CONTENTS

Sr. No.

PARTICULARS

Page No.

CHAPTER I INTRODUCTION
1.1

INTRODUCTION

`4

1.2

TYPES OF CURRENCY CONVERTIBILITY

1.3

RUPEE CONVERTIBILITY

CHAPTER II CURRENT ACCOUNT CONVERTIBILITY

2.1

COMPONENTS-GOODS

14

2.2

SERVICES

15

2.3

INCOME

18

CHAPTER III CAPITAL ACCOUNT CONVERTIBILITY

3.1

BASICS & APPLICATION

20

3.2

DIFFERENCE BETWEEN CAPITAL & CURRENT ACCOUNT

CONVERTIBILITY

21

3.3

PRINCIPLES GOVERNING CAPITAL ACCOUNT

CONVERTIBILITY

23

3.4

RESTRICTIONS ON CAPITAL ACCOUNT

CONVERTIBILITY

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CHAPTER IV BURNING ISSUE

4.1

WHY IS FCAC IMPORTANT & WHAT ARE THE REASONS

FAVOURING SUCH A CONCEPT?

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4.2

TARAPORE COMMITTEE APPOINTMENT

27

4.3

HOW DOES CAPITAL A/C CONVERTIBILITY AFFECT US?

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CHAPTER V CONCLUSION
CHAPTER VI - REFERNECE ( BIBLIOGRAPHY )

INTRODUCTION
Each country has its own currency through which both national and
international transactions are performed. All the international business
transactions involve an exchange of one currency for another. For example, if
any Indian firm borrows funds from international financial market in US dollars
for short or long term then at maturity the same would be refunded in particular
agreed currency along with accrued interest on borrowed money. It means that
the borrowed foreign currency brought in the country will be converted into
Indian currency, and when borrowed fund are paid to the lender then the home
currency will be converted into foreign lenders currency. Thus, the currency
units of a country involve an exchange of one currency for another. The price of
one currency in terms of other currency is known as exchange rate.
The foreign exchange markets of a country provide the mechanism of
exchanging different currencies with one and another, and thus, facilitating
transfer of purchasing power from one country to another. With the multiple
growths of international trade and finance all over the world, trading in foreign
currencies has grown tremendously over the past several decades. Since the
exchange rates are continuously changing, so the firms are exposed to the risk
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of exchange rate movements. As a result the assets or liability or cash flows of a

firm which are denominated in foreign currencies undergo a change in value
over a period of time due to variation in exchange rates. This variability in the
value of assets or liabilities or cash flows is referred to exchange rate risk. Since
the fixed exchange rate system has been fallen in the early 1970s, specifically in
developed countries, the currency risk has become substantial for many
business firms. As a result, these firms are increasingly turning to various risk
hedging products like foreign currency futures, foreign currency forwards,
foreign currency options, and foreign currency swaps. Convertibility essentially
means the ability of residents and non-residents to exchange domestic currency
for foreign currency, without limit, whatever is the purpose of the transactions.

Convertibility: why?

Externally inconvertible currencies may be of rather limited value to their

holder. An exported item from a developing country to the USSR, for example,
may be paid for in rubles or the currency of a country that has ratified Article
VIII.

The

proceeds

may

be

used

to

purchase

goods

anywhere.

In 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. This is, of course, a case of trade discrimination
that is condemned by traditional theory. This means that goods are not being
purchased from the cheapest source. Recent economic writing has, however,
reopened the question in view of the continued existence of inconvertible
currencies. Where 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 utilize 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.

TYPES OF CURRENCY CONVERTIBILITY:

1: Fully convertible currency.
2: Partially convertible currency.
3: Non convertible currency.
Convertibility of a currency determines the ability of an individual, corporate or
government to convert its local currency to another currency or vice versa with
or without central bank/government intervention. Based on the above
restrictions or free and readily conversion features currencies are classified as:
Fully Convertible - When there are no restrictions or limitations on the
amount of currency that can be traded on the international market and the
government does not artificially impose a fixed value or minimum value
on the currency in international trade. The US dollar is an example of a
fully convertible currency and for this reason, US dollars are one of the
major currencies traded in the FOREX market.
Partially Convertible - Central Banks control international investments
flowing in and out of the country, while most domestic trade transactions
are handled without any special requirements, there are significant
restrictions on international investing and special approval is often

required in order to convert into other currencies. The Indian Rupee is an

example of a partially convertible currency.
Nonconvertible - Neither participate in the international FOREX market
nor allow conversion of these currencies by individuals or companies. As
a result, these currencies are known as blocked currencies. e.g.: North
Korean Won and the Cuban Peso

