Rupee convertibility

Rupee convertibility means the system where any amount of rupee can be converted into any other currency without any question asked about the purpose for which the foreign exchange is to be used. Convertibility of rupees is known as the freedom of exchange of rupee with other all international currency. It means that rupee can convert in USA dollars more easily and USA dollars can convert in Indian currency for buying and selling of goods and services. Though impressionistic reports suggest that the rupee is already convertible in the unofficial markets, this is a fact not the case. Free convertibility refers to officially sanctioned market mechanism for currency conversion. Convertibility is the quality of paper money substitutes which entitles the holder to redeem them on demand into money proper. Non-convertibility can generally be defined with reference to transaction for which foreign exchange cannot be legally purchased (e.g. import of consumer goods etc.), or transactions which are controlled and approved on a case by case basis (like regulated imports etc.). A move towards free convertibility implies a reduction in the number / volume of the above types of transactions. Currency convertibility refers to the freedom to convert the domestic currency into other internationally accepted currencies and vice versa. Convertibility in that sense is the obverse of controls or restrictions on currency transactions. While current account convertibility refers to freedom in respect of payments and transfers for current international transactions, capital account convertibility (CAC) would mean freedom of currency conversion in relation to capital transactions in terms of inflows and outflows. Article VIII of the transactions or which would unduly delay transfers of funds in settlement of commitments. International Monetary

Fund (IMF) puts an obligation on a member to avoid imposing restrictions on the making of payments and transfers for current international transactions. Members may cooperate for the purpose of making the exchange control regulations of members more effective. Article VI (3), however, allows members to exercise such controls as are necessary to regulate international capital movements, but not so as to restrict payments for current It is basically a policy that allows the easy exchange of local currency (cash) for foreign currency at low rates. This is so local merchants can easily conduct transnational business without needing foreign currency exchanges to handle small transactions. Capital Account Convertibility is mostly a guideline to changes of ownership in foreign or domestic financial assets and liabilities. Tangentially, it covers and extends the framework of the creation and liquidation of claims on, or by the rest of the world, on local asset and currency markets. It is basically a policy that allows the easy exchange of local currency (cash) for foreign currency at low rates. This is so local merchants can easily conduct transnational business without needing foreign currency exchanges to handle small transactions. CAC is mostly a guideline to changes of ownership in foreign or domestic financial assets and liabilities. Tangentially, it covers and extends the framework of the creation and liquidation of claims on, or by the rest of the world, on local asset and currency markets.

TYPES OF CURRENCYThere are various types of currency-

1.

Fully convertible currency-The

U.S.

dollar

is

an

example of a fully convertible currency. There are no restrictions or limitations on the amount of dollars that can be traded on the international market, and the U.S. Government does not artificially impose a fixed value or minimum value on the dollar in international trade. For this reason, dollars are one of the major currencies traded in the FOREX market.

2.

Partially convertible currency-The

Indian rupee is

only partially convertible due to the Indian Central Banks control over international investments flowing in and out of the country. While most domestic trade transactions are handled without any special requirements, there are still significant restrictions on international investing and special approval is often required in order to convert rupees into other currencies. Due to Indias strong financial position in the international community, there is discussion of allowing the Indian rupee to float freely on the market, altering it from a partially convertible currency to a fully convertible one.

3.

Nonconvertible currency-Almost

all nations allow for

some method of currency conversion; Cuba and North Korea are the exceptions. They neither participate in the international FOREX

market nor allow conversion of their currencies by individuals or companies. As a result, these currencies are known as blocked currencies; the North Korean won and the Cuban national peso cannot be accurately valued against other currencies and are only used for domestic purposes and debts. Such nonconvertible currencies present a major obstruction to international trade for companies who reside in these countries.

