India's currency is not yet fully convertible. However, there have been talks of making the rupee (INR) fully convertible and setting up an onshore INR market. (Not to be confused with the Nepalese rupee or the Pakistani rupee.) There are many advantages and disadvantages associated with rupee convertibility which have led to a continuous debate since reforms were first introduced during the early 1990s.
India has taken several steps to alter some of its standardized currency policies including demonetization. But is India ready to move to a fully convertible currency? In this article, we look at the current state of Indian markets within the existing partial rupee convertibility scenario, what a change could mean for India and the world, and the pros and cons of rupee convertibility.
- Convertibility is the ease with which a country's currency can be converted into gold or another currency through global exchanges.
- India's rupee is a partially convertible currency—rupees can be exchanged at market rates in certain cases, but approval is required for larger amounts.
- Making the rupee a fully convertible currency would mean increased liquidity in financial markets, improved employment and business opportunities, and easy access to capital.
- Some of the disadvantages include higher volatility, an increased burden of foreign debt, and an effect on the balance of trade and exports.
What Is Currency Convertibility?
Convertibility is the ease with which a country's currency can be converted into gold or another currency through global exchanges. It indicates the extent to which the regulations allow inflow and outflow of capital to and from the country. Currencies that aren't fully convertible, on the other hand, are generally difficult to convert into other currencies.
Currency convertibility is an important part of global commerce because it opens up trade with other countries. Having a convertible currency allows a government to pay for goods and services in a currency that may not be the buyer's own. Having a nonconvertible currency makes it harder for a government to participate in the international market because these transactions generally take longer to execute.
A nation's economy may be related to whether its currency is convertible. Stronger currencies tend to be converted more easily than others, while growth may be stagnant for currencies with poor convertibility because these countries may miss trade opportunities.
The State of the Indian Currency
Until the early 1990s (pre-reform period), anyone willing to transact in a foreign currency would need permission from the Reserve Bank of India (RBI), regardless of the purpose. People wanting to engage in foreign travel, foreign studies, the purchase of imported goods, or to get cash for foreign currencies received (like with exports) were all required to go through the RBI. All such forex exchanges occurred at pre-determined forex rates finalized by the RBI.
After liberal economic reforms were introduced in 1991, many significant developments occurred that impacted the way forex transactions were conducted. Exporters and importers were allowed to exchange foreign currencies for the trade of unbanned goods and services, there was easy access to forex for studying or traveling abroad, and a relaxation on foreign business and investments with minimal (or no) restrictions depending on the industry sectors.
However, Indians still require regulatory approval if they want to invest an amount above a pre-determined threshold level for the purpose of investments or purchasing assets overseas. Similarly, incoming foreign investments in certain sectors like insurance or retail are capped at a specific percentage and require regulatory approvals for higher limits.
As of 2019, the Indian rupee is a partially convertible currency. This means that although there is a lot of freedom to exchange local and foreign currency at market rates, a few important restrictions remain for higher amounts, and these still need approval. The regulators also pitch in from time-to-time to keep the exchange rates within permissible limits instead of keeping the INR as a completely free-floating currency left to market dynamics. In the case of extreme volatility in rupee exchange rates, the RBI swings into action by purchasing/selling U.S. dollars (kept as foreign reserve) to stabilize the rupee.
Although there is a lot of freedom to exchange local and foreign currency at market rates, the Indian rupee is a partially convertible currency, meaning the exchange of higher amounts is restricted and still needs approval.
Full convertibility would mean the rupee exchange rate would be left to market factors without any regulatory intervention. There may be no limit on inflow or outflow of capital for various purposes including investments, remittances, or asset purchases/sales.
Current Account vs. Capital Account Convertibility
Any currency may be current account or capital account convertible, or both. Current account convertibility implies that the Indian rupee can be converted to any foreign currency at existing market rates for trade purposes for any amount. It allows for easy financial transactions for the export and import of goods and services. Any individual involved in trade can get foreign currency converted at designated banks or dealers. In essence, current account convertibility remains within the institutional trading realms. At the beginning of the reforms, the rupee was made partially convertible for goods, services, and merchandise only. During the mid-1990s, the rupee was fully made current account convertible for all trading activities, remittances, and indivisibles.
However, the rupee continues to remain capital account non-convertible. Capital account convertibility allows freedom to convert local financial assets into foreign financial assets and vice-versa. It includes easy and unrestricted flow of capital for all purposes which may include free movement of investment capital, dividend payments, interest payments, foreign direct investments in domestic projects and businesses, trading of overseas equities by local citizens and domestic equities by foreigners, foreign remittances, and the sale/purchase of immovable property globally. One can still bring in foreign capital or take out local money for these purposes, but there are ceilings imposed by the government that require approvals.
