Current account convertibility refers to the freedom to convert a country's currency into foreign currencies for trade-related transactions like imports, exports, and investment income. Capital account convertibility extends this freedom to include converting a country's currency for financial transactions like purchasing foreign assets and securities. A country can have partial convertibility by allowing currency conversion for some current account transactions but maintaining controls over capital account transactions.

1. CURRENT ACCOUNT CONVERTIBILITY OF INDIAN
RUPEES
A
PROJECT REPORT
Submitted to the faculty of Management
In partial fulfillment of requirements for the degree of
Post Graduate Diploma
In
Foreign Trade
SINHGAD BUSINESS SCHOOL
SUBMITTED BY
MANISH NAGAR
PGDFT II SEM
SBS - 110004
1

2. `
CERTIFICATE
This is to certify that the project entitled “CURRENT ACCOUNT
CONVERTIBILITY OF INDIAN RUPEES” has been carried out by
MANISH NAGAR under my guidance in partial fulfillment of the requirement
for the degree of Post Graduate Diploma In Foreign Trade during academic year
2011-2012.
GUIDE DIRECTOR
Mrs. Prashant pawar Mrs. M.S.Sathe
.
2

3. ACKNOWLEDGEMENT
I take this opportunity to express my deep sense of gratitude and indebt-
ness to Mrs.prashant pawar under whose able guidance the present work has
been completed. I am very thankful devotion of help and Suggestions.
I am also thankful to my whole teacher staff for their direct indirect
support to me.
Manish nagar
3

4. Index
Sr. pg.no
No.
1 Introduction 5
2 Convertibility why? 7
3 What does current account convertibility means? 8
4 Types of convertibility 9
5 Types of accounts 13
6 Impacts of current and capital account convertibility 14
7 Benefits of current and capital account convertibility 16
8 Convertibility on Current Account 19
9 Current Situation on Current Account 21
10 Path that lead to Current Account Convertibility 22
11 Necessary reforms, policies and pre-conditions 29
12 Limitations 48
13 Conclusion 49
4

5. Introduction
Each country has its own currency through which both national and
international transactions are performed. All the international business
transactions involve an exchange of one currency for another. For example, If
any Indian firm borrows funds from international financial market in US dollars
for short or long term then at maturity the same would be refunded in particular
agreed currency along with accrued interest on borrowed money. It means that
the borrowed foreign currency brought in the country will be converted into
Indian currency, and when borrowed fund are paid to the lender then the home
currency will be converted into foreign lender’s currency. Thus, the currency
units Of a country involve an exchange of one currency for another. The price
of one currency in terms of other currency is known as exchange rate.
The foreign exchange markets of a country provide the mechanism of
exchanging different currencies with one and another, and thus, facilitating
transfer of purchasing power from one country to another. With the multiple
growths of international trade and finance all over the world, trading in foreign
currencies has grown tremendously over the past several decades. Since the
exchange rates are continuously changing, so the firms are exposed to the risk
of exchange rate movements. As a result the assets or liability or cash flows of a
5

6. firm which are denominated in foreign currencies undergo a change in value
over a period of time due to variation in exchange rates. This variability in the
value of assets or liabilities or cash flows is referred to exchange rate risk. Since
the fixed exchange rate system has been fallen in the early 1970s, specifically in
developed countries, the currency risk has become substantial for many
business firms. As a result, these firms are increasingly turning to various risk
hedging products like foreign currency futures, foreign currency forwards,
foreign currency options, and foreign currency swaps. Convertibility
essentially means the ability of residents and non-residents to
exchange domestic currency for foreign currency, without limit,
whatever is the purpose of the transactions.
6

7. Convertibility: why?
Externally inconvertible currencies may be of rather limited value to their
holder. An exported item from a developing country to the USSR, for example,
may be paid for in rubles or the currency of a country that has ratified Article
VIII. The proceeds may be used to purchase goods anywhere.
In considering possible import suppliers, therefore, a developing country will
have some interest in directing its importers to those countries that will have
some interest in directing its importers to those countries whose inconvertible
currencies are in large supply. This is, of course, a case of trade discrimination
that is condemned by traditional theory. This means that goods are not being
purchased from the cheapest source. Recent economic writing has, however,
reopened the question in view of the continued existence of inconvertible
currencies. Where it is profitable on the export side to trade with countries
maintaining inconvertible currencies, and the government wishes to encourage
imports from those countries to offset its credit balances, it will utilize its
exchange distribution mechanism to limit the availability of convertible
exchange where there are alternative suppliers of the same type of goods in
inconvertible currency countries.
7

8. What exactly does current account convertibility of rupee means?
Current Account Convertibility means that rupee can now be freely
convertible into any foreign currencies for acquisition of assets like shares,
properties and assets abroad. Further, the banks can accept deposits in any
currency. At present, Indian rupee was partly convertible on current account. It
provided flexibility to buy or sell foreign exchange for specific activities like
payments for trade related activities, interest payments, remittances, business
expenses etc. Further, an individual was allowed to buy shares worth $ 25,000
per anumn only. India has come a long way from the FERA, 1947 to FERA,
1973 and now to FEMA, 2000. It has seen the days from non-convertibility of
money to partial convertibility of money. Now, after the instructions from the
PM, the finance minister Mr. P. Chidambaram said that RBI and centre shall
announce steps for greater convertibility of rupee. This reform shall mean a lot
for our country’s development and growth plus it shall mark a new era in terms
of globalization and liberalization. For an economy which was so close, such a
step is indeed a landmark – a mile stone achieved.
8

