For the rapid growth of world trade and capital flows

between countries convertibility of a currency is

desirable. Without free and unrestricted convertibility of
currencies into foreign exchange trade and capital flows
between countries cannot take place smoothly.
Therefore, to achieve higher rate of economic growth
and thereby to improve living standards through
greater trade and capital flows, the need for
convertibility of currencies of different nations has been
greatly felt. Under Bretton Woods system fixed
exchange rate system was adopted by various
countries.
In order to maintain the exchange rate of their
currencies in terms of dollar or gold various countries
imposed several controls over the use of foreign
exchange. This required some restrictions on the use of
foreign exchange and its allocation among different
uses, the currency of a nation was converted into
foreign exchange on the basis of officially fixed
exchange rate.
When Bretton Woods system collapsed in 1971, the
various countries switched over to the floating foreign
exchange rate system. Under the floating or flexible
exchange rate system, exchange rates between
different national currencies are allowed to the
determined through market demand for and supply of
them. However, various countries still imposed
restrictions on the free convertibility of their currencies
in view of their difficult balance of payment situation.

Currency Convertibility

Currency convertibility is a process with which a

country's currency can be converted into gold or
another currency. Convertibility is extremely important
for international commerce. When a currency in
inconvertible, it poses a risk and barrier to trade with
foreigners who have no need for the domestic currency.
It refers to the freedom to convert domestic currency
into other internationally accepted currencies and vice
versa at market determined rates of exchange. The
convertibility of currency (rupee) in to other foreign
currencies is done on both sides i.e. from current
account convertibility and from capital account
convertibility side.

Current 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,
Pounds, Yens 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.
In other words, Current account convertibility allows
free inflows and outflows for all purposes other than for
capital purposes such as investments and loans. Or we
can say, it allows residents to make and receive traderelated payments receive dollars (or any other
foreign currency) for export of goods and services and
pay dollars for import of goods and services, make
sundry remittances, access foreign currency for travel,
studies abroad, medical treatment and gifts, etc. And
on the other side, Capital account convertibility means
the freedom to convert local financial assets into
foreign financial assets and vice versa at market
determined rates of exchange. It enables full currency
convertibility and opening of the financial system.
Capital account convertibility is considered to be one of
the major features of a developed economy. It helps
attract foreign investment. At the same time, capital
account convertibility makes it easier for domestic
companies to tap foreign markets. It is sometimes
referred to as Capital Asset Liberation

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.

Capital Account Convertibility of Rupee:

Under Capital Account Convertibility any Indian or
Indian company is entitled to move freely from the
Rupee to another currency to convert Indian financial
assets into foreign financial assets and back, at an
exchange rate fixed by the foreign exchange market
and not by RBI.
In a way, capital account convertibility removes all the
restrains on international flows on Indias capital
account. There is a basic difference between current
account convertibility and capital account convertibility.
In the case of current account convertibility, it is
important to have a transaction importing and
exporting of goods, buying and selling of services,
inward or outward remittances, etc. involving payment
or receipt of one currency against another currency. In
the case of capital account convertibility, a currency
can be converted into any other currency without any
transaction.
The Reserve Bank of India appointed in 1997 the
Committee on Capital Account Convertibility with Mr.
S.S. Tarapore, former Deputy Governor of RBI as its
chairman. Tarapore Committee defined capital account
convertibility as the freedom to convert local financial
assets with foreign financial assets and vice-versa at
market determined rates of exchange.

In simple language, capital account convertibility allows

anyone to freely move from local currency into foreign
currency and back. The purpose of capital convertibility
is to give foreign investors an easy market to move in
and move out and to send a strong message that Indian
economy was strong enough and that India had
sufficient forex reserves to meet any flight of capital
from the country to any extent.
The Budget 2002-03 has adopted a cautious step
towards Capital Account Convertibility by allowing NRI
to repatriate their Indian income. Considering the
present condition along with the comfortable foreign
exchange reserve of the country at present, the
government is now favoring a make towards fuller
capital account convertibility in the context of changes
in the last two decades. For the mean time on 18th
March, 2006 Prime Minister Dr. Manmohan Singh asked
the Finance Ministry and RBI to work out a roadmap for
fuller capital account convertibility based on current
realities. Dr. Singh is of the view that such roadmap for
fuller capital account convertibility would attract
greater foreign investments into the country.
Thus it is expected that the Government of India and
the RBI are going to announce a roadmap soon for the
attainment of fuller capital account convertibility of the
country. However, while taking decision for full
convertibility of rupee, the Government should take
adequate care of its possible consequences.
In the meantime on 29th March, 2006, 160 renowned
Indian economists asked the government to desist from
mowing towards full convertibility of rupee as it was
brought with dangerous consequences. They argued,
We urge the UPA government from such an
unnecessary and dangerous measure. This (full float of

rupee) would expose Indian economy to extreme

volatility.
The statement made by about 160 leading economists
from various institutions across the country and signed
by Prof. Prabhat Patnaik of JNU, Delhi also expressed
apprehension that to expose the country to
unpredictable movements in capital flows would create
a potential for fragility and crisis and particularly when
the stock market is witnessing a speculative boom.
Indias external sector was vulnerable till recently, with
the current account deficit above the comfort level of
2.5 per cent of the gross domestic product. It was 4.2
per cent of gross domestic product (GDP) in 2011-12
and rose to 4.7 per cent in 2012-13. After severe curbs,
including restrictions on import of precious metals, the
deficit fell to 1.7 per cent in 2013-14. In 2014-15, it
continued to stay low, with the third quarter showing a
deficit of 1.6 per cent.
Presently, Capital account convertibility of the rupee is
a distant dream because macroeconomic parameters
have to be stable before it is implemented. The low
current account deficit should be sustained and the
fiscal deficit needs to be contained. The rupee as a
currency
should
be
more
frequently
traded
internationally, then only capital account convertibility
is possible.