Full Convertibility of the Indian Rupee: An analysis of the Feasibility

Convertible currencies are defined as currencies that are readily bought, sold, and
converted without the need 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 profit.

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.

Partially convertible currency

The Indian rupee is only partially convertible due to the Indian Central Bank’s
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
India’s 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.

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 the quality of paper money substitutes which entitles the holder
to redeem them on demand into money proper.

CONVERTIBILITY – EVOLUTION OF THE CONCEPT

Historically, the banknote has followed a common or very similar pattern in the
western nations. Originally decentralized and issued from various independent
banks, it was gradually brought under state control and became a monopoly
privilege of the central banks. In the process, the fact that the banknote was
merely a substitute for the real commodity money (gold and silver) was gradually
lost sight of. Under the gold standard, banknotes were payable in gold coins. The
same way under the silver standard, banknotes were payable in silver coins, and
under a bi-metallic standard, payable in either gold or silver coins, at the option of
the debtor (the issuing bank).

Under the gold exchange standard banks of issue were obliged to redeem their
currencies in gold bullion. Due to limited growth in the supply of gold reserves,
during a time of great inflation of the dollar supply, the United States eventually
abandoned the gold exchange standard and thus bullion convertibility in 1974
Under the contemporary international currency regimes, all currencies’ inherent
value derives from fiat, thus there is no longer any thing (gold or other tangible
store of value) for which paper notes can be redeemed. One currency can be
converted into another in open markets and through dealers. Some countries
pass laws restricting the legal exchange rates of their currencies, or requiring
permits to exchange more than a certain amount. Thus, those countries’
currencies are not fully convertible. Some countries’ currencies, such as North
Korea’s won and Cuba’s national peso, cannot be converted.

Nations attempted to revive the gold standard following World War I, but it
collapsed entirely during the Great Depression of the 1930s. Some economists
said adherence to the gold standard had prevented monetary authorities from
expanding the money supply rapidly enough to revive economic activity. In any
event, representatives of most of the world’s leading nations met at Bretton
Woods, New Hampshire, in 1944 to create a new international monetary system.
Because the United States at the time accounted for over half of the world’s
manufacturing capacity and held most of the world’s gold, the leaders decided to
tie world currencies to the dollar, which, in turn, they agreed should be
convertible into gold at $35 per ounce.

Under the Bretton Woods system, central banks of countries other than the
United States were given the task of maintaining fixed exchange rates between
their currencies and the dollar. They did this by intervening in foreign exchange
markets. If a country’s currency was too high relative to the dollar, its central
bank would sell its currency in exchange for dollars, driving down the value of its
currency. Conversely, if the value of a country’s money was too low, the country
would buy its own currency, thereby driving up the price.

The Bretton Woods system lasted until 1971. By that time, inflation in the United
States and a growing American trade deficit were undermining the value of the
dollar. Americans urged Germany and Japan, both of which had favorable
payments balances, to appreciate their currencies. But those nations were
reluctant to take that step, since raising the value of their currencies would
increase prices for their goods and hurt their exports. Finally, the United States
abandoned the fixed value of the dollar and allowed it to “float” — that is, to
fluctuate against other currencies. The dollar promptly fell. World leaders sought
to revive the Bretton Woods system with the so-called Smithsonian Agreement in
1971, but the effort failed. By 1973, the United States and other nations agreed to
allow exchange rates to float.

Economists call the resulting system a “managed float regime,” meaning that
even though exchange rates for most currencies float, central banks still intervene
to prevent sharp changes. As in 1971, countries with large trade surpluses often
sell their own currencies in an effort to prevent them from appreciating (and
thereby hurting exports). By the same token, countries with large deficits often
buy their own currencies in order to prevent depreciation, which raises domestic
prices. But there are limits to what can be accomplished through intervention,
especially for countries with large trade deficits. Eventually, a country that
intervenes to support its currency may deplete its international reserves, making
it unable to continue buttressing the currency and potentially leaving it unable to
meet its international obligations.
FIXED AND FLOATING EXCHANGE RATES

Exchange Rate systems are classified on the basis of the flexibility that the
monetary authorities show towards fluctuations in the exchange rates and have
been traditionally divided into 2 categories, namely:
• systems with a fixed exchange rate
• systems with a flexible exchange rate.