Here are some of the benefits of making the INR into a fully convertible currency:
Sign of Stable and Mature Markets
Regulators like to keep control over their territories. Free and open entry to an enormous number of global market participants would increase the risk of losing regulatory control due to large market size and a huge flow of capital. Opening up to a fully convertible currency is a solid sign that a country and its markets are stable and mature enough to handle the free and unrestricted movement of capital, which attracts investments making the economy better.
Increased Liquidity in Financial Markets
Full capital account convertibility opens up the country’s markets to global players including investors, businesses, and trade partners. This allows easy access to capital for different businesses and sectors, positively impacting a nation’s economy.
Improved Employment and Business Opportunities
With increased participation from global players, new businesses, strategic partnerships, and direct investments flourish. It also helps in the creation of new employment opportunities across various industry sectors, as well as nurturing entrepreneurship for new businesses.
Onshore Rupee Market Development
The growing international interest in the Indian rupee is evident from the development of offshore rupee markets in locations like Dubai, London, New York, and Singapore. Trading of the INR is still far lower than other currencies such as the euro. In 2021, INR contracts traded against the dollar an average of 16,784 times per day compared to 162,338 contracts converted from Euro to USD. Making the rupee fully convertible would enable greater trades and global flow of the Indian currency, helping national markets with improved liquidity, better regulatory purview, and reduced dependence and risks from offshore market participants.
Easy Access to Foreign Capital
Local businesses can benefit from easy access to foreign loans at comparatively lower costs—lower interest rates. Indian companies currently have to take the ADR/GDR route to list on foreign exchanges. After full convertibility, they will be able to directly raise equity capital from overseas markets.
Better Access to a Variety of Goods and Services
Amid current restrictions, one does not see much variety in India for foreign goods and services. Walmart (WMT) and Tesco stores aren’t that common, although a handful exist in partnership with local retail chains. Full convertibility will open doors for all global players to the Indian market, making it more competitive and better for consumers and the economy alike.
Progress in Multiple Industry Sectors
Sectors like insurance, fertilizers, retail, etc. have restrictions on foreign direct investments (FDIs). Full convertibility will open the doors of many big international players to invest in these sectors, enabling much-needed reforms and bringing variety to the Indian masses.
Fancy buying a house on the coast of Florida or buying a million-dollar yacht in London? At present, any Indian individual or business would need permission from authorities to do so. After full convertibility, there will be no limits on the amounts exchanged and no need for approvals.
Improved Financial System
The Tarapore Committee, which was tasked with assessing the full convertibility of the rupee, has noted these benefits after full rupee convertibility, including:
- Indian businesses will be able to issue foreign currency-denominated debt to local Indian investors.
- Indian businesses will be able to hold foreign currency deposits in local Indian banks for capital requirements.
- Indian banks will be able to borrow and/or lend to foreign banks in foreign currencies.
- Easy options to buy/sell gold freely and offer gold-based deposits and loans with higher (or even uncapped) limits.
Amid a lack of suitable regulatory control and rates subject to open markets with a large number of global market participants, high levels of volatility, devaluation, or inflation in forex rates may happen, challenging the country’s economy.
Foreign Debt Burden
Businesses can easily raise foreign debt, but they are prone to the risk of high repayments if exchange rates become unfavorable. Imagine an Indian business taking a U.S. dollar loan at a rate of 4%, compared to one available in India at 7%. However, if the U.S. dollar appreciates against the Indian rupee, more rupees will be needed to get the same number of dollars, making the repayment costly.
Effects on Balance of Trade and Exports
A rising, unregulated rupee makes Indian exports less competitive in the international markets. Export-oriented economies like India and China prefer to keep their exchange rates lower to retain the low-cost advantage. Once the regulations on exchange rates go away, India risks losing its competitiveness in the international market.
Lack of Fundamentals
Full capital account convertibility has worked well in well-regulated nations that have a robust infrastructure in place. India’s basic challenges—a high dependence on exports, burgeoning population, corruption, socio-economic complexities, and challenges of bureaucracy—may lead to economic setbacks post-full rupee convertibility.
Is India Ready?
India is expected to become a truly global economy in the near future, and it will need fuller integration into the global economic system. Making the rupee fully convertible is an expected step in that direction.
How soon India can do this depends on many conditions being met including low levels of non-performing assets (NPA), fiscal consolidation, optimum levels of forex reserves, control on inflation, manageable current account deficit (CAD), robust infrastructure for regulating financial markets, and efficient monitoring of financial organizations and businesses.
The Bottom Line
Despite economic progress being made by India on many fronts, there have been regular challenges at both the global and local levels including the global financial crisis of 2008-09, a lack of inflation control, and rising NPAs—all of which have delayed full convertibility of the rupee. It may take another three to five years for India to fully prepare itself for full rupee convertibility.