in emerging economies. These economies have a financial sector with one or more of following conditions: • high liability dollarization • financial fragility
• strong balance sheet effects When liabilities are denominated in foreign currencies while assets are in the local currency, unexpected depreciations of the exchange rate deteriorate bank and corporate balance sheets and threaten the stability of the domestic financial system. For this reason emerging countries appear to face greater fear of floating, as they have much smaller variations of the nominal exchange rate, yet face bigger shocks and interest rate and reserve movements. This is the consequence of frequent free floating countries’ reaction to exchange rate movements with monetary policy and/or intervention in the foreign exchange market.
CURRENT AND CAPITAL ACCOUNT TRANSACTIONS
CURRENT ACCOUNT TRANSACTIONS
Section 2(j) defines a Current Account Transaction as a transaction and without prejudice to the generality of the foregoing such transaction includes1. Payments due in connection with foreign trade, other current business, services and short term banking and credit facilities in the ordinary course of business, 2. Payments due as interest on loans and as net income from investments 3. Remittances for living expenses of parents, spouse and children residing abroad, and 4. Expenses in connection with foreign travel, education and medical care of parents, spouse and children. Any person can sell or draw foreign exchange to or from authorized person if such sale or drawal is a current account transaction. Reasonable restriction on current account transactions can be imposed by Central Government in public interest, in consultation with RBI.
CAPITAL ACCOUNT TRANSACTIONS
Section 2(e) of the Foreign Exchange Management Act, 1999 defines a Capital Account Transaction as a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India, and includes transactions referred to in sub-section (3) of Section 6. Following Capital Account Transactions are prohibited as per Foreign Exchange Management (Permissible Capital Account Transactions) Regulations, 2000 – Transactions not permitted in FEMA - Capital account transactions not permitted in the FEMA Act, Rules or Regulations. In other words, all capital account transactions are prohibited, unless specifically permitted. In current account transactions the position is reverse, that is all current transactions are permitted unless specifically prohibited. Investment in certain sectors – Foreign investment in India in any company, firm or proprietary concern engaged or proposing to engage in the following business is completely prohibited: • Chit Fund • Nidhi Company • Agricultural or plantation activities • Real Estate business or construction of farmhouses • Trading in Transferable Development Rights (certificates issued in respect of land acquired for public purposes either by the Central Government or State Government in consideration of surrender of land by the owner without monetary consideration. The TDR is transferable in part or whole. In practice, the distinction between current and capital account transactions is not always clear-cut. There are transactions which straddle the current and capital account.
Illustratively, payments for imports are a current account item but to the extent these are on credit terms, a capital liability emerges and with increase in trade payments, trade finance would balloon and the resultant vulnerability should carefully be kept in view in moving forward to FCAC. Contrarily, extending credit to exports is tantamount to capital outflows. As regards residents, the capital restrictions are clearly more stringent than for nonresidents. Furthermore, resident corporates face a relatively more liberal regime than resident individuals. Till recently, resident individuals faced a virtual ban on capital outflow but a small relaxation has been undertaken in the recent period. Section 4 of FEMA provides that no person resident of India shall acquire, hold, own, possess or transfer any foreign exchange, foreign security or any immovable property situated outside India, except as provided in the Act.
CAPITAL ACCOUNT CONVERTIBILITY:Capital Account Convertibility is a monetary policy that centers around the ability to conduct transactions of local financial assets into foreign financial assets freely and at market determined exchange rates. It is sometimes referred to as Capital Asset Liberation. It is basically a policy that allows the easy exchange of local currency (cash) for foreign currency at low rates. This is so local merchants can easily conduct transnational business without needing foreign currency exchanges to handle small transactions. CAC is mostly a guideline to changes of ownership in foreign or domestic financial assets and liabilities. Tangentially, it covers and extends the framework of the creation and liquidation of claims on, or by the rest of the world, on local asset and currency markets. Capital Account Convertibility has 5 basic statements designed as points of action: 1. All types of liquid capital assets must be able to be exchanged freely, between any two nations, with standardized exchange rates. 2. The amounts must be a significant amount (in excess of $500,000).
3. Capital inflows should be invested in semi-liquid assets, to prevent churning and excessive outflow. 4. Institutional investors should not use Capital Account Convertibility to manipulate fiscal policy or exchange rates. 5. Excessive inflows and outflows should be buffered by national banks to provide collateral. The status of capital account convertibility in India for various non-residents is as follows: for foreign corporates, and foreign institutions, there is a reasonable amount of convertibility; for non-resident Indians (NRIs) there is approximately an equal amount of convertibility, but one accompanied by severe procedural and regulatory impediments. For non-resident individuals other than NRIs, there is near-zero convertibility. Movement towards an Fuller Capital Account Convertibility implies that all non-residents (corporates and individuals) should be treated equally. This would mean the removal of the tax benefits presently accorded to NRIs via special bank deposit schemes for NRIs, viz., Non-Resident External Rupee Account [NR(E)RA] and Foreign Currency NonResident (Banks) Scheme [FCNR(B)]. Non-residents, other than NRIs, should be allowed to open FCNR(B) and NR(E)RA accounts without tax benefits, subject to Know Your Customer (KYC) and Financial Action Task Force (FATF) norms. In the case of the present NRI schemes for various types of investments, other than deposits, there are a number of procedural impediments and these should be examined by the Government and the RBI. A person resident in India is permitted to open, hold and maintain with an Authorized Dealer in India a Foreign Currency Account known as Exchange Earner’s Foreign Currency (EEFC) Account subject to the terms and conditions of the Exchange Earner’s Foreign Currency Account Scheme specified. Further, all categories of foreign exchange earners are allowed to credit up to 100 per cent of their foreign exchange earnings, as specified in the paragraph 1 (A) of the Schedule, to their EEFC Account. Any person resident in India,
i)
may take outside India (other than to Nepal and Bhutan) currency notes of Government of India and Reserve Bank of India notes up to an amount not exceeding Rs.7,500 (Rupees seven thousand five hundred only) per person; and
ii)
who had gone out of India on a temporary visit, may bring into India at the time of his return from any place outside India (other than from Nepal and Bhutan), currency notes of Government of India and Reserve Bank of India notes up to an amount not exceeding Rs.7,500 (Rupees seven thousand five hundred only) per person.