RUPEE CONVERTIBILITY
6

Classification

Current Account Convertibility

Current account is defined as including the value of trade in merchandise,

services, investment, income and unilateral transfers. Current account
convertibility, being essential to the development of multilateral trade, three
approaches to current account convertibility has been adapted by developing
countries. These are the pre-announcement, by-product, and front-loading
approaches. Each approach is distinguished by the importance it attaches to
convertibility relative to other economic objectives.
Capital Account Convertibility
Capital account includes transactions of financial assets. Its convertibility refers
to the freedom to convert local financial assets into foreign assets in any form
and vice versa at market-determined rates of exchange. Capital controls
normally restrict or prohibit cross-border movement of capital. Thus, controls
on capital movements include prohibitions: need for prior approval;
authorization and notification; multiple currency practices; discriminatory taxes;
and reserve requirements or interest penalties imposed by the authorities that
regulate the conclusion or execution of transactions. The coverage of the
regulations would apply to receipts as well as payments and to actions initiated
by non-residents and residents.
To begin with lets understand the concept of currency convertibility. Currency
convertibility may be defined as the freedom to convert one currency into other
internationally accepted currencies. Thus in a CAG regime the country places
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no exchange controls or restrictions on foreign exchange transactions. There are

two forms of convertibility convertibility for current international transactions
and the convertibility for international capital movements. While India is still to
opt for full Capital Account Convertibility, the government has made the rupee
convertible on the current account. This implies that companies and resident
Indians can make and receive payments for import/export of goods and services
and be able to access foreign currency for travel, education, medical or other
designated purposes. Though there is no formal definition of CAC, the Tarapore
Committee provides some clarity in this regard as it defines the same as - the
freedom to convert local financial assets into foreign financial assets and vice
versa at market determined rates of exchange. In other words, Capital account
convertibility means that the home currency can be freely converted into foreign
currencies for acquisition of capital assets abroad. Thus, implementation of the
capital account convertibility regime will allow Indian residents to invest,
disinvest or transact in any property or assets/liability of any country, convert
one currency to another or move funds anywhere in the world, solely guided by
discretion of the concern individual or company & not restricted by law.

CURRENT ACCOUNT CONVERTIBILITY

Current account convertibility refers to freedom in respect of Payments and

transfers for current international transactions. In other words, if Indians are
allowed to buy only foreign goods and services but restrictions remain on the
purchase of assets abroad, it is only current account convertibility. As of now,
convertibility of the rupee into foreign currencies is almost wholly free for
current account i.e. in case of transactions such as trade, travel and tourism,
education abroad etc.
Components of Current Account
Covered in the current account are all transactions (other than those in financial
items) that involve economic values and occur between resident non-resident
entities. Also covered are offsets to current economic values provided or
acquired without a quid pro quo. Specifically, the major classifications
are goods and services, income, and current transfers.

1. Goods and services

Goods
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General merchandise covers most movable goods that residents export to

or import from non residents.

Goods for processing covers exports (or, in the compiling economy,

imports) of goods crossing the frontier for processing abroad and subsequent reimport (or, in the compiling economy, export) of the goods, which are valued on
a gross basis before and after processing. The treatment of this item in
the goods account is an exception to the change of ownership principle.

Repairs on goods covers repair activity on goods provided to or received

from non residents on ships, aircraft, etc. repairs are valued at the prices (fees
paid or received) of the repairs and not at the gross values of the goods before
and after repairs are made.

Goods procured in ports by carriers covers all goods (such as fuels,

provisions, stores, and supplies) that resident/nonresident carriers (air, shipping,
etc.) procure abroad or in the compiling economy. The classification does not
cover auxiliary services (towing, maintenance, etc.), which are covered under
transportation.

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Nonmonetary gold covers exports and imports of all gold not held as
reserve assets (monetary gold) by the authorities. Nonmonetary gold is treated
the same as any other commodity and, when feasible, is subdivided into gold
held as a store of value and other (industrial) gold.
Services

Transportation covers most of the services that are performed by residents

for nonresidents (and vice versa) and that were included in shipment and other
transportation in the fourth edition of the Manual.

