The Historical Perspective
Although an international monetary system has been
in existence since monies have been traded, its analyses have
been traditionally started from the late 19th century when the
gold standard began.
The Gold Standard: 1880-1914
Although an exact date for the beginning of the gold
standard cannot be pinpointed, the 1880-90 period is important.
Under a gold standard, currencies are valued in terms of a gold
equivalent known as the mint parity price (an ounce of gold
was worth $ 20.67 in terms of the U.S. dollar over the gold
standard period). Then, because each currency is defined in
terms of its gold value, all currencies are linked together
in a system of fixed exchange rates. For instance, if 1 unit
of currency A is worth 0.10 ounces of gold, whereas 1 unit of
currency B is worth 0.20 oz. of gold, then 1 unit of currency
B is worth twice as much as A. Thus, the exchange rate of 1
currency B=2 currency A is established.
Gold was used as a monetary standard because it is an internationally-recognized
homogeneous commodity that is easily storable, portable, and
divisible into standardized units, such as ounces. Since gold
is costly to produce, it possesses another important attribute--governments
cannot easily increase its supply.
The Gold
Exchange Standard : 1944-1970
Memories of the economic warfare of the inter-war years
led to an international conference at Bretton Woods, New Hampshire,
in 1944 at the close of World War II. There was a desire to
transform the international monetary system into one based on
mutual cooperation and freely convertible currencies. The Bretton
Woods agreement required that each country fix the value of
its currency in terms of gold (this established the "par"
value of each currency and was to ensure parity across currencies).
The U.S. $ was the key currency in the system, and $1 was equated
in value to 1/35 oz. of gold. Since every currency had a defined
value in gold, all currencies were linked in a system of fixed
exchange rates.
The members were committed to maintaining the value of the currency
within +/-1% of parity. The various central banks were to achieve
this goal by buying and selling their currencies (usually against
the dollar) on the foreign-exchange market. When a country experienced
difficulty maintaining its parity value due to balance of payments
disequilibria, it could turn to the International Monetary Fund
(IMF), which was created to monitor the provision of short-term
loans to countries experiencing temporary balance of payment
difficulties.
CONVERTIBILITY: ITS ESSENCE
Legally, a currency is considered convertible when the concerned
country formally accepts the obligations of Article VIII, Sections
2,3 and 4 of the Articles of Agreement of the I MF. A currency
is externally convertible when "all holdings of that currency
by non-residents are freely exchangeable into any foreign (non-
resident) currency at exchange rates within the official margins…all
payments that residents of the country are authorized to make
to non-residents may be made in any externally convertible currency
that residents can buy in foreign exchange markets." Contrarily,
if there are no restrictions on the ability of a country to
use their holdings of domestic currency to acquire any foreign
currency and hold it, or transfer it to any nonresident for
any purpose, that country’s currency is said to be internally
convertible. Thus external convertibility = partial convertibility
and total convertibility = external + internal convertibility.
CONVERTIBILITY: WHY?
Externally inconvertible currencies may be of rather limited
value to their holder. An exported item from a developing country
to the USSR, for example, may be paid for in rubles or the currency
of a country that has ratified Article VIII. If the latter,
the proceeds may be used to purchase goods anywhere.
In considering possible import suppliers, therefore, a developing
country will have some interest in directing its importers to
those countries that will have some interest in directing its
importers to those countries whose inconvertible currencies
are in large supply. This is, of course, a case of trade discrimination
that is condemned by traditional theory. For it means that goods
are not being purchased from the cheapest source. Recent economic
writing has, however, reopened the question in view of the continued
existence of inconvertible currencies. Where it is profitable
on the export side to trade with countries maintaining inconvertible
currencies, and the government wishes to encourage imports from
those countries to offset its credit balances, it will utilize
its exchange distribution mechanism to limit the availability
of convertible exchange where there are alternative suppliers
of the same type of goods in inconvertible currency countries
CURRENT ACCOUNT CONVERTIBILITY
The current account is defined as including the value of trade
in merchandise, services, investment, income and unilateral
transfers. Current account convertibility, being essential to
the development of multilateral trade, three approaches to current
account convertibility have been adapted by developing countries.
These are the pre-announcement, by-product, and front-loading
approaches. Each approach is distinguished by the importance
it attaches to convertibility relative to other economic objectives.
CAPITAL ACCOUNT CONVERTIBILITY
Capital account includes transactions of financial assets. Its
convertibility refers to the freedom to convert local financial
assets into foreign assets in any form and vice versa at market-determined
rates of exchange.
Capital controls, strictly defined, include restrictions that
affect the capital account of the b.o.p. They normally restrict
or prohibit cross-border movement of capital. Thus, controls
on capital movements include prohibitions: need for prior approval;
authorization and notification; multiple currency practices;
discriminatory taxes; and reserve requirements or interest penalties
imposed by the authorities that regulate the conclusion or execution
of transactions. The coverage of the regulations would apply
to receipts as well as payments and to actions initiated by
non-residents and residents.
