Full convertibility of Rupee

The full convertibility of the Indian Rupee refers to the ability of the currency to be freely converted into foreign currencies for all kinds of transactions, including both current and capital account operations, without any restrictions imposed by the Reserve Bank of India (RBI) or the government. It signifies a stage where individuals, businesses, and investors can exchange rupees for foreign currencies (and vice versa) at market-determined rates, facilitating seamless movement of goods, services, and capital across borders.

Background

The concept of currency convertibility in India emerged during the economic reforms of the early 1990s. Before liberalisation, the Indian Rupee was subject to strict exchange control regulations under the Foreign Exchange Regulation Act (FERA), and foreign exchange transactions were heavily restricted.
With the initiation of economic reforms in 1991, India adopted a more market-oriented approach to external sector management. The Liberalised Exchange Rate Management System (LERMS) was introduced in 1992, allowing partial convertibility of the rupee. In 1994, India accepted the obligations under Article VIII of the International Monetary Fund (IMF), which made the rupee fully convertible on the current account. However, the currency remains partially convertible on the capital account to date.

Types of Convertibility

Convertibility of a currency can be broadly classified into two types:

1. Current Account Convertibility: This allows free conversion of domestic currency into foreign currency for transactions related to trade in goods and services, remittances, and other current payments. India achieved this form of convertibility in 1994, meaning residents can buy and sell foreign exchange for purposes such as imports, travel, education, and remittances without prior government approval.
2. Capital Account Convertibility: This permits unrestricted conversion for capital transactions, such as investment in foreign assets, acquisition of property abroad, and movement of capital for investment or borrowing purposes. India has partial capital account convertibility, allowing limited movement of capital with certain restrictions, particularly for residents.

Evolution of Convertibility in India

The process of achieving greater currency flexibility has evolved gradually in India:

• 1992: Introduction of the dual exchange rate system under LERMS, partially liberalising foreign exchange.
• 1993: Transition to a unified market-determined exchange rate.
• 1994: India achieved current account convertibility by adopting IMF Article VIII.
• 1997: The Tarapore Committee on Capital Account Convertibility (CAC) was established to examine the feasibility of full convertibility; it recommended a phased approach over three years with specific preconditions related to fiscal consolidation, low inflation, and strengthened financial systems.
• 2006: The Second Tarapore Committee revisited the issue and suggested another roadmap for gradual liberalisation between 2006 and 2011, focusing on prudential regulations, stronger banking supervision, and fiscal discipline.

Preconditions for Full Convertibility

Both Tarapore Committees emphasised several macroeconomic and institutional preconditions necessary before allowing full capital account convertibility:

• Low fiscal deficit and sustainable public debt levels.
• Low and stable inflation rate to maintain currency stability.
• Strong financial sector supervision to prevent speculative attacks or currency crises.
• Adequate foreign exchange reserves to manage volatility in external flows.
• Sound external debt management to avoid excessive reliance on short-term borrowing.
• Exchange rate flexibility with effective market monitoring mechanisms.

Advantages of Full Convertibility

Full convertibility of the rupee offers several potential benefits for the economy:

• Enhanced Capital Mobility: Facilitates free movement of capital across borders, promoting investment and economic integration.
• Increased Foreign Investment: Greater confidence among investors due to unrestricted repatriation of profits and capital.
• Efficient Resource Allocation: Enables better utilisation of global capital, fostering competitiveness and growth.
• Integration with Global Economy: Strengthens India’s position in international trade and finance.
• Improved Monetary Discipline: Encourages responsible fiscal and monetary policies to maintain stability and credibility.
• Promotion of Indian Multinationals: Eases foreign acquisitions and global expansion of Indian companies.

Risks and Challenges

However, full convertibility also poses several risks that require cautious management:

• Volatile Capital Flows: Sudden inflows and outflows of foreign capital may cause exchange rate instability and affect macroeconomic balance.
• Currency Speculation: Open convertibility can make the rupee vulnerable to speculative attacks and capital flight.
• Inflationary Pressure: Large capital inflows may increase liquidity, leading to inflationary tendencies.
• Financial Sector Exposure: Weak banking and financial systems may face risks from external shocks.
• External Vulnerability: Greater openness may lead to dependence on global financial cycles, making crisis management more complex.

Present Status

As of now, the Indian Rupee is fully convertible on the current account but only partially convertible on the capital account. The RBI allows certain capital account transactions such as:

• Foreign direct investment (FDI) and portfolio investment.
• Limited outward remittances by individuals (up to prescribed limits under the Liberalised Remittance Scheme).
• External commercial borrowings (ECBs) by Indian corporates.

The government and RBI have maintained a cautious approach, balancing liberalisation with macroeconomic stability. While there is growing discussion about moving towards fuller capital account convertibility, global financial volatility and concerns over capital flight have led policymakers to proceed gradually.

Recent Developments

Recent years have seen incremental steps toward rupee internationalisation and broader convertibility:

• Introduction of the Indian Rupee trade settlement mechanism (2022) to promote rupee-based international trade.
• Expansion of foreign investment limits and simplification of external borrowing norms.
• Development of offshore rupee markets and currency derivatives to deepen financial markets.
• Efforts to include the rupee in global trade settlements with friendly countries to reduce dependence on dominant foreign currencies such as the US dollar.