Currency convertibility - Advantages and drawbacks

Currency convertibility - Advantages and drawbacks

Question - Recently, the RBI and the Minister of State for Finance said India must move towards full capital account convertibility. Discuss the advantages and drawbacks of currency convertibility and why capital account convertibility is beneficial for India.

Concept of Capital Account Convertibility

• Capital account convertibility: freedom for converting rupees into foreign currency and back again for capital transactions

• Conversion is done at market determined exchange rates

• Prompts free exchange of currency and unlimited capital mobility

• Tarapore Committee on Capital Account Convertibility in 2006 saw many of its recommendations implemented

A. Advantages of Currency Convertibility

1. Encourages Exports

• Market forex rate is higher than officially fixed exchange rates so exporters can get more rupee against foreign exchange;

• low import intensity exports are boosted

2. Import Substitution

• Free or market determined exchange rate is more than previous officially fixed exchange rate

• Imports become expensive and import substitution results

• This promotes economic self sufficiency

3. Remittance Incentives

• Rupee convertibility also provides more incentives for sending forex remittances legally

4. Self Balancing Mechanism

• When there is deficit BOP due to over valued exchange, currency convertibility leads to depreciation of currency and boosts exports through lowered prices

• It also discourages imports leading to automatic correction of deficit BOP

• Contrary occurs for surplus BOP and under valued exchange rate

5. Competitive Specialisation

• Currency convertibility causes market exchange rate to show purchasing power of currencies based on prices and costs of goods found in different nations; Where nations have competitive advantage, cost of goods are lower encouraging exports

• Import of goods where the country lacks an advantage will result

• Specialisation and international trade is carried out based on competitive advantage

• Currency convertibility thereby integrates world economy through easy access to forex

• It promotes trade and capital flows between nations

B. Drawbacks of Currency Convertibility

• Cost push inflation may result of market determined exchange rates are higher than officially fixed exchange rates and prices of essential imports rise

• If currency convertibility is not well managed, market exchange rate can cause domestic currency depreciation harming trade and capital flows in the nation

• Convertibility of currency makes it extremely volatile when currency depreciates due to speculative actions for example 1997-98 capital flight from South East Asian economies.

• Currency depreciation makes capital inflows less likely

C. Capital Account Convertibility/CAC of Rupee: Benefits for India

• Capital account convertibility removes limitations on global flows on the capital account of India

• Currencies can be converted into any other currency without the need for a transaction in case of CAC; freedom of movement from local to foreign currency and back strengthens the economy

• CAC also promotes fund availability to supplement national resources

• It promotes national economic growth

• CAC also provides enhanced access to global financial markets

• It reduces the capital cost

• Indians also get incentive to hold and acquire foreign securities and/or assets

• It also makes financial system globally competitive

Facts and Stats

Current Account Deficit

- India’s external sector was recently vulnerable with current account deficit pegged above 2.5 percent of GDP
- It was 4.2% of GDP in 2011-2012
- It rose to 4.7% in 2012-2013
- The deficit fell to 1.7% in 2013-2014 on account of import of precious metals
- In 2014-2015, it has so far remained low; Q3 showed deficit of 1.6%

Fiscal Situation

- This is fragile; turning point was 2007 recession
- Fiscal deficit has been 4.6 to 6.5 percent in last 6 years before reaching 4.1% in 2013 to 2014
- Fiscal deficit target is lower; target of 3.9% has been aimed for current fiscal
- Deficit target will then be lowered to 3.5 and 3% in 2016-2017 and 2017-2018 respectively