According to Regulation 7 of the Foreign Exchange Management (Foreign Currency Accounts by a Person Resident in India) Regulations, 2000, (i) A citizen of a foreign State, resident in India, being an employee of a foreign company or a citizen of India, employed by a foreign company outside India and in either case on deputation to the office /branch /subsidiary /joint venture in India of such foreign company may open, hold and maintain a foreign currency account with a bank outside India and receive the whole salary payable to him for the services rendered to the office/branch/subsidiary/joint venture in India of such foreign company, by credit to such account, provided that income-tax chargeable under the Income-tax Act,1961 is paid on the entire salary as accrued in India. (ii) A citizen of a foreign State resident in India being in employment with a company incorporated in India may open, hold and maintain a foreign currency account with a bank outside India and remit the whole salary received in India in Indian Rupees, to such account, for the services rendered to such an Indian company, provided that income-tax chargeable under the Income-tax Act, 1961 is paid on the entire salary accrued in India. It would be desirable to consider a gradual liberalisation for resident corporates/business entities, banks, non-banks and individuals. The issue of liberalisation of capital outflows for individuals is a strong confidence building measure, but such opening up has to be well calibrated as there are fears of waves of outflows. The general experience is that as
the capital account is liberalised for resident outflows, the net inflows do not decrease, provided the macroeconomic framework is stable. As India progressively moves on the path of convertibility, the issue of investments being channeled through a particular country so as to obtain tax benefits would come to the fore as investments through other channels get discriminated against. Such discriminatory tax treaties are not consistent with an increasing liberalisation of the capital account as distortions inevitably emerge, possibly raising the cost of capital to the host country. With global integration of capital markets, tax policies should be harmonised. It would, therefore, be desirable that the Government undertakes a review of tax policies and tax treaties.
FULL RUPEE CONVERTIBILITY: GOOD, BAD OR UGLY?
PRINCIPAL ADVISER PLANNING COMMISSION What are we talking about — full currency convertibility; a fully open capital account; or both? No one seems to be terribly clear. Most people, including the pontificators, tend to treat these concepts as synonymous — which is simply wrong. It is conceptually quite possible to have one without necessarily having the other. Currency convertibility refers to the absence of any restriction on the holding of foreign currencies by residents and of the national currency by foreigners, and on free conversion between currencies. It does not preclude restrictions on the type and quantity of noncurrency assets that residents can hold abroad or foreigners can hold in the country. An open capital account, on the other hand, is the absence of restrictions on non-currency asset holdings, and can exist without free conversion of the currency. It may, therefore, be desirable to discuss each of these concepts separately. Consider first the issue of an open capital account.
This is commonly held to have three important benefits: augmenting investible resources in the country through greater access to international capital; overcoming weaknesses in the domestic financial architecture through access to international capital markets; and enhancing domestic savings by expanding the portfolio choice of domestic savers to include foreign assets.
RUPEE AS A CONVERTIBLE CURRENCY AND ITS IMPLICATIONS
The recent decision of the government to have full convertibility of the Indian Rupee which will affect everyone in the country but is remotely understandable by a few, is one such important decision, which is designed to please the international financial institutions and the 10 percent of the population of India who are either rich or of upper middle class. It is essential to judge a policy by examining both the costs and benefits of it. The government is talking about the illusory benefits of this convertibility, which will basically remove all obstacle to the free flow of money and as a result goods and services also can move freely. The government, in a fully convertible regime, will not be able to control these flows directly. Indirect controls will be implemented by changing interest rates and taxes but the effectiveness of this control according to the international experiences is uncertain.
ADVANTAGES
? The benefits of free flows of money in a fully convertible regime means foreigners would be able to invest in the Indian stock markets, buy up companies and property including land (unless there are restrictions). ? Indian people and companies can import anything they would like, buy shares of foreign companies and property in foreign lands and can transfer money as they please without going through the Hawala business.
? Indians who have not paid their taxes or repaid their loans taken from the Indian banks will be free to transfer their money to foreign countries outside the jurisdiction of the Indian authority. ? The expected benefits for India would depend on the attractiveness of the country as a safe destination for short-term investments. ? Long-term investments do not depend on convertibility. ? Short term investments i.e., foreign investments in shares and bonds of the Indian companies and Indian government depend on the demonstration of profit of the Indian companies . ? The continuous good health of the Indian economy in terms of low budget deficits, low balance of payments deficits, low level of government borrowings and low level of non-performing loan in the Indian banking system. Another advantage of full convertibility of Rupee for the Indian rich is that they can import as they like and buy properties abroad as they were allowed to do so during the days of British Raj. It has certain advantages for the Indian companies who will be able to import both raw materials and machineries or set up foreign establishments at will.
DISADVANTAGES
? Full convertibility also has adverse consequences for the India’s domestic producers of these raw materials and machineries, as they have to compete against foreign suppliers who like Chinese may have deliberate low rate of exchange for their currencies thus making their goods low in price. ? Foreign suppliers also can be supported by all kinds of subsidies by their government so as to make their prices very low. ? Agricultural exports from Europe, USA, Thailand, and Australia can ruin India’s own agriculture.
