Convertibility of Exchange Rate - FAQ (Part: 2)

How convertibility was achieved through “LERMS”?

LERMS representing Liberalised Exchange Management System was introduced in the year 1992 as part of a package of reforms intended to secure instant and permanent remedies for the problems ailing the Indian economy at that time. Some of the problems facing the country at that timer were as under:-

1. The balance of payments position facing the country had become critical and foreign exchange reserves had depleted to dangerously low levels i.e. $585 million, which was sufficient for financing just one week of India’s exports.

2. . Export momentum built during 1986-87 to 1989-90 was lost and exports decelerated to 9% in U.S. Dollars.

3. Imports had to be severely curbed in 1990-91 because of shortage of foreign exchange. This affected the availability of many essential items and also led to a distinct slow down in industrial growth.

4. Inflation was rocking the country and fiscal deficit was going uncontrolled, resulting domestic prices unfavourable for export promotion.

5. The system of administered exchange allocations and rate fixation gave rise to parallel markets in foreign exchange, trade mis-invoicing and capital flights. Persons who required foreign exchange and were unable to get the same under the regulations in force had recourse to the ‘hawala’ markets and brought the required foreign exchange at premium rates. Exporters under-invoiced their export earnings and moved away foreign exchange abroad or repatriated the same at a premium through the hawala route. There was considerable leakage of accruals in foreign exchange earnings due to NRI remittances being routed through these markets.

6. The unauthorised market also acted as conduits for financing smuggling operations into and out of the country. The black market for foreign exchange was supported by the unofficial gold movements into India.

7. There was urgent need to usher in a policy to end economic isolation of the country, remove the controlled economic regime, and follow market oriented economic policy to link India with the global economy

The package of urgent economic reforms not only to put an end to the above problems facing the country, but also to permanently curb their occurrence included the following:

1. The Liberalised Exchange Control Management Scheme

2. A liberal trade policy for both exports and imports

3. Curbing fiscal deficit and government spending and hold inflation under control

In March 1992 the Government announced the full convertibility of the Rupee in Current Account. A fully convertible rupee provides full freedom to both residents and non-residents to trade in goods, services and assets, thereby to integrate the domestic economy into the world economy. Convertibility on current account along with trade liberalization measures has enhanced the competitiveness of the domestic tradables and has made the world prices to prevail in the domestic economy. The rupee convertibility process has been implemented since July 1991, involving several important elements:

• The relaxation of quantitative restrictions on imports by doing away with import quotas and licensing.

• The reduction of the level and dispersion of import tariff rates

• The elimination of several export subsidization schemes

• The liberalization of exchange restrictions on capital flows, particularly the inflow in foreign direct investments and portfolio investments, and

• Introduction of the market-driven exchange rates of the rupee, instead of the administered system through the mechanism of the basket-peg.

Liberalization of Trade Policy:

1. In July 91, trade policy introduced EXIM scrips at a standard rate of 30 per cent of the FOB value of exports to Exporters. These scrips were freely tradable in the open market, which fetched about 30% premium to the exporters.

2. Due to operational difficulties the system of EXIM scrips were abolished in 1992-93 budget and the partial convertibility of the rupee was introduced with effect from 1st March 1992. whereby 60% of all exports and inward remittances were convertible into rupees at the market determined rates and the remaining 40 per cent being surrendered to Reserve Bank at the official exchange rate for financing of the essential imports.

3. A new export and import policy (EXIM Policy) came into force on 1st April 1992. The new EXIM policy allows licence-free import of all goods except those specified in the negative list. The negative list contained 3 banned items, 68 restricted items and canalised items.

4. The EPGC (Export Promotion Capital Goods) allowed exporters to import capita goods at concessional duty subject to prescribed export obligation.

5. With regards to exports a negative list of 79 items was drawn up. Of these 7 items are banned items, 51 items are exportable subject to licensing, 11 items are exportable subject to quantitative ceilings and 10 items are exported through canalising agencies

It is in this background that the full convertibility of the rupee in Current Account was announced. The measure abolished the dual exchange system, and thus it completely floats the rupee in the market exchange markets. Under the present float, exporters an realise their entire earnings at the free market rates, while all imports, including the government imports consisting of petroleum, fertilizers and defence have also to be paid at free market rates.