9. Types of convertibility
9

10. Current account convertibility
Current account is defined as including the value of trade in merchandise,
services, investment, income and unilateral transfers. Current account
convertibility, being essential to the development of multilateral trade, three
approaches to current account convertibility has been adapted by developing
countries. These are the pre-announcement, by-product, and front-loading
approaches. Each approach is distinguished by the importance it attaches to
convertibility relative to other economic objectives.
Capital account convertibility
Capital account includes transactions of financial assets. Its convertibility refers
to the freedom to convert local financial assets into foreign assets in any form
and vice versa at market-determined rates of exchange. Capital controls
normally restrict or prohibit cross-border movement of capital. Thus, controls
on capital movements include prohibitions: need for prior approval;
authorization and notification; multiple currency practices; discriminatory taxes;
and reserve requirements or interest penalties imposed by the authorities that
regulate the conclusion or execution of transactions. The coverage of the
regulations would apply to receipts as well as payments and to actions initiated
by non-residents and residents.
10

11. To begin with let’s understand the concept of currency convertibility. Currency
convertibility may be defined as the freedom to convert one currency into other
internationally accepted currencies. Thus in a CAG regime the country places
no exchange controls or restrictions on foreign exchange transactions. There are
two forms of convertibility – convertibility for current international transactions
and the convertibility for international capital movements. While India is still to
opt for full Capital Account Convertibility, the government has made the rupee
convertible on the current account. This implies that companies and resident
Indians can make and receive payments for import/export of goods and services
and be able to access foreign currency for travel, education, medical or other
designated purposes. Though there is no formal definition of CAC, the Tarapore
Committee provides some clarity in this regard as it defines the same as - the
freedom to convert local financial assets into foreign financial assets and vice
versa at market determined rates of exchange. In other words, Capital account
convertibility means that the home currency can be freely converted into foreign
currencies for acquisition of capital assets abroad. Thus, implementation of the
capital account convertibility regime will allow Indian residents to invest,
disinvest or transact in any property or assets/liability of any country, convert
one currency to another or move funds anywhere in the world, solely guided by
discretion of the concern individual or company & not restricted by law.
11

12. External and internal convertibility
when all holdings of the currency by non-residents are freely exchangeable into
any foreign (non- resident) currency at exchange rates within the official
margins than that currency is said to be externally convertible. All payments
that residents of the country are authorized to make to non-residents may be
made in any externally convertible currency that residents can buy in foreign
exchange markets. And if there are no restrictions on the ability of a country to
use their holdings of domestic currency to acquire any foreign currency and
hold it, or transfer it to any nonresident for any purpose, that country’s currency
is said to be internally convertible. Thus external convertibility is the partial
convertibility and total convertibility is the sum of external and internal
convertibility.
TYPES OF ACCOUNTS:
12

13. Current Account:
A record of all international transactions for goods and services. The
current account combines the transactions of the trade account and the services
account. Merchandise Trade Account: A record of all international transactions
for goods only. Goods include physical items like autos, steel, food, clothes,
appliances, furniture, et al
Services Account:
A record of all international transactions for services only. Services include
transportation, insurance, hotel, restaurant, legal services, Consulting, et al
13

14. Impacts of current and capital account convertibility
Impact on corporate sector
However, it is interesting to note the impact which such free flow of currency
would have on Indian corporate. In the last two–three years we have been
witnessing the growing phenomena of India Inc. being on the acquisition spree
abroad. In 2002 while Indian companies acquired 49 companies the same has
grown to around 100 with total money used for the same increasing from US $
1800 mn to US $ 2300 mn during the same period. The trend which was earlier
restricted to certain sectors like information technology has now spread across
the industries whether it is automobile, pharmaceuticals, auto-ancillary, ITES
(IT Enabled Services) and so on. In the overseas markets Indian companies are
buying out even bigger size companies in order to become a globally efficient
company and thus tackle the global competition successfully. Also The
acquisition drive in 2005 was not restricted to traditional US and UK but Indian
companies went to countries as diverse as Australia, Romania, Germany,
Bulgaria, South Africa etc. Ushering of CAC regime would facilitate the
process of globalization of India Inc. as a whole. This is because so far Indian
companies have been predominantly utilizing the proceeds from the overseas
issues like ECB (External Commercial Borrowing), FCCB (Foreign Currency
Convertible Bonds) to finance their overseas buyout. However, this indirect
14

15. route has been delaying the actual acquisition process and the consequent
integration of the acquired entity with the rest of the business of the acquiring
company. But if there no restriction on foreign currency availability for Indian
company then it would substantially boost their financial flexibility. They can
expedite the process of International acquisition once the target company is
identified. Thus, overseas buy outs would be very fast and efficient which in
turn would reduce the time period required to enjoy benefit of the acquisition
done.
Increasing globalization
Making the overseas acquisition hassle free would also provide an impetus to
the entire process of Indian companies truly becoming global size with more
number of companies opting for it which were restrained so far due to limited
access to international funds. In fact this could be high time for Indian
government to speed up the CAC reforms since there are several US companies
going bankrupt in the recent months whereas Indian companies has not taken
the advantage of it so far. Thus creation of more conducive environment & free
exchange of currencies would create a policy background which would enable
Indian companies to acquire overseas companies more aggressively going
forward.
Benefits of current and capital account convertibility
15

16. Apart from the above mentioned benefits Indian corporate sector would also
enjoy certain benefits in the long term. In this entire procedure companies with
high focus on exports & globalization would benefit immensely. Thus the top
rung companies from the software, textile, pharma, auto, auto components
industries having growing and substantial export revenues would have added
advantage. This is due to the fact that it would result into hassle free movement
of the currencies which would ensure that they can more efficiently utilize the
overseas earnings. Also this will simplify the investment diversification process
for Indian companies as they will have greater choice of parking their surplus
funds with global investment venues at their disposal. So not only Indian
citizens but corporate India will also have wider investment options and can
spread their investment across various countries.
OVERVIEW OF THE FOREIGN EXCHANGE MARKET IN INDIA
16