? The freedom for India’s rich to buy companies and property abroad may lead to massive diversion of funds from investments in the home economy of India to investments abroad. This would amount to export of jobs to foreign countries creating more and more unemployment at home. ? The most dangerous consequence of convertibility is that Rupee will be under the control of currency speculators. ? A fully convertible regime for the Rupee will certainly include participation of Rupee in the international currency market and in the ‘future market’ of Rupee, the playground for the international speculators. It is very much possible for the speculators to buy massive amount of Rupee to drive up its exchange rate and then they can suddenly sell all to gain enormous profit. That will drive down Rupee to a very low depth suddenly. ? If the Reserve Bank of India wants to protect Rupee in such a situation, within a few days India will have no foreign exchange left in reserve and the country will go bankrupt. 1997 Asian Financial Crisis The Asian Financial Crisis was a period of financial crisis that gripped much of Asia beginning in July 1997, and raised fears of a worldwide economic meltdown due to financial contagion. The crisis started in Thailand with the financial collapse of the Thai baht caused by the decision of the Thai government to float the baht, cutting its peg to the USD, after exhaustive efforts to support it in the face of a severe financial overextension that was in part real estate driven. At the time, Thailand had acquired a burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency. As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and other asset prices, and a precipitous rise in private debt A similar situation took place in South Korea, Malaysia and Indonesia, all with their then convertible currency. Malaysia has survived by imposing fixed exchange rate, exchange
control, and making Malaysian dollar nonconvertible. Both India and China were unaffected because their economies at that time were closed and their currencies were non-convertible. Money supply as experience suggests can work only on the negative direction; i.e., if the country reduces the money supply inflation can be controlled at the cost of reduced investments and increased unemployment. If the country, instead, increases the money supply to stimulate the economy it can cause inflation and eventually unemployment will go up as well because of possible bankruptcy of the private companies as a result of high inflation. The argument of Keynes that if there are underemployed resources in the economy increased money supply resultant from increased government spending cannot cause inflation is not valid for a dual economy like India where the 10 percent of the population live in a different planet from the other 90 percent of the population.
INTEREST RATE – A DANGEROUS WEAPON
Interest rate is a dangerous instrument. If the government reduces it, there will be inflation, speculative movements in the market and disincentives for the savers, which would reduce future investments. Reduced interest rate for a convertible Rupee will reduce the exchange rate of the Rupee. The currency speculators will start selling Rupee and short-term investments will fly out of the country. There would be a free fall of the Rupee in the international currency market. As a result the economy may go bankrupt without any foreign exchange. The result can be collapse of the private companies leaving millions of people unemployed. If the government increases the interest rate exchange rate of Rupee will go up. Shortterm investment will flood the market, speculators will buy more Rupee, but the exporters will be unable to sell their products abroad because of higher price of Indian exports as a result of higher exchange rate of Rupee. High exchange rate of Rupee also mean lower price of imported products. As a result both manufacturers and farmers will
suffer from enhanced competitions from the manufactured products from the East and South East Asia and farm products from USA, Europe, Australia and Thailand. Thus, interest rate is a dangerous weapon to depend upon. If a country wants to use it extensively the economy will go up and down creating havoc for the people. In 1988 Nigel Lawson, the then Chancellor of Exchequer of Britain used lower interest rate to stimulate the economy creating speculative bubble for a few years until 1991, then he had to increase the interest rate to a very high level to protect the British pound from the speculators causing serious depression of the economy and high unemployment. If the interest rate is determined by the market, as it should be in a convertible currency regime with unrestricted flows of money, India government will not have any control over the economy to give it a direction. The only instrument that may be available is the public expenditure policy. The government can stimulate the economy by increasing public expenditure, which may have uncertain consequences for the fate of Indian Rupee. Due to increased public expenditure, rate of growth of the economy and employment may go up, but at the same time there will be increased deficits in the balance of payments. Increased rate of growth may invite short-term investments and international speculators will buy more Rupee. However, increased budget deficit will cause increased deficits in the balance of payments, which will soon drive out short-term investments and speculators will start selling Rupee. India should learn from China. China has no convertibility of Yuan, instead there are extensive controls on financial, and commodity flows in or out of the country. Foreign companies cannot have 100 percent ownership; they must have partnership with Chinese state owned companies. Foreign companies cannot repatriate profit, as they like; they must bring new technology, they must export most of their products. China imports what it needs, although theoretically it is a member of the World Trade Organization. China does not allow short-term investments, but it is the most attractive destination for the long-term foreign investments.
Chinese Yuan does not take part in the international foreign exchange market and thus, protected from the currency speculators. China has reduced the exchange rate of Yuan by 40 percent in 1984 and kept it fixed only to increase it by only 2 percent in 2005 when it has gigantic reserve of US dollars and massive trade surplus with the rest of the world. Very low exchange rate of Yuan is one of the most important reasons why China has managed to capture the markets of every important countries of the world
CONCLUSION
The rupee exchange rate is neither completely free-floating nor fixed, but is “managed” by the Reserve Bank of India through buying and selling other currencies. Up until April, the Reserve Bank was buying lots of U.S. dollars — perhaps as much as $24 billion in the previous six months — to keep the rupee at around 44 to the dollar. But with investor sentiment so hot on India and money pouring in from abroad — international investors have bought more than $7.5 billion worth of Indian stocks so far this year, compared to $8 billion in all of 2006 — the Reserve Bank found itself having to spend more and more on foreign currencies just to keep the rupee stable. Convertibility of Rupee will give pleasure to the 10 percent of Indian people who are either rich or upper middle class, traders in the stock market, speculators, bankers, and accountants. The rest 90 percent of the people will be adversely affected with loss of employments in the manufacturing sector and bankruptcy in the agricultural sector and total economic uncertainly. During the days of the British Raj, Rupee was convertible, India had very large surplus in the balance of payments. India’s share in the world trade was much higher than what it is today. However, millions of Indians used to starve to death from time to time; millions of acres of land were left uncultivated by the bankrupt farmers; there were hardly any industry except for a few textile mills, only 15 percent of the population had any education at all. Yet at the same time, one could buy Rolls Royce and Scotch whisky in
Bombay and Calcutta; Jinnah could buy his apartment in Bond Street of London; Maharaja of Patiala could build palace in Paris. The strengthening rupee may also send an even more important signal: India is not China. It helps of course that India’s trade surplus with the U.S. last year was just $11.7 billion compared to China’s whopping $232.5 billion. But by allowing the rupee to strengthen over the past few months, India is showing it’s prepared to play much more fairly in the global market. India is seen as a more or less unambiguous ally to the U.S.But economists say that jumping into capital account convertibility game without considering the downside of the step could harm the economy. The East Asian economic crisis is cited as an example by those opposed to capital account convertibility.Even the World Bank has said that embracing capital account convertibility without adequate preparation could be catastrophic. But India is now on firm ground given its strong financial sector reform and fiscal consolidation, and can now slowly but steadily move towards fuller capital account convertibility.