THE INDIAN SCENARIO
(1997-2000)
Introduction
The international experience with CAC shows that, in general,
liberalization of the capital account induces large capital
inflows that can cause real appreciation in the exchange rate
and erode the effectiveness of domestic monetary policies. Further
more, an open capital account imposes tremendous pressure on
the financial system and weakens the financial system. While
it is necessary to recognize that these weaknesses could precipitate
systematic hazards irrespective of whether or not CAC is introduced,
the move to CAC would demand a strongly disciplined financial
system and would warrant early rectification of infirmities
in the system. There are distinct benefits of CAC, such as,
availability of a larger capital stock at international prices
to supplement domestic resources, risk diversification, allocative
efficiency and improvement in intermediation of financial resources,
development of financial markets and a disciplining influence
on macro-economic policies.
India had already adopted current account convertibility in
August1994 by formally ratifying Article VIII of the Articles
of Agreement of the (IMF). Furthermore, CAC is already instituted
for foreign investors, both direct and portfolio, non-resident
depositors and resident corporate houses and institutions.
Controls, however, continue to operate on the ability of resident
individuals and corporate entities to send capital abroad as
also on inflows and outflows of capital associated with banks
and non-bank financial utilities.
THE TARAPORE COMMITTEE REPORT
Chaired by its former Deputy Governor, S. S. Tarapore, a
Committee was appointed by the Reserve bank of India on February
28, 1997, in pursuance of the commitment made by the Finance
Minister Shri P. Chidambaram in his Budget for 1997-98. The
RBI had at that time indicated that the Committee will complete
its work by May 30,1997. The terms of reference of the committee
were to (1) review the international experience in relation
to capital account convertibility (CAC) and to indicate the
preconditions for CAC, (2) recommend measures for achieving
CAC, (3) specify the sequence and time frame for such measures,
and (4) suggest domestic policy measures and changes in institutional
framework. The Committee has recommended a phased implementation
of CAC over a three-year period: Phase I (1997-8), Phase II
(1998-9) and Phase III (1999-2000).
It has also recommended that fiscal consolidation, a mandated
inflation target and the strengthening of the financial system
should be regarded as crucial preconditions/signposts for
bringing CAC to India.
Fiscal Consolidation: There should be a reduction in the
Centre’s Gross Fiscal Deficit to GDP ratio from a budgeted
4.5% in 1997-98 to 4.0% in 1998-9, and further to 3.5% in
1999-2000, accompanied by a reduction in the states' deficit,
and also a reduction in the quasi-fiscal deficit. Recognizing
that the practice of financing the amortization of government
borrowings by borrowing afresh is clearly unsustainable and
would inevitably result in a crisis, the Committee has recommended
introduction of a Consolidated Sinking Fund (CSF) as part
of a more transparent fiscal system. The Committee has urged
that any increase in the profit transfer from the RBI to the
Government as well as the proceeds from disinvestment should
be used entirely towards building up a CSF.
Mandated Inflation Rate: For the three-year period, the MIR
should be, on an average, 3-5%. There should be an early empowering
of the RBI on the inflation mandate approved by Parliament,
which alone should be able to alter that mandate. Once it
is given, the RBI should be free to attain the target, with
appropriate guidelines on changing the mandate.
Strengthening the Financial System: This was viewed as the
most important precondition for changing to CAC, and therefore
weaknesses in the financial sector need to be addressed early.
Interest rates should be fully deregulated in 1997-8 and there
should be no formal or informal interest rate controls. The
average effective Cash Reserve Ratio (CRR), 9.3% in April
1997, should be reduced to 8% in 1999-2000. Furthermore, drastic
measures should be taken to bring down gross Non-Performing
Assets (NPAs) from the tentatively estimated 13.7% of the
total advances in March 1997 to 12% in 1997-8, 9% in 1998-9
and 5% in 1999-2000. Concerned that some weak banks are growing
at rates faster than the system, the Committee recommended
that weak banks should be converted into narrow banks, i.e.,
those whose incremental resources are invested only in government
securities. In extreme cases of weakness, restraints should
be applied on liability growth.
IN DEFENCE OF CAPITAL ACCOUNT CONVERTIBILITY
India seems to be on the second stage of economic
reforms and Capital Account Convertibility is an important
ingredient of these reforms. measures. To briefly sum up,
the current macro-economic situation is favorable for a phased
introduction of CAC. The time could not be more propitious
and we should not let the hour go by. India is clearly ready
to undertake the first step towards CAC, and we should not
be hesitant in grasping the bull by the horns.
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Currency Convertibility
