When you make payments, current account convertibility refers to your ability to freely change your rupees into other internationally accepted currencies and vice versa. It is the free trade in commodities to change native currency into a foreign currency and vice versa (services, transfers, or income from investment). If you want to know What Is Current Account Convertibility in details keep reading this article till the end.
Currencies can be converted to foreign exchange markets by individuals and corporations. In order to satisfy their international commitments, exporters, importers, residents, businesses, foreign investors, domestic investors abroad, etc. want to transform their domestic money into foreign currency.
The term “current account convertibility” refers to the movement of funds into and out of an account that is not linked to any sort of capital income or expense. Transactions which are considered part of current account convertibility usually include commercial problems such as the purchase of goods or services such as the acquisition of a new kitchen appliance or the payment of the plane fare for the package of travel. This is distinct from capital account convertibility, which would entail transactions like making loan payments or utilizing cash to buy investments that are liabilities or capital assets.
Current account convertibility occurs when the transactions in question necessitate some form of currency conversion to be performed. For instance, if a customer in the United States wanted to buy a CD from a customer in the United Kingdom using cash from his or her checking account, the transaction would require currency conversion from US dollars to British pounds.
Similarly, if a client wanted to buy and import items from a foreign provider, there’s a significant probability that a currency conversion would be necessary, which would need knowing the current exchange rate and applying it to the transaction.
Whether a transaction involves current account convertibility or capital account convertibility is usually determined by the application of certain financial and trade regulations. These rules are typically set by the countries involved in the transaction. The total value of the transaction is sometimes the focus, with smaller sums being regarded as a current account transaction and amounts above a certain threshold being considered a capital account transaction. Transactions involving specialized assets such as heavy equipment are processed as capital account convertibility in some nations, regardless of the amount of money involved.
All financial exchanges between countries are made up of current account transactions (such as a country’s exports and imports of commodities and services) and capital account transactions (which represent net changes in ownership of national assets). The capital account includes all sorts of investment assets, such as debt, shares, and property, as well as corporate assets, such as commodities generated by a foreign company’s Indian subsidiary.
Current account convertibility entails loosening limits on current international transactions and allowing for payment of current transactions involving foreign exchange at market-determined prices. The rupee was made completely convertible in India for a current account for all trade transactions, remittances, and indivisibles in the mid-1990s (operationalized on August 19, 1994). To comply with Article VIII of the International Monetary Fund (IMF), which forbids any exchange limitations on current international transactions, India had to formalize current account convertibility.
Current account convertibility in India
Current account convertibility allows for the free movement of foreign currency for imports and exports, internal and external foreign currency transactions, access to foreign currency for medical and tourism purposes, travel, studying abroad, and other uses at current market prices. However, capital account convertibility in India is still only partially convertible.
This indicates that Indians have a capacity under current account convertibility to acquire and sell goods and services, but still need regulatory approval when investing or purchasing assets outside of India for a specific limit. Additionally, in certain sectors such as insurance or retail (certain investments are limited in a particular percentage), FDI restrictions persist, and regulatory permits continue in these areas to be necessary to achieve increased investment limits.
While convertibility on the current account provides for free entry and supply to India of foreign currencies with a high level of free trade at market rates, regulators still usually need to be authorized under the liberalized payment system for higher exchange rates beyond the limit set for foreign currency acquisitions for traveling or studying outside India, medicine or tourism. Moreover, RBI is taking steps to stabilize the rupee and keep exchange rates at allowed prices when buying/selling US dollars in the event of excessive volatility in the Rupee foreign-currency market.
Current account convertibility in the Indian economy
During and after 1991 economic reforms, the Indian Government launched steps to allow for the partial convertibility of rupees into foreign currency under liberalized currency management schemes in which 60 percent of all electronic receipts could be freely transferred to rupees, with the fixed exchange rate quoted by authorized dealers, while the remaining 40 are freely Convertable to rupees. Current account transactions include all commodities and services being imported and exported.
