DR.

RAM MANOHAR LOHIYA NATIONAL LAW

UNIVERSITY
2016-2017

Subject: ECONOMICS

Project on:
CONVERTIBILITY OF RUPEE IN INDIA

SUBMITTED TO: SUBMITTED BY:

Dr. Mitali Tiwari AYUSHI VERMA
ASST.PROFESSOR B.A.LL.B (HONS)SEM 3
RMLNLU ROLL NO.-37

ACKNOWLEDGMENT
I am most profoundly grateful to my teacher Dr. Mitali Tiwari for providing me this

wonderful opportunity to work upon this project after doing which we feel to have

enlightened ourselves in this regard and for her precious time she spent guiding us for the

completion of this project.

I also thank the members of the library staff for their cooperation in making available the

books and magazines and allowing us to access the internet even during their free time and

whenever we required to do so.

Last but not the least I would also like to thank my friends. It was only because of their

excellent help that I have been able to complete my project.

TABLE OF CONTENTS
INTRODUCTION

The convertibility of a currency such as Rupee has different meanings in

different times. In existing standards, it means that the countrys currency
becomes convertible in foreign exchange and vice versa in the market. The
definition should be seen in historical aspect of foreign currency regulation in
India. Almost at the same when India got independence, the Foreign Exchange
Regulation Act 1947 was enacted with the object of regulating certain dealings
in foreign exchange and the import and export of currency and bullion. The
focus of this act was on dealings in Foreign exchange and payments which
directly affect foreign exchange resources. This act was later replaced by the
Foreign Exchange Regulation, Act, 1973, which we call FERA. Later FERA
was laid to rest and its successor is now FEMA.

Those were the days of restriction on foreign exchange. No one could keep
foreign exchange without the knowledge and due permission of RBI. The
exchange control consisted of restrictions on the purchase and sale of foreign
exchange by general public and payments to and from non-residents. There
were also restrictions on the import and export of Indian currency, foreign
currency and bullion. In those times, the exchange rates used to be different than
what they are today. Today we have a market determined exchange rate system,
but during those times, RBI used to dictate its Official Exchange Rate on which
Indian currency could be converted into foreign currency and vice versa. All
transactions in foreign exchange were governed by this official rate of
exchange. This means that Rupee was inconvertible at the market rate. An
importer who wanted to import from abroad was supposed to buy dollars at the
RBI dictated rates. Similarly, an exporter who just got dollars was supposed to
sell them to RBI appointed Authorize agents at RBI decided rate.

The major implications of these restrictions were:

1- All foreign exchange earned and received by any person in India were
required to be sold to RBI authorised dealers.
2- This means that all foreign exchange earned or received could be
converted and utilised only according to the priorities fixed by the
Government.
MEANING OF CURRENCY CONVERTIBILITY:

By convertibility of a currency we mean currency of a country can be freely

converted into foreign exchange at market determined rate of exchange that is,
exchange rate as determined by demand for and supply of a currency.

For example, convertibility of rupee means that those who have foreign
exchange (e.g. US dollars, Pound Sterlings etc.) can get them converted into
rupees and vice-versa at the market determined rate of exchange. Under
convertibility of a currency there are authorised dealers of foreign exchange
which constitute foreign exchange market.

The exporters and others who receive US dollars, Pound Sterlings etc. can go to
these dealers which are generally banks and get their dollars exchanged for
rupees at the market determined rates of exchange. Similarly, under currency
convertibility, importers and other who require foreign exchange can go to these
banks dealing in foreign exchange and get rupees converted into foreign
exchange.

CURRENT ACCOUNT AND CAPITAL ACCOUNT CONVERTIBILITY

OF CURRENCY:

A currency may be convertible on current account (that is, exports and imports
of merchandise and invisibles) only. A currency may be convertible on both
current and capital accounts. We have explained above the convertibility of a
currency on current account only.
By capital account convertibility we mean that in respect of capital flows, that
is, flows of portfolio capital, direct investment flows, flows of borrowed funds
and dividends and interest payable on them, a currency is freely convertible into
foreign exchange and vice-versa at market determined exchange rate.

Thus, by convertibility of rupee on capital account means those who bring in

foreign exchange for purchasing stocks, bonds in Indian stock markets or for
direct investment in power projects, highways steel plants etc. can get them
freely converted into rupees without taking any permission from the
government.

Likewise, the dividends, capital gains, interest received on purchased stock,

equity etc. profits earned on direct investment get the rupees converted into US
dollars, Pound Sterlings at market determined exchange rate between these
currencies and repatriate them.

Since capital convertibility is risky and makes foreign exchange rate more
volatile, is introduced only sometime after the introduction of convertibility on
current account when exchange rate of currency of a country is relatively stable,
deficit in balance of payments is well under control and enough foreign
exchange reserves are available with the Central Bank.

CONVERTIBILITY OF INDIAN RUPEE:

In the seventies and eighties many countries switched over to the free
convertibility of their currencies into foreign exchange. By 1990, 70 countries
of the world had introduced currency convertibility on current account; another
10 countries joined them in 1991.
As a part of new economic reforms initiated in 1991 rupee was made partly
convertible from March 1992 under the Liberalised Exchange Rate
Management scheme in which 60 per cent of all receipts on current account
(i.e., merchandise exports and invisible receipts) could be converted freely into
rupees at market determined exchange rate quoted by authorised dealers, while
40 per cent of them was to be surrendered to Reserve Bank of India at the
officially fixed exchange rate.