In the former system the exchange rate is usually a political decision, in the latter
the prices are determined by the market forces, in accordance with demand and
supply. These systems are often referred to as Fixed Peg (sometimes also
described as “hard peg”) and Floating systems. But as usual, between these two
extreme positions there exists also an intermediate range of different systems
with limited flexibility, usually referred to as “soft pegs”.

Fixed Exchange Rate

A country’s decision to tie the value of its currency to another country’s currency,
gold (or another commodity), or a basket of currencies.

A fixed exchange rate is usually used to stabilize the value of a currency, against
the currency it is pegged to. This makes trade and investments between the two
countries easier and more predictable, and is especially useful for small
economies where external trade forms a large part of their GDP.

It can also be used as a means to control inflation. However, as the reference

value rises and falls, so does the currency pegged to it. In addition, according to
the Mundell-Fleming model, with perfect capital mobility, a fixed exchange rate
prevents a government from using domestic monetary policy in order to achieve
macroeconomic stability.

Fixing value of the domestic currency relative to that of a low-inflation country is

one approach central banks have used to pursue price stability. The advantage of
an exchange rate target is its clarity, which makes it easily understood by the
public. In practice, it obliges the central bank to limit money creation to levels
comparable to those of the country to whose currency it is pegged. When credibly
maintained, an exchange rate target can lower inflation expectations to the level
prevailing in the anchor country. Experiences with fixed exchange rates, however,
point to a number of drawbacks. A country that fixes its exchange rate surrenders
control of its domestic monetary policy.

A fixed currency exchange rate is one that is set by a government, usually through
a central bank. A currency is pegged to another currency at a certain rate. For
example, the Chinese yuan might be fixed to the U.S. dollar, meaning that its
exchange rate is held within a range, depending on the U.S. dollar. Some
countries fix their currencies to the Japanese yen or the euro. In other cases, a
fixed currency may be pegged to a basket of currencies.

The main criticism of a fixed exchange rate is that flexible exchange rates serve to
automatically adjust the balance of trade. When a trade deficit occurs, there will
be increased demand for the foreign (rather than domestic) currency which will
push up the price of the foreign currency in terms of the domestic currency. That
in turn makes the price of foreign goods less attractive to the domestic market
and thus pushes down the trade deficit. Under fixed exchange rates, this
automatic re-balancing does not occur.

The belief that the fixed exchange rate regime brings with it stability is only partly
true, since speculative attacks tend to target currencies with fixed exchange rate
regimes, and in fact, the stability of the economic system is maintained mainly
through capital control. A fixed exchange rate regime should be viewed as a tool
in capital control.

For instance, China has allowed free exchange for current account transactions
since December 1, 1996. Of more than 40 categories of capital account, about 20
of them are convertible. These convertible accounts are mainly related to foreign
direct investment. Because of capital control, even the renminbi is not under the
managed floating exchange rate regime, but free to float, and so it is somewhat
unnecessary for foreigners to purchase renminbi.

Floating Exchange Rate

A floating currency is one that is more influenced by the market. Supply and
demand sets the exchange rate. For example, if more people want to buy euros,
and sell dollars to do so, the value of the euro rises in response, while the value of
the dollar — relative to the Euro falls in forex trading.

In the modern world, the majority of the world’s currencies are floating. Central
banks often participate in the markets to attempt to influence exchange rates, but
such interventions are becoming less effective and less important as the markets
have become larger and less naive. Such currencies include the most widely
traded currencies: the United States dollar, the euro, the Japanese yen, the British
pound, the Swiss franc and the Australian dollar.