BIBILIOGRAPHY
WEB-SITE ? http://wiki.answers.com/Q/What_is_rupee_convertibility ? http://www.answers.com/topic/convertibil… ? http://articles.economictimes.indiatimes.com/2006-0328/news/27457635_1_convertibility-currency-free-conversion ? http://jurisonline.in/2010/06/full-convertibility-of-the-indian-rupee-an-analysisof-the-feasibility/ ? http://economics.about.com/od/foreigntrade/a/bretton_woods.htm
SNAPSHOTS
doc_658050868.doc
( AFFILIATED TO KURUKSHETRA UNIVERSITY . KURUKSHETRA )
A SEMINAR REPORT ON
FULL RUPEE CONVERTABILITYGOOD, BAD OR UGLY?
GUIDED BY : Ms. Amanjeet kaur (Asst. Professor)
SUBMITTED BY :
THEORITICAL FRAMEWORK
CONSTRUCT : RELEVANCE OF FULL RUPEES CONVERTABILITY INDEPENDENT VARIABLE : Govt. Programe & policies regarding full convertabilty of rupees DEPENDENT VARIABLE : Econmomic Status of country Foreign Market Condition
CONTENTS
WHAT DOES FULL CONVERTIBILITY OF RUPEES MEAN? FULL CONVERTIBILITY OF THE INDIAN RUPEE CONVERTIBILITY – EVOLUTION OF THE CONCEPT FIXED AND FLOATING EXCHANGE RATES GLOBAL SCENARIO CURRENT ACCOUNT TRANSACTIONS CAPITAL ACCOUNT TRANSACTIONS FULL RUPEE CONVERTIBILITY: GOOD, BAD OR UGLY? RUPEE AS A CONVERTIBLE CURRENCY AND ITS IMPLICATIONS ADVANTAGES DISADVANTAGES INTEREST RATE – A DANGEROUS WEAPON CONCLUSION
INTRODUCTION FULL RUPEE CONVERTIBILITY MEANING
In foreign exchange, ability to exchange money for other currencies or for gold without government restriction. Also said of a currency that foreign residents will accept as payment for goods or services. Convertibility is the quality of money which is officially backed by government reserves of a precious metal, usually by the gold standard. Under convertibility, currency is seen as more reliable and less prone to exchange-rate fluctuations (though gold, of course, also changes in value). The Bretton Woods Institutions were set up partially to allow countries to peg their currencies to the US dollar instead of their own gold reserves; the U.S. eventually abandoned the gold standard, and thus convertibility, in 1971. It can also refer to the convertibility of one currency into another. Some countries pass laws restricting the legal exchange rates or requiring permits to exchange more than a certain amount. Thus, those countries' currencies are not fully convertible. Officially, the Indian rupee has a market determined exchange rate. However, the RBI trades actively in the INR/USD currency market to impact effective exchange rates. Thus, the currency regime in place for the Indian rupee with respect to the US dollar is a de facto controlled exchange rate. This is sometimes called a dirty or managed float. Other rates such as the INR/EUR and INR/JPY have volatilities that are typical of floating exchange rates. It should be noted, however, that unlike China, successive administrations (through RBI, the central bank) have not followed a policy of pegging the INR to a specific foreign currency at a particular exchange rate. RBI
intervention in currency markets is solely to deliver low volatility in the exchange rates, and not to take a view on the rate or direction of the Indian rupee in relation to other currencies.
FULL CONVERTIBILITY OF THE INDIAN RUPEE
The Prime Minister, Dr. Manmohan Singh in a speech at the Reserve Bank of India, Mumbai, on March 18, 2006 referred to the need to revisit the subject of capital account convertibility. To quote: “Given the changes that have taken place over the last two decades, there is merit in moving towards fuller capital account convertibility within a transparent framework…I will therefore request the Finance Minister and the Reserve Bank to revisit the subject and come out with a roadmap based on current realities”. Convertible currencies are defined as currencies that are readily bought, sold, and converted without the need for permission from a central bank or government entity. Most major currencies are fully convertible; that is, they can be traded freely without restriction and with no permission required. The easy convertibility of currency is a relatively recent development and is in part attributable to the growth of the international trading markets and the FOREX markets in particular. Historically, movement away from the gold exchange standard once in common usage has led to more and more convertible currencies becoming available on the market. Because the value of currencies is established in comparison to each other, rather than measured against a real commodity like gold or silver, the ready trade of currencies can offer investors an opportunity for profit.
FULLY CONVERTIBLE CURRENCY
The U.S. dollar is an example of a fully convertible currency. There are no restrictions or limitations on the amount of dollars that can be traded on the international market, and the U.S. Government does not artificially impose a fixed value or minimum value on the
dollar in international trade. For this reason, dollars are one of the major currencies traded in the FOREX market.
PARTIALLY CONVERTIBLE CURRENCY
The Indian rupee is only partially convertible due to the Indian Central Bank’s control over international investments flowing in and out of the country. While most domestic trade transactions are handled without any special requirements, there are still significant restrictions on international investing and special approval is often required in order to convert rupees into other currencies. Due to India’s strong financial position in the international community, there is discussion of allowing the Indian rupee to float freely on the market, altering it from a partially convertible currency to a fully convertible one.
