What is currency convertibility?

Currency convertibility means the freedom to convert one currency into other internationally accepted currencies. There are two popular categories of currency convertibility, namely : y y Convertibility for current international transactions; and Convertibility for international capital movements.

Currency convertibility implies the absence of exchange controls or restrictions on foreign exchange transactions.

What is meant by Current Account Convertibility: Current account convertibility is popularly defined as the freedom to buy or sell foreign exchange for :a. The international transactions consisting of payments due in connection with foreign trade, other current businesses including services and normal short-term banking and credit facilities

b. Payments due as interest on loans and as net income from other investments c. Payment of moderate amounts of amortisation of loans for depreciation of direct investments

d. Moderate remittances for family living expenses e. Authorised Dealers may also provide exchange facilities to their customers without prior approval of the RBI beyond specified indicative limits, provided, they are satisfied about the bonafides of the application such as, business travel, participation in overseas conferences/seminars, studies/ study tours abroad, medical treatment/check-up and specialised apprenticeship training.

What is meant by Capital Account Convertibility? Tarapore Committee on Capital Account Convertibility appointed in February, 1997 defines Capital Account Convertibility as the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. In other terms we can say Capital Account Convertibility (CAC) means that the home currency can be freely converted into foreign currencies for acquisition of capital assets abroad and vice versa.

Background of Capital Account Convertibility : Foreign exchange transactions are broadly classified into two types: current account transactions and capital account transactions. In the early nineties, Indias foreign exchange reserves were so low that these were hardly enough to pay for a few weeks of imports. To overcome this crisis situation, Indian Government had to pledge a part of its gold reserves to the Bank of England to obtain foreign exchange. However, after reforms were initiated and there was some improvement on FOREX front in 1994, transactions on the current account were made fully convertible and foreign exchange was made freely available for such transactions. But capital account transactions were not fully convertible. The rationale behind this was clear.that India wanted to conserve precious foreign exchange and protect the rupee from volatile fluctuations. By late nineties situation further improved, a committee on capital account convertibility was setup in February, 1997 by the Reserve Bank of India (RBI) under the chairmanship of former RBI deputy governor S.S. Tarapore to "lay the road map" to capital account convertibility. The committee recommended that full capital account convertibility be brought in only after certain preconditions were satisfied. These included low inflation, financial sector reforms, a flexible exchange rate policy and a stringent fiscal policy. However, the report was not accepted due to Asian Crisis. Thus, at present in India we have a restricted capital account convertibility. Indian entities (i.e. individuals, companies or otherwise) are allowed to invest or acquire assets outside India or a foreign entity remit funds for investment or acquisition of assets with specified cap on such investments and for specific purpose. A full convertibility will allow free movement of funds in and out of India without any restrictions on purpose and amount. Thus, after full convertibility is allowed, residents in India will be able to transfer money abroad and receive from other entities across the world. However, government will certainly make rules and regulations to ensure these do not lead to money laundering or funding for illegal activities. Prime Minister Manmohan Singh on 18th March 2006 said that the country's economic position internally and externally had become 'far more comfortable' and it was worth looking into greater capital account convertibility. In a speech at the Reserve Bank of India (RBI) in the country's financial hub Mumbai, Prime Minister Manmohan Singh said he would ask the Finance Minister and RBI to come out with a roadmap to greater convertibility 'based on current realities'. PM also said "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," Singh said. RBI in its circular issued in March, 2006 has laid down that economic reforms in India have accelerated growth, enhanced stability and strengthened both external and financial sectors. Our trade as well as financial sector is already considerably integrated with the global economy. India's cautious approach towards opening of the capital account and viewing capital account liberalisation as a process contingent upon certain preconditions has stood India in good stead. Given the changes that have taken place over the last two decades, however, there is merit in moving towards fuller capital account convertibility within a transparent framework. There is, thus, a need to revisit the subject and come out with a roadmap towards fuller Capital Account Convertibility based on current realities. In consultation with the Government of India, the Reserve Bank of India has appointed a committee to set out the framework for fuller Capital Account Convertibility.

The Committee consists of the following: i. Shri S.S Tarapore Chairman ii. Dr. Surjit S. Bhalla Member iii. Shri M.G Bhide Member iv. Dr. R.H. Patil Member v. Shri A.V Rajwade Member vi. Dr. Ajit Ranade Member

Impact of Capital Account Convertibility After full convertibility is adopted by India, it will lead to acceptance of Indian Rupee currency all over the world. In case of two convertible currencies, Forward Exchange Rates reflect interest rate differentials between these two currencies. Thus, we can say that the Forward Exchange Rate for the higher interest rate currency would depreciate so as to neutralize the interest rate difference. However, sometimes there can be opportunities when forward rates do not fully neutralize interest rate differentials. In such situations, arbitrageurs get into the act and forward exchange rates quickly adjust to eliminate the possibility of risk-less profits. Capital account convertibility is likely to bring depth and large volumes in long-term INR currency swap markets. Thus for a better market determination of INR exchange rates, the INR should be convertible.
Capital account convertibility, a mirage?
With many signposts that are difficult to reach, it is hardly likely that India will move towards free float of the rupee The title of the Tarapore Committee report is "Towards fuller convertibility'' and not "Full convertibility". The distinction is crucial to an understanding of convertibility.