The Canadian dollar most closely resembles the ideal floating currency as the
Canadian central bank has not interfered with its price since it officially stopped
doing so in 1998. The US dollar runs a close second with very little changes in its
foreign reserves; by contrast, Japan and the UK intervene to a greater extent.
From 1946 to the early 1970s, the Bretton Woods system made fixed currencies
the norm; however, in 1971, the United States government abandoned the gold
standard, so that the US dollar was no longer a fixed currency, and most of the
world’s currencies followed suit.

It is not possible for a developing country to maintain the stability in the rate of
exchange for its currency in the exchange market. There are two options open for
them-
1. Let the exchange rate be allowed to fluctuate in the open market according to
the market conditions, or
2. An equilibrium rate may be fixed to be adopted and attempts should be made
to maintain it as far as possible.

If there is a fundamental change in the circumstances, the rate should be changed

accordingly. The rate of exchange under the first alternative is known as
fluctuating rate of exchange and under second alternative, it is called flexible rate
of exchange. In the modern economic conditions, the flexible rate of exchange
system is more appropriate as it does not hamper the foreign trade.

In cases of extreme appreciation or depreciation, a central bank will normally

intervene to stabilize the currency. Thus, the exchange rate regimes of floating
currencies may more technically be known as a managed float. A central bank
might, for instance, allow a currency price to float freely between an upper and
lower bound, a price “ceiling” and “floor”. Management by the central bank may
take the form of buying or selling large lots in order to provide price support or
resistance, or, in the case of some national currencies, there may be legal
penalties for trading outside these bounds.

A free floating exchange rate increases foreign exchange volatility. There are
economists who think that this could cause serious problems, especially in
emerging economies. These economies have a financial sector with one or more
of following conditions:
• high liability dollarization
• financial fragility
• strong balance sheet effects

When liabilities are denominated in foreign currencies while assets are in the local
currency, unexpected depreciations of the exchange rate deteriorate bank and
corporate balance sheets and threaten the stability of the domestic financial
system.

For this reason emerging countries appear to face greater fear of floating, as they
have much smaller variations of the nominal exchange rate, yet face bigger shocks
and interest rate and reserve movements. This is the consequence of frequent
free floating countries’ reaction to exchange rate movements with monetary
policy and/or intervention in the foreign exchange market.

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 includes-
1. 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
4. Expenses in connection with foreign travel, education and medical care of
parents, spouse and children.
Any person can sell or draw foreign exchange to or from authorized person if such
sale or drawal 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 corporates 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 Liberalised 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 8-5-2007 and now to USD 200,000.

There is justification for some liberalisation 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 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.

CAPITAL ACCOUNT CONVERTIBILITY

Capital 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 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.

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 non-residents 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 non-resident individuals 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
Earner’s Foreign Currency (EEFC) Account subject to the terms and conditions of
the Exchange Earner’s 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.

RUPEE AS A CONVERTIBLE CURRENCY AND ITS IMPLICATIONS

The recent decision of the government to have full convertibility of the Indian
Rupee which will affect everyone in the country but is remotely understandable
by a few, is one such important decision, which is designed to please the
international financial institutions and the 10 percent of the population of India
who are either rich or of upper middle class.

It is essential to judge a policy by examining both the costs and benefits of it. The
government is talking about the illusory benefits of this convertibility, which will
basically remove all obstacle to the free flow of money and as a result goods and
services also can move freely. The government, in a fully convertible regime, will
not be able to control these flows directly. Indirect controls will be implemented
by changing interest rates and taxes but the effectiveness of this control
according to the international experiences is uncertain.

Advantages
The benefits of free flows of money in a fully convertible regime means foreigners
would be able to invest in the Indian stock markets, buy up companies and
property including land (unless there are restrictions). Indian people and
companies can import anything they would like, buy shares of foreign companies
and property in foreign lands and can transfer money as they please without
going through the Hawala business. Indians who have not paid their taxes or
repaid their loans taken from the Indian banks will be free to transfer their money
to foreign countries outside the jurisdiction of the Indian authority.

