Capital account convertibility – Convertibility of rupee

Capital account and, by extension, full convertibility of the rupee has emerged as an often debated issue in the context of the liberalization process in India.It is worth nothing, at the outset, that India is not alone in its endeavor to make its currency convertibility, nor is it the only country which is facing the daunting task of overcoming several hurdles on its way to full currency convertibility. Indeed, only the developed economics of North America, Western Europe, Japan and Australia have joined the race towards full convertibility. A number of Latin American, Central European and Asian Countries, however, have joined the race towards full convertibility. Aside from India, the list of these countries include Argentina, China, Chile, Columbia, Indonesia, Malaysia, Philippines, Republic of Korea and Thailand. Importantly, these countries are not at the same stage of currency convertibility. The Korean currency, for example, is much convertible than the Chinese currency. Indeed, it is important to note at the outset that the issue is not a matter of choice between convertibility and non-convertibility. There exists a wide spectrum between these two extremes, and India and the aforementioned countries lie at various points of this spectrum. The important issue, in other words, is to decide the extent to which a currency (say, the rupee) will be convertible at a point of time, and the pace at which it will attain higher levels of convertibility in the future.

In order to appreciate the meaning and the implication of currency convertibility, however, one has to first take into consideration two different aspects. A currency, it has to be noted, can be convertible on the current account of balance of payments (BOP), and/or on the capital account of BOP. The currency is deemed fully convertible if it is convertible on both these accounts. A clear understanding of the notion of convertibility, therefore, entails an understanding of the current and capital accounts of BOP.

As such, the current account of the BOP comprises trade in goods and services. In other words, the current account balance takes into account exports, imports, and net foreign income from unilateral transfers. The capital account of the BOP, on the other hand, takes into account cross-border flow of funds that are associated with financial or other assets in the trading countries. For example, the direct and portfolio investments made by foreign investors, in India, are captured by the capital account balance of the BOP. The capital account also encompasses foreign investments of Indian companies, foreign aid and bank deposits of Non-resident Indians (NRI).

A currency is deemed convertible on the current account if it can be freely converted into other convertible currencies for purchase and sale of commodities and services. For example, if the rupee is convertible on the current account an Indian firm should be able to freely convert rupee into Yen (JPY) to purchase mods from a Japanese Company. Similarly, a German company should be able to freely convert the mark (DM) into rupee to pay an Indian software consultancy firm for its services. It is evident that the ideal of free trade lies at the heart of current account convertibility.

Capital account convertibility, on the other hand, implies the right to transact in financial and other assets with foreign countries without restriction. For example, if a currency is convertible on the capital account, the residents of the domestic currency may freely convert it into other (convertible) currencies to purchase and maintain bank accounts abroad. Similarly, residents of other countries should also be able to freely convert their currencies into the domestic currency to purchase domestic capital and money market instruments. In other words, capital account convertibility is associated with the vision of free capital mobility.

Convertibility as an issue, and subsequently as a goal, was a priority in the agenda of the member countries of the International Monetary Fund (IMF) which was born out of the Bretton Woods Agreement. During the Bretton Woods period, the term convertibility is used in two different contexts: convertibility into gold and convertibility into other currencies. Only the United States maintained gold convertibility during Bretton woods. Convertibility into other currencies for current account transaction purposes was a main goal of Bretton Woods and was reached, to a large extent, early on in the system; however, the agreements to the IMF allowed more flexibility with regard to the imposition of exchange controls on capital account transactions. The flexibility was partly a result of a prevailing feeling that short-run speculative capital flows could be potentially destabilising and governments should therefore have the freedom to resist them.”

Owing to other reasons, developing countries have historically not had convertible currencies. Typically, their currencies have been partially convertible on the current account and the capital of the BOP, the rationale for the choice being embedded in the macroeconomic realities and the policy perspectives of the countries concerned. In India, the rupee was made convertible on the current account in August 1994. However, the currency as yet has limited convertibility on the capital account, and that indeed is the centre of a countrywide debate. What might be the rationale behind the aforementioned choice: making rupee convertible on the current account while maintaining exchange control for capital account transactions? What, indeed, are the policy implications of free capital mobility that is associated with capital account and have full convertibility? Is India ready for full currency convertibility?