NON-CONVERTIBLE CURRENCY
Almost all nations allow for some method of currency conversion; Cuba and North Korea are the exceptions. They neither participate in the international FOREX market nor allow conversion of their currencies by individuals or companies. As a result, these currencies are known as blocked currencies; the North Korean won and the Cuban national peso cannot be accurately valued against other currencies and are only used for domestic purposes and debts. Such nonconvertible currencies present a major obstruction to international trade for companies who reside in these countries. Convertibility is the quality of paper money substitutes which entitles the holder to redeem them on demand into money proper.
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). 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 Korea’s won and Cuba’s 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 world’s 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 world’s manufacturing capacity and held most of the world’s 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 country’s 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 country’s money was too low, the country would buy its own currency, thereby driving up the price. 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.
FIXED AND FLOATING EXCHANGE RATES
Exchange Rate systems are classified on the basis of the flexibility that the monetary authorities show towards fluctuations in the exchange rates and have been traditionally divided into 2 categories, namely: • systems with a fixed exchange rate • systems with a flexible exchange rate. In the former system the exchange rate is usually a political decision, in the latter the prices are determined by the market forces, in accordance with demand and supply. These systems are often referred to as Fixed Peg (sometimes also described as “hard peg”) and Floating systems. But as usual, between these two extreme positions there exists also an intermediate range of different systems with limited flexibility, usually referred to as “soft pegs”.
FIXED EXCHANGE RATE
A country’s decision to tie the value of its currency to another country’s currency, gold (or another commodity), or a basket of currencies.A fixed exchange rate is usually used to stabilize the value of a currency, against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable, and is especially useful for small economies where external trade forms a large part of their GDP. It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the MundellFleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. Fixing value of the domestic currency relative to that of a low-inflation country is one approach central banks have used to pursue price stability. The advantage of an exchange rate target is its clarity, which makes it easily understood by the public. In practice, it obliges the central bank to limit money creation to levels comparable to those of the country to whose currency it is pegged. When credibly maintained, an exchange rate target can lower inflation expectations to the level prevailing in the anchor country. Experiences with fixed exchange rates, however, point to a number of drawbacks. A country that fixes its exchange rate surrenders control of its domestic monetary policy. A fixed currency exchange rate is one that is set by a government, usually through a central bank. A currency is pegged to another currency at a certain rate. For example, the Chinese yuan might be fixed to the U.S. dollar, meaning that its exchange rate is held within a range, depending on the U.S. dollar. Some countries fix their currencies to the Japanese yen or the euro. In other cases, a fixed currency may be pegged to a basket of currencies.
For instance, China has allowed free exchange for current account transactions since December 1, 1996. Of more than 40 categories of capital account, about 20 of them are convertible. These convertible accounts are mainly related to foreign direct investment. Because of capital control, even the renminbi is not under the managed floating exchange rate regime, but free to float, and so it is somewhat unnecessary for foreigners to purchase renminbi.
FLOATING EXCHANGE RATE
A floating currency is one that is more influenced by the market. Supply and demand sets the exchange rate. For example, if more people want to buy euros, and sell dollars to do so, the value of the euro rises in response, while the value of the dollar — relative to the Euro falls in forex trading. The Canadian dollar most closely resembles the ideal floating currency as the Canadian central bank has not interfered with its price since it officially stopped doing so in 1998. The US dollar runs a close second with very little changes in its foreign reserves; by contrast, Japan and the UK intervene to a greater extent. From 1946 to the early 1970s, the Bretton Woods system made fixed currencies the norm; however, in 1971, the United States government abandoned the gold standard, so that the US dollar was no longer a fixed currency, and most of the world’s currencies followed suit.It is not possible for a developing country to maintain the stability in the rate of exchange for its currency in the exchange market.There are two options open for them1. Let the exchange rate be allowed to fluctuate in the open market according to the market conditions, or 2. An equilibrium rate may be fixed to be adopted and attempts should be made to maintain it as far as possible. If there is a fundamental change in the circumstances, the rate should be changed accordingly. The rate of exchange under the first alternative is know as fluctuating rate of exchange and under second alternative, it is called flexible rate of exchange. In the
modern economic conditions, the flexible rate of exchange system is more appropriate as it does not hamper the foreign trade.
GLOBAL SCENARIO
There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency “strong” or “high” relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis. The debate of making a choice between fixed and floating exchange rate regimes is set forth by the Mundell-Fleming model, which argues that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave third to the market forces. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price “ceiling” and “floor”. Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.A free floating exchange rate increases foreign exchange volatility. There are economists who think that this could cause serious problems, especially in emerging economies. These economies have a financial sector with one or more of following conditions: • high liability dollarization • financial fragility
• strong balance sheet effects When liabilities are denominated in foreign currencies while assets are in the local currency, unexpected depreciations of the exchange rate deteriorate bank and corporate balance sheets and threaten the stability of the domestic financial system. For this reason emerging countries appear to face greater fear of floating, as they have much smaller variations of the nominal exchange rate, yet face bigger shocks and interest rate and reserve movements. This is the consequence of frequent free floating countries’ reaction to exchange rate movements with monetary policy and/or intervention in the foreign exchange market.
CURRENT AND CAPITAL ACCOUNT TRANSACTIONS
CURRENT ACCOUNT TRANSACTIONS
Section 2(j) defines a Current Account Transaction as a transaction and without prejudice to the generality of the foregoing such transaction includes1. Payments due in connection with foreign trade, other current business, services and short term banking and credit facilities in the ordinary course of business, 2. Payments due as interest on loans and as net income from investments 3. Remittances for living expenses of parents, spouse and children residing abroad, and 4. Expenses in connection with foreign travel, education and medical care of parents, spouse and children. Any person can sell or draw foreign exchange to or from authorized person if such sale or drawal is a current account transaction. Reasonable restriction on current account transactions can be imposed by Central Government in public interest, in consultation with RBI.
