Currency Convertibility

THE HISTORICAL PERSPECTIVE Although an international monetary system has been in existence since monies have been traded, its analyses have been traditionally started from the late 19th century when the gold standard began. The Gold Standard: 1 !"1#1$

Although an exact date for the beginning of the gold standard cannot be pinpointed, the 1880-90 period is important. nder a gold standard, currencies are valued in terms of a gold e!uivalent "nown as the mint parity price #an ounce of gold was worth $ %0.&' in terms of the .(. dollar over the gold standard period). *hen, because each currency is defined in terms of its gold value, all currencies are lin"ed together in a system of fixed exchange rates. +or instance, if 1 unit of currency A is worth 0.10 ounces of gold, whereas 1 unit of currency , is worth 0.%0 o-. of gold, then 1 unit of currency , is worth twice as much as A. *hus, the exchange rate of 1 currency ,.% currency A is established. /old was used as a monetary standard because it is an internationally-recogni-ed homogeneous commodity that is easily storable, portable, and divisible into standardi-ed units, such as ounces. (ince gold is costly to produce, it possesses another important attribute--governments cannot easily increase its supply. The Gold E%chan&e Standard : 1#$$"1#'! 0emories of the economic warfare of the inter-war years led to an international conference at ,retton 1oods, 2ew 3ampshire, in 1944 at the close of 1orld 1ar 55. *here was a desire to transform the international monetary system into one based on mutual cooperation and freely convertible currencies. *he ,retton 1oods agreement re!uired that each country fix the value of its currency in terms of gold #this established the 6par6 value of each currency and was to ensure parity across currencies). *he .(. $ was the "ey currency in the system, and $1 was e!uated in value to 1789 o-. of gold. (ince every currency had a defined value in gold, all currencies were lin"ed in a system of fixed exchange rates. *he members were committed to maintaining the value of the currency within :7-1; of parity. *he various central ban"s were to achieve this goal by buying and selling their currencies #usually against the dollar) on the foreign-exchange mar"et. 1hen a country experienced difficulty maintaining its parity value due to balance of payments dise!uilibria, it could turn to the 5nternational 0onetary +und #50+), which was created to monitor the provision of short-term loans to countries experiencing temporary balance of payment difficulties. CO(VERTI)ILIT*: ITS ESSE(CE <egally, a currency is considered convertible when the concerned country formally accepts the obligations of Article =555, (ections %,8 and 4 of the Articles of Agreement of the 5 0+. A currency is externally convertible when 6all holdings of that currency by non-residents are freely exchangeable into any foreign #non- resident) currency at exchange rates within the official margins>all payments that residents of the country are authori-ed to ma"e to non-residents may be made in any externally convertible currency that residents can buy in foreign exchange mar"ets.6 ?ontrarily, if there are no restrictions on the ability of a country to use their holdings of domestic currency to ac!uire any foreign currency and hold it, or transfer it to any nonresident for any purpose, that country@s currency is said to be internally convertible. *hus external convertibility . partial convertibility and total convertibility . external : internal convertibility. CO(VERTI)ILIT*: +H*, Axternally inconvertible currencies may be of rather limited value to their holder. An exported item from a developing country to the ((B, for example, may be paid for in rubles or the currency of a country that has ratified Article =555. 5f the latter, the proceeds may be used to purchase goods anywhere. 5n considering possible import suppliers, therefore, a developing country will have some interest in directing its importers to those countries that will have some interest in directing its importers to those countries whose inconvertible currencies are in large supply. *his is, of course, a case of trade discrimination that is condemned by traditional theory. +or it means that goods are not being purchased from the cheapest source. Becent economic writing has, however, reopened the !uestion in view of the continued existence of inconvertible currencies. 1here it is profitable on the export side to trade with countries maintaining inconvertible currencies, and the government wishes to encourage imports from those countries to offset its credit balances, it will utili-e its exchange distribution mechanism to limit the availability of convertible exchange where there are alternative suppliers of the same type of goods in inconvertible currency countries C-RRE(T ACCO-(T CO(VERTI)ILIT* *he current account is defined as including the value of trade in merchandise, services, investment, income and unilateral transfers. ?urrent account convertibility, being essential to the development of multilateral trade, three

