Current and Capital Account Convertibility in India

Currency convertibility plays a major role in the economy of the country. Convertibility refers to the relative ease with which the currency can be converted into other assets.

Current Account Convertibility refers to the freedom to convert the currency into another currency for the purpose of international trade in goods and services (and other invisibles like transfer payments/income from investment).

Capital Account Convertibility refers to the freedom to convert the currency into another currency for the purpose of investment in assets (like financial assets).

As movement of goods/services and investments in assets hold significant importance in the functioning of the economy, currency convertibility is crucial for economic development.

Background

The Indian Rupee was linked to the British Pound in the pre-Independence period. After World War II was over and the Bretton Woods System was set up, the Indian Rupee was pegged to the US Dollar (and Gold under the Gold Standard). The value of the Indian Rupee remained fairly constant till the mid-1960s. During this period, India had a high dependence on foreign economies for the supply of goods for domestic consumption. The Government also borrowed from abroad for meeting its own expenses. Two wars in the first half of the 1960s (Indo-China, 1962 and Indo-Pak, 1965 wars) coupled with drought in 1966 resulted in high inflation and price rise. Higher inflation had further deteriorated India’s already negative foreign trade (higher imports and lower exports). The Government was also running a consistent fiscal deficit since the 1950s (high expenditure on Infrastructure in the Second Year Plan). The prevalence of twin deficits made it difficult for the Government to borrow from abroad because of high debt levels (due to consistent deficit).

When the foreign Governments refused to lend or provide aid to India till India reduced the domestic restrictions on the foreign trade, the Government of India was left with no other option but to devalue the Indian Rupee in 1966. The 1965 war was a major factor in devaluation as war had increased the Government’s budget deficit (Defence Spending was 24% of the total expenditure in 1965–66) and the US had stopped aid in the wake of the war. In June 1966, Rupee was devalued from INR 4.76/USD to INR 7.5/USD (INR was devalued by 57.5%)

This exchange rate was maintained till 1971. After the Bretton Woods System broke down in 1971, India pegged its currency to the British Pound Sterling. In 1975, the Indian Rupee was pegged to a basket of currencies in order to ensure stability of the currency and avoid risks associated with a single currency peg. The system continued till 1991.

Overview

The Balance of Payment Crisis of 1991 again necessitated another devaluation in 1991. The Rupee was devalued in two steps; 9% on July 1, 1991 and another 11% on July 3, 1991.

In March 1992, the Liberalized Exchange Rate Management System was introduced as a step towards transition to a market determined exchange rate system. LERMS was a scheme to gradually liberalize the exchange rate markets; as a move towards immediate full convertibility could have led to instability just as India was emerging from the crisis of 1991.

Under the LERMS the Rupee was made partially convertible. LERMS introduced a dual exchange rate system. 40% of the foreign exchange earnings through exports and remittances were purchased at the official exchange rate determined by the RBI. The 40% of the purchases were to be submitted to the RBI at the official exchange rate to improve the Foreign Exchange Reserves as well as for financing imports.

The rest of the 60% of the exchange inflows were to be converted at the market determined rate. The imports of goods were also to be carried out at market determined rates except for certain special goods like petroleum, oil products, fertilizers, pharmaceuticals etc. which were to be imported at official exchange rate.

RBI could also intervene in the market if the market rate deviated a large extent from the official rate.

In March 1993, the LERMS was abolished and the dual exchange rate system was removed. The limitation of 60:40 ratio was no longer applicable and all receipts of the foreign exchange were to be converted at the market determined rate. Thus the dual exchange rate system was replaced by a unified exchange rate system.

The Rupee was made fully convertible on the current account in August 1994. Article VIII of the Articles of Agreement of the IMF was accepted. Article VIII restricts the members of the Fund from putting any restriction on payments/transactions on current international accounts without the approval of the IMF. The country can’t maintain multiple exchange rates.

Further relaxations were undertaken in foreign exchange controls in the subsequent years. In 1997, the RBI removed the ceiling on the remittance of foreign exchange for multiple purposes and authorized dealers could undertake transactions for those purposes without prior approval of the RBI.

Impact

India’s Balance of Payments situation improved subsequent to liberalization of the exchange control regime.