Convertibility

is

two-step

process-

current

account and capital account. Current account convertibility

is a monetary policy that centers

around the ability to conduct transactions of local financial assets into foreign financial assets freely and at market determined exchange rates. It is sometimes referred to as Capital Asset Liberation. It refers to freedom in respect of Payments and transfers for current international transactions. 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. As of now, convertibility of the rupee into foreign currencies is almost wholly free for current account for permission from a central bank or government entity. Most major currencies are fully convertible; that is, they can be traded freely without restriction and with no permission required. The easy convertibility of currency is a relatively recent development and is in part attributable to the growth of the international trading markets and the FOREX markets in particular. Historically, movement away from the gold exchange standard once in common usage has led to more and more convertible currencies becoming available on the market. Because the value of currencies is established in comparison to each other, rather than measured against a real commodity like gold or silver, the ready trade of currencies can offer investors an opportunity for profi

Capital Account convertibility

amount of foreign currency into the country.

in its entirety would mean

that any individual, be it Indian or Foreigner will be allowed to bring in any Full convertibility also known as Floating rupee means the removal of all controls on the cross-border movement of capital, out of India to anywhere else or vice versa. Capital account convertibility or CAC refers to the freedom to convert local financial assets into foreign financial assets or vice versa at marketdetermined rates of interest.If CAC is introduced along with current account convertibility it would mean full convertibility. Complete convertibility would mean no restrictions and no questions. In general, restrictions on foreign currency movements are placed by developing countries which have faced foreign exchange problems in the past is to avoid sudden erosion of their foreign exchange reserves which are essential to maintain stability of trade balance and stability in their economy. With Indias Forex reserves increasing steadily, it has slowly and steadily removed restrictions on movement of capital on many counts. The last few steps as and when they happen will allow an Indian individual to invest in Microsoft or Intel shares that are traded on NASDAQ or buy a

beach resort on Bahamas or sell home or small industry to Mr. James bond and invest the proceeds abroad without any restrictions

CURRENT AND CAPITAL ACCOUNT TRANSACTIONS Current Account Transactions-Section 2(j) defines a Current
Account Transaction as a transaction and without prejudice to the generality of the foregoing such transaction includes1. Payments due in connection with foreign trade, other current business, services and short term banking and credit facilities in the ordinary course of business, 2. Payments due as interest on loans and as net income from investments 3. Remittances for living expenses of parents, spouse and children residing abroad, and, Expenses in connection with foreign travel, education and medical care of parents, spouse and children. 4. Any person can sell or draw foreign exchange to or from authorized person if such sale or withdrawal is a current account transaction. Reasonable restriction on current account transactions can be imposed by Central Government in public interest, in consultation with RBI.

Capital Account Transactions

Section 2(e) of the Foreign

Exchange Management Act, 1999 defines a Capital Account Transaction as a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India, and includes transactions referred to in sub-section (3) of Section 6.

Following Capital Account Transactions are prohibited as per Foreign Exchange Management (Permissible Capital Account Transactions) Regulations, 2000 Transactions not permitted in FEMA - Capital account transactions not permitted in the FEMA Act, Rules or Regulations. In other words, all capital account transactions are prohibited, unless specifically permitted. In current account transactions the position is reverse, that is all current transactions are permitted unless specifically prohibited. Investment in certain sectors Foreign investment in India in any company, firm or proprietary concern engaged or proposing to engage in the following business is completely prohibited: Chit Fund Nidhi Company Agricultural or plantation activities Real Estate business or construction of farmhouses Trading in Transferable Development Rights (certificates issued in respect of land acquired for public purposes either by the Central Government or State Government in consideration of surrender of land by the owner without monetary consideration. The TDR is transferable in part or whole. In practice, the distinction between current and capital account transactions is not always clear-cut. There are transactions which straddle the current and capital account. Illustratively, payments for imports are a current account item but to the extent these are on credit terms, a capital liability emerges and with increase in trade payments, trade finance would balloon and the resultant vulnerability should carefully be kept in view in moving forward to FCAC. Contrarily, extending credit to exports is tantamount to capital outflows. As regards residents, the capital restrictions are clearly more stringent than for non-residents. Furthermore, resident corporate face a relatively more liberal regime than resident individuals. Till recently, resident