The expected benefits for India would depend on the attractiveness of the
country as a safe destination for short-term investments. Long-term investments
do not depend on convertibility. China has no convertibility, instead a fixed
exchange rate for the last 12 years. Yet, China is the most important destination
for long-term foreign investments. Thus, discussions about the full convertibility
should be about the desirability of short-term investments and their implications.

Short term investments i.e., foreign investments in shares and bonds of the Indian
companies and Indian government depend on the demonstration of profit of the
Indian companies and the continuous good health of the Indian economy in terms
of low budget deficits, low balance of payments deficits, low level of government
borrowings and low level of non-performing loan in the Indian banking system.
From these points of view India cannot be a very attractive destination as the
health of the economy despite of the propaganda of the Indian government is
very weak with huge government debt, revenue deficits, Rs.150,000 Crores of
uncollected taxes and Rs.120,000 Crores of unpaid loans in the banks, increasing
price of petroleum and increasing balance of payments deficits of the country.
With 80 percent of people live on less than 2 dollars a day, and 70 percent of the
people live on less than 1 dollar a day, profitable market in India is also very small.
If the Indian companies working under these constraints cannot demonstrate
good and continuous profit, short-term investments will fly out very easily if there
is any sign of economic downturn when there is a fully convertible Rupee. The
result will be further increase in the balance of payments deficits and fall of the
exchange rate of Rupee, which will provoke Indians to take their money out of
India.

Another advantage of full convertibility of Rupee for the Indian rich is that they
can import as they like and buy properties abroad as they were allowed to do so
during the days of British Raj. It has certain advantages for the Indian companies
who will be able to import both raw materials and machineries or set up foreign
establishments at will.

Disadvantages

Full convertibility also has adverse consequences for the India’s domestic
producers of these raw materials and machineries, as they have to compete
against foreign suppliers who like Chinese may have deliberate low rate of
exchange for their currencies thus making their goods low in price. Foreign
suppliers also can be supported by all kinds of subsidies by their government so as
to make their prices very low. Agricultural exports from Europe, USA, Thailand,
and Australia can ruin India’s own agriculture.

There are many such historical examples in India. Within 20 years between 1860
and 1880, India’s domestic manufacturing industries were wiped out by free trade
and convertible Rupee during the days of British Raj. Indian farmers during those
days could not cultivate their lands, as the imported food products were cheaper
than whatever they could produce. Demonstration of wealth by the Nawabs and
Maharajas of India in Paris and London during the days of British Raj has not done
any good for starving millions of India but was responsible for massive misuse of
India’s foreign currency reserve created by the sweat and blood of the India’s
poor in those days. Full convertibility of Rupee and free trade may bring back
those dark days.

The freedom for India’s rich to buy companies and property abroad may lead to
massive diversion of funds from investments in the home economy of India to
investments abroad. This would amount to export of jobs to foreign countries
creating more and more unemployment at home. Japan in recent years suffers
from this phenomenon, where increasingly Japanese companies are transferring
funds to China for investments, taking advantage of the very low wage rate and
low exchange rate of Yuan, thus creating unemployment at home. Although China
has massive surplus in the balance of payments, huge reserve of dollars and
gigantic flows of foreign investments, a non-convertible Yuan and controls on
transfer of money have kept China’s exchange rate low enough so that Chinese
goods can capture the markets of every important country of the world.
The most dangerous consequence of convertibility is that Rupee will be under the
control of currency speculators. A fully convertible regime for the Rupee will
certainly include participation of Rupee in the international currency market and
in the ‘future market’ of Rupee, the playground for the international speculators.
It is very much possible for the speculators to buy massive amount of Rupee to
drive up its exchange rate and then they can suddenly sell all to gain enormous
profit. That will drive down Rupee to a very low depth suddenly. If the Reserve
Bank of India wants to protect Rupee in such a situation, within a few days India
will have no foreign exchange left in reserve and the country will go bankrupt.