In the few years after the crisis and the reforms, the exports improved while the imports remained constant in dollar terms leading to improvement in the Balance of Payments.

The Forex Reserves also witnessed an improving trend. The forex reserves increased from USD 5.8 billion in March 1991 to USD 25.2 billion in March 1995. The increasing trend continued in the later 1990s with the reserves touching USD 38 billion in March 2000. In September 2020, the forex reserves stood at USD 502 billion.

The remittance from Indian residents abroad also increased significantly due to removal of barriers and free conversion of the foreign currency.

Exhibit: Trend of Remittance

Another advantage of Current Account Convertibility is that it leads to self correction in the exchange rate. If the currency depreciates too much, the exports become cheaper and the demand for domestic goods abroad increases. This increases the demand for domestic currency and thus leading to appreciation in exchange rate. If the currency appreciates too much, reverse happens (exports become expensive and demand decreases) and ultimately the exchange rate achieves an equilibrium.

India’s external sector became fairly stable with the improvement in the foreign investment norms.

Exhibit: Current and Capital Account Trend in India (1990–2019)

Capital Account Convertibility

While the Indian Rupee has been made fully convertible on the Current Account, there are still considerable restrictions on the convertibility on the Capital Account.

Capital Account Convertibility is related to the flow of money into the Capital Account like investment in financial assets (Capital Markets (Portfolio Investment in equity stocks, bonds), dividend and interest incomes on financial assets, investments in infrastructure projects etc. at a market determined exchange rate.

Advantages of Capital Account Convertibility

Allowing Capital Account Convertibility has several advantages.

Capital Account Convertibility attracts foreign investment. As the investors are able to take out investments at a market determined rate, economies with Capital Account Convertibility are perceived as less risky. There is generally a larger inflow of foreign capital into a country with full capital convertibility and macroeconomic stability.

Foreign investment also helps create more business and employment opportunities.

Government and Private sector can also access foreign capital, reducing the cost of capital. Money can be borrowed from foreign countries at a lower rate and invested in domestic infrastructure. Domestic financial institutions (like banks) can also borrow cheaper money from abroad and improve their capital base.

Disadvantages of Capital Account Convertibility

However there are multiple disadvantages of Capital Account Convertibility.

Full convertibility on Capital Account makes the exchange market more volatile and consequently increases the risks. A flight of capital (large outflow of foreign investment) may result in response to adverse domestic economic shock which can cause a large depreciation of domestic currency. The exchange market may also become prone to speculators.

A large depreciation resulting due to flight of capital may worsen the fiscal condition of the Government if it holds large foreign debt. As the foreign loan must be paid in foreign currency, depreciation in exchange rate results in higher payment in terms of domestic currency (e.g. For a debt of USD 1 billion borrowed at exchange rate of INR 50/USD, total repayment will be INR 50 billion. If the exchange rate depreciates to INR 60/USD, the total repayment will increase to INR 60 billion).

Conditions necessary to achieve Capital Account Convertibility

Given the disadvantages associated with Capital Account Convertibility, it is necessary that certain conditions must be met before the introduction of full Capital Account Convertibility especially in case of developing countries:

• Most economists argue that the Capital Account Convertibility should be allowed only after allowing full current account convertibility. Reverse sequence (opening Capital Account before Current Account) may result in appreciation of exchange rate which can hamper the opening of the current account (as exports would become expensive) and an adverse impact on the trade balance.
• The Government Fiscal Deficit must be under control, so that the Government is not exposed to high foreign currency debt risk. Stable fiscal deficit also ensures a stable fiscal policy regime which also enhances general macroeconomic stability. A large fiscal deficit may cause higher interest rates (high Government borrowing) which can attract volatile short term foreign capital. The volatile short term foreign capital may put pressure on the exchange rate (push up during inflow and pull down during outflow) impacting foreign trade as well.
• The country’s domestic financial sector must be well developed. The system should be free from excessive interest rate controls or Government mandated lending to certain sectors.
• The country should have high foreign exchange reserves in order to handle any adverse economic shock which may lead to high outflows of capital (leading to depreciation pressure on exchange rate).
• The Current Account Deficit must be under control as high CAD may result in high borrowing and high debt servicing obligations which impacts fiscal deficit.
• The authorities must maintain an appropriate degree of exchange rate flexibility. The policy should not let the rate appreciate so much so as to hamper the competitiveness of the exports. Nor should the authorities spend too much forex reserve or maintain high interest rates in order to maintain a fixed exchange rate.