CAPITAL ACCOUNT TRANSACTIONS
Section 2(e) of the Foreign Exchange Management Act, 1999 defines a Capital Account Transaction as a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India, and includes transactions referred to in sub-section (3) of Section 6. Following Capital Account Transactions are prohibited as per Foreign Exchange Management (Permissible Capital Account Transactions) Regulations, 2000 – Transactions not permitted in FEMA - Capital account transactions not permitted in the FEMA Act, Rules or Regulations. In other words, all capital account transactions are prohibited, unless specifically permitted. In current account transactions the position is reverse, that is all current transactions are permitted unless specifically prohibited. Investment in certain sectors – Foreign investment in India in any company, firm or proprietary concern engaged or proposing to engage in the following business is completely prohibited: • Chit Fund • Nidhi Company • Agricultural or plantation activities • Real Estate business or construction of farmhouses • Trading in Transferable Development Rights (certificates issued in respect of land acquired for public purposes either by the Central Government or State Government in consideration of surrender of land by the owner without monetary consideration. The TDR is transferable in part or whole. In practice, the distinction between current and capital account transactions is not always clear-cut. There are transactions which straddle the current and capital account.
Illustratively, payments for imports are a current account item but to the extent these are on credit terms, a capital liability emerges and with increase in trade payments, trade finance would balloon and the resultant vulnerability should carefully be kept in view in moving forward to FCAC. Contrarily, extending credit to exports is tantamount to capital outflows. As regards residents, the capital restrictions are clearly more stringent than for nonresidents. Furthermore, resident corporates face a relatively more liberal regime than resident individuals. Till recently, resident individuals faced a virtual ban on capital outflow but a small relaxation has been undertaken in the recent period. Section 4 of FEMA provides that no person resident of India shall acquire, hold, own, possess or transfer any foreign exchange, foreign security or any immovable property situated outside India, except as provided in the Act.
CAPITAL ACCOUNT CONVERTIBILITY:Capital Account Convertibility is a monetary policy that centers around the ability to conduct transactions of local financial assets into foreign financial assets freely and at market determined exchange rates. It is sometimes referred to as Capital Asset Liberation. It is basically a policy that allows the easy exchange of local currency (cash) for foreign currency at low rates. This is so local merchants can easily conduct transnational business without needing foreign currency exchanges to handle small transactions. CAC is mostly a guideline to changes of ownership in foreign or domestic financial assets and liabilities. Tangentially, it covers and extends the framework of the creation and liquidation of claims on, or by the rest of the world, on local asset and currency markets. Capital Account Convertibility has 5 basic statements designed as points of action: 1. All types of liquid capital assets must be able to be exchanged freely, between any two nations, with standardized exchange rates. 2. The amounts must be a significant amount (in excess of $500,000).
3. Capital inflows should be invested in semi-liquid assets, to prevent churning and excessive outflow. 4. Institutional investors should not use Capital Account Convertibility to manipulate fiscal policy or exchange rates. 5. Excessive inflows and outflows should be buffered by national banks to provide collateral. The status of capital account convertibility in India for various non-residents is as follows: for foreign corporates, and foreign institutions, there is a reasonable amount of convertibility; for non-resident Indians (NRIs) there is approximately an equal amount of convertibility, but one accompanied by severe procedural and regulatory impediments. For non-resident individuals other than NRIs, there is near-zero convertibility. Movement towards an Fuller Capital Account Convertibility implies that all non-residents (corporates and individuals) should be treated equally. This would mean the removal of the tax benefits presently accorded to NRIs via special bank deposit schemes for NRIs, viz., Non-Resident External Rupee Account [NR(E)RA] and Foreign Currency NonResident (Banks) Scheme [FCNR(B)]. Non-residents, other than NRIs, should be allowed to open FCNR(B) and NR(E)RA accounts without tax benefits, subject to Know Your Customer (KYC) and Financial Action Task Force (FATF) norms. In the case of the present NRI schemes for various types of investments, other than deposits, there are a number of procedural impediments and these should be examined by the Government and the RBI. A person resident in India is permitted to open, hold and maintain with an Authorized Dealer in India a Foreign Currency Account known as Exchange Earner’s Foreign Currency (EEFC) Account subject to the terms and conditions of the Exchange Earner’s Foreign Currency Account Scheme specified. Further, all categories of foreign exchange earners are allowed to credit up to 100 per cent of their foreign exchange earnings, as specified in the paragraph 1 (A) of the Schedule, to their EEFC Account. Any person resident in India,
i)
may take outside India (other than to Nepal and Bhutan) currency notes of Government of India and Reserve Bank of India notes up to an amount not exceeding Rs.7,500 (Rupees seven thousand five hundred only) per person; and
ii)
who had gone out of India on a temporary visit, may bring into India at the time of his return from any place outside India (other than from Nepal and Bhutan), currency notes of Government of India and Reserve Bank of India notes up to an amount not exceeding Rs.7,500 (Rupees seven thousand five hundred only) per person.