individuals faced a virtual ban on capital outflow but a small relaxation has been undertaken in the recent period. Section 4 of FEMA provides that no person resident of India shall acquire, hold, own, possess or transfer any foreign exchange, foreign security or any immovable property situated outside India, except as provided in the Act. According to Section 6(4), a person resident may hold, own, transfer or invest in foreign currency, foreign security or any immovable property situated outside India, if such currency, security or property was acquired, held or owned by such person when he was resident outside India or inherited from a person who was resident outside India. In addition to various remittances provided, a resident individual can remit upto USD 200,000 per financial year for permitted capital account and current account transactions under the Liberalized Remittance Scheme. Initially it was USD 25,000 when introduced in 2003, which was increased to USD 50,000 on 20-12-2006, then to USD 100,000 on 8-52007 and now to USD 200,000. There is justification for some liberalization in the rules governing resident individuals investing abroad for the purpose of asset diversification. The experience thus far shows that there has not been much difficulty with the present order of limits for such outflows. It would be desirable to consider a gradual liberalization for resident corporates/business entities, banks, non-banks and individuals. The issue of liberalization of capital outflows for individuals is a strong confidence building measure, but such opening up has to be well calibrated as there are fears of waves of outflows. The general experience is that as the capital account is liberalized for resident outflows, the net inflows do not decrease, provided the macroeconomic framework is stable.

Partial Convertibility: -

Considerable evidence has accumulated over the years that for most countries, deregulation of foreign trade transactions must precede deregulation of international capital account flows. For an economy in transition from a controlled to a market based one, international capital movements can be highly destabilizing and disruptive. It is essential that capital flows be regulated under a separate controlled regime during the initial movement towards convertibility. The PCR system introduced to combine the advantage of relatively suitable managed float and the BOP- balancing property of a freely floating rate. This involves creation of two exchange rate channels: a. A market channel in which the exchange rate is determined by market forces of free). b. An official channel where the exchange rate continues to be determined by RBI on the base of the value of rupee in relation to the basket of currencies and fixed, but access to the market is restricted. RBI introduced a system called the Liberalized Exchange Rate Management System (LERMS) effective from 1st March 1992. Till 1st March 1992 all foreign exchange remitted into India was implicitly handed over to RBI by Authorized Dealers (ADs) and then RBI made a Foreign exchange available for approved purpose. Under new system, the RBIs retention ratio has been reduced from 100% to 40% of all foreign exchange remittances received with effect from 1.3.1992. The ADs apply the official exchange rate in calculating the value of rupees to be paid to the remitter for this 40% and surrender the exchange to the RBI. The remaining 60% of the value of the remittance is purchased by AD at a market-determined exchange rate. AD s, retain this 60% portion for sale to other AD s, authorized broker or buyer of foreign exchange.
.

supply and demand of foreign exchange where

access if free for all transactions(other than those specified as not

Capital Account Convertibility

Capital Account Convertibility has 5 basic statements designed as points of action: 1. All types of liquid capital assets must be able to be exchanged freely, between any two nations, with standardized exchange rates. 2. The amounts must be a significant amount (in excess of $500,000). 3. Capital inflows should be invested in semi-liquid assets, to prevent churning and excessive outflow. 4. Institutional investors should not use Capital Account Convertibility to manipulate fiscal policy or exchange rates. 5. Excessive inflows and outflows should be buffered by national banks to provide collateral. The status of capital account convertibility in India for various nonresidents is as follows: for foreign corporates, and foreign institutions, there is a reasonable amount of convertibility; for non-resident Indians (NRIs) there is approximately an equal amount of convertibility, but one accompanied by severe procedural and regulatory impediments. For nonresident an individual other than NRIs, there is near-zero convertibility. Movement towards an Fuller Capital Account Convertibility implies that all non-residents (corporates and individuals) should be treated equally. This would mean the removal of the tax benefits presently accorded to NRIs via special bank deposit schemes for NRIs, viz., Non-Resident External Rupee Account [NR(E)RA] and Foreign Currency Non-Resident (Banks) Scheme [FCNR(B)]. Non-residents, other than NRIs, should be allowed to open FCNR(B) and NR(E)RA accounts without tax benefits, subject to Know Your Customer (KYC) and Financial Action Task Force (FATF) norms. In the