Travel covers goods and servicesincluding those related to health and

educationacquired from an economy by non resident travelers (including
excursionists) for business and personal purposes during their visits (of less than
one year) in that economy. Travel excludes international passenger services,
which are included in transportation. Students and medical patients are treated
as travelers, regardless of the length of stay. Certain othersmilitary and
embassy personnel and non resident workersare not regarded as travelers.
However, expenditures by non resident workers are included in travel, while
those of military and embassy personnel are included in government services.

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Communications services cover communications transactions between

residents and nonresidents. Such services comprise postal, courier, and
telecommunications services .

Construction services covers construction and installation project work

that is, on a temporary basis, performed abroad/ or in Extra territorial enclaves
by resident/non resident enterprises and associated personnel. Such work does
not include that undertaken by a foreign affiliate of a resident enterprise or by
an unincorporated site office that, if it meets certain criteria, is equivalent to a
foreign affiliate.

Insurance services covers the provision of insurance to non residents by

resident insurance enterprises and vice versa. This item comprises services
provided for freight insurance (on goods exported and imported), services
provided for other types of direct insurance (including life and non-life), and
services provided for reinsurance.

Financial services (other than those related to insurance enterprises and

pension funds) covers financial intermediation services and auxiliary services
conducted between residents and nonresidents. Included are commissions and
fees for letters of credit, lines of credit, financial leasing services, foreign
13

exchange transactions, consumer and business credit services, brokerage

services, underwriting services, arrangements for various forms of hedging
instruments, etc. Auxiliary services include financial market operational and
regulatory services, security custody services, etc.

Computer

and

information

services covers

resident/non-resident

transactions related to hardware consultancy, software implementation,

information services (data processing, data base, news agency), and
maintenance and repair of computers and related equipment.

Royalties and license fees covers receipts (exports) and payments

(imports) of residents and non-residents for (i) the authorized use of intangible
non produced, nonfinancial assets and proprietary rightssuch as trademarks,
copyrights, patents, processes, techniques, designs, manufacturing rights,
franchises, etc. and (ii) the use, through licensing agreements, of produced
originals or prototypessuch as manuscripts, films, etc.

Other business services provided by residents to nonresidents and vice

versa covers merchandising and other trade-related services; operational leasing
services; and miscellaneous business, professional, and technical services.

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Personal, cultural, and recreational services covers (i) audiovisual and

related services and (ii) other cultural services provided by residents to nonresidents and vice versa. Included under (i) are services associated with the
production of motion pictures on films or video tape, radio and television
programs, and musical recordings. (Examples of these services are rentals and
fees received by actors, producers, etc. for productions and for distribution
rights sold to the media.) Included under (ii) are other personal, cultural, and
recreational servicessuch as those associated with libraries, museumsand
other cultural and sporting activities.

Government services i.e. covers all services (such as expenditures of

embassies and consulates) associated with government sectors or international
and regional organizations and not classified under other items.

2. Income

Compensation of employees covers wages, salaries, and other benefits, in

cash or in kind, and includes those of border, seasonal, and other non-resident
workers (e.g., local staff of embassies).

Investment income covers receipts and payments of income associated,

respectively, with residents holdings of external financial assets and with

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residents liabilities to nonresidents. Investment income consists of direct

investment income, portfolio investment income, and other investment income.
The direct investment component is divided into income on equity (dividends,
branch profits, and reinvested earnings) and income on debt (interest); portfolio
investment income is divided into income on equity (dividends) and income on
debt (interest); other investment income covers interest earned on other capital
(loans, etc.) and, in principle, imputed income to households from net equity in
life insurance reserves and in pension funds.

CAPITAL ACCOUNT CONVERTIBILITY

Inflows and outflows of capital

Borrowing from or lending abroad.
Sales and purchases of securities abroad.
Capital Foreign Direct Investments
Short term and Long term Investments
Government Loans

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APPLICATION:
Ultimate aim for such a concept is foreign investors could invest in other
countries without barriers.
This has led to many factories going overseas thus creating innumerable job
opportunities.
CAC should be used with proper restraints.

How is CAC different from current account convertibility?