According to Regulation 7 of the Foreign Exchange Management (Foreign Currency Accounts by a Person Resident in India) Regulations, 2000, (i) A citizen of a foreign State, resident in India, being an employee of a foreign company or a citizen of India, employed by a foreign company outside India and in either case on deputation to the office /branch /subsidiary /joint venture in India of such foreign company may open, hold and maintain a foreign currency account with a bank outside India and receive the whole salary payable to him for the services rendered to the office/branch/subsidiary/joint venture in India of such foreign company, by credit to such account, provided that income-tax chargeable under the Income-tax Act,1961 is paid on the entire salary as accrued in India. (ii) A citizen of a foreign State resident in India being in employment with a company incorporated in India may open, hold and maintain a foreign currency account with a bank outside India and remit the whole salary received in India in Indian Rupees, to such account, for the services rendered to such an Indian company, provided that income-tax chargeable under the Income-tax Act, 1961 is paid on the entire salary accrued in India. It would be desirable to consider a gradual liberalisation for resident corporates/business entities, banks, non-banks and individuals. The issue of liberalisation of capital outflows for individuals is a strong confidence building measure, but such opening up has to be well calibrated as there are fears of waves of outflows. The general experience is that as
the capital account is liberalised for resident outflows, the net inflows do not decrease, provided the macroeconomic framework is stable. As India progressively moves on the path of convertibility, the issue of investments being channeled through a particular country so as to obtain tax benefits would come to the fore as investments through other channels get discriminated against. Such discriminatory tax treaties are not consistent with an increasing liberalisation of the capital account as distortions inevitably emerge, possibly raising the cost of capital to the host country. With global integration of capital markets, tax policies should be harmonised. It would, therefore, be desirable that the Government undertakes a review of tax policies and tax treaties.
FULL RUPEE CONVERTIBILITY: GOOD, BAD OR UGLY?
PRINCIPAL ADVISER PLANNING COMMISSION What are we talking about — full currency convertibility; a fully open capital account; or both? No one seems to be terribly clear. Most people, including the pontificators, tend to treat these concepts as synonymous — which is simply wrong. It is conceptually quite possible to have one without necessarily having the other. Currency convertibility refers to the absence of any restriction on the holding of foreign currencies by residents and of the national currency by foreigners, and on free conversion between currencies. It does not preclude restrictions on the type and quantity of noncurrency assets that residents can hold abroad or foreigners can hold in the country. An open capital account, on the other hand, is the absence of restrictions on non-currency asset holdings, and can exist without free conversion of the currency. It may, therefore, be desirable to discuss each of these concepts separately. Consider first the issue of an open capital account.
This is commonly held to have three important benefits: augmenting investible resources in the country through greater access to international capital; overcoming weaknesses in the domestic financial architecture through access to international capital markets; and enhancing domestic savings by expanding the portfolio choice of domestic savers to include foreign assets.
RUPEE AS A CONVERTIBLE CURRENCY AND ITS IMPLICATIONS
The recent decision of the government to have full convertibility of the Indian Rupee which will affect everyone in the country but is remotely understandable by a few, is one such important decision, which is designed to please the international financial institutions and the 10 percent of the population of India who are either rich or of upper middle class. It is essential to judge a policy by examining both the costs and benefits of it. The government is talking about the illusory benefits of this convertibility, which will basically remove all obstacle to the free flow of money and as a result goods and services also can move freely. The government, in a fully convertible regime, will not be able to control these flows directly. Indirect controls will be implemented by changing interest rates and taxes but the effectiveness of this control according to the international experiences is uncertain.
ADVANTAGES
? The benefits of free flows of money in a fully convertible regime means foreigners would be able to invest in the Indian stock markets, buy up companies and property including land (unless there are restrictions). ? Indian people and companies can import anything they would like, buy shares of foreign companies and property in foreign lands and can transfer money as they please without going through the Hawala business.
? Indians who have not paid their taxes or repaid their loans taken from the Indian banks will be free to transfer their money to foreign countries outside the jurisdiction of the Indian authority. ? The expected benefits for India would depend on the attractiveness of the country as a safe destination for short-term investments. ? Long-term investments do not depend on convertibility. ? Short term investments i.e., foreign investments in shares and bonds of the Indian companies and Indian government depend on the demonstration of profit of the Indian companies . ? The continuous good health of the Indian economy in terms of low budget deficits, low balance of payments deficits, low level of government borrowings and low level of non-performing loan in the Indian banking system. Another advantage of full convertibility of Rupee for the Indian rich is that they can import as they like and buy properties abroad as they were allowed to do so during the days of British Raj. It has certain advantages for the Indian companies who will be able to import both raw materials and machineries or set up foreign establishments at will.
DISADVANTAGES
? Full convertibility also has adverse consequences for the India’s domestic producers of these raw materials and machineries, as they have to compete against foreign suppliers who like Chinese may have deliberate low rate of exchange for their currencies thus making their goods low in price. ? Foreign suppliers also can be supported by all kinds of subsidies by their government so as to make their prices very low. ? Agricultural exports from Europe, USA, Thailand, and Australia can ruin India’s own agriculture.
? The freedom for India’s rich to buy companies and property abroad may lead to massive diversion of funds from investments in the home economy of India to investments abroad. This would amount to export of jobs to foreign countries creating more and more unemployment at home. ? The most dangerous consequence of convertibility is that Rupee will be under the control of currency speculators. ? A fully convertible regime for the Rupee will certainly include participation of Rupee in the international currency market and in the ‘future market’ of Rupee, the playground for the international speculators. It is very much possible for the speculators to buy massive amount of Rupee to drive up its exchange rate and then they can suddenly sell all to gain enormous profit. That will drive down Rupee to a very low depth suddenly. ? If the Reserve Bank of India wants to protect Rupee in such a situation, within a few days India will have no foreign exchange left in reserve and the country will go bankrupt. 1997 Asian Financial Crisis The Asian Financial Crisis was a period of financial crisis that gripped much of Asia beginning in July 1997, and raised fears of a worldwide economic meltdown due to financial contagion. The crisis started in Thailand with the financial collapse of the Thai baht caused by the decision of the Thai government to float the baht, cutting its peg to the USD, after exhaustive efforts to support it in the face of a severe financial overextension that was in part real estate driven. At the time, Thailand had acquired a burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency. As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and other asset prices, and a precipitous rise in private debt A similar situation took place in South Korea, Malaysia and Indonesia, all with their then convertible currency. Malaysia has survived by imposing fixed exchange rate, exchange
control, and making Malaysian dollar nonconvertible. Both India and China were unaffected because their economies at that time were closed and their currencies were non-convertible. Money supply as experience suggests can work only on the negative direction; i.e., if the country reduces the money supply inflation can be controlled at the cost of reduced investments and increased unemployment. If the country, instead, increases the money supply to stimulate the economy it can cause inflation and eventually unemployment will go up as well because of possible bankruptcy of the private companies as a result of high inflation. The argument of Keynes that if there are underemployed resources in the economy increased money supply resultant from increased government spending cannot cause inflation is not valid for a dual economy like India where the 10 percent of the population live in a different planet from the other 90 percent of the population.
