Introduction
Currency convertibility can be defined as the ability to exchange one currency for another at a given conversion rate and in terms of the usability of a currency for foreign transactions. Various degrees of convertibility can be identified, ranging from the extremes of total convertibility to total inconvertibility.
It can also refer to the ease with which the currency of a country can be freely converted into any other foreign currency or gold at market determined exchange rate. [UPSC 2015]
Types of Currency Convertibility
- Partial Convertibility / Dual exchange system: Portion allowed by the government which can be converted into foreign currency with least restrictions.
- Union Budget for 1992-93, introduced it on current account; Still operational on capital account.
- Restrictions on FDI: Prohibited sectors; Sectoral Cap; Government’s Approval in certain sectors.
- Restrictions on FPI: Individual and Aggregate FPI Limit, FPI Limit in G-Secs and Corporate Bonds.
- External Commercial Borrowings: RBI sets annual limits.
- Foreign Direct Investment (FDI): Investment through capital instruments by a person resident outside India
- In an unlisted Indian company;
- In 10 percent or more of the post issue paid-up equity capital on a fully diluted basis of a listed Indian company.
- FDIs include Subsidiaries of foreign companies in India, Majority foreign equity holding in Indian companies, Companies exclusively financed by foreign companies, Non-debt Financial resources (Foreign currency convertible bonds) Foreign institutional investment with certain conditions, Global depository receipts;
- Non-resident external deposits will create debts in the balance of payment accounts, hence not a part of FDI [UPSC 2012, 2021]
- Foreign Portfolio Investment (FPI): Investment made by a person resident outside India in capital instruments where such investment is
- Less than 10 percent of the post issue paid-up equity capital on a fully diluted basis of a listed Indian company or
- Less than 10 percent of the paid up value of each series of capital instruments of a listed Indian company.
- Portfolio investment comes under FPI.
- FII helps in increasing capital availability in general, while FDI only targets specific sectors [UPSC 2011]
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- Full Convertibility: Freedom to convert domestic currency into any foreign currency and vice-versa without any regulatory intervention.
- In 1994, the GOI declared full convertibility of Rupee on Current account.
- Current Account transactions: Imports, Exports, Remittances, Gifts, Donations, etc.
Capital Account Convertibility
- Advantages
- Improved access to international financial markets.
- Greater financial competitiveness.
- Indian residents can hold and transact foreign currency denominated deposits with Indian banks.
- Increase in FII/FPI flow.
- Disadvantages
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- Improper management of CAC can lead to currency depreciation and affect trade and capital flows.
- Speculative activity can lead to capital flight from the country.
- Imposing control would become difficult in a globalized environment once CAC is introduced.
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Important Terminology
- Hard Currency: Any globally traded currency which has global demand, high liquidity (adequate supply) and stable (does not fluctuate).
- Example: US Dollar, The Euro.
- Soft Currency: It is just the opposite of Hard currency. E.g., Indian Rupee is the Soft currency in the Indian Forex market
- Hot Currency: It is the term for the Forex market and is the temporary name for any Hard currency; If any Hard currency is exiting any economy at a fast pace for the time, the Hard currency is said to be hot currency.
- Heated Currency (currency under Heat or under Hammering): Domestic currency which is under pressure (heat) of depreciation due to any hard currency’s high tendency of exiting the economy.
- Cheap Currency: When a government starts re-purchasing its bonds before their maturities and at full maturity prices, there is an increase in supply of money which is called cheap money.
- Dear Currency: Government issues bonds, the flow of money increases from public to the government hence supply of money in the market decreases, which is dear currency.
- Weak Currency: Cheapens the rate of a country’s export, making them more attractive to international buyers.
- Currency War: Takes place when countries seek to devalue their currency to gain a competitive advantage.
- Currency Manipulator: This is a label given by the US government to countries it feels are engaging in unfair currency practices by deliberately devaluing their currency against the dollar.
Conclusion
- There are various types, including fully convertible, partially convertible, and non-convertible currencies.
- Fully convertible currencies allow unrestricted exchange and are typically associated with stable economies, facilitating international trade and investment. Partially convertible currencies have some restrictions on exchange, while non-convertible currencies have significant limitations, often due to government controls or economic instability.
- Each type has implications for cross-border transactions, capital flows, and economic policy, influencing global financial markets and economic integration.
April 5, 2024
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