THE ISSUE of convertibility of the rupee is back centrestage with the Reserve Bank of India releasing the Tarapore Committee's report. In March this year, following Prime Minister Manmohan Singh's suggestion to revisit the issue of convertibility, the RBI constituted the expert group. Nine years earlier, in 1997, another expert group, also headed by Mr.Tarapore, had prescribed a road map for the introduction of full convertibility, also known as capital account convertibility. Then, as now, the launch of capital account convertibility was made conditional on the attainment of specific macroeconomic goals. The details vary but both reports lay stress on fiscal consolidation and financial sector reform as crucial preliminaries to full convertibility of the rupee. The time-tables drawn up by the expert groups just three years beginning 1997 (by the first committee) and now

five years are meant to underline the importance of economic consolidation and provide a sequence for the proposed liberalisation.
Three-phased approach

The more recent report advocates a three-phased approach, the first phase beginning this year (2006-07), the second during 2007-09 and the last ending 2011. Even before the rather lengthy report of the Tarapore II Committee has been assimilated, there have been strong reactions to it. Capital account convertibility has always been a much-hyped subject, often without much understanding of what it entails. Specifically, the benefits it is supposed to confer on the economy are exaggerated while its pitfalls are blithely ignored. In fact, there may be a fundamental misconception of what it denotes. In India, most current account transactions have been freed from controls over the years. Resident individuals now have the freedom to remit as well as receive foreign exchange on a variety of transactions. Thus, unlike a decade ago, anyone can finance his overseas education with practically no limit. Foreign exchange is freely available for travel abroad as well as for medical expenses.
No precise definition

Neither current account convertibility nor capital account convertibility admits of a concise definition. While there are internationally understood norms for indicating a country's "convertibility" status, these are not precise. All they connote is that the authorities will stipulate fewer controls on money transfers into and out of a country. However, whether on current or capital account, even developed countries have some kind of negative lists. Incidentally, these lists have expanded what with tough anti-money laundering laws and the all-pervasive need to fight terrorism. It follows that there is no such thing as full convertibility of the domestic currency in absolute terms. Capital account convertibility in the sense of residents freely investing in property or financial assets abroad and foreigners in India still remains a distant, impractical dream. In any case, even if the monetary authorities in India allow residents to invest anywhere in the world, it does not automatically make such investments possible. This is because many countries restrain investments in specific sectors of their economies. That is easily understood in the light of the debate on sectoral caps for foreign direct investments in India. It is often forgotten that even developed countries have such restrictions. The title of the Tarapore Committee report is "Towards fuller convertibility'' and not "Full convertibility". The distinction is crucial to an understanding of convertibility, its status as also the various safeguards suggested. Hence the clamour for capital account convertibility is really for relaxations on capital transfers rather than for a withdrawal of all types of control. Critics of the report say its time-table is too long. They ignore the fact that substantial liberalisation has already occurred in India even on capital account transfers. It is difficult to see what other benefits will accrue to the economy from liberalisation, especially when it is carried out quickly ignoring the commonsense safeguards.

On the other hand, many developing countries, from Southeast Asia to Latin America, that have had a more liberal exchange control regime including "fuller capital account convertibility" have suffered grievously. At the first sign of a loss of confidence in the economy, non-residents and domestic investors alike in those countries shifted their capital abroad. In fact, since 1998, following the debacle in many East Asian and Southeast Asian countries, capital account convertibility has ceased to be fashionable among policy makers. Exhaustive studies conducted by international rating agencies prove the point that a full convertibility status does not by itself make a country a more attractive investment destination. More important are traits such as fiscal rectitude and a strong financial sector. These are exactly the signposts the Tarapore Committee has advocated. The fact that these are difficult to reach in the current Indian context is an entirely different matter. For instance, in the area of banking sector reform, while everyone agrees that greater autonomy is good for the public sector banks and that there should be equal treatment for banks irrespective of ownership, it is difficult to visualise a reduction in government stake in PSBs to 33.33 per cent as suggested by the committee. Even fiscal consolidation as enshrined in the FRBM legislation is now being called into question insofar as it is seen as hindering resource mobilisation for the Eleventh Plan.
Participatory notes

The recommendation to phase out participatory notes (PNs) instruments issued by foreign financial institutions that are backed by shares in India through which unidentified overseas investors can access Indian markets is unlikely to be accepted by the Government. However the course suggested is a prudent one as PNs are widely believed to be conduits for unaccounted money in India flowing back. With many signposts that are difficult to reach, it is hardly likely that India will move towards fuller convertibility by adhering to the path set out. In that sense the value of the Tarapore Committee's report might well lie in its focus on crucial macroeconomic and procedural issues of the day. C. R. L. NARASIMHAN

For the accountancy use of the term., see Capital account (financial accounting).