Current account convertibility allows free inflows and outflows for all purposes
other than for capital purposes such as investments and loans. In other words, it
allows residents to make and receive trade-related payments receive dollars
(or any other foreign currency) for export of goods and services and pay dollars
for import of goods and services, make sundry remittances, access foreign
currency for travel, studies abroad, medical treatment and gifts etc.

Is India ready to switch to full convertibility of rupee on capital account?

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Some steps have already been taken to facilitate the full capital account
convertibility in the country. Foreign exchange has been allowed to flow into
Indian stock markets through registered institutional investors. In addition,
many categories of the resident Indians have been allowed to open foreign
currency accounts abroad. Indian companies have also been making overseas
acquisitions for which they have been given access to foreign currency
resources.

It would, however, be wrong to presume that full convertibility on the capital

account would result in lifting of all the restrictions. Even the developed
countries like the USA block foreign investment in some of the sectors. Despite
the government decision in this regard, it has not been easy for the non-resident
Indians to acquire property and real estate in the country. The government of
India, though has allowed Direct Foreign Investment (FDI) in most of the fields,
yet certain caps have been put by the government on the FDI in some of the
sectors.. Benefits would be in terms of more flow of foreign capital into the
economy, resulting in higher investment and the resultant growth rate. Further,
the financial and capital markets would bring more profits to the domestic
investors. The economy must be nearer to the global standards in the matter
of fiscal deficit, inflation rate, interest rates, foreign exchange reserves, etc.
It is said that the economy can be said to be ripe for capital account
convertibility only if interest rates are low and de-regulated and the inflation
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rate in the three consecutive years had been around three per cent. Considering
the above prerequisites it appears that the Indian economy is not yet
prepared for switching over to the capital account convertibility.

PRINCIPLES GOVERNING CAPITAL ACCOUNT

CONVERTIBILITY

CAC has 5 basic statements designed as points of action

All types of liquid capital assets must be able to be exchanged freely,

between any two nations in the world, with standardized exchange rates.

The amounts must be a significant amount (in excess of $500,000).

Capital inflows should be invested in semi-liquid assets, to prevent

churning and excessive outflow.

Institutional investors should not use CAC to manipulate fiscal policy or

exchange rates.

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Excessive inflows and outflows should be buffered by national banks to

provide collateral.

Current Account
In short
Includes all imports-exports, pension payments-both ways, remittances-to
& fro
Indian scenario-fully convertible
Freedom in respect of current international transactions

Capital account convertibility

In short
Inflows outflows of capital, borrowing or lending from abroad, sale and
purchase of securities.
Indian scenario-partially convertible.

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RESTRICTIONS ON CAPITAL ACCOUNT

Limits to companies borrowing abroad. Restrictions exist on Indians

sending money abroad that does not have to do with importing goods and
services.

Restriction on foreigners investing in India

Restriction on amount that FII can hold.
Purchasing a company is permissible but a limit exists on the amount that
can be sent.

WHY IS FCAC(FULL CONVERTIBILITY ON CAPITAL

ACCOUNT) IS IMPORTANT & WHAT ARE THE REASONS
WHICH ARE IN FAVOUR OF SUCH A CONCEPT?
Reduction of black money-

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Such a concept helps an economy to open up and make it

transparent.

Induces domestic competitionSuch a concept would open the market to foreign investment as
restriction would be relaxed and domestic competitors would have
to be on their toes to keep up.
Increases job opportunitiesSuch a benefit goes hand in hand with increase in domestic
competition.
A catalyst for financial markets, institutional development, new
technologies.
Diversification

TARAPORE COMMITTEE APPOINTMENT

The RBI has appointed a committee to set out the framework for fuller
Capital Account Convertibility
To revisit the subject of FCAC in the context of progress in economic
reforms, the stability of the external and financial sectors, accelerated
growth and global integration.
Suggestions of the committee:
1. Reduction in gross fiscal deficit as a percentage of GDP
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2. A certain level of rate of inflation for a certain period

3. A fully de-regulated interest rate structure.
4. A reduction of non-performing assets as a percentage of
total advances.

Such factors were the pre-requisites towards attainment of FCAC.

Unfortunately the performance was below satisfactory as none of the conditions
could be met.

For Example:
Gross fiscal deficit did not show a reducing trend and it did not reduce as
expected.
Interest rates could not be completely deregulated.
Non-performing assets did not reduce as expected.