17. During the early 1990s, India embarked on a series of structural reforms in the
foreign exchange market. The exchange rate regime, that was earlier pegged,
was partially floated in March 1992 and fully floated in March 1993. The
unification of the exchange rate was instrumental in developing a market-
determined exchange rate of the rupee and was an important step in the progress
towards total current account convertibility, which was achieved in August
1994. Although liberalization helped the Indian forex market in various ways, it
led to extensive fluctuations of exchange rate. This issue has attracted a great
deal of concern from policy-makers and investors. While some flexibility in
foreign exchange markets and exchange rate determination is desirable,
excessive volatility can have an adverse impact on price discovery, export
performance, sustainability of current account balance, and balance sheets. In
the context of upgrading Indian foreign exchange market to international
standards, a well- developed foreign exchange derivative market (both OTC as
well as Exchange-traded) is imperative With a view to enable entities to manage
volatility in the currency market, RBI on April 20, 2007 issued comprehensive
guidelines on the usage of foreign currency forwards, swaps and options in the
OTC market. At the same time, RBI also set up an Internal Working Group to
explore the advantages of introducing currency futures. Current Account
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18. It refers to currency convertibility required in the case of transactions relating to
exchange of goods and services, money transfers and all those transactions that
are classified in the current account.
In Short, Current account includes all transactions, which give rise to or use of
our National income
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)
18

19. Convertibility on Current Account
India is fully convertible on the current account A full convertibility means
movement of funds in & out of India without any restrictions &
permissions.Provides full freedom to both residents and non-residents to trade
in goods/services. RBI has placed a cap in creation of a capital asset In India,
most current account transactions have been freed from controls over the years.
Current account convertibility 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.
Liberalization of current account transactions leading to current account
convertibility a compositional shift in capital flows away from debt- to non-
debt-creating flows strict regulation of external commercial borrowings,
especially short-term debt discouraging volatile elements of flows from
nonresident Indians gradual liberalization of outflows disintermediation of the
government in the flow of external assistance Introducing a market-determined
exchange rate regime
19

20. Dual exchange rate system
Liberalised Exchange Rate Management System involving dual exchange rate
system was instituted in March 1992 The dual exchange rate system was
essentially a transitional stage leading to the ultimate convergence of the dual
rates made effective from March 1, 1993 Two rates of exchange: Official rate of
exchange & Market rate of exchange 60% of the export earnings could be
converted at the free market determined rate. (which was around Rs.28) The
balance 40% of the earnings should be sold to RBI through authorised dealers
at the Official rate of exchange. (generally higher at Rs.32)
Full convertibility of the current account
This unification of exchange rates brought about the era of market determined
exchange. Rate regime of rupee, based on demand and supply in the forex
market.Liberalize the access to foreign exchange for all current business
transactions including travel, education, medical expenses, etc.Under Article
VIII of the IMF’s Articles of Agreement in August 1994.
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21. Current Situation on Current Account
India is fully convertible on the current accountProvides full freedom to both
residents and non-residents to trade in goods/services. RBI has placed a cap in
creation of a capital asset
21

22. Path that lead to Current Account Convertibility
Economists understand that capital mobility, fixed exchange rates and interest
rates autonomy cannot exist together in any economy. The effects of monetary
and fiscal policy in an open economy depend on capital mobility. Under
floating exchange rates, monetary policy is a powerful tool for policy.
Developing countries that seek to manage all three of the ingredients through
policy often attempt (like India) to adopt a ‘moving peg’ system that corrects
exchange rates through a series of time lagged steps. The problem in this
22

23. approach is that the central bank (the RBI, for example) has to intervene
periodically in the market to buy or sell dollars to prop up the current exchange
rate. Resident Indians are allowed to invest abroad without any limits. Non
Resident Indians (NRI) [now a very wide term] is allowed to repatriate proceeds
of their assets sold in India. Permitted allowances for business travel, education,
health, etc., are extremely generous. The ceilings on corporate investments
abroad or in joint ventures are very liberal, as also for securing external debt. In
2005-2006, repatriation from India in the form of interest and dividend
payments as well as profits of corporate was in excess of US$10 billion, the
highest figure ever in the last five decades. Thus, in most respects, there is
almost total current account flexibility. It is, however, true that the Indian rupee
is still not an ‘international’ currency, that is, it cannot be bought and sold in the
exchange market. Up to 1991, when India faced a major foreign exchange
crisis, there had been very rigid controls on both the external capital as well as
the current account. The liberalization process that started after 1991 and the
terms of the IMF conditionality helped to relieve the current account
transactions and the resulting growth and investments in the economy
augmented the forex reserves of the country. The improvements encouraged the
government to set up a committee in 1997 to spell out a road map for the full
convertibility of the rupee. First was that gross fiscal deficit as a percentage of
GDP should go down from 4.5% budgeted for 1997-98 to 3.5% by 2000.The
gross fiscal deficit, on the other hand, increased to 5.9% in 2002-2003? It only
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24. came down to 4.1% in 2005-06. It is targeted to come down to 3.8% in 2006-07,
but still not close to the 3 % that is required by the Fiscal Responsibility Budget
Management Act. There is also the concern about stated fiscal deficits that had
reached high levels, and have only recently started coming down. Another
precondition was that the annual rate of inflation should be in the 3% to 5%
range. This has been maintained in India for over a decade and is close to 5%
now. However, higher energy and commodity prices are likely to be a cause for
concern on this front. The third precondition was that the foreign exchange
reserves of the country should be sufficient for six months’ imports.
Phenomenal increases in foreign exchange reserves were seen after 1999-2000.
In 2002-2003 alone, the reserves grew by US$21.3 billion. At present, foreign
exchange reserves are equal to two years import cover. The final condition was
that non-performing assets of banks should not be more than five percent of the
deposits. This is close to being reached. Soon after the submission of the report
in 1997, the East Asian crisis broke and there was rethinking on the issues of
full convertibility. In fact, economists all over, including the IMF, started
advocating a more gradual approach. The policy developments of the
subsequent years focused on gradual relaxations of the exchange rate regime,
more oriented towards greater flexibility for trade and investment than for
macroeconomic management of monetary or fiscal policy. The relaxations have
progressively extended to most sectors of the economy, and for quite some time
now, there have been suggestions for clarity of policy in respect of CAC.
24

