6. Economics Notes 45

Elaborate Notes

Convertibility of Indian Rupee

• Definition and Context: Currency convertibility refers to the freedom to exchange a country’s domestic currency for foreign currencies and vice versa, without restrictions from the central bank or government. The exchange rate at which this conversion occurs is determined by market forces of demand and supply. This concept is central to a country’s integration with the global economy. In India, the journey towards convertibility began as a key component of the Liberalisation, Privatisation, and Globalisation (LPG) reforms initiated in 1991, following a severe Balance of Payments (BoP) crisis.

• Types of Convertibility: Convertibility is categorized based on the nature of the underlying transaction, which corresponds to the two main accounts of the Balance of Payments.

  1. Current Account Convertibility: This allows for the free conversion of the rupee for all transactions classified under the current account. These include:

     • Trade in Goods: Payments for exports and imports.
     • Trade in Services: Payments for services like tourism, software services, shipping, and financial services.
     • Unilateral Transfers: Remittances, gifts, and donations sent or received from abroad.
     • Income: Profits, dividends, and interest payments on foreign investments.
     • Historical Milestone: India moved towards current account convertibility in a phased manner. Following the recommendations of the C. Rangarajan Committee on Balance of Payments, the government introduced a dual exchange rate system called the Liberalised Exchange Rate Management System (LERMS) in 1992. This was a transitional step. India formally adopted full convertibility on the current account in August 1994, thereby accepting the obligations under Article VIII of the IMF’s Articles of Agreement.

  2. Capital Account Convertibility (CAC): This implies the freedom to convert local financial assets into foreign financial assets and vice versa. It facilitates unrestricted cross-border movement of capital. Transactions under this account include:

     • Foreign Direct Investment (FDI): Investment to acquire lasting interest in an enterprise.
     • Foreign Portfolio Investment (FPI): Investment in securities and other financial assets.
     • External Commercial Borrowings (ECBs): Loans raised by Indian corporations from foreign sources.
     • External Assistance: Loans from multilateral and bilateral sources.
     • NRI Deposits: Deposits made by Non-Resident Indians in Indian banks.
     • Status in India: India has adopted a cautious and gradual approach to CAC. While many restrictions have been eased over the years, the rupee remains only partially convertible on the capital account. Prior approval from the Reserve Bank of India (RBI) or the government is still mandatory for certain transactions, especially those involving large capital outflows by residents.

• Committees on Capital Account Convertibility:

  • Tarapore Committee I (1997): Chaired by former RBI Deputy Governor S.S. Tarapore, this “Committee on Capital Account Convertibility” was constituted to lay down a roadmap for fuller CAC. It recommended a phased, three-year approach contingent upon achieving certain macroeconomic pre-conditions. However, the onset of the East Asian Financial Crisis in 1997, which was partly blamed on premature capital account liberalisation by affected countries, prompted Indian policymakers to adopt a more cautious stance, and the committee’s recommendations were largely put on hold.
  • Tarapore Committee II (2006): This “Committee on Fuller Capital Account Convertibility” was set up to revisit the subject. It also suggested a phased approach (2006-07 to 2010-11) and reiterated the importance of meeting certain macroeconomic indicators as pre-conditions. Its recommendations, like its predecessor’s, have not been fully implemented, especially after the Global Financial Crisis of 2008 reinforced the perceived benefits of maintaining some capital controls as a tool for financial stability.

Benefits and Limitations of Full Convertibility

• Benefits:

  • Attraction of Foreign Investment: Full CAC signals a stable and liberal economic environment, which can significantly boost inflows of both FDI and FPI, providing capital for industrial expansion and infrastructure development.
  • Economic and Industrial Progress: Access to a global pool of capital at potentially lower costs can fuel investment across various sectors, leading to technological upgradation, improved efficiency, and overall economic growth.
  • Enhanced Opportunities: Increased investment and business activity can lead to the creation of more jobs and entrepreneurial opportunities. Indian companies would also find it easier to invest and acquire assets abroad.
  • Internationalisation of the Rupee: Full convertibility is a prerequisite for a currency to be widely accepted and held internationally. This would reduce exchange rate risk for Indian traders and enhance the country’s economic stature.

• Limitations:

  • Capital Flight: In times of economic instability or loss of confidence, full CAC can facilitate a sudden and massive outflow of capital, leading to a sharp depreciation of the currency, a stock market crash, and a potential financial crisis. This was witnessed during the 1997 East Asian Crisis.
  • Vulnerability to External Shocks: An open capital account makes the domestic economy more susceptible to global economic cycles, interest rate changes in developed economies (e.g., by the US Federal Reserve), and speculative attacks on the currency. This limits the autonomy of domestic monetary policy.
  • Uncontrolled External Debt: The freedom for corporations to borrow from abroad without limits can lead to an unsustainable build-up of external debt. If the domestic currency depreciates, the cost of servicing this foreign currency-denominated debt can skyrocket, leading to widespread defaults.
  • Risk of Speculation: Free movement of capital can encourage speculative “hot money” flows, where investors move funds rapidly to take advantage of short-term interest rate or exchange rate differentials. This can create significant volatility in financial markets.