CONCLUSION

The rupee exchange rate is neither completely free-floating nor fixed, but is
“managed” by the Reserve Bank of India through buying and selling other
currencies. Up until April, the Reserve Bank was buying lots of U.S. dollars —
perhaps as much as $24 billion in the previous six months — to keep the rupee at
around 44 to the dollar. But with investor sentiment so hot on India and money
pouring in from abroad — international investors have bought more than $7.5
billion worth of Indian stocks so far this year, compared to $8 billion in all of 2006
— the Reserve Bank found itself having to spend more and more on foreign
currencies just to keep the rupee stable. When inflation shot up to over 6% in
April, Bank officials appeared to decide — they never comment explicitly on such
matters — to stop buying dollars. The result was, over the next couple of months,
a strengthening of the rupee to close to 40 to $1.

Convertibility of Rupee will give pleasure to the 10 percent of Indian people who
are either rich or upper middle class, traders in the stock market, speculators,
bankers, and accountants. The rest 90 percent of the people will be adversely
affected with loss of employments in the manufacturing sector and bankruptcy in
the agricultural sector and total economic uncertainly.

During the days of the British Raj, Rupee was convertible, India had very large
surplus in the balance of payments. India’s share in the world trade was much
higher than what it is today. However, millions of Indians used to starve to death
from time to time; millions of acres of land were left uncultivated by the bankrupt
farmers; there were hardly any industry except for a few textile mills, only 15
percent of the population had any education at all. Yet at the same time, one
could buy Rolls Royce and Scotch whisky in Bombay and Calcutta; Jinnah could
buy his apartment in Bond Street of London; Maharaja of Patiala could build
palace in Paris. We are returning back to those days through the acts of an un-
elected (only selected for the upper hose of the parliament) Prime Minister Man
Mohan Singh whose loyalty is not to the people of India but to the international
financial institutions.

In any democratic country for any serious matter like turning the Rupee into a
convertible currency there must be referendums. There were referendums in
each and every European country when they wanted to create the European
monetary system whereby each European currency would be aligned to each
other to create a common currency Euro. Although India claims to be a
democracy, Indian policy makers try their best to avoid the public opinion, even
the parliament. Major issues like India’s membership of the World Trade
Organization, abolition of the planned economy and privatization of public assets,
free trade, and now the convertibility of Rupee should be debated in the
parliament and people of India should be allowed to give their verdict in
referendums if India wants to be a true democracy.

The strengthening rupee may also send an even more important signal: India is
not China. It helps of course that India’s trade surplus with the U.S. last year was
just $11.7 billion compared to China’s whopping $232.5 billion. But by allowing
the rupee to strengthen over the past few months, India is showing it’s prepared
to play much more fairly in the global market. India is seen as a more or less
unambiguous ally to the U.S.

Of course, the Reserve Bank could still intervene to push India’s rupee lower
again. But both the anonymous government official warning of rupee-related job
losses and investors see the rupee continuing to rise in the coming months. If that
happens expect to hear a lot more bleating from India’s exporters — and not a
word of complaint from India’s trading partners around the world.

Capital account convertibility is considered to be one of the major features of a

developed economy. It helps attract foreign investment. It offers foreign investors
a lot of comfort as they can re-convert local currency into foreign currency
anytime they want to and take their money away.

At the same time, capital account convertibility makes it easier for domestic
companies to tap foreign markets. At the moment, India has current account
convertibility. This means one can import and export goods or receive or make
payments for services rendered. However, investments and borrowings are
restricted.

But economists say that jumping into capital account convertibility game without
considering the downside of the step could harm the economy. The East Asian
economic crisis is cited as an example by those opposed to capital account
convertibility.

Even the World Bank has said that embracing capital account convertibility
without adequate preparation could be catastrophic. But India is now on firm
ground given its strong financial sector reform and fiscal consolidation, and can
now slowly but steadily moves towards fuller capital account convertibility.