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Convertibility
CONCEPT
The concept of convertibility formerly referred
(in the era of the gold standard and some time
thereafter) to the right to convert a currency
into Gold at a given rate of exchange.
Nowadays it is essentially means the ability
of residents and non-residents to exchange
freely domestic currency for foreign
currency without limit, whatever is the
purpose of the transactions.
Convertibility can apply to currencies of
countries that have fixed or flexible rate
regimes.
A distinction can be drawn between soft and
hard concepts of convertibility.
Soft convertibility entails the ability to freely
exchange currencies at market determined
exchange rate while the hard convertibility
entails the right to freely exchange currencies
at a given exchange rate.
The key distinction is here who bears the
exchange risk: under soft convertibility the
holders of currency do, while under the hard
convertibility the country issuing the currency
does
THE RATIONALE
The question of market convertibility concerns
the circumstances under which the holder of
one currency can sell it in order to acquire
another. A multilateral system requires that
those who are paid in one currency be able to
convert that currency into any other currency
that they need to make payments since in the
absence of such a right, they are under
pressure to spend their earnings on goods from
the country in which the currency is acquired
IMF
articles,
therefore,
contained
an
obligation on member countries to make their
currencies convertible.
The obligation was however qualified in two
ways. First countries were entitled to avail
themselves of a transitional period of undefined
length before accepting the obligations.
Second it was only currency balances acquired in
the course or needed to make current account
transactions that the issuing country was
obligated to convert on request. It was assumed
that most countries would control capital
transactions
IMF AND CURRENT ACCOUNT CONVERTIBILITY
ARTILCE VIII
IMF’s Articles of Agreement or Charter were
designed primarily to address the contemporary
imperative of restoring the free flow of
international trade in goods and services which
has been disrupted by the depression of 1930s
and World War II.
The scope of IMF members’ commitment to
achieving convertibility which is included in
Article VIII was therefore limited to current
account transactions.
Article VIII singles out exchange restrictions
and
other
discriminatory
currency
arrangements or practices as impediments to
current account convertibility
A member undertaking the obligations of Article
VIII must therefore indicate that its currency
arrangements are free of such practices. In so
doing the member gives confidence to the
international community that it will pursue
sound economic policies that will obviate the
need to use restrictions on payments and
transfers for current international transactions
All members of IMF except USA, Mexico and
three Central American Republics initially
availed themselves of the loophole provided by
the transitional period allowed under Article
VIII. Beginning 1990s however IMF intensified
its efforts in this regard.
CAPITAL ACCOUNT CONVERTIBILITY
Capital Account Convertibility refers to the
freedom to convert local financial assets into
foreign financial assets and vice-versa, at
market determined rates of exchange. 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
WHY LIBERALISE CAPITAL ACCOUNTS
The arguments in favour of liberalization are
essential two
It is an inevitable step in development and thus
cannot be avoided
It can bring major benefits to a country’s
residents and government enabling them to
borrow and lend on more favourable terms and
in more sophisticated markets. A country’s own
financial market can grow in efficiency with the
introduction of advanced financial instruments
and technologies.
And with better allocation of both saving and
investment economic growth can be more rapid
and sustainable. This is not to dismiss the reality
that with liberalization the economy will be more
vulnerable to market sentiment and that market
shifts – while usually rational – will be excessive
at times
BENEFITS OF CONVERTIBILITY TO INDIA
Capital Account Convertibility will open the
window to foreign funds to cover the savings
gap – the difference between the domestic
savings and the domestic investment thus
increasing the availability of investible funds
Rates of return on debt and equity in India are
high by world standards. With convertibility
foreign funds will flow into India to arbitrage
the differential away and reduce these rates of
return. Thus the cost of capital for Indian
companies in equity and debt finance will
drop. The lower cost of capital will make more
investment projects viable generating a faster
pace of investment and growth in the economy
Investors
can
diversify
their
portfolio
internationally
thereby
decreasing
their
vulnerability to domestic shocks
Companies can go global by investing abroad.
It should encourage Indian entrepreneurs to
seek a global presence
CAC would bring in its wake international
competition. This in turn would propel the
economy to a higher level of efficiency
CHALLENGES AND OPPORTUNITIES
The opening up of the capital account would
put our bankers, central bank and the stock
markets on their mettle and at the same time
expand their horizon. Managers of banks and
corporates have to become sensitized to the
global market place much more than they
have been so far.
The move towards full convertibility should
result in the integration of the market which
implies that the treasury function will come to
the centrestage of banks and corporates. Profit
making opportunities will come by only out of
an intelligent and rational anticipation of
trends. There is thus a great premium to be
placed on timely availability of accurate
information and talent
Thank you