25. The need for a clear road map at this stage arises from several considerations.
The floating peg regime that the RBI is implementing is becoming untenable.
As long as the RBI had significant quantities of government bonds to unload, it
could sterilize the liquidity caused by the buying of dollars by the release of
these bonds into the market. As the stocks of these bonds ran out, a new
mechanism of market sterilization bonds was thought up in 2004, by which the
RBI continues the sterilization process through the issue of these instruments.
As these are off the Consolidated Fund of India and do not enter into the
revenue streams of the government, they do not add to the fiscal deficit, though
the interest on these is to be paid for by the budget and has, to that extent, a
fiscal implication. It is an ad-hoc measure intended to have a control over
liquidity and hence over interest rates and inflation, but not a measure that
would be able to be used long term. It has succeeded moderately in the last year
due to lower needs of sterilization as current account flows turned negative last
year. There is increasing exposure of firms to external currency borrowing and
this requires a stable currency regime to be in place urgently. When the central
bank intervenes in the currency market, it creates an illusion that the currency is
not volatile, and this encourages firms, banks and governments to be reckless in
dollar borrowing. Borrowers tend not to hedge currency risks. When the central
bank is no longer able to sustain this illusion, there are sharp currency
movements that inevitably hurt the borrowers. Sound policies require that the
government should not have dollar liabilities. In India, de facto dollar
25

26. borrowing is taking place through devices such as bond issues by the Securities
and Exchange Board of India (SEBI) or NRI deposits of banks. Since banks are
not allowed to bust, these are actually sovereign liabilities. It should make sense
to allow Foreign Institutional Investors (FIIs) to access rupee borrowings and to
discourage firms from external borrowings until the currency regime and the
currency derivatives are in good shape. But, at the moment, the reverse is the
case. The problem is exacerbated by the fact that the rupee is pegged to the
United States dollar. Borrowers are encouraged by the belief that the dollar is a
safe currency. As the rupee/dollar exchanges lurch into periods of volatility, it
would hurt the borrowers and the institutions significantly. Thirdly, progressive
relaxations of controls have led to anomalies in terms of opportunities for
investments and repatriation. The slew of regulations on FDI, on investment in
external primary markets, on internal fund flows etc require a complex
regulatory policing that the banks, the RBI and SEBI are finding difficult to
handle. Several of these regulations have loopholes that are being exploited. An
important example is the use of Participatory Notes in the financial markets.
These are funds at the hands of FIIs that have been subscribed to by unknown
institutions and individuals, and are in the nature of ‘hot’ money. Attempts to
regulate them have not succeeded significantly; the RBI is worried about
likelihood of sudden outflows and of destabilizing effects. Managing the
rupee’s float within a system of limited convertibility and full interest rate
autonomy has become a nightmare. The RBI has had a difficult time balancing
26

27. capital inflows against the nation’s policy on money supply, interest rates,
inflation, price stability and growth. CAC has therefore become a necessity. The
timing is to India’s advantage with growing trade, expanding and transparent
financial markets, and increasing integration with global markets. Full
convertibility freely floating exchange rates would restore India’s autonomy
over money supply, interest rates and growth.
Changing International and Emerging Market Perspectives
There is some literature which supports a free capital account in the Context of
global integration, both in trade and finance, for enhancing growth and welfare.
The perspective on CAC has, however, undergone some change following the
experiences of emerging market economies (EMEs) in Asia and Latin America
which went through currency and banking crises in the 1990s.A few countries
backtracked and re-imposed some capital controls as part of crisis resolution.
While there are economic, social and human costs of crisis, it has also been
argued that extensive presence of capital controls, when an economy opens up
the current account, creates distortions, making them either ineffective or
unsustainable. The costs and benefits or risks and gains from capital account
liberalization or controls are still being debated among both academics and
policy makers. The IMF, which had mooted the idea of changing its Charter to
include capital account liberalization in its mandate, shelved this proposal.2.5
27

28. these developments have led to considerable caution being exercised by EMEs
in opening up the capital account. The link between capital account
liberalization and growth is yet to be firmly established by empirical research.
Nevertheless, the mainstream view holds that capital account liberalization can
be beneficial when countries move in tandem with a strong macroeconomic
policy framework, sound financial system and markets, supported by prudential
regulatory and supervisory policies.
28

