Currency and Convertibility

The FOREX Market The FOREX market is where currencies are traded The market incorporates all arrangements used to buy and sell foreign

exchange (not a physical place but a network of telephones, emails and faxes connecting all the large banks in the world).

Volumes traded daily are huge: $3 trillion per day Most transactions involve exchange of $US for other currencies. In

large transactions, traders exchange one currency for $US and then buy another currency with the dollar. The $US is thus called a vehicle currency.

What Is An Exchange Rate?The price of a nation’s currency in terms of another

currency.It is the value of a currency measured against a foreign

currency An exchange rate thus has two components, the

domestic currency and a foreign currency

Exchange ratesThe price determined in the FOREX market is the exchange rate. The exchange rate is the price of one country's currency measured in terms of

another country's currency.It converts values from one country’s unit of measure (currency) to another country’s unit of measure (currency).

When a currency becomes more valuable relative to another currency it has appreciated. The price of foreign exchange has fallen (e.g, one $US buys 130 yen instead of 120 yen previously).

When a currency becomes less valuable relative to other currencies, it has depreciated. The price of foreign exchange has risen (e.g., $US buys 110 yen instead of 120 yen previously).

Exchange rate determination Demand and Supply. Exchange rates are determined by the

equilibrating interaction of buyers and sellers of currencies in the FOREX market.

Two of the most important factors affecting demand and supply are relative inflation rates and relative interest rates.

Differences in price levels are a crucial aspect of exchange rates determination

How changes in currency values affect the nation ?

Example: assume 2 countries (US, France), 2 currencies ($US, ff) and one traded good (men's shirts).• Price Comparison:

– US-made shirts– French-made shirts

$50 ff250

• Exchange rate: $1 = 5 francs. The PPP condition:

• Comparison shopping after the dollar depreciates ($1 = 4 francs)

• The exchange rate affects the price competitiveness of all traded goods– it is thus the single most important price in an economy. It has a major impact on a country’s wealth.

US shopper prices French Shopper pricesUS-made shirt $50 $50=ff200

French-made shirt ff250=$62.50 ff250

US Shopper prices French Shopper pricesUS-made shirt $50 $50=ff250

French-made shirt ff250=$50 ff250

Currency ConvertibilityWhat it is ?

Convertibility essentially means the ability of residents and non-residents to exchange domestic currency for foreign currency, without limit, whatever be the purpose of the transactions.

Types Of Currency Convertibility.

1. Fully convertible currency.

2. Partially convertible currency.

3. Non-convertible currency.

Non convertible Currency

Also known as a "blocked currency".

Any currency that is used primarily for domestic transactions and is not openly traded on a forex market. This usually is a result of government restrictions, which prevent it from being exchanged for foreign currencies

Types of convertibility

Current Account

Capital Account

Current AccountCurrent account convertibility refers to freedom in respect of Payments and transfers for current international transactions.

Transactions relating to:

- Exchange of goods and services

- Money transfers

In other words, if Indians are allowed to buy only foreign goods and services but restrictions remain on the purchase of assets abroad, it is only current account convertibility.

Current Account Transactions

• All imports and exports of merchandise.

• Invisible Exports and Imports (sale/purchase of services)

• Inward private remittances (to & fro)

• Pension payments (to & fro)

• Government Grants (both ways)

Capital account

• Inflows and Outflows of capital.

• Borrowing from or Lending to aboard.

• Sales and Purchase of securities aboard.

Capital Account Transactions

Capital Direct Foreign Investments.

Investment in securities.

Other Investments.

Government Loans.

Short-term investments.

Capital Account Transaction’s Classification

Portfolio Investment .

Stocks, Bonds, Bank Loans, Derivatives.

DirectInvestment.

Real estate Production

facilities Equity

investment.

Other investment.

Holdings in loans Bank accounts Currencies

Capital Account Convertibility

Capital account convertibility (CAC) refers to the freedom of converting local financial assets into foreign financial assets and vice versa at market determined rates of exchange. It refers to the elimination of restraints on international flows on a country’s capital account, facilitating full currency convertibility and opening of the financial system.

