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Convertibility: meaning

Convertibility refers to the ease with which the domestic currency of a country could be exchanged with that of a foreign currency. It also implies that no restriction is imposed on the end use of the currency exchanged. Thus the four connotations that are attached with the convertibility are:

1.       Ease of exchange of domestic currency with the foreign currency

2.       There is no limit or cap on the amount, to exchange the currency

3.       The above two points (1 and 2) hold good irrespective of the purpose of exchange or the end use.

4.       All this (1, 2 and 3) happens without the need for permission from a central bank or government entity.


Current account convertibility:

It refers to convertibility of a currency for goods and services and transfer payments.


Capital account convertibility:

It refers to the convertibility of currency for transfer of claims to money or titles to investment.SS Tarapore committee on Fuller Convertibility  defines Capital account convertibility as the freedom to convert local financial assets into foreign financial assets and vice versa.


Difference between Capital account convertibility and Current account convertibility:

Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. Thus current account convertibility refers to unrestricted exchange of domestic currency with the foreign currency and vice-versa for goods and services, income, and current transfers. Capital account convertibility refers to exchange of currency for investments and borrowings.


Indian scenario:

In India we have partial rupee convertibility i.e. the rupee is convertible on the current account but not on the capital account.


Implications of the Capital account convertibility:

Capital account convertibility can be instrumental in attracting foreign investment for domestic companies. At the same time it would tender lot of comfort to foreign investor to convert and re-convert their investment into foreign and domestic currencies respectively. Since investment is generally speculative in nature, and without any restriction of any kind this could lead to frequent inflow and outflow of capital resulting into destabilizing of the economy if it is not robust to withstand such fluctuations. The East Asian financial crisis of late 1990’s was the result of destabilization of economies of various East Asian countries which adhered to Capital account convertibility without any cushion against the fluctuations.


Lessons to be learnt from the East Asian Crisis:

According to Tarapore committee on Fuller Capital Account Convertibility  “this crisis in East Asian countries arise mainly from inadequate preparedness before liberalization in terms of domestic and external sector policy consolidation, strengthening of prudential regulation and development of financial markets, including infrastructure, for orderly functioning of these markets. Most currency crises arise out of prolonged overvalued exchange rates, leading to unsustainable current account deficits. A transparent fiscal consolidation is necessary and desirable, to reduce the risk of currency crisis.”


Should we go for Capital account convertibility?

Capital account convertibility can be advantageous for the country if we are adequately prepared to handle it. Certain preconditions like limiting fiscal deficit, maintaining adequate foreign exchange reserves, controlling inflation and regulating financial markets are must to accrue the benefit from Capital account convertibility.

China has become exemplary for the economies for attracting foreign investment and she has been able to grow double digit without convertibility.

We are gradually easing the restrictions on the capital inflow which is the main motto for Capital account convertibility as well.

However, committed to the agenda of reforms which has now become irreversible we have to gradually moving towards the Capital account convertibility. But lessons from East Asian economies, experience of China and domestic scenario of high inflation and fiscal deficit suggest that there is no dire need to go for the Capital account convertibility at this moment.


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