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

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