Currently Restrictions : Capital Account

Limits to companies borrowing abroad. Restriction on foreigner investing in India. Restriction on amount that FII can hold. Purchasing a company is allowed but limit exit on the

amount that can be send. Global Diversification of household portfolio is practically

non-existent.

RUPEE CONVERTIBILITY

Introduction

• The Indian rupee(Devanagari: रुपया)) is the official currency of “The republic of India”.

• Today, the currency is available in the form of “Bank notes” and “coins of the rupee”.

Convertibility of RupeeConvertibility of a currency implies that a currency can be transferred into another currency without any limitations or any control.

A currency is said to be fully convertible, if it can be converted into some other currency at the market price of that currency. Convertibility can be related as the extent to which a country's regulations allow free flow of money into and outside the country.

Convertibility of rupees is known as freedom of exchange of rupee with other all international currency

History of Rupee Convertibility Upto 1991, there was rigid control on both Capital and Current

account. After start of liberalization in1991, India had accepted the IMF

rules for currency reforms. Capital account convertibility was introduced in India in August

1994. In 1997 the government had set up a committee (Tarapore

committee) to spell out a road map for the full convertibility of the rupee.

Current Account Convertibility

Indian scenario - fully convertible.

Full freedom to both residents and non-residents.

RBI has placed a cap in creation of a capital asset Freedom in respect of payments and transfers for current

international transactions.

Benefits of capital account convertibility to India:

The Tarapore Committee mentioned the following benefits of capital account convertibility to India:

1. Availability of large funds to supplement domestic resources and thereby promote economic growth.

2. Improved access to international financial markets and reduction in cost of capital.

3. Incentive for Indians to acquire and hold international securities and assets, and4. Improvement of the financial system in the context of global competition.5. Freedom to convert local financial assets into foreign ones at market-

determined exchange rates6. Leads to free exchange of currency at lower rates and an unrestricted mobility

of capital

Tarapore CommitteeReasons for the introduction of Capital Account Convertability in India:

It was meant to ensure total financial mobility in the country

It also aimed in the efficient appropriation or distribution of international capital in India

Pre - conditions:The fiscal deficit needs to be reduced to 3.5% of the GDP

Inflation rates need to be controlled between 3-5%

Non-performing assets (NPAs) need to be brought down to 5%

Cash Reserve Ratio (CRR) needs to be reduced to 3%

A monetary exchange rate band of plus minus 5% should be instituted

Tarapore Committee Committee on capital account credibility, set up by

RBI(Reserve Bank of India) under the chairmanship of former RBI deputy governor S.S. Tarapore.

Economists Surjit S Bhalla, M G Bhide, R H Patil, A V Rajwade and Ajit Ranade were the members of the Committee.

The Tarapore Committee on Capital Account Convertibility

Reserve Bank of India appointed the second Tarapore committee to set out the framework for fuller Capital Account Convertibility.

The committee was established to revisit the subject of fuller capital account convertibility in the context of the progress in economic reforms, the stability of the external and financial sectors, accelerated growth and global integration.

The report of this committee was made public by RBI on 1st September 2006. In this report, the committee suggested 3 phases of adopting the full convertibility of rupee in capital account.

First Phase in 2006-7

Second phase in 2007-09

Third Phase by 2011.

RecommendationsFollowing were some important recommendations of this committee:

The ceiling for External Commercial Borrowings (ECB) should be raised for automatic approval.

NRI should be allowed to invest in capital markets and NRI deposits should be given tax benefits.

Improvement of the Banking regulation.

FII (Foreign Institutional Investors) should be prohibited from investing fresh money raised to participatory notes.

Existing PN holders should be given an exit route to phase out completely the PN notes.

At present the rupee is fully convertible on the current account, but only partially convertible on the capital account.

MACROECONOMIC AND FINANCIAL INDICATORS

Various macro economic indicators of India

Source : RBI