Convertibility of Exchange Rate - FAQ

1. Give a brief account of Exchange Rate Developments that took place after the B.O.P. crisis of 1992

In the year 1990-91 balance of payments position facing the country became critical and foreign exchange reserves had been depleted to dangerously low levels. Imports had to be severely curtailed in the course 1990-91 because of shortage of foreign exchange. Importers were asked to deposit an amount equal to 200% of the L.C. value with Banks in advance to be eligible for getting the L.Cs opened. This affected the availability of many essential items and also led to distinct slow down of industrial growth.

The urgent need of the hour was assessed as under:-

1. To aim at quick revival of the momentum of exports.

2. To create strong incentives to economise on imports, without resorting to proliferation of licensing controls, which promote delay and inefficiency, generate arbitrariness and stifle enterprise.

3. There was urgent need to create an environment free from Bureaucratic controls in which our exporters will be able to respond with speed and flexibility to changing international conditions.

4. To recognise the change that is taking place in the world economy, where countries are shedding isolation ands getting increasingly integrated, and to shape our economic policies as part of the prevailing global environment.

Government announced an initial package of trade policy reforms on 4th July 1991. Its main features are as under:

1. Essential imports such as POL and fertilizers were fully protected.

2. Import of other raw materials and components were linked to export performance through an enlargement and restructuring of the replenishment licensing system.

3. A tradeable Exim Scrip allowing for free foreign exchange for import of goods up to 30% of the F.O.B. export value was allowed to exporters. These scrips were freely tradable in the open market, which fetched about 30% premium to the exporters.

4. Government abolished cash compensatory support for exporters.

5. Licensing complexities were reduced.

6. In view of procedural anomalies the Exim Scrip system was subsequently withdrawn and Government announced partial convertibility of the rupee in the Central Budget for 1992-93 by way of a dual exchange system, which allowed conversion of 60% of the foreign exchange earnings at the rate determined in the foreign exchange market. The balance 40% foreign exchange was to be surrendered to the Reserve Bank at official exchange rate for financing of essential imports. The exporters were getting a rate equivalent to the weighted average of market rate (for 60%) and official rate (for 40%), while private imports were paid at market rates.

7. Shortly thereafter in March 1992, the Government announced 100% convertibility on Current Account, under which 100% foreign exchange earnings can be converted at market rates.

After years of administered exchange rate full convertibility came to India. A fully convertible currency provides freedom to both residents and non-residents to trade in goods, services and assets, thereby, integrates the domestic economy into the world economy. Convertibility in current account along with trade liberalization measures are bound to enhance competitiveness of domestic tradables and make world prices to prevail in the domestic economy. Convertibility measures that accompany the easing of controls on foreign investment and capital inflows are expected to boost technology transfers and enhance productive growth of the domestic economic distortions of an otherwise inward looking trade regime.

The rupee convertibility process has thus been implemented since July 1991, involving several important elements as under:

1. The relaxation of QR (Quantitative Restrictions) Regime involving import quotas and licensing.

2. The reduction of the level and dispersions of import tariff rates

3. The elimination of several export subsidization schemes;

4. The liberalization of exchange restrictions on capital inflows, particularly the inflow the foreign direct and portfolio investments, and

5. The introduction of market driven exchange rates of the rupee, instead of administered system through the mechanism of basket peg

Full convertibility of the currency does not prevent our discretion to protect our essential trade interests. Generally countries with currency convertibility have practiced various degree of controls to suit national interests from time to time. Full convertibility does not mean the unrestricted use of rupee for all types of external transactions. All transactions are still conducted within the framework of exchange controls, as prescribed by the R.B.I. On trade account and on account of the receipt side of the invisible, the rupee is fully convertible at market determined exchange rates. The payment side of the invisible and receipts and payment of capital account are subject to exchange control. However exchange rate for all these permissible transactions are undertaken at free market exchange rates.

2.Define "Convertibility"

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.

The full convertibility features are LERMS (Liberalized Exchange Control Management System) and its main features are summarised as under:-

• The exchange rates of the rupee are determined by the free market forces of demand and supply. Free market rates are quoted by authorised dealers (ADs).

• Like any other market prices, the exchange rates both spot and forward can vary within a day, between days and even around medium term rend.

• All commercial transactions in the current account and capital account are undertaken at the free-market driven rates, whether on government or private account.

• Foreign exchange remittances abroad are subject to exchange control regulations although the AD can remit in many areas upto certain amounts without Reserve Bank’s permission. This implies full convertibility is not applicable to the invisible trade.

• All export proceeds and inward remittances need to be surrendered with a 156% retention option in a foreign currency account with the AD.

• The intervention currency continues to be U.S. dollar, which the Reserve Bank can buy and sell from and to the Ads at its discretion. This route can provide temporary stability in the exchange markets.

• The Reserve Bank provides two way quotes of the U.S. Dollar, which can change several times in a day, depending on market pressures.

• The Reserve Bank will not ordinarily buy or sell any other currency, either spot ort forward; rather will undertake swap transactions with the Ads. A swap involves the Reserve Bank buying the U.S. Dollar spot and selling forward simultaneously for delivery in two to six months.

• The RBI will sell U.S. Dollars to the AD at the market rate, for debt service payments on Government Account and other payments, only a transitory arrangement, such as for meeting 40% value of imports under advance licences, special import licences, REP licences for import of raw materials, gems and jewellery exports, and for meeting the full value of imports under the outstanding EXIM scrips and such other licences treated on part with these scrips.

• For trade with Russian Republics where the invoicing is in freely convertible currency the market related exchange rate are applicable.

• Transactions routed through the ACU arrangement (except those settled in the Indian rupees) will be based on Reserve Bank’s rate for ACU currencies and for the Asian Monetary Unit.

3. What do you understand by the term “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.

Current Account Transactions covers the following.

1. All imports and exports of merchandise

2. Invisible Exports and Imports (sale/purchase of services)

3. Inward private remittances to & fro

4. Pension payments (to & fro)

5. Government Grants (both ways)

Capital Account transactions consist of the following:

1. Direct Foreign Investments (both inward & outward)

2. Investment in securities (both ways)

3. Other Investments (both ways)

4. Government Loans (both ways)

5. 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.