These 40 per cent exchange receipts on current account was meant for meeting
Government needs for foreign exchange and for financing imports of essential
commodities. Thus, partial convertibility of rupee on current account meant a
dual exchange rate system.

This partial convertibility of rupee on current account was adopted so that

essential imports could be made available at lower exchange rate to ensure that
their prices do not rise much. Further, full convertibility of rupees at that stage
was considered to be risky in view of large deficit in balance of payments on
current account.

As even after partial convertibility of rupee foreign exchange value of rupee

remained stable, full convertibility on current account was announced in the
budget for 1993-94. From March 1993, rupee was made convertible for all trade
in merchandise. In March 1994, even indivisibles and remittances from abroad
were allowed to be freely convertible into rupees at market determined
exchange rate. However, on capital account rupee remained nonconvertible.

ADVANTAGES OF CURRENCY CONVERTIBILITY IN INDIA:

Convertibility of a currency has several advantages which we discuss
briefly:

1. Encouragement to exports:

An important advantage of currency convertibility is that it encourages exports

by increasing their profitability. With convertibility profitability of exports
increases because market foreign exchange rate is higher than the previous
officially fixed exchange rate. This implies that from given exports, exporters
can get more rupees against foreign exchange (e.g. US dollars) earned from
exports. Currency convertibility especially encourages those exports which have
low import-intensity.

2. Encouragement to import substitution:

Since free or market determined exchange rate is higher than the previous
officially fixed exchange rate, imports become more expensive after
convertibility of a currency. This discourages imports and gives boost to import
substitution.

3. Incentive to send remittances from abroad:

Thirdly, rupee convertibility provided greater incentives to send remittances of

foreign exchange by Indian workers living abroad and by NRI. further, it makes
illegal remittance such hawala money and smuggling of gold less attractive.

4. A self balancing mechanism:

Another important merit of currency convertibility lies in its self-balancing

mechanism. When balance of payments is in deficit due to over-valued
exchange rate, under currency convertibility, the currency of the country
depreciates which gives boost to exports by lowering their prices on the one
hand and discourages imports by raising their prices on the other.

In this way, deficit in balance of payments get automatically corrected without

intervention by the Government or its Central bank. The opposite happens when
balance of payments is in surplus due to the under-valued exchange rate.

5. Specialisation in accordance with comparative advantage:

Another merit of currency convertibility ensures production pattern of different

trading countries in accordance with their comparative advantage and resource
endowment. It is only when there is currency convertibility that market
exchange rate truly reflects the purchasing powers of their currencies which is
based on the prices and costs of goods found in different countries.

Since prices in competitive environment reflect that prices of those goods are
lower in which the country has a comparative advantage, this will encourages
exports. On the other hand, a country will tend to import those goods in the
production of which it has a comparative disadvantage. Thus, currency
convertibility ensures specialisation and international trade on the basis of
comparative advantage from which all countries derive benefit.

6. Integration of World Economy:

Finally, currency convertibility gives boost to the integration of the world

economy. As under currency convertibility there is easy access to foreign
exchange, it greatly helps the growth of trade and capital flows between the
countries. The expansion in trade and capital flows between countries will
ensure rapid economic growth in the economies of the world. In fact, currency
convertibility is said to be a prerequisite for the success of globalisation.
DRAWBACKS OF CURRENCY CONVERTIBILITY:

Cost push inflation may result of market determined exchange rates are higher
than officially fixed exchange rates and prices of essential imports rise .

If currency convertibility is not well managed, market exchange rate can cause
domestic currency depreciation harming trade and capital flows in the nation.

Convertibility of currency makes it extremely volatile when currency

depreciates due to speculative actions for example 1997-98 capital flight from
South East Asian economies.

Currency depreciation makes capital inflows less likely.

INDIA FAVOURS FULL RUPEE CONVERTIBILITY TO BECOME TOP

ECONOMY:

India needs to move towards full capital account convertibility to become a

leading global economy.

The rupee has been convertible on the current account since 1994, meaning it
can be changed freely into foreign currency for purposes like trade-related
expenses. But it cannot be converted freely for activities such as acquiring
overseas assets. Fuller convertibility is expected to facilitate rapid growth
through higher investment and improve efficiency in the financial sector
through greater competition.
"If we have to be among the top three-four economies in the world, we have to
make it possible for our capital markets to be broader and deeper, and for that to
happen capital account convertibility also becomes important," Sinha said,
without specifying any time frame.

Reserve Bank of India chief Raghuram Rajan expressed hope that the rupee
would become fully convertible in a "short number of years". Analysts say
India's inflation, interest rates, and trade and financial system would have to be
globally competitive before it allows free movement of capital in and out of the
local currency.

In mid-2013, the central bank was forced to resort to capital controls to stabilise
a fast sliding rupee after foreign funds started pulling out of the country in the
wake of speculation over when the U.S. Federal Reserve would taper its
massive bond buying programme.