What are the dangers of CAC? Or points in favour of restrictions?

1. Huge Inflow & Enormous outflowGood years get good inflow of capital and vice versa as per herd
behavior by which the investors tend to follow the movement of other investors
so if one moves out the other also does the same.

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Eg: South Asian Countries received more than 150US$ by the first half of 1997
starting from 1996,but in the second half due to the threat of a crisis lost
102US$.

2. Misallocation of capital inflowsSuch capital inflows may tend to use up the funds for low quality
domestic investments like investments in the stock markets real estates &
prevent from investing in building up industries & factories which gives better
job opportunities. Also exports suffer and thus create external imbalances.

3.Export of domestic savingsDomestic savings would be invested in foreign banks thus leading to
savings being dragged away from the country. And in times of crisis, domestic
savings and foreign investments would also move out thus making the country
helpless in trying times.

4.Creation of unequal playing field24

Only the rich can borrow from foreign banks while the farmers face
the axe from such banks as well as domestic banks as domestic ones also tend to
increase their interest rates and reduce subsidies in order to keep up with the
foreign banks.

2012 FDI Reforms

FDI in insurance sector up now to 49% from 26%.

FDI in single retail sector available upto 100%
FDI in multi retail sector available upto 51%
FDI in housing sector available upto 51%

The basic point highlighted here is that restrictions are getting relaxed and the
Govt is showing some hope towards FCAC although there are many pre
requisites left to be accomplished.

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Limits to Partial CAC

Limits specified by the Reserve Bank of India:1.Private visit abroad is $10,000: of which only$5,000 can be in cash
2.Business travel, the yearly limit is $25,000
3.Gift or donate up to $5,000 in a year.
4.Going abroad for employment, or are going for studies abroad: the limit in
both these cases is$100,000
5.Investment into foreign stock markets up to the extent of $25,000 in a year

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HOW DOES CAPITAL A/C CONVERTIBILITY AFFECT US?

As most of us know, resident Indians cannot move their money abroad freely.
That is, one has to operate within the limits specified by the Reserve Bank of
India and obtain permission from RBI for anything concerning foreign currency.

For example, the annual limit for the amount you are allowed to carry on a
private visit abroad is $10,000: of which only $5,000 can be in cash. For
business travel, the yearly limit is $25,000. Similarly, you can gift or donate up
to $5,000 in a year.

27

The RBI limit raises the limit if you are going abroad for employment, or are
emigrating to another country, or are going for studies abroad: the limit in both
these cases is $100,000.
You are also allowed to invest into foreign stock markets up to the extent of
$25,000 in a year.
For the average Indian, these 'limits' seem generous and might not affect him at
all. But for heavy spenders and those with visions of buying a house abroad or a
Van Gogh painting, it will mean a lot. . .

But with the markets opening up further with the advent of capital account
convertibility, one would be able to look forward to more and better goods and
services.
And how will it affect Non-Resident Indians?
Capital account convertibility may NRIs as it will help remove all shackles on
movement of their funds.

Currently, NRIs have to produce a whole lot of documents and certificates if

they want to buy a house in India (for which the lock-in period is 10 years,
28

meaning they can't take their money back overseas if they sell the house after
having owned it for less than 10 years), or send money to India from their
overseas accounts.

CONCLUSION
India has been relentlessly moving on the path towards liberalization, opening
up its markets and loosening its controls over many economic matters so as to
integrate with the global economy.

Despite the opposition to globalization from some quarters, India has been quite
watchful in its approach to embracing global economy. The issue of capital
account convertibility is one such where the nation has tread very cautiously.

A high-level committee to look into this matter, appointed by the Reserve Bank
of India recommended that India move to fuller capital account convertibility
over the next five years and has laid down the roadmap for the move.

29

Various pre requisites need to be fulfilled:

Reduction in gross fiscal deficit as a percentage of GDP

A certain level of rate of inflation for a certain period
A fully de-regulated interest rate structure.
A reduction of non-performing assets as a percentage of total advances.

Such steps will help India match with the global standards and these steps
would also pave the way for Full Capital Convertibility.

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BIBLIOGRAPHY

Recent Development in International Currency Market by: Lucjan T.

Orlowski
www.investopedia.com
www.hindubusinessline.com
www.ias.org
www.phindia.com
www.rbi.org

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