This 40% of foreign currency was intended to meet the government’s departmental needs and pay for the government’s imports of critical commodities. This is why it was referred to as the Dual Currency System.
Advantages of Current account convertibility
- Facility to freely transmit your foreign income to India: Current account convertibility enables you to receive and convert the income sent by your family members working abroad, without going through a complicated procedure prior.
- Promote international trade: Current account convertibility facilitates the conversion of foreign currency into domestic currency and vice versa. This helps to integrate trade across countries around the world. By eliminating trade barriers, it increases international trade links among countries.
- Encouragement to exports: A major advantage of current account conversion is that it promotes exports by improving profits. Export convertibility grows because the exchange rate of the market exchange is higher than the government fixed exchange rate. This means that exporters can receive more foreign exchange rupees from exporters’ exports (e.g. US dollars). In particular, currency convertibility favors low-import exports.
- Imports and exports can be carried out at market-determined rates: Before the free current account conversion, one must either forfeit a portion of their foreign exchange receivable to Indian rupees at the rates specified by RBI or convert it to Indian rupees. Previously, the rate decided was usually lower than the market rate. This enables you to convert your foreign currency at the market-determined rate that is fairer than pre-determined rates.
- Encouragement to import substitution: Imports become more expensive following a currency’s convertibility because the free or market-determined exchange rate is higher than the prior government-regulated exchange rate. This discourages imports and encourages the replacement of imports.
- An incentive to send remittances from abroad: Rupee convertibility gave more incentives for Indian employees residing overseas and NRIs to send remittances of foreign exchange. It also makes illegal remittances like “hawala money” and gold smuggling less appealing.
- A self-balancing mechanism: The self-balancing mechanism is another key advantage of current account convertibility. When the balance of payments is in deficit due to exchange rates being overvalued, the currency of the country is under convertibility and it degrades, boosting its exports, on the one hand, by cutting prices and discouraging imports, on the other, by increasing prices.
This automatically corrects the balance of payments deficit without the Government or its Central Bank interference. Instead, the balance of payments is excess because the exchange rate is undervalued.
- Comparative advantage specialization: Another advantage of currency convertibility gives a production pattern in line with its relative advantage and resources for different trading countries. When currencies are convertible, the exchange rate simply represents the purchasing power of the currencies, which is based on prices and expenses in different nations.
Exports will be encouraged since prices in a competitive market reflect reduced pricing for those goods in which the country has a comparative advantage. On the other hand, in a country that has a comparative disadvantage, it will be prone to import such products into production. As a result, currency convertibility ensures specialization and international trade based on comparative advantage, which benefits all countries.
- Integration of the World Economy: Lastly, currency convertibility promotes global economic integration. Currency convertibility facilitates the growth of trade and capital flows between countries by providing simple access to foreign exchange. Trade and capital flow between countries will expand, ensuring significant economic growth in the world’s economies. Indeed, currency convertibility is regarded to be a precondition for globalization success.
Disadvantages of Current account convertibility
- Effects on Balance of Trade and Exports: In overseas markets, a rising, unregulated currency makes Indian exports less competitive. Export-based economies such as India and China prefer to keep their exchange rates down so that the low-cost benefit remains. Once the exchange-rate rules fall away, India is in danger of losing its worldwide competitiveness.
- Lack of basics: In well-regulated nations with a strong infrastructure, the convertibility of full current accounts has worked successfully. India’s fundamental issues — high export dependency, rising populations, corruption, socio-economic complexities, and bureaucratic challenges — may cause economic failures after full rupee convertibility.
- High Volatility: High degrees of volatility, devaluation, or inflation in forex rates may occur due to a lack of appropriate regulatory control and rates subject to open markets with a large number of global market participants, posing a threat to the country’s economy.
- The burden of Foreign Debt: Businesses can readily take on international loans, but they run the danger of having to make large repayments if exchange values deteriorate. Consider an Indian company taking out a 4 percent U.S. dollar loan versus a 7 percent credit offered in India. However, if the US dollar is up to the Indian rupee, more rupees will be needed to receive the same amount of dollars, making the refund expensive.