In Macroeconomics and international finance, the capital account (also known as financial account) is one of two primary components of the balance of payments, the other being the current account. Whereas the current account reflects a nation's net income, the capital account reflects net change in national ownership of assets. A surplus in the capital account means money is flowing into the country, but unlike a surplus in the current account, the inbound flows will effectively be borrowings or sales of assets rather than earnings. A deficit in the capital account means money is flowing out the country, but it also suggests the nation is increasing its claims on foreign assets.

The term "capital account" is used with a narrower meaning by the IMF and affiliated sources. The IMF splits what the rest of the world call the capital account into two top level divisions: financial account and capital account, with by far the bulk of the transactions being recorded in its financial account.

The Capital account in Macroeconomics

At high level:

Breaking this down:

The International Finance Centre in Hong Kong. A nation's capital account records change in ownership of financial assets between it and the rest of the world.
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Foreign direct investment (FDI) , refers to long term capital investment such as the purchase or construction of machinery, buildings or even whole manufacturing plants. If foreigners are investing in a country, that is an inbound flow and counts as a surplus item

on the capital account. If a nations citizens are investing in foreign countries, that's an outbound flow that will count as a deficit. After the initial investment, any yearly profits not re-invested will flow in the opposite direction, but will be recorded in the current account rather than as capital.[1]
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Portfolio investment refers to the purchase of shares and bonds. It's sometimes grouped together with "other" as short term investment. As with FDI, the income derived from these assets is recorded in the current account - the capital account entry will just be for any international buying and selling of the portfolio assets.[1] Other investment includes capital flows into bank accounts or provided as loans. Large short term flows between accounts in different nations are commonly seen when the market is able to take advantage of fluctuations in interest rates and / or the exchange rate between currencies. Sometimes this category can include the reserve account.[1]

Reserve account. The reserve account is operated by a nation's central bank, and can be a source of large capital flows to counteract those originating from the market. Inbound capital flows, especially when combined with a current account surplus, can cause a rise in value (appreciation) of a nation's currency, while outbound flows can cause a fall in value (depreciation). If a government (or, if it's authorised to operate independently in this area, the bank itself) doesn't consider the market-driven change to its currency value to be in the nation's best interests, it can intervene.[2] This article is about the macroeconomic current account. For day to day bank accounts, see Current account (banking).
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Cumulative Current Account Balance 1980 2008 (US$ Billions) based on the IMF data

In economics, the current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade (exports minus imports of goods and services), net factor income (such

as interest and dividends) and net transfer payments (such as foreign aid). You may refer to the list of countries by current account balance. The current account balance is one of two major measures of the nature of a country's foreign trade (the other being the net capital outflow). A current account surplus increases a country's net foreign assets by the corresponding amount, and a current account deficit does the reverse. Both government and private payments are included in the calculation. It is called the current account because goods and services are generally consumed in the current period.[1] The balance of trade is the difference between a nation's exports of goods and services and its imports of goods and services, if all financial transfers, investments and other components are ignored. A Nation is said to have a trade deficit if it is importing more than it exports. Positive net sales abroad generally contributes to a current account surplus; negative net sales abroad generally contributes to a current account deficit. Because exports generate positive net sales, and because the trade balance is typically the largest component of the current account, a current account surplus is usually associated with positive net exports. This however is not always the case with secluded economies such as that of Australia featuring an income deficit larger than its trade deficit.[2] The net factor income or income account, a sub-account of the current account, is usually presented under the headings income payments as outflows, and income receipts as inflows. Income refers not only to the money received from investments made abroad (note: investments are recorded in the capital account but income from investments is recorded in the current account) but also to the money sent by individuals working abroad, known as remittances, to their families back home. If the income account is negative, the country is paying more than it is taking in interest, dividends, etc. The difference between Canada's income payments and receipts have been declining exponentially as well since its central bank in 1998 began its strict policy not to intervene in the Canadian Dollar's foreign exchange.[3] The various subcategories in the income account are linked to specific respective subcategories in the capital account, as income is often composed of factor payments from the ownership of capital (assets) or the negative capital (debts) abroad. From the capital account, economists and central banks determine implied rates of return on the different types of capital. The United States, for example, gleans a substantially larger rate of return from foreign capital than foreigners do from owning United States capital. In the traditional accounting of balance of payments, the current account equals the change in net foreign assets. A current account deficit implies a paralleled reduction of the net foreign assets.
current account = changes in net foreign assets