Conceptual and Explanatory Notes

Bretton Woods System

Bretton Woods System refers to the international monetary system set up in July 1944 during the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire, US. This conference led to the creation of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD) in December, 1945. The motive behind creation of these institutions was the belief of leaders in the WWII period that free international trade promoted peace and development. The idea was to create institutions to provide financial assistance to countries experiencing balance of payment or debt crisis. Such assistance would prevent them from adopting protectionist policies like during the Great Depression of 1929–30, which was a driving factor for WWII.

It also created a system of Gold Standard, in which the value of the US Dollar was linked to the Gold and other currencies were pegged to the US Dollar. The establishment of the Gold Standard stabilized the international currency market and reduced volatility. This helped the international trade. Currency stability also facilitated the international lending programme of the IMF and the WB.

The Gold standard eventually broke in 1973. But the Bretton Woods Institutions, the IMF and the World Bank have continued to play a crucial role in the World Economy.

IMF provides loans to countries struggling with balance of payment/currency or sovereign debt crisis, while the WB, provides assistance to developing countries for development projects.

Impossible Trinity/Trilemma

In International Economics Impossible Trinity or Trilemma refers to the hypothesis that it is impossible to achieve fixed exchange rate, free capital movement and independent monetary policy all together. The concept was developed by Mundell and Fleming in the early 1960s. Independent monetary policy means the Central Bank can set the domestic interest rates independently.

There is enough empirical evidence to support this hypothesis.

There are three options for the policymakers

1. Free Capital Flow and Fixed Exchange Rate: The Central Bank can’t maintain an interest rate different from the interest rate prevalent in the external sector as it would lead to appreciation/depreciation of the currency.
2. Free Capital Flow and Independent Monetary Policy: The different interest rates will cause appreciation/depreciation of the currency resulting in floating exchange rate.
3. Independent Monetary Policy and Fixed Exchange Rate: Higher domestic interest rate will attract foreign capital which will lead to appreciation in exchange rate. To maintain a fixed exchange rate, the flow of capital must be restricted.

The hypothesis is based on the concept of Interest Rate Parity. Interest rate parity states that in the absence of any arbitrage, the interest rates available on deposits in banks of two countries are the same. Arbitrage is achieving profits from the condition of different prices of the same product in different markets.

Exhibit: The Impossible Trinity (Adapted from: Oxelheim, 1990)

Interest Rate Parity

Interest Rate Parity expresses the relationship between the currency exchange rate and the interest rate. It is the condition of absence of any arbitrage between the exchange rate and the interest rate.

It is based on the concept that the return due to domestic interest rate is equal to the return on foreign interest rate adjusted to the exchange rate. In the absence of the parity, an arbitrageur can earn arbitrage profits by borrowing in a country with lower interest rate, converting into foreign currency and investing in a country with higher interest rate and then converting back.

Consider the US-India combination. Assume current exchange rate is INR 60/USD. Further assume interest rates in India and the US by 5% and 3% respectively. Then according to Interest Rate Parity, the future exchange rate should be

60*(1+5%)/(1+3%) = INR 61.16 /USD

Derivation

Assume investment of USD 1000 in India.

Investment in terms of INR = 1000*60 = INR 60,000

Investment after 1 Year = 60,000*(1+5%) = 63,000

Investment after 1 Year in the US = 1000*(1+3%) = USD 1030

When there is no arbitrage

USD 1,030 = INR 63,000

USD 1 = 63,000/1,030 = 61.165

In the absence of parity, an arbitrage condition exists.

Assume the exchange rate is INR 60/USD. Then the amount on maturity is USD (63,000/60) = USD 1050. This is higher than the amount if the money were invested in the US. Thus there will be inflow of capital due to higher returns in India. This will lead to appreciation in the currency leading to convergence to the no-arbitrage value of exchange rate of INR 61.165/USD.