Partial convertibility of the rupee

Partial convertibility of the rupee refers to a system under which the Indian rupee can be freely converted into foreign currencies for certain types of transactions, such as trade in goods and services, but remains restricted for others, particularly for capital account transactions. This system allows limited freedom in the exchange of the rupee while maintaining safeguards to protect the economy from excessive volatility and capital flight. It represents a transitional stage between a fully controlled and a fully convertible currency regime.

Background and Historical Context

Before the early 1990s, India followed a fixed exchange rate system with strict foreign exchange controls under the Foreign Exchange Regulation Act (FERA), 1973. The rupee was non-convertible, and foreign exchange transactions required approval from the Reserve Bank of India (RBI). This restrictive regime aimed to conserve foreign exchange but also discouraged trade, investment, and economic openness.
The Balance of Payments crisis of 1991 marked a turning point in India’s economic policy. Severe foreign exchange shortages compelled the government to introduce major economic reforms, including liberalisation, privatisation, and globalisation. As part of this reform process, India adopted a more market-oriented exchange rate system and initiated steps toward making the rupee convertible.
In 1992–93, the government introduced the Liberalised Exchange Rate Management System (LERMS), which laid the foundation for partial convertibility of the rupee.

Introduction of Partial Convertibility

Under the LERMS, implemented in March 1992, India adopted a dual exchange rate system:

• 40% of foreign exchange earnings had to be surrendered to the Reserve Bank of India at the official exchange rate, and
• The remaining 60% could be converted at market-determined rates.

This dual system was a transitional arrangement designed to ease India into a market-based currency regime.
In March 1993, the dual exchange rate was unified, and the rupee was made partially convertible on the current account. This meant that transactions involving trade in goods and services, interest payments, and remittances could be carried out freely at market-determined exchange rates without prior government approval.

Current Account Convertibility

Partial convertibility in India is primarily linked to current account transactions. Following the recommendations of the High-Level Committee on Balance of Payments (1993) chaired by Dr. C. Rangarajan, India accepted Article VIII of the IMF Articles of Agreement in August 1994, thereby achieving current account convertibility.
Under this regime, residents and businesses can freely buy and sell foreign currency for:

• Imports and exports of goods and services.
• Interest payments, dividends, and royalties.
• Business travel, education, and medical expenses abroad.
• Inward and outward remittances within specified limits.

However, restrictions remain on the capital account, which includes investments, loans, and acquisition of assets abroad.

Capital Account Convertibility and Its Relation to Partial Convertibility

While the rupee is fully convertible on the current account, it is only partially convertible on the capital account. Capital account transactions involve the movement of capital, such as investments and loans, across borders. These are subject to regulation to protect the economy from sudden capital outflows or speculative movements that could destabilise the currency.
The Tarapore Committee on Capital Account Convertibility (1997), chaired by S.S. Tarapore, recommended a phased approach towards full convertibility, contingent upon:

• Low inflation (3–5%).
• Fiscal deficit below 3.5% of GDP.
• Strong financial sector reforms.
• Adequate foreign exchange reserves.

Although India has made progress in liberalising capital flows—such as allowing foreign institutional investment (FII), foreign direct investment (FDI), and limited overseas investment by residents—the rupee remains only partially convertible to maintain macroeconomic stability.

Advantages of Partial Convertibility

Partial convertibility offers several benefits to the Indian economy:

• Facilitates International Trade: By making current account transactions easier, it enhances the competitiveness of Indian exporters and importers.
• Encourages Foreign Investment: Greater exchange rate flexibility builds investor confidence and attracts FDI and portfolio inflows.
• Improves Efficiency: Market-determined exchange rates ensure realistic valuation of the rupee based on demand and supply.
• Supports Economic Integration: Encourages participation in global markets, promoting growth and development.
• Maintains Stability: By retaining controls over capital account movements, India protects itself from volatile speculative flows that could trigger financial crises.

Risks and Challenges

While partial convertibility balances openness and stability, it also poses certain risks:

• Exchange Rate Volatility: Market-determined rates can fluctuate sharply in response to global economic changes.
• External Shocks: Dependence on foreign capital flows may expose the economy to sudden reversals.
• Speculative Pressures: Greater convertibility can encourage speculative currency trading, affecting stability.
• Administrative Complexity: Managing partial convertibility requires continuous monitoring and regulation by the RBI.

Policy Developments Since 1993

After the 1993 unification of exchange rates, India progressively liberalised its foreign exchange regime:

• 1994: Full current account convertibility achieved.
• 1997: Tarapore Committee recommended a phased plan for capital account convertibility.
• 2006: Tarapore Committee II proposed further steps with stricter preconditions.
• 2000s onward: Gradual liberalisation of FDI and portfolio flows, and permission for resident individuals to invest abroad under the Liberalised Remittance Scheme (LRS).
• Post-2014: Continued reforms under RBI’s Foreign Exchange Management Act (FEMA), 1999, with enhanced freedom for businesses and individuals.

Despite liberalisation, the RBI continues to regulate external borrowing, foreign investment limits, and overseas transactions to safeguard economic stability.

Role of the Reserve Bank of India

The RBI plays a crucial role in maintaining the balance between liberalisation and control under the partial convertibility framework:

• It intervenes in the foreign exchange market to prevent excessive volatility.
• It manages foreign exchange reserves to ensure adequate liquidity.
• It regulates capital inflows and outflows through FEMA guidelines.
• It sets limits for overseas investments and external commercial borrowings (ECBs).

This managed approach allows India to benefit from global integration while minimising exposure to global financial instability.

Contemporary Relevance

Partial convertibility continues to be a prudent policy choice for India, considering its large and diverse economy. Full capital account convertibility, though desirable in theory, carries risks, as seen in financial crises such as the Asian Crisis (1997) and the Global Financial Crisis (2008).
In recent years, with strong foreign exchange reserves and a stable macroeconomic environment, there has been renewed discussion about gradually increasing rupee convertibility, especially for trade invoicing and capital flows. The RBI’s efforts to internationalise the rupee, such as promoting rupee-based trade settlements with select countries, mark steps towards greater convertibility.