INTEREST RATE – A DANGEROUS WEAPON
Interest rate is a dangerous instrument. If the government reduces it, there will be inflation, speculative movements in the market and disincentives for the savers, which would reduce future investments. Reduced interest rate for a convertible Rupee will reduce the exchange rate of the Rupee. The currency speculators will start selling Rupee and short-term investments will fly out of the country. There would be a free fall of the Rupee in the international currency market. As a result the economy may go bankrupt without any foreign exchange. The result can be collapse of the private companies leaving millions of people unemployed. If the government increases the interest rate exchange rate of Rupee will go up. Shortterm investment will flood the market, speculators will buy more Rupee, but the exporters will be unable to sell their products abroad because of higher price of Indian exports as a result of higher exchange rate of Rupee. High exchange rate of Rupee also mean lower price of imported products. As a result both manufacturers and farmers will
suffer from enhanced competitions from the manufactured products from the East and South East Asia and farm products from USA, Europe, Australia and Thailand. Thus, interest rate is a dangerous weapon to depend upon. If a country wants to use it extensively the economy will go up and down creating havoc for the people. In 1988 Nigel Lawson, the then Chancellor of Exchequer of Britain used lower interest rate to stimulate the economy creating speculative bubble for a few years until 1991, then he had to increase the interest rate to a very high level to protect the British pound from the speculators causing serious depression of the economy and high unemployment. If the interest rate is determined by the market, as it should be in a convertible currency regime with unrestricted flows of money, India government will not have any control over the economy to give it a direction. The only instrument that may be available is the public expenditure policy. The government can stimulate the economy by increasing public expenditure, which may have uncertain consequences for the fate of Indian Rupee. Due to increased public expenditure, rate of growth of the economy and employment may go up, but at the same time there will be increased deficits in the balance of payments. Increased rate of growth may invite short-term investments and international speculators will buy more Rupee. However, increased budget deficit will cause increased deficits in the balance of payments, which will soon drive out short-term investments and speculators will start selling Rupee. India should learn from China. China has no convertibility of Yuan, instead there are extensive controls on financial, and commodity flows in or out of the country. Foreign companies cannot have 100 percent ownership; they must have partnership with Chinese state owned companies. Foreign companies cannot repatriate profit, as they like; they must bring new technology, they must export most of their products. China imports what it needs, although theoretically it is a member of the World Trade Organization. China does not allow short-term investments, but it is the most attractive destination for the long-term foreign investments.
Chinese Yuan does not take part in the international foreign exchange market and thus, protected from the currency speculators. China has reduced the exchange rate of Yuan by 40 percent in 1984 and kept it fixed only to increase it by only 2 percent in 2005 when it has gigantic reserve of US dollars and massive trade surplus with the rest of the world. Very low exchange rate of Yuan is one of the most important reasons why China has managed to capture the markets of every important countries of the world
CONCLUSION
The rupee exchange rate is neither completely free-floating nor fixed, but is “managed” by the Reserve Bank of India through buying and selling other currencies. Up until April, the Reserve Bank was buying lots of U.S. dollars — perhaps as much as $24 billion in the previous six months — to keep the rupee at around 44 to the dollar. But with investor sentiment so hot on India and money pouring in from abroad — international investors have bought more than $7.5 billion worth of Indian stocks so far this year, compared to $8 billion in all of 2006 — the Reserve Bank found itself having to spend more and more on foreign currencies just to keep the rupee stable. Convertibility of Rupee will give pleasure to the 10 percent of Indian people who are either rich or upper middle class, traders in the stock market, speculators, bankers, and accountants. The rest 90 percent of the people will be adversely affected with loss of employments in the manufacturing sector and bankruptcy in the agricultural sector and total economic uncertainly. During the days of the British Raj, Rupee was convertible, India had very large surplus in the balance of payments. India’s share in the world trade was much higher than what it is today. However, millions of Indians used to starve to death from time to time; millions of acres of land were left uncultivated by the bankrupt farmers; there were hardly any industry except for a few textile mills, only 15 percent of the population had any education at all. Yet at the same time, one could buy Rolls Royce and Scotch whisky in
Bombay and Calcutta; Jinnah could buy his apartment in Bond Street of London; Maharaja of Patiala could build palace in Paris. The strengthening rupee may also send an even more important signal: India is not China. It helps of course that India’s trade surplus with the U.S. last year was just $11.7 billion compared to China’s whopping $232.5 billion. But by allowing the rupee to strengthen over the past few months, India is showing it’s prepared to play much more fairly in the global market. India is seen as a more or less unambiguous ally to the U.S.But economists say that jumping into capital account convertibility game without considering the downside of the step could harm the economy. The East Asian economic crisis is cited as an example by those opposed to capital account convertibility.Even the World Bank has said that embracing capital account convertibility without adequate preparation could be catastrophic. But India is now on firm ground given its strong financial sector reform and fiscal consolidation, and can now slowly but steadily move towards fuller capital account convertibility.
BIBILIOGRAPHY
WEB-SITE ? http://wiki.answers.com/Q/What_is_rupee_convertibility ? http://www.answers.com/topic/convertibil… ? http://articles.economictimes.indiatimes.com/2006-0328/news/27457635_1_convertibility-currency-free-conversion ? http://jurisonline.in/2010/06/full-convertibility-of-the-indian-rupee-an-analysisof-the-feasibility/ ? http://economics.about.com/od/foreigntrade/a/bretton_woods.htm
SNAPSHOTS
doc_658050868.doc