case of the present NRI schemes for various types of investments, other than deposits, there are a number of procedural impediments and these should be examined by the Government and the RBI. A person resident in India is permitted to open, hold and maintain with an Authorized Dealer in India a Foreign Currency Account known as Exchange Earners Foreign Currency (EEFC) Account subject to the terms and conditions of the Exchange Earners Foreign Currency Account Scheme specified. Further, all categories of foreign exchange earners are allowed to credit up to 100 per cent of their foreign exchange earnings, as specified in the paragraph 1 (A) of the Schedule, to their EEFC Account. All categories of foreign exchange earners are allowed to credit up to 100 per cent of their foreign exchange earnings, as specified in the paragraph 1 (A) of the Schedule, to their EEFC Account. As such, it will be in order for the Authorised Dealers to allow SEZ developers to open, hold and maintain EEFC Account and to credit up to 100 per cent of their foreign exchange earnings, as specified in the paragraph 1 (A) of the Schedule. Any person resident in India, i. may take outside India (other than to Nepal and Bhutan) currency notes of Government of India and Reserve Bank of India notes up to an amount not exceeding Rs.7,500 (Rupees seven thousand five hundred only) per person; and ii. who had gone out of India on a temporary visit, may bring into India at the time of his return from any place outside India (other than from Nepal and Bhutan), currency notes of Government of India and Reserve Bank of India notes up to an amount not exceeding Rs.7,500 (Rupees seven thousand five hundred only) per person. According to Regulation 7 of the Foreign Exchange Management (Foreign Currency Accounts by a Person Resident in India) Regulations, 2000,

i.

A citizen of a foreign State, resident in India, being an employee of a foreign company or a citizen of India, employed by a foreign company outside India and in either case on deputation to the office /branch /subsidiary /joint venture in India of such foreign company may open, hold and maintain a foreign currency account with a bank outside India and receive the whole salary payable to him for the services rendered to the office/branch/subsidiary/joint venture in India of such foreign company, by credit to such account, provided that income-tax chargeable under the Income-tax Act,1961 is paid on the entire salary as accrued in India.

ii.

A citizen of a foreign State resident in India being in employment with a company incorporated in India may open, hold and maintain a foreign currency account with a bank outside India and remit the whole salary received in India in Indian Rupees, to such account, for the services rendered to such an Indian company, provided that income-tax chargeable under the Income-tax Act, 1961 is paid on the entire salary accrued in India.

It would be desirable to consider a gradual liberalisation for resident corporates/business entities, banks, non-banks and individuals. The issue of liberalisation of capital outflows for individuals is a strong confidence building measure, but such opening up has to be well calibrated as there are fears of waves of outflows. The general experience is that as the capital account is liberalised for resident outflows, the net inflows do not decrease, provided the macroeconomic framework is stable. As India progressively moves on the path of convertibility, the issue of investments being channeled through a particular country so as to obtain tax benefits would come to the fore as investments through other channels get discriminated against. Such discriminatory tax treaties are not consistent with an increasing liberalisation of the capital account as distortions inevitably emerge, possibly raising the cost of capital to the host country. With global integration of capital markets, tax policies

should be harmonised. It would, therefore, be desirable that the Government undertakes a review of tax policies and tax treaties. A hierarchy of preferences may need to be set out on capital inflows. In terms of type of flows, allowing greater flexibility for rupee denominated debt which would be preferable to foreign currency debt, medium and long term debt in preference to short-term debt, and direct investment to portfolio flows. There are reports of large flows of private equity capital, all of which may not be captured in the data (this issue needs to be reviewed by the RBI). There is a need to monitor the amount of short-term borrowings and banking capital, both of which have been shown to be problematic during the crisis in East Asia and in other EMEs. Greater focus may be needed on regulatory and supervisory issues in banking to strengthen the entire risk management framework. Preference should be given to control volatility in cross-border capital flows in prudential policy measures. Given the importance that the commercial banks occupy in the Indian financial system, the banking system should be the focal point for appropriate prudential policy measures.

Background of Capital Account Convertibility :

Foreign exchange transactions are broadly classified into two types: current account transactions and capital account transactions. In the early nineties, Indias foreign exchange reserves were so low that these were hardly enough to pay for a few weeks of imports. To overcome this crisis situation, Indian Government had to pledge a part of its gold reserves to the Bank of England to obtain foreign exchange. However, after reforms were initiated and there was some improvement on FOREX front in 1994, transactions on the current account were made fully convertible and foreign exchange was made freely available for such transactions. But capital account transactions were not fully convertible.