29. Capital Account Convertibility: Necessary Reforms, Policies and
Pre-Conditions
• Fiscal Policy, Monetary Policy, Sterilization and
Exchange Rate Policy
Country experience with capital flows shows that financial integration boosts
growth by increasing investment and consumption and reduces volatility of
consumption with the increased opportunities for risk diversification and inter-
temporal consumption smoothing. However, large capital flows also lead to
rapid monetary, expansion, inflation, and real exchange rate appreciation. The
appropriate design of macroeconomic policy is extremely important in an
integrated world. Country experiences and the growing literature on the policy
response to a surge in capital flows shows that counter cyclical measures such
as tight monetary and fiscal policies and flexibility in the exchange rate are
essential to mange private capital flows. Other structural measures pertaining to
the financial sector, regulation, supervision and capital controls are discussed
elsewhere in this paper.
Fiscal Control
Sound macroeconomic polices are a basic pre-requisite for capital account
convertibility. The experience of the Southern Cone countries shows that fiscal
deficits emerge as one of the important factors accounting for success or failure
of liberalization programs. The experience has shown that government finances
29

30. and tax efforts need to be sufficiently strong to prevent the need for domestic
financial repression. Taxes on financial intermediation encourage capital
outflows and are no substitute for tax receipts. There is an urgent need in many
Developing countries to broaden the tax base. Fiscal control is needed so that
monetary policy can be assigned to the external objective. (Mundell, 1962). In
the absence of fiscal control, monetary policy is assigned to internal balance,
which can only be achieved with the aid of capital controls to insulate the
country from international capital movements. The aim of policy should be to
assign fiscal policy to attain internal balance and monetary policy to attain
external balance. Sound government finances would help in the achievement of
this objective. The experience of Singapore and Indonesia has shown that
manipulating the flow of liquidity into the banking system using government
excess savings partly frees the interest rate from demand management so that it
Can be used for exchange rate management. High stocks of domestic public
debt approaching unsustainable levels raises the chances of capital flight as
domestic investors fear a default on domestic debt. Keeping these factors in
mind, it is essential to control the fiscal deficit and finance it with a minimal
recourse to the inflation tax. Financing of the deficit through issuance of bonds
is problematic with an open capital account if it undermines the credibility of
the country servicing domestic debt. Fiscal discipline gives a signal to investors
as to the health of the economy. Moreover, if the fiscal situation is not under
control, Central Bank polices can become ineffective because of the lack of
30

31. fiscal discipline. Country experiences demonstrate the perverse effects that
sustained fiscal imbalances can have in the context of an open capital account.
In the 1990s, the Brazilian government ran persistent fiscal deficits that
encouraged expectations of continued inflation and high interest rates that
reinforced capital inflows into Brazil. The Brazilian experience also
demonstrates the ambiguities generated by a federal system in terms of fiscal
policy. While the Brazilian federal deficit dramatically deteriorated in
1993-1994, there was doubt as to whether it accurately reflected the fiscal
positions of the states. Consequently, when the state of Minas Gerais ran into
fiscal difficulties in 1998, it generated a national crisis as investors worried that
it was merely a prelude to further harmful disclosures. The large inflows into
Brazil
during the 1990s in the midst of this unsure fiscal environment suggests that
push factors (i.e. falling interest rates in advanced countries) may have
predominated over pull factors (i.e. domestic reform, improved macroeconomic
performance). It might also suggest an investor euphoria driven by the signing
of the North American Free Trade Agreement in 1993 that stimulated flows to
the Latin America as a whole. As will be discussed later, the presence of an
elaborate capital control regime was unable to offset the negative effects of this
structural imbalance. In India, another country with a federal structure,
continued fiscal imbalances are currently placing greater pressure on the
country’s external accounts. Increasing fiscal imbalances leading up to Kenya’s
31

32. first democratic elections in late 1992, along with other factors, hindered the
country’s ability to induce inflows of capital despite its open capital account.
Those countries that have successfully liberalized the capital account – such as
Argentina, and Chile have all, with the exception of Colombia, shown a high
degree of fiscal discipline. Malaysia managed to attract capital inflows over
along period because of prudent fiscal policy.
Monetary Policy
The degree of financial integration also has implications for the conduct of
monetary policy. For some countries greater financial integration will impair
their ability to run independent monetary policies. As we move to a seamless
capital market very few interest rates will be determined domestically apart
from interest rates at the very short end. Attempts to depart from the
international structure of interest rates may result in very large and possibly
volatile capital flows exerting speculative pressure on exchange rates.
Movements in exchange a rate because of independent monetary polices may
cause increases in the currency risk component of interest rates. Monetary
policy may therefore in some countries have to passively adopt the monetary
policy of a large financial trading partner, than confronting volatile and harmful
Exchange rate pressures. These are the conditions in a perfectly integrated
financial world. In the intermediate stage of international financial integration a
Central Bank does have some control over monetary policy to avoid
32

33. macroeconomic instability caused by large capital flows. Some of the options
for managing capital flows in the short run are:
• To buy up reserves but sterilize the intervention by selling an equal value of
Domestic currency bonds.
• To increase the cash reserve ratio applying to bank deposits credits from
Abroad and swap operations.
• Monetary policy support through a tax on inflows.
A pre-requisite for the success of sterilization policy is the move from direct to
Indirect instruments of monetary policy. In some countries problems can occur
Because of the lack of depth in the money and government securities market.
In some small African economies problems can arise because of limiting
Structural factors and the size of the economy. While open market operations
Are necessary conditions for managing private capital flows, for countries with
less developed financial sectors it may be more effective to stay with direct
tools of monetary policy? Uganda, for example, finds its capacity to sterilize
inflows heavily constrained by the lack of sufficient monetary instruments and
the thinness of the market. We need to open the debate on financial
intermediation of international flows in this scenario. Even with open market
operations, sterilization is not without costs. This policy is designed to mitigate
the impact of capital inflows on money supply leading to inflationary pressures,
exchange rate appreciation and controlling the domestic money stock. Some of
the costs of sterilization are discussed below.
33

