Exchange Rate Mechanism, Current Account Convertibility and Capital Account Convertibility
Evolution of Exchange Rate Mechanism in India:
The exchange rate is a key financial variable that affects decisions made by foreign exchange investors, exporters, importers, bankers, businesses, financial institutions, policymakers and tourists in the developed as well as developing world. Exchange rate fluctuations affect the value of international investment portfolios, competitiveness of exports and imports, value of international reserves, currency value of debt payments, and the cost to tourists in terms of the value of their currency. Movements in exchange rates thus have important implications for the economy’s business cycle, trade and capital flows and are therefore crucial for understanding financial developments and changes in economic policy.
India has been operating on a managed floating exchange rate regime from March 1993, marking the start of an era of a market determined exchange rate regime of the rupee with provision for timely intervention by the central bank. As has been the experience with the exchange rate regimes the world over, the Reserve Bank as the central bank of the country has been actively participating in the market dynamics with a view to signaling its stance and maintaining orderly conditions in the foreign exchange mark. As a result of calibrated and gradual capital account openness, the financial markets, particularly forex market, in India have also become increasingly integrated with the global network since 2003-04. This is reflected in the extent and magnitude of capital that has flown to India in recent years.
Current Account and Capital
Account Convertibility:
As per the “BALANCE OF PAYMENTS MANUAL FOR INDIA”, Current Account and Capital Account are defined as
follows:
Current Account:
The current account includes flows of goods, services, primary income, and secondary income between residents and non-residents and thus constitutes an important segment of BoP. While the “goods and services account” generally forms a major part of the current account, the primary income account reflects amounts payable and receivable in return for providing temporary use of labour, financial resources, or non-produced non-financial assets (natural resources). The secondary income account shows redistribution of income between resident and non-residents, i.e, when resources for current purposes are provided without economic value being exchanged in return (transfers). The net effect of all the transactions under the above accounts is known as the “current account balance”. In other words, the current account balance shows the difference between the sum of exports of goods and services as well as income receivable, on the one hand, and the sum of imports and income payable on the other. From a macroeconomic perspective, the value of the current account balance reflects the inflow/outflow of foreign resources bridging the savings-investment gap.
Capital Account:
The capital account comprises credit and debit transactions under non-produced nonfinancial assets and capital transfers between residents and non-residents. Thus, acquisitions and disposals of non-produced non-financial assets, such as land sold to embassies and sales of leases and licences, as well as transfers which are capital in nature, are recorded under this account.
Current and Capital
Account Convertibility:
Currency convertibility refers to the freedom to convert the
domestic currency into other internationally accepted currencies and vice
versa. Convertibility in that sense is the obverse of controls or restrictions
on currency transactions. While current account convertibility refers to
freedom in respect of ‘payments and transfers for current international
transactions’, capital account convertibility (CAC) would mean freedom of
currency conversion in relation to capital transactions in terms of inflows and
outflows.
Capital Account Convertibility (CAC) refers to the freedom to convert local financial assets into foreign financial assets and vice versa. It is associated with changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by, the rest of the world. CAC can be, and is, coexistent with restrictions other than on external payments. Unlike Current Account Convertibility, India is following a gradualist approach towards capital account convertibility. Unlike current account which is fully convertible, there are restrictions on capital account convertibilty.
Decisions taken by Government of India, on account of Indian Exchange Rate are as follows:
1947-1971: Par Value system of
exchange rate. Rupee’s external par value was fixed in terms of gold with the
pound sterling as the intervention currency.
1971: Breakdown of
the Bretton-Woods system and floatation of major currencies. Rupee was linked
to the pound sterling in December 1971.
1975: To ensure stability of the Rupee, and avoid the weaknesses associated with a single currency peg, the Rupee was pegged to a basket of currencies. Currency selection and weight assignment was left to the discretion of the RBI and not publicly announced.
1978: RBI allowed the domestic banks to undertake intra-day trading in foreign exchange.
1978-1992: Banks began to start quoting two-way prices against the Rupee as well as in other currencies. As trading volumes increased, the ‘Guidelines for Internal Control over Foreign Exchange Business’ were framed in 1981. The foreign exchange market was still highly regulated with several restrictions on external transactions, entry barriers and transactions costs. Foreign exchange transactions were controlled through the Foreign Exchange Regulations Act (FERA). These restrictions resulted in an extremely efficient unofficial parallel (hawala) market for foreign exchange.
