The Pros and Cons of a Fully Convertible Rupee

The Indian currency, the rupee (INR), is not yet fully convertible. However, there are talks of making it fully convertible and setting up an onshore INR market. There are many advantages and disadvantages associated with rupee convertibility, which have led to a long continuous debate over the last two decades since reforms were first introduced during the early 1990s. India has made great strides in economic growth, reporting a 7.7% gross domestic product rate in 2018 and in second place globally for highest growth. The country has taken several steps to alter some of its standardized currency policies including demonetization, but is India ready to move to the fully convertible currency? (For more, see: India Is Eclipsing China's Economy As Brightest BRIC Star.) 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 in global exchanges. It indicates the extent to which the regulations allow inflow and outflow of capital to and from the country.

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 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 and businesses 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 travel abroad, and a relaxation on foreign business and investments with minimal (or no) restrictions depending on the industry sectors.

However, Indians still require regulatory approvals 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 today, the Indian rupee is partly convertible, which 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 approvals. The regulators also pitch in from time-to-time to keep the exchange rates within permissible limits, instead of keeping INR as a completely free-floating currency left to the 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.

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 purchase/sale). 

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 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. In the beginning of reforms, the rupee was made partially convertible for goods, services and merchandise only. During mid-1990s, the rupee was made fully convertible for current account 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. As of today, one can still bring in foreign capital or take out local money for these purposes, but there are ceilings imposed by the government that need approvals.

• Sign of stable and mature markets: Regulators like to keep control on 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 huge flow of capital. Opening up to fully convertible currency is a solid sign that a country and its markets are stable and mature enough to handle free and unrestricted movement of the 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 creating new employment opportunities across various industry sectors, as well as nurturing entrepreneurship for new businesses.

• High volatility: Amid a lack of suitable regulatory control and rates subject to open markets with 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 Indian rupee, more rupees will be needed to get same number of dollars, making the repayment costly.
• Affects 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 exchanges 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. (For more, see: The Reasons Why China Buys U.S. Treasury Bonds.)

India is expected to become a truly global economy in the near future, and it will need a fuller integration into the world economic system. Making the rupee fully convertible is an expected step in that direction.

How soon India can move on 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.

Despite economic progress being made by India on many fronts, there have been regular challenges at global and local levels, including the global financial crisis of 2008-09, a lack of inflation control and rising NPAs, which have delayed full rupee convertibility. It may take another three-to-five years for India to fully prepare itself for full rupee convertibility.