"Current Account” and “Capital Account” Convertibility
Current account includes all transactions, which give rise to or use of our National income, while Capital Account consist of short term and long term capital transactions. As per FEMA "capital account transaction" means a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India of persons resident outside India. Those which are not Capital Account transactions are current Account transactions.
Current Account Transactions covers the following.
All imports and exports of merchandise
Invisible Exports and Imports (sale/purchase of services
Inward private remittances to & fro
Pension payments (to & fro)
Government Grants (both ways)
Capital Account transactions consist of the following
Direct Foreign Investments (both inward & outward)
Investment in securities (both ways)
Other Investments (both ways)
Government Loans (both ways
Short-term investments on both directions.
The substance of convertibility is to dispense with the discretionary management of foreign exchange and exchange rates and to adopt a more liberal and market driven exchange allocation process. All transactions are still conducted within the framework of exchange controls, as prescribed by the RBI. Full convertibility on current account is manifested as below:
On trade account and on account of the receipt side of the invisibles, the rupee is fully convertible at market determined exchange rates.
The payment side of the invisible and receipts and payments of capital account are subject to exchange control
However, exchange rates for all these permissible transactions are undertaken at the free market exchange rates
Capital Account is deemed convertible when residents and non-residents are allowed to effect such transactions without any restrictions i.e. without prior permission of the RBI. In such a context without any restrictions Indians should be able to secured foreign direct investment from abroad. Foreigners at their discretion should be able to make portfolio investments in this country. Presently these transactions are subject to prior permission of R.B.I. However R.B.I. is following a constructive and promotional approach and encouraging foreign investments in India. Indian Industrialist having good projects for direct foreign investment or foreign institutional investors desiring to make portfolio investments in this country are encouraged and they do not face problems on account of exchange control by R.B.I. Exchange control is limited to exchange monitoring.
In a strict sense a currency can be considered convertible, only if both residents and non-residents have full freedom to use and exchange it for any purpose whatsoever, at some definite rate of exchange. However in practice large number of currencies are considered convertible with various degrees of restrictions and controls.
The International Monetary Fund provides a working definition of convertibility under Article VIII, which states as under:
“No member shall, without the approval of the fund, impose restrictions on making of payment and transfers for current transactions.”
The IMF concept considers convertibility only for current account transactions, thus leaving at the discretion of the country to regulate flows on capital account. Generally countries with currency convertibility have practised various degree of controls to suit their national interests from time to time. Thus currency convertibility implies absence of restrictions on foreign exchange transactions and not necessarily on trade or capital flow. This point has been clarified properly by IMF, which states as under:-
“Thus, although measure formulated as quantitative limitation on imports will have the indirect effect, it is not for that reason a restriction on payments within the meaning of the provision…Restrictions on trade do not become restrictions on payment within the meaning of Article VIII, because they are imposed for balance of payments reasons”.
Under the present floating system, exporters can realise their entire export earnings at the free market rate. All imports, including the Government imports consisting of petroleum, food, fertilizers and defence have to be paid at free market rates. The substance of convertibility efforts is to dispense with the discretionary management of foreign exchange and exchange rates and to adopt a more liberal and market driven exchange allocation process. It needs to be noted that here that the full convertibility does not mean the unrestricted use of the rupee for all types of India’s external transactions. All transactions are still conducted within the framework of exchange controls, as prescribed by the R.B.I.
Foreign Exchange Reserve & its Management by the Monetary Authority of the Country
(quoted from IMF Publication titled "Guidelines for Foreign Exchange Reserve Management ")
"Reserves consist of official public sector foreign assets that are readily available to and controlled by the monetary authorities. Reserve asset portfolios usually have special characteristics that distinguish them from other foreign currency assets. First and foremost, official reserve assets normally consist of liquid or easily marketable foreign currency assets that are under the effective control of, and readily available to, the reserve management entity. Furthermore, to be liquid and freely useable for settlements of international transactions, they need to be held in the form of convertible foreign currency claims of the authorities on nonresidents"
"Reserve management is a process that ensures that adequate official public sector foreign assets are readily available to and controlled by the authorities for meeting a defined range of objectives for a country or union. In this context, a reserve management entity is normally made responsible for the management of reserves and associated risks. Typically, official foreign exchange reserves are held in support of a range of objectives including to:
"support and maintain confidence in the policies for monetary and exchange rate management including the capacity to intervene in support of the national or union currency;
"limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed and in doing so;
"provide a level of confidence to markets that a country can meet its external obligations
"demonstrate the backing of domestic currency by external assets;
"assist the government in meeting its foreign exchange needs and external debt obligations; and
"maintain a reserve for national disasters or emergencies.
"Sound reserve management practices are important because they can increase a country's or region's overall resilience to shocks. Through their interaction with financial markets, reserve managers gain access to valuable information that keeps policy makers informed of market developments and views on potential threats. The importance of sound practices has also been highlighted by experiences where weak or risky reserve management practices have restricted the ability of the authorities to respond effectively to financial crises, which may have accentuated the severity of these crises. Moreover, weak or risky reserve management practices can also have significant financial and reputational costs. Several countries, for example, have incurred large losses that have had direct, or indirect, fiscal consequences. Accordingly, appropriate portfolio management policies concerning the currency composition, choice of investment instruments, and acceptable duration of the reserves portfolio, and which reflect a country's specific policy settings and circumstances, serve to ensure that assets are safeguarded, readily available and support market confidence.