34. • Presumably capital flows into developing countries attracted by the higher rate
Of return. If the capital flows are sterilized, the policy will prevent interest rate
Differential going down attracting further capital flows.
• A policy of sterilization involves issuing domestic bonds to offset an increase
In currency Flow, results in an increase in public debt.14
• If the government does not issue domestic bonds, it will have to provide its
own currency leading to an increase in money supply and inflation. The
consequent build up of reserves would mean the case of a poor country lending
abroad. If sterilization takes place through domestic bonds, the country can
incur costs amounting to the difference between the interest paid on bonds at
home and the interest received on foreign reserves. The costs of sterilization
policy have been clearly reflected in country experience. Both Colombia and
Chile experienced high sterilization costs that led them to move to a capital
Control regime. Other forms of sterilization through reserve requirements and
taxes on capital inflows are discussed elsewhere is this paper. They have been
successful in some countries (such as Chile, Colombia and Thailand) in altering
the average maturity of the capital inflow, but not the total capital flow. The
experience of Chile is particularly interesting in relation to the constraints on
monetary policy in a small, open economy with a liberalized capital account
(see Annex 1 for a more detailed discussion of the Chilean experience). The
conflict between controlling domestic inflation (even with fiscal accounts in
balance) and preventing a sharp appreciation of the real exchange rate in the
34

35. context of large capital inflows, prompted Chile to search for greater flexibility
of monetary policy through the implementation of controls on capital inflows.
The Chilean controls appear to have provided a ‘wedge’ between domestic and
international rates that provided greater scope for authorities to target domestic
inflation, while avoiding the costs of sterilization (although it must be noted that
other costs were incurred, see Annex 1). The above measures can only be used
in the short-run. Their continuance can lead to agents developing new ways of
bypassing these regulations. In the long run, the only solution is to speed up the
financial and overall reform, so that outflows can be liberalized so that the two
way movement of capital takes care of financial intermediation, without the
necessity for some of these measures. The process would be aided by a flexible
exchange rate policy. Monetary policy would get some autonomy in countries
where the conditions are right to operate an exchange rate band.
Exchange Rate Policy
The significance of a flexible exchange rate goes up for an economy with an
open capital account as the influence of international variables is transmitted
more quickly than in an economy with a relatively closed capital account. What
is important for an open capital? This is the general case. The case study of
India illustrates that the huge stock of ad hoc treasury bills were available for
sterilization without increasing the stock of public debt. Account management is
35

36. that exchange rate policy should be flexible, with market participants bearing
exchange risk instead of the balance sheet of a central bank. Furthermore, the
Resulting uncertainty from a flexible exchange rate may discourage short-term
flows. Exchange rate uncertainty may discourage short-term flows. The
maintenance of a pegged exchange rate by the Thai authorities in the 1995-1997
periods constrained policy making, discouraged hedging by market participants
and reinforced capital inflows. It also provided a fixed target for speculators
who were quick to observe the inconsistency between an interest rate defense of
the baht peg and the health of the financial sector. A further advantage of
allowing greater exchange rate flexibility is that the appreciation of the
exchange rate is which is likely to occur through an appreciation of the nominal
exchange rate and not through higher inflation. This gives room for pursuing
autonomous monetary policy. It would force market participants to hedge their
positions and this would be a beneficial development for foreign exchange
market development. A drawback of a floating exchange rate regime is that it
may be associated with high volatility, which may damage the growth of
strategic sectors like non-traditional exports. Country experience suggests that
as capital account convertibility has progressed, countries have adopted more
flexible exchange rate regimes. Of the countries surveyed in Annex 2,
Colombia, Peru, Chile, Uganda, and Korea have all opted to introduce greater
flexibility into their exchange rate regime. Only, Argentina with its currency
board regime and Malaysia, which pegged the ringgit to the dollar as part of its
36

37. adjustment policy after the Asian crisis, have reverted to inflexible regimes. The
particular nature of the Argentine and Malaysian experiences should be noted.
Argentina sought credibility for its macroeconomic policy stance after
prolonged economic crises in the 1980s and the currency board was the surest
Method of acquiring this in international markets. Malaysia initiated its pegged
regime in the context of a broad policy of capital controls on outflows, which
helped ensure its maintenance. Thus, the general experience of capital account
liberalization is that a greater degree of exchange rate flexibility is required,
even if this takes the form of a currency band which helps reduce the volatility
associated with free floating regimes. It is for this reason that many countries
such as Israel, Colombia, Chile and Mexico adopted an intermediate regime of
an exchange rate band. Exchange rate bands can be implemented in countries
that have depth in the foreign exchange market and the market is well
developed so that two-way expectations can drive the exchange rate. It is an
intermediate regime, in which monetary policy can be used for domestic
objectives most of the time and but will be assigned to the external objective
when necessary to avoid what might be a serious misalignment. Correction of
exchange rate misalignments cannot be safely left to the market. The choice of
an appropriate exchange rate involves a trade-off between the benefit of
targeting inflation and the external competitiveness of a country. Actual policy
will have to be a mix of both these objectives as either extreme is harmful to a
country. Increased capital
37