The rationale behind this was clear. India wanted to conserve precious foreign exchange and protect the rupee from volatile fluctuations. By late nineties situation further improved, a committee on capital account convertibility was setup in February, 1997 by the Reserve Bank of India under the chairmanship of former RBI deputy governor S.S. Tarapore to "lay the road map" to capital account convertibility. The committee recommended that full capital account convertibility be brought in only after certain preconditions were satisfied. These included low inflation, financial sector reforms, a flexible exchange rate policy and a stringent fiscal policy. However, the report was not accepted due to Asian Crisis. The five-member committee has recommended a three-year time frame for complete convertibility by 1999-2000. The highlights of the report including the preconditions to be achieved for the full float of money are as follows:-

Pre-Conditions Set By Tarapore Committee:

Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5 per cent in 1997-98 to 3.5% in 1999-2000. A consolidated sinking fund has to be set up to meet government's debt repayment needs; to be financed by increased in RBI's profit transfer to the govt. and disinvestment proceeds. Inflation rate should remain between an average 3-5 per cent for the 3-year period 1997-2000 Gross NPAs of the public sector banking system needs to be brought down from the present 13.7% to 5% by 2000. At the same time, average effective CRR needs to be brought down from the current 9.3% to 3%. RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a neutral Real Effective Exchange Rate RBI should be transparent about the changes in REER.

External sector policies should be designed to increase current receipts to GDP ratio and bring down the debt servicing ratio from 25% to 20%.

Four indicators should be used for evaluating adequacy of foreign exchange reserves to safeguard against any contingency. Plus, a minimum net foreign asset to currency ratio of 40 per cent should be prescribed by law in the RBI Act. The Committee's recommendations for a phased liberalization of controls on capital outflows over the three year period which have been set out in detail in a tabular form in Chapter 4 of the Report, inter alia, include:(i) Indian Joint Venture/Wholly Owned Subsidiaries (JVs/WOSs) should be allowed to invest up to US $ 50 million in ventures abroad at the level of the Authorised Dealers (ADs) in phase 1 with transparent and comprehensive guidelines set out by the RBI. The existing requirement of repatriation of the amount of investment by way of dividend etc., within a period of 5 years may be removed. Furthermore, JVs/WOs could be allowed to be set up by any party and not be restricted to only exporters/exchange earners. ii) Exporters/exchange earners may be allowed 100 per cent retention of earnings in Exchange Earners Foreign Currency (EEFC) accounts with complete flexibility in operation of these accounts including cheque writing facility in Phase I. iii) Individual residents may be allowed to invest in assets in financial market abroad up to $ 25,000 in Phase I with progressive increase to US $ 50,000 in Phase II and US$ 100,000 in Phase III. Similar limits may be allowed for non-residents out of their non-repatriable assets in India

iv) SEBI registered Indian investors may be allowed to set funds for investments abroad subject to overall limits of $ 500 million in Phase I, $ 1 billion in Phase II and $ 2 billion in Phase III. v) Banks may be allowed much more liberal limits in regard to borrowings from abroad and deployment of funds outside India. Borrowings (short and long term) may be subject to an overall limit of 50 per cent of unimpaired Tier 1 capital in Phase 1, 75 per cent in Phase II and 100 per cent in Phase III with a sub-limit for short term borrowing. in case of deployment of funds abroad, the requirement of section 25 of Banking Regulation Act and the prudential norms for open position and gap limits would apply. vi) Foreign direct and portfolio investment and disinvestment should be governed by comprehensive and transparent guidelines, and prior RBI approval at various stages may be dispensed with subject to reporting by ADs. All non-residents may be treated on part purposes of such investments. vii) In order to develop and enable the integration of Forex, money and securities market, all participants on the spot market should be permitted to operate in the forward markets; FIIs, non-residents and non-resident banks may be allowed forward cover to the extent of their assets in India; all India Financial Institutions (FIs) fulfilling requisite criteria should be allowed to become full-fledged ADs; currency futures may be introduced with screen based trading and efficient settlement system; participation in money markets may be widened, market segmentation removed and interest rates deregulated; the RBI should withdraw from the primary market in Government securities; the role of primary and satellite dealers should be increased; fiscal incentives should be provided for individuals investing in Government securities; the Government should set up its own office of public debt.