"Sound reserve management policies and practices can support, but not substitute for, sound macroeconomic management. Moreover, inappropriate economic policies (fiscal, monetary and exchange rate, and financial) can pose serious risks to the ability to manage reserves."
The objectives of sound Reserve Management are defined by the Fund (IMF) as under:-
"Reserve management should seek to ensure that: (i) adequate foreign exchange reserves are available for meeting a defined range of objectives; (ii) liquidity, market, and credit risks are controlled in a prudent manner; and (iii) subject to liquidity and other risk constraints, reasonable earnings are generated over the medium to long term on the funds invested."
Foreign Exchange Reserves of India
The foreign exchange Reserves of our country took its lowest dip, In the year 1990-91, when balance of payments position facing the country became critical and foreign exchange reserves had been depleted to dangerously low levels, less than 1 bn US #$. It heralded the onset of liberalisation of Indian Economy releasing a chain of economic and financial reforms, resulting in the progressive building up of our reserves. It has now reached a formidable level around 120 bn US $ now. The earlier problem of managing chronic shortages is now replaced by the Dilemma of handling a bulging pool, the problem of a growing plenty. This leads one to ponder over the costs & benefits and the attendant risks. This matter is analysed in depth by the former Governor of RBI Dr. Bimal Jalan, while addressing a conference of 14th National Assembly of Forex Association of India 14.8.2003 .
"Another issue, which has figured prominently in the current debate, relates to foreign exchange reserves. As is well known, India’s foreign exchange reserves have increased substantially in the past few years and are now among one of the largest in the world. The fact that most of the constituents of India’s balance of payments are showing positive trends – on the current as well as capital accounts – is a reflection of the increasing competitiveness of the Indian economy and strong confidence of the international community in India’s growth potential. For the first time after our Independence 56 years ago, the fragility of the balance of payments is no longer a concern of policy makers. This is a highly positive development and regarded as such by the country at large.
"Nevertheless, there are two concerns that have been expressed by expert commentators – one is about the "cost" of additional reserves, and second concerns the impact of "arbitrage" in inducing higher inflows. So far as the cost of additional reserves is concerned, it needs to be borne in mind that the bulk of additions to reserves in the recent period is on account of non-debt creating inflows. India’s total external debt, including NRI (Non-Resident Indian) deposits, has increased relatively slowly as compared with the increase in reserves, particularly in the last couple of years. In fact, India pre-paid more than $ 3 billion of external debt earlier this year. It may also be mentioned that rates of interest paid on NRI deposits and multilateral loans in foreign currency are in line with or lower than prevailing international interest rates.
"On NRI rupee deposits, interest rates in the last couple of years have been in line with interest rates on deposits by residents, and are currently even lower than domestic interest rates. So far as other non-debt creating inflows (i.e., foreign direct investment, portfolio investment or remittances) are concerned, such inflows by their very nature are commercial in nature and enjoy the same returns and risks, including exchange rate risk, as any other form of domestic investment or remittance by residents. The cost to the country of such flows is the same whether they are added to reserves or are matched by equivalent foreign currency outflow on account of higher imports or investments abroad by residents. On the whole, under present conditions, it seems that the "cost" of additional reserves is really a non-issue from a broader macro-economic point of view.
"Indian interest rates have come down substantially in the last three or four years. They are, however, still higher than those prevailing in the U.S., Europe, U.K. or Japan. This provides an "arbitrage" opportunity to holder of liquid assets abroad, who may take advantage of higher domestic interest rates in India leading to a possible short-term upsurge in capital flows. However, there are several considerations, which indicate that "arbitrage" per se is unlikely to have been a primary factor in influencing remittances or investment decisions by NRIs or foreign entities in the recent period. Among these are :
"The minimum period of deposits by NRIs in Indian rupees is now one year, and the interest rate on such deposits is subject to a ceiling rate of 2.5 per cent over Libor. This is broadly in line with one-year forward premium on the dollar in the Indian market (interest rates on dollar deposits by NRIs are actually below Libor).
"Outside of NRI deposits, investments by Foreign Institutional Investors (FIIs) in debt funds is subject to an overall cap of only $ 1 billion in the aggregate. In other words, the possibility of arbitrage by FIIs in respect of pure debt funds is limited to this low figure of $ 1 billion (excluding investments in a mix of equity and debt funds).
"Interest rates and yields on liquid securities are highly variable abroad as well as in India, and the differential between the two rates can change very sharply within a short time depending on market expectations. It is interesting to note that the yield on 10 year Treasury bills in the U.S. had risen to about 4.4 per cent as compared with 5.6 per cent on Government bonds of similar maturity in India at the end of July 2003. Taking into account the forward premia on dollars and yield fluctuations, except for brief period, there is likely to be little incentive to send large amounts of capital to India merely to take advantage of the interest differential.
" On the whole, it is likely that external flows into India have been motivated by factors other than pure arbitrage. Figures on sources of reserve accretion available upto the end of last year (2002-03) confirm this view. It is also pertinent to note that domestic interest rates among industrial countries also vary considerably. For example, in Japan, they are close to zero. In the U.K., they are above 4 per cent, and in the U.S. about 1.5 per cent. There is no evidence that capital has been moving out of U.S. to U.K. or Europe merely on account of interest differential. Within a certain low range, capital flows are likely to be more influenced by outlook for growth and inflation than pure arbitrage even among industrial countries with full CAC"
More about Exchange Rate Regime is discussed in the following articles.