Basically two types of macroeconomic constraints are sought to be resolved in the new regime: the balance of payments and the inflation regimes. The balance of payment of constraint is sought to be alleviated through a market driven exchange allocation and exchange rate process. Once exchange rates are market determined and import controls abolished, firms who will be paying at the market rates would be using the imported inputs. The market rate is expected to self-balance the demand and supply of foreign exchange, thus, curbing the excess demand situation and correcting the present trade imbalances.

The inflation constraint is embedded in the monetary fiscal policy mix that may become inconsistent with the desired exchange rate. Along with liberal trade and exchange policies, the Government in addition taking all steps for export promotion also controls fiscal deficit and government spending. Government of India in fact has been highly successful in maintaining generally inflation below 5% level since 1992.

5.Do you foresee full convertibility in coming future?

Capital account captures short-term and. Long term internal borrowing and lending. So also investment in business acquisitions of assets in a foreign country, investment in shares and securities in overseas market, debt repayment are examples which involve outflow of capital from the country. If full convertibility on capital account is to be introduced, the rupee should be freely convertible into any other foreign currency in the market. But in a free market there can be only one price for the currency i.e. one exchange rate. A national currency cannot be said to be convertible, if it has more than one exchange rate. This is the situation, which exists at present in India. The rupee has become fully convertible on trade and current account, but not on capital account. The term “Capital Account Convertibility” (CAC) means that the Rupee can be freely converted into foreign currencies for acquisition of capital assets abroad. In this context it will not be out of context to reproduce the statement made by the then Finance Minister Dr. Man Mohan Singh. He said-

“There are certain risks involved in the capital account convertibility. Therefore for the time being, we would concentrate on making the rupee convertible in current account. It is after that the logical step would be to think of rupee convertibility on the capital account.”

Even though the above statement was made in March 1993., essential conditions are not fulfilled so far for Indian rupee to be made fully convertible which will necessitate relaxation of capital controls, i.e. capital outflows and inflows. The positive gains made by the Indian economy since introduction of current account convertibility and trade liberalization are as under.

1. The Indian Economy has been showing signs of growth after liberalisation.

2. The country enjoys comfortable foreign exchange reserve and balance of payment position.

3. Changes in exchange rate of the rupee are gradual and there are no violent fluctuations.

4. Rate of inflation is showing downward trend over a long period.

5. Reserve Bank of India is following a liberal credit policy.

6. Interest rates are declining.

On the other hands the negative factors are as under;

1. Infrastructural inadequacies.

2. Fiscal deficit is not contained at desired/budgeted levels

3. Huge amount of non-performing assets in banking system

4. Government revenue expenditure has not been brought under total control

5. The coalition government at the centre is not in a position to quickly take firm or tough decisions

In this connection the Committee of Capital Account convertibility set up by Reserve Bank of India under former R.B.I. Dy. Governor, Mr.S.S.Tarapore to “lay the Road Map” to capital account convertibility submitted its report sometimes back. The Committ5ee has recommended that the implementation CAC be spread over a three-year period, 1997-98, 1998-99 and 1999-2000. Its major recommendations are:

1. The gross fiscal deficit be brought down from the budgeted 5 percent in 1997-98 to 3.5 per cent by 2000.

2. A consolidated sinking fund be created which will address the crisis of a ballooning public debt.

3. The inflation be brought down to an average 3.5 percent between 1997 to 2000.

4. Reducing gross NPA level in the Banking sector to 5 per cent

5. Bringing down the average CRR drastically to 3 per cent

The Indian economy is predominantly dependent even today on monsoon. Government controls on industry, which has been a way of life for over four decades. These are now being gradually dismantled. The reforms on financial sectors and banking sectors remain an unfinished task.

It is therefore clear that convertibility as in USA, UK, Germany and some other developed countries will be a feasible proposition for Indian Rupee only if the economic fundamentals of the country are positive and further progress made in all the crucial areas.

Views expressed by the Governor, Dy.Governor of RBI on the subject by way of speeches delivered at important forums are appended to focus current RBI thinking on the subject

1. Speech by Dr. Y.V. Reddy Governor, Reserve Bank of India at the Central Bank Governors Symposium convened by the Bank of England in London on June 25, 2004 - Subject "Remarks on capital account liberalisation and capital controls"

2. Speech by Dr.Bimal Jalan (then Governor RBI) on Capital Account Convertibility, Address a the 14th National Assembly of Forex Association of India on 14.8.2003

3. Key Note Address b Smt K.J.Udeshi Executive Director, RBI at the Assembly of the Forex Dealers' Association of India at Bangalore on September 28, 2002 delivered by I -Subject - "The Issue of Capital Account Convertibility"