38. Mobility limits the possibility of targeting the real exchange rate and therefore
allowing the exchange rate to fluctuate within a band is a desirable policy. A
credible announcement by the authorities that they will intervene to keep the
exchange rate within the band will encourage market corrections or limitations
to the misalignments without diverting monetary policy from its domestic
objectives. Refraining from intervening continually in the market will
discourage complacent traders who prevent market corrections through their
behavior. At the margin of the band, as part of official policy, the central bank is
expected to intervene but not necessary as market can carry out the corrective
speculation. With this policy the central bank can allow the market to work and
yet keep the surprise element in its policy. The central bank can also from time
to time review its own choice of the equilibrium exchange rate and signal a
major change is warranted by its own intervention and moving the parity around
which the exchange rate is fluctuating. Whether countries opt for a managed
floating exchange rate regime or an exchange rate band depending upon their
own circumstances, flexibility of the exchange rate is necessary with an open
capital account.
38

39. • Sequencing Current and Capital Account Liberalization
McKinnon (1973 and 1982) Frenkel (1982) and Edwards (1984) made a case
for liberalizing the capital account following the opening of the current account
and the domestic financial system. According to McKinnon if the opposite
sequencing were followed, excessive capital inflows would result in a
substantial appreciation of the real exchange rate, which would then
Hamper the opening up of the current account. Arguments for a simultaneous
opening of the current and capital account have been advanced by Little,
Scitovsky, and Scot, (1970), Michaely, (1986) and Krueger (1984).
Since many developing economies have signed Article VIII agreements with the
IMF, the issue of sequencing current and capital account liberalization needs
further qualification as to the time period between current and capital account
liberalization as the capital account can be porous because of a liberalized
current account. It also needs to focus on the type of restrictions needed on the
current account to avoid the loss of capital in the transition stage.
Inflation Rate
Among central bankers there is an increasing belief that an inflation rate in the
low, single-digit range is a desirable objective of policy. The achievement of
this policy will require central banks to have greater independence and
39

40. insulation from populist pressures. With an increasingly integrated world
economy and low inflation rates in the industrial countries, it is necessary for
developing countries to break inflationary expectations and achieve inflation
rates not far out of line with those in the industrial countries. High rates of
inflation are destabilizing and require high nominal and real rates of interest
which have negative real effects and could reinforce capital inflows (Brazil).
Conversely, artificially maintained low interest rates could induce large net
outflows of capital.
Financial Sector Reform
A central component of any policy directed at promoting capital account
liberalization is the reform and restructuring of the financial sector to avert
inefficient allocations of capital. In an environment of liberalized capital flows,
weaknesses of the financial system can cause macroeconomic instability and
crises (Thailand, Indonesia, and Kenya). The choice is therefore between a
careful reform of the financial system before or during the process of
liberalization, or emergency reforms after a crisis. Banking systems remain
weak in many
Developing countries burdened either by interest rate controls or mandated
lending to favored groups or firms. In addition, many systems have very high
reserve requirements relative to international levels. Reducing these
40

41. requirements diminishes the effectiveness of monetary policy in the absence of
indirect policy tools. Thus, the development of indirect tools such as open
market operations and interest rates should become a key objective of policy.
Reform must also encompass improved accounting standards, increased
monitoring and surveillance of bank risk exposure, and prudential standards that
conform to international standards (Basle Committee).
Monetary Policy
The development and deepening of financial markets following reform, also
changes the context in which monetary policy is conducted. A move from direct
monetary policy controls to indirect controls is desirable, as it avoids distortions
in financial intermediation and is more flexible for policy purposes. In addition,
the development of indirect controls also enables the central bank to more
effectively carry out sterilization operations in capital inflow episodes.
Appreciation of the exchange rate due to capital inflows diverts investment
away from the tradable sector when in persists for a long time. Sterilization is
needed to deal with this or it can be combined with other instruments such as
reserve requirements, taxes or a partial liberalization of outflows. In small
economies the financial markets lack of depth and it may be feasible to rely on
more direct monetary policy tools.
41

42. Exchange Rate Policy
Exchange rate policy becomes even more central to policymaking concerns
with moves towards capital account convertibility. Authorities must decide on
the optimal degree of exchange rate flexibility with an aim to prevent either
unsustainable appreciations of the real exchange rate that can undermine
competitiveness or expensive interest rate defences of fixed rates and/or costly
sterilization operations. The balance between these considerations is complex,
although there is a general belief that exchange rate regimes have to be more
Flexible under capital account convertibility.
Current Account Balance
Current account deficits are commonly found in developing countries, reflecting
the use of global savings to achieve desired levels of growth and investment.
Experience suggests that prudent limits must be set on expanding deficits. The
counterpart of current account deficits are expanding external liabilities, and as
the deficit rises debt servicing begins to account for an increasing proportion of
external earnings that could be otherwise used to increase imports. Thus, high
current account deficits may constrain growth by retarding importsas well as
leading to fears of contraction and/or crisis.
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43. Foreign Exchange Reserves
With capital account convertibility, the level of international reserves becomes a
key consideration for policymakers. Reserves help to cushion the impact of
cyclical changes in the balance of payments and help offset unanticipated
shocks, which can lead to reversals of capital flows. Reserves also help sustain
confidence in both domestic policy and exchange rate policy. The optimal level
of reserves is of course contingent on a country’’ specific circumstances,
including its balance of payments, exchange rate regime and access to
international finance. Indicators of reserve adequacy should be derived from
measures of import cover and debt servicing. Another important ratio to monitor
is the ratio of short-term debt and portfolio stocks to reserves to guard against
sudden depreciation.
Lowering tariff barriers
Reforming the trade regime to make it more open to the international economy
is part of the structural reforms that should precede CAC. High tariffs, in
addition to their allocative inefficiency, encourage direct investment in the
economy that is not directed towards export markets, but rather towards ‘tariff
43