viii) There is a strong case for liberalizing the overall policy regime on gold; Banks and FIs fulfilling well defined criteria may be allowed to participate in gold markets in India and abroad and deal in gold products. The assumption of the committee was that these pre-conditions would take care of possible problems created by unseen flight of capital. Given a sound fiscal and financial set-up, the flight of capital was unlikely to be large, particularly in the short run, as capital would be invested and not all of it would be in a liquid form.

Present

Status

Major

Pre-Conditions

by

Tarapore Committee
Status as on March 2006
1 Reduction in gross fiscal deficit to 3.5% by 1999-2000 .The present fiscal deficit is still at 4.1% (above the level of 3.5%). However, estimates for the next fiscal year are pegged at 3.8% 2. The inflation rate for 3 years should be an average 3% to 5%. Inflation at present is around 4.00%. 3. Forex reserves should at least be enough to cover 6 months import cover .The present forex reserves are enough to cover more than one years imports. 4. Gross NPAs to be brought down to 5% by 1999-2000 .Gross NPA for the banking sector is still marginally higher than 5% 5. CRR to be reduced to 3% by 1999-2000 .CRR is still at 5.00%

6. Interest Rate to be fully deregulated. All interest rates, except Saving Fund interest rates, have already been deregulated. The process of opening up the Indian economy has proceeded in steady steps. First, the exchange rate regime was allowed to be determined by market forces as against the fixed exchange rate linked to a basket of currencies. Second, this was followed by the convertibility of the Indian rupee for current account transactions with India accepting the obligations under Article VIII of the IMF in August 1994. Third, capital account convertibility has proceeded at a steady pace. RBI views capital account convertibility as a process rather than as an event. Fourth, the distinct improvement in the external sector has enabled a progressive liberalisation of the exchange and payments regime in India. Reflecting the changed approach to foreign exchange restrictions, the restrictive Foreign Exchange Regulation Act (FERA), 1973 has been replaced by the Foreign Exchange Management Act, 1999. Thus, at present in India we have restricted capital account convertibility. Indian entities (i.e. individuals, companies or otherwise) are allowed to invest or acquire assets outside India or a foreign entity remit funds for investment or acquisition of assets with specified cap on such investments and for specific purpose. A full convertibility will allow free movement of funds in and out of India without any restrictions on purpose and amount. Thus, after full convertibility is allowed, residents in India will be able to transfer money abroad and receive from other entities across the world. However, government will certainly make rules and

regulations to ensure these do not lead to money laundering or funding for illegal activities. Prime Minister Manmohan Singh on 18th March 2006 said that the country's economic position internally and externally had become 'far more comfortable' and it was worth looking into greater capital account convertibility. In a speech at the Reserve Bank of India (RBI) in the country's financial hub Mumbai, Prime Minister Manmohan Singh said he would ask the Finance Minister and RBI to come out with a roadmap to greater convertibility 'based on current realities'. PM also said "Given the changes that have taken place over the last two decades, there is merit in moving towards fuller capital account convertibility within a transparent framework," Singh said. RBI in its circular issued in March, 2006 has laid down that economic reforms in India have accelerated growth, enhanced stability and strengthened both external and financial sectors. Our trade as well as financial sector is already considerably integrated with the global economy. India's cautious approach towards opening of the capital account and viewing capital account liberalisation as a process contingent upon certain preconditions has stood India in good stead. Given the changes that have taken place over the last two decades, however, there is merit in moving towards fuller capital account convertibility within a transparent framework. There is, thus, a need to revisit the subject and come out with a roadmap towards fuller Capital Account Convertibility based on current realities. In consultation with the Government of India, the Reserve Bank of India has appointed a committee to set out the framework for fuller Capital Account Convertibility. The terms of reference of the Committee will be:

i. To review the experience of various measures of capital account liberalisation in India, ii. To examine implications of fuller capital account convertibility on monetary and exchange rate management, financial markets and financial system, iii. To study the implications of dollarisation in India of domestic assets and liabilities and internationalisation of the Indian rupee, iv. To provide a comprehensive medium-term operational framework, with sequencing and timing, for fuller capital account convertibility taking into account the above implications and progress in revenue and fiscal deficit of both Centre and states, v. To survey regulatory framework in countries which have advanced towards fuller capital account convertibility, vi. To suggest appropriate policy measures and prudential safe- guards to ensure monetary and financial stability, and vii. To make such other recommendations as the Committee may deem relevant to the subject. Technical work is being initiated in the Reserve Bank of India. The Committee will commence its work from May 1, 2006 and it is expected to submit its report by July 31, 2006. The Committee will adopt its own procedures and meet as often as necessary. The Reserve Bank of India will provide Secretariat to the Committee.

FACTORS WHICH ARE CRITICAL / OF CONCERN IN ADOPTING CAPITAL ACCOUNT CONVERTIBILITY:

There are number of issues which are of concern for adopting capital account convertibility. The impact of allowing unlimited access to short-term external

commercial borrowing for meeting working capital and

other domestic

requirements. In respect of short-term external commercial borrowings, there is already a strong international consensus that emerging markets should keep such borrowings relatively small in relation to their total external debt or reserves. Many of the financial crises in the 1990s occurred because the short-term debt was excessive. When times were good, such debt was easily accessible. The position, however, changed dramatically in times of external pressure. All creditors who could redeem the debt did so within a very short period, causing extreme domestic financial vulnerability. The occurrence of such a possibility has to be avoided, and we would do well to continue with our policy of keeping access to short-term debt limited as a conscious policy at all times good and bad. Providing unrestricted freedom to domestic residents to convert their domestic bank deposits and idle assets (such as, real estate), in response to market developments or exchange rate expectations. The day-to-day movement in exchange rates is determined by "flows" of funds, i.e. by demand and supply of spot or forward transactions in the market. Now, suppose the exchange rate is depreciating unduly sharply (for whatever reasons) and is expected to continue to do so for the near future. Now, further suppose that domestic residents, therefore, that they should convert a part or whole of their stock of domestic assets from domestic currency to foreign currency. This will be financially desirable as the domestic value of their converted assets is expected to increase because

of anticipated depreciation. And, if a large number of residents so decide simultaneously within a short period of time, as they may, this expectation would become self-fulfilling. A severe external crisis is then unavoidable. Although at present our reserves are high and exchange rate movements are, by and large, orderly. However, there can be events like Kargil ware or Pokhran Test, which creates external uncertainty, Domestic stock of bank deposits in rupees in India is presently close to US $ 290 billion, nearly three and a half times our total reserves. At the time of Kargil or Pokhran or the oil crises, the multiple of domestic deposits over reserves was in fact several times higher than now. One can imagine what would have had happened to our external situation, if within a very short period, domestic residents decided to rush to their neighborhood banks and convert a significant part of these deposits into sterling, euro or dollar. No emerging market exchange rate system can cope with this kind of contingency. This may be an unlikely possibility today, but it must be factored in while deciding on a long term policy of free convertibility of "stock" of domestic assets. Incidentally, this kind of eventuality is less likely to occur in respect of industrial countries with international currencies such as Euro or Dollar, which are held by banks, corporates, and other entities as part of their long-term global asset portfolio (as distinguished from emerging market currencies in which banks and other intermediaries normally take a daily long or short position for purposes of currency trade.

Impact of Capital Account Convertibility

After full convertibility is adopted by India, it will lead to acceptance of Indian Rupee currency all over the world. In case of two convertible currencies, Forward Exchange Rates reflect interest rate differentials between these two currencies. Thus, we can say that the Forward Exchange Rate for the higher interest rate currency would depreciate so as to neutralize the interest rate difference. However, sometimes there can be opportunities when forward rates do not fully neutralize interest rate differentials. eliminate the possibility of risk-less profits. Capital account convertibility is likely to bring depth and large volumes in long-term INR currency swap markets. Thus for a better market determination of INR exchange rates, the INR should be convertible. In such situations, arbitrageurs get into the act and forward exchange rates quickly adjust to

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