1990-1991: Balance of Payments crisis
July 1991: To stabilize the foreign exchange market, a two step downward exchange rate adjustment was done (9% and 11%). This was a decisive end to the pegged exchange rate regime.
March 1992: To ease the transition to a market determined exchange rate system, the Liberalized Exchange Rate Management System (LERMS) was put in place, which used a dual exchange rate system. This was mostly a transitional system.
As per the LERMS, all foreign exchange remittances, whether earned through exports of goods or services, or remittances, will be converted into rupees in the following manner: 40% of the foreign exchange remitted will be converted at the official exchange rate while the remaining 60% will be converted at a market determined rate.
March 1993: The dual rates converged, and the market determined exchange rate regime was introduced. All foreign exchange receipts could now be converted at market determined exchange rates.
August 1994: Initial reform measures on the heels of the balance of payments crisis in 1991 were predominantly directed at current account convertibility leading to acceptance of obligations under Article VIII of the International Monetary Fund’s (IMF) Articles of Agreement by August 1994.
With this, the exchange rate of the rupee thus became market determined,
with the Reserve Bank ensuring orderly conditions in the foreign exchange market
through its sales and purchases.
However, India accepted current account convertibility with following safeguards:
1. First, the
requirement of repatriation and surrender of export proceeds was continued.
Exporters were however, allowed to retain a portion of their earnings in
foreign currency accounts in India which could be used for approved purposes,
thereby avoiding costs of conversion and reconversion.
2. Secondly, all authorised dealers were allowed to sell foreign exchange for underlying current account transactions, which could be readily identified and supported by some documentary evidence.
3. Thirdly, indicative value limits were given for different kinds of transactions so that the amounts sold were reasonable in relation to the purpose. For higher amounts, the banks had to approach the RBI. This operational framework for current account transactions strengthened the effectiveness of management of capital account.
Article VIII of the International Monetary Fund (IMF) puts an obligation on a member to avoid imposing restrictions on the making of payments and transfers for current international transactions. Members may cooperate for the purpose of making the exchange control regulations of members more effective. Article VI (3), however, allows members to exercise such controls as are necessary to regulate international capital movements, but not so as to restrict payments for current transactions or which would unduly delay transfers of funds in settlement of commitments.
Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER):
The indices of Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) are used as indicators of external competitiveness. NEER is the weighted average of bilateral nominal exchange rates of the home currency in terms of foreign currencies. Conceptually, the REER, defined as a weighted average of nominal exchange rates adjusted for relative price differential between the domestic and foreign countries, relates to the purchasing power parity (PPP) hypothesis.
The Reserve Bank of India (RBI) has been constructing five-country and fourty country indices of NEER and REER as part of its communication policy and to aid researchers and analysts. Theses indices are published in the Bank’s monthly Bulletin.
Three major developments as set out in the following paragraphs have necessitated a review of the existing indices.
First, introduction of the Euro (notes and coins) with effect from January 1, 2002 necessitated the need to replace the existing national currencies of the Euro zone by the common currency for the members, which formed part of RBI’s 5-country and 36-country REER/NEER indices. The European Commission (Eurostat) introduced a harmonised index of consumer prices (HICP) for the member countries, which entailed individual consumer price indices to be replaced by HICP in the construction of the REER.
Second, there has been a significant shift in India’s trade relations across countries/regions, mainly towards developing and emerging economies during the last decade, requiring a change in the currency basket and the weights assigned to India’s trading partners included in the REER.
Third, the base year of the Wholesale Price Index of India (WPI), was changed to 2015 - 16, necessitating a change in the base year for 36-country REER and NEER indices.
Against the above backdrop, the Reserve Bank has now decided to replace its existing 5-country indices with new six-currency indices of NEER/REER. The thirty six-country indices have also been revised and replaced with new 40-currency indices of NEER/REER.
Reference:
- The Ministry of Statistics and Programme Implementation
- Balance of Payments Manual for India - RBI
- Report of the Committee on Fuller Capital Account Convertibility
- Operationalising Capital Account Liberalisation : Indian Experience - Y V Reddy
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