44. jumping’. Lowering tariffs is therefore linked to the promotion of a diversified
export base.
Diversified export base
A diversified export base helps cushion the economy from sudden terms of
trade or other shocks that may emerge from dependence on a narrow range of
exports. Such shocks have immediate effects upon the current account and with
a loss of confidence in the country’s capacity to meet debt repayments or
sustain the current rate of capital inflows, may drive a capital account crisis as
well. Developing countries have traditionally been vulnerable to such shocks to
the export sector, often arising from dependence on primary commodity
exports. The process of promoting non-traditional exports can encompass
promotion of domestic firms through some kind of industrial policy or through
the encouragement of foreign direct investment. In the latter case, it is essential
that countries promote FDI in exportable sectors.
Current account liberalization can lead to a de facto liberalization of the capital
account because it is possible for capital to leave through leads and lags.
Kasekende et al. (1997) and Kimei et al. (1997) find evidence of significant
capital flows through current account transactions and foreign exchange bureaus
for Uganda and Tanzania. Kahn (1991) found substantial evidence of capital
flight through the current account for South Africa. Some developing countries
44

45. retain certain restrictions on the current account with Article VIII status.13 It is
however difficult to gauge which restrictions achieve the objectives for which
They have been set. This is an area for research. India maintained certain
restrictions on the current account with Article VIII status to avoid the
movement of capital through the current account because controls on the
movement of capital by the resident sector have not been liberalized. Hence,
certain preventive measures were built into the regulations relating to current
account transactions. (In recent weeks some small steps have been made to
liberalize this sector but the focus is still on micro management of exchange
controls.) An attempt is made to capture the impact of opening of the current
account on the porosity of the capital account. Estimates of misinvoicing of
trade data based on partner country comparison of the country with
industrialized countries for a select sample of four countries is revealing.
External Sector Indicators
Recent developments in the balance of payment (BoP) indicate continuing
resilience of the external sector even as the Indian economy is entering an
expansionary phase of the business cycle. There has been an emergence of a
current account deficit (CAD) in 2004-05 and 2005-06 after surpluses in the
45

46. preceding three years (2001-04). For a developing country like India, imports of
raw materials, intermediates, capital goods, technology and services hold the
key to scaling up growth in the medium-term. It is important to recognize that
current BoP has significantly improved over 1990-91.
Current Account Deficit
Since the crisis of 1990-91, during which a CAD of 3 per cent of GDP turned
out to be unsustainable, the appropriate level of the CAD for India has been the
subject of considerable deliberation. The appropriate level of the CAD is a
dynamic concept and cannot be fixed in time, or cast in stone. The openness is
based on the increase in the current receipts to GDP ratio to 24.5 per cent in
2005-06, which is substantially higher than the ratio of 8.0 per cent in 1990-91.
Current receipts in 2005-06 pay for 95 per cent of current payments, up from 72
per cent in 1990-91. Acceleration in the growth of current earnings economises
on the need to seek access to International financial markets and strengthens the
ability to run a higher CAD (and achieve higher growth) without encountering a
financing constraint. Stepping up the growth of current receipts is essential for
sustaining a higher CAD. Viability of the CAD is a function of the availability
of normal capital flows, as opposed to exceptional financing. Net capital flows
have regularly exceeded the CAD requirements by a fair measure, enabling
46

47. large accretions to the reserves. During 2005-06, the CAD has been comfortably
financed by net capital flows with over US$ 15 billion added to the foreign
exchange reserves. Compositional shifts in favour of foreign investment have
actually strengthened the economy's absorptive capacity. The share of non-debt
creating flows in net capital flows has, in fact, risen from 1 per cent in 1990-91
to nearly 50 per cent in 2004-05. The operating ‘viability’ criterion for
determining the access to capital flows is the ability to service external
liabilities as embodied in a low ratio of debt service payments to current
receipts. The debt service ratio (DSR) has fallen to as low as 10.2 per cent in
2005-06 and the ratio of the external debt stock to GDP was a modest 15.8 per
cent. The DSR could safely be in the range of 10-15 per cent. If the ratio of
current account deficit to GDP is regarded as the target variable, the ratio of
Current receipts to GDP can be regarded as the instrument variable.
Accordingly, a sustainable current account deficit is dependent on the current
receipts to GDP ratio. A rising current receipts to GDP ratio will enable a higher
current account deficit which would enable a higher investment ratio. Given the
present CR/GDP ratio of 24.5 per cent, the CR/CP ratio of 95 per cent and a
debt service ratio in the range of 10-15 per cent, a CAD/GDP ratio of 3 per cent
could be comfortably financed. Should the CAD/GDP ratio rise substantially
over 3 per cent there would be a need for policy action.
47

48. Limitation of the Study:
The analysis will be purely based on the primary and secondary data. The
primary data comprise only of feedback collected from retail investors. It will
not include institutional investors. The currency future is a new concept.
48

49. Conclusion
The process of macro economic reforms which ushered in 1991 has evolved
slowly but steadily over the last one and half decade contributing for building
stronger Indian economy. The next major step in this direction would be Indian
opting for Capital Account Convertibility because it continues to be a desirable
objective for providing another growth impetus for Indian economy as whole
and Indian companies in particular. Though there are certain caveats like it may
lead to aggressive moves by international players ( by exercising their financial
muscle) and further intensify the competition for domestic companies but a
carefully drafted policy suitable to Indian requirement and steady
implementation of it would minimize ill effects and maximize the gains.
49

50. Bibliography
Report of the RBI-SEBI standing technical committee on exchange traded
Currency futures) 2008
Recent Development in International Currency Market by: Lucjan T. Orlowski)
Websites:
http://www.google.com
http://www.scribd.com
http://www.management paradise.com
http://www.wikipedia.com
http://www..com
http://www.sebi.gov.in
http://www.bloomberg.com
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