approaches to current account convertibility have been adapted by developing countries. *hese are the preannouncement, by-product, and front-loading approaches. Aach approach is distinguished by the importance it attaches to convertibility relative to other economic obCectives. CAPITAL ACCO-(T CO(VERTI)ILIT* ?apital account includes transactions of financial assets. 5ts convertibility refers to the freedom to convert local financial assets into foreign assets in any form and vice versa at mar"et-determined rates of exchange. ?apital controls, strictly defined, include restrictions that affect the capital account of the b.o.p. *hey normally restrict or prohibit cross-border movement of capital. *hus, controls on capital movements include prohibitionsD need for prior approvalE authori-ation and notificationE multiple currency practicesE discriminatory taxesE and reserve re!uirements or interest penalties imposed by the authorities that regulate the conclusion or execution of transactions. *he coverage of the regulations would apply to receipts as well as payments and to actions initiated by non-residents and residents. THE I(.IA( SCE(ARIO /1##'"0!!!1 I(TRO.-CTIO( *he international experience with ?A? shows that, in general, liberali-ation of the capital account induces large capital inflows that can cause real appreciation in the exchange rate and erode the effectiveness of domestic monetary policies. +urther more, an open capital account imposes tremendous pressure on the financial system and wea"ens the financial system. 1hile it is necessary to recogni-e that these wea"nesses could precipitate systematic ha-ards irrespective of whether or not ?A? is introduced, the move to ?A? would demand a strongly disciplined financial system and would warrant early rectification of infirmities in the system. *here are distinct benefits of ?A?, such as, availability of a larger capital stoc" at international prices to supplement domestic resources, ris" diversification, allocative efficiency and improvement in intermediation of financial resources, development of financial mar"ets and a disciplining influence on macro-economic policies. 5ndia had already adopted current account convertibility in August1994 by formally ratifying Article =555 of the Articles of Agreement of the #50+). +urthermore, ?A? is already instituted for foreign investors, both direct and portfolio, non-resident depositors and resident corporate houses and institutions. ?ontrols, however, continue to operate on the ability of resident individuals and corporate entities to send capital abroad as also on inflows and outflows of capital associated with ban"s and non-ban" financial utilities. THE TARAPORE CO22ITTEE REPORT ?haired by its former Feputy /overnor, (. (. *arapore, a ?ommittee was appointed by the Beserve ban" of 5ndia on +ebruary %8, 199', in pursuance of the commitment made by the +inance 0inister (hri G. ?hidambaram in his ,udget for 199'-98. *he B,5 had at that time indicated that the ?ommittee will complete its wor" by 0ay 80,199'. *he terms of reference of the committee were to #1) review the international experience in relation to capital account convertibility #?A?) and to indicate the preconditions for ?A?, #%) recommend measures for achieving ?A?, #8) specify the se!uence and time frame for such measures, and #4) suggest domestic policy measures and changes in institutional framewor". *he ?ommittee has recommended a phased implementation of ?A? over a three-year periodD Ghase 5 #199'-8), Ghase 55 #1998-9) and Ghase 555 #1999-%000). 5t has also recommended that fiscal consolidation, a mandated inflation target and the strengthening of the financial system should be regarded as crucial preconditions7signposts for bringing ?A? to 5ndia. +iscal ?onsolidationD *here should be a reduction in the ?entre@s /ross +iscal Feficit to /FG ratio from a budgeted 4.9; in 199'-98 to 4.0; in 1998-9, and further to 8.9; in 1999-%000, accompanied by a reduction in the statesH deficit, and also a reduction in the !uasi-fiscal deficit. Becogni-ing that the practice of financing the amorti-ation of government borrowings by borrowing afresh is clearly unsustainable and would inevitably result in a crisis, the ?ommittee has recommended introduction of a ?onsolidated (in"ing +und #?(+) as part of a more transparent fiscal system. *he ?ommittee has urged that any increase in the profit transfer from the B,5 to the /overnment as well as the proceeds from disinvestment should be used entirely towards building up a ?(+. 0andated 5nflation BateD +or the three-year period, the 05B should be, on an average, 8-9;. *here should be an early empowering of the B,5 on the inflation mandate approved by Garliament, which alone should be able to alter that mandate. Ince it is given, the B,5 should be free to attain the target, with appropriate guidelines on changing the mandate. (trengthening the +inancial (ystemD *his was viewed as the most important precondition for changing to ?A?, and therefore wea"nesses in the financial sector need to be addressed early. 5nterest rates should be fully deregulated in 199'-8 and there should be no formal or informal interest rate controls. *he average effective ?ash Beserve Batio #?BB), 9.8; in April 199', should be reduced to 8; in 1999-%000. +urthermore, drastic

measures should be ta"en to bring down gross 2on-Gerforming Assets #2GAs) from the tentatively estimated 18.'; of the total advances in 0arch 199' to 1%; in 199'-8, 9; in 1998-9 and 9; in 1999-%000. ?oncerned that some wea" ban"s are growing at rates faster than the system, the ?ommittee recommended that wea" ban"s should be converted into narrow ban"s, i.e., those whose incremental resources are invested only in government securities. 5n extreme cases of wea"ness, restraints should be applied on liability growth. I( .E3E(CE O3 CAPITAL ACCO-(T CO(VERTI)ILIT* 5ndia seems to be on the second stage of economic reforms and ?apital Account ?onvertibility is an important ingredient of these reforms. measures. *o briefly sum up, the current macro-economic situation is favorable for a phased introduction of ?A?. *he time could not be more propitious and we should not let the hour go by. 5ndia is clearly ready to underta"e the first step towards ?A?, and we should not be hesitant in grasping the bull by the horns.