Pre-conditions for Full Convertibility (as per Tarapore Committee)

The Tarapore Committees emphasized that a country must strengthen its macroeconomic fundamentals before embracing full convertibility. These pre-conditions act as shock absorbers.

1. Low Fiscal Deficit: The committee recommended reducing the gross fiscal deficit to 3.5% of GDP. A high fiscal deficit can lead to inflation and high-interest rates, which are destabilizing in an open capital account environment.
2. Mandated Inflation Target: A stable and low inflation rate is crucial for currency stability. The committee suggested a mandated inflation target of 3-5%.
3. Strengthening the Financial Sector: This involves improving the health of the banking system by reducing Non-Performing Assets (NPAs), meeting capital adequacy norms (as per Basel Accords), and developing deep and liquid financial markets. A weak financial sector can collapse under the pressure of capital volatility.
4. Reduction of Public Debt: High levels of public debt can strain government finances and increase the risk perception of the economy.
5. Adequate Forex Reserves: A strong buffer of foreign exchange reserves is essential to intervene in the currency market to manage excessive volatility and to withstand sudden capital outflows.

The consensus view, therefore, is that a gradual, calibrated approach is superior to a “big bang” liberalisation of the capital account.

Internationalisation of Rupee

• Concept: This refers to the process of increasing the use of the Indian Rupee (INR) in cross-border transactions. It implies that the INR would be widely used and accepted by non-residents for trade invoicing, settlement, and as a currency for holding financial assets (i.e., as a reserve currency).
• Requirements:
  • Currency Stability: Low and stable inflation and a credible macroeconomic policy framework are essential to maintain the purchasing power and stability of the currency.
  • Liquidity: Deep and open financial markets are needed so that non-residents can easily buy and sell rupee-denominated assets without causing significant price fluctuations.
  • Easy Availability: The currency should be easily accessible to non-residents.
  • Capital Account Convertibility: This is a crucial prerequisite, as non-residents must be confident that they can convert their rupee holdings back into their home currency at will.
• Global Context: Currently, the most prominent international currencies are the US Dollar (USD), Euro (EUR), British Pound Sterling (GBP), Japanese Yen (JPY), and, more recently, the Chinese Renminbi (RMB), which was included in the IMF’s SDR basket in 2016.
• India’s Position and Measures: India’s share in global trade is relatively small (around 2%), which limits the natural demand for the rupee. However, the government and RBI are taking steps to promote its internationalisation, such as permitting trade settlement in INR with certain countries and developing offshore rupee markets.

India’s External Debt

• Definition: This is the total amount of debt that the residents of India (including the government, corporations, and individuals) owe to non-residents (foreign creditors). The debt is denominated in foreign currencies.
• Creditors: These can be foreign governments, international financial institutions like the World Bank and IMF, foreign private commercial banks, and other institutional and individual lenders.
• Components:
  • Commercial Borrowings: The largest component, consisting of loans raised by Indian companies from foreign commercial banks and financial markets.
  • NRI Deposits: Deposits made by Non-Resident Indians in Indian banks.
  • Multilateral Debt: Loans from institutions like the World Bank, Asian Development Bank (ADB), etc.
  • Bilateral Debt: Loans from individual countries.
  • Trade Credit: Credit extended for imports directly by overseas suppliers.
  • IMF and World Bank Debt: Loans availed from these institutions.
• Key Characteristics (as per recent RBI data):
  • Composition by Borrower: The share of non-government debt is significantly higher than that of government debt.
  • Composition by Currency: The US dollar remains the dominant currency for India’s external debt, accounting for over 50% of the total, followed by the Indian Rupee, Yen, and Euro. This exposes the country to exchange rate risk against the dollar.

Bretton Woods Institutions

• Historical Context: The Bretton Woods Conference, officially known as the United Nations Monetary and Financial Conference, was held in July 1944 in Bretton Woods, New Hampshire, USA. It was attended by delegates from 44 Allied nations. Its primary objective was to establish a new international economic order and framework for post-World War II reconstruction and to avoid the currency devaluations and protectionist trade policies that had contributed to the Great Depression of the 1930s.
• Key Outcomes: The conference led to the signing of agreements to create two major international institutions:
  1. International Bank for Reconstruction and Development (IBRD): The original institution of what is now the World Bank Group. Its initial mandate was to finance the reconstruction of war-torn European nations. Over time, its focus shifted to poverty reduction and the economic development of developing countries through long-term loans for infrastructure and institutional development.
  2. International Monetary Fund (IMF): Tasked with ensuring the stability of the international monetary system, particularly the system of fixed exchange rates pegged to the US dollar (which was in turn pegged to gold) that the conference established.
• Failed Proposal: The conference also proposed the creation of an International Trade Organization (ITO) to regulate world trade. However, the agreement for the ITO was not ratified by the US Senate. In its place, a less ambitious provisional agreement, the General Agreement on Tariffs and Trade (GATT), was signed in 1947, which eventually evolved into the World Trade Organization (WTO) in 1995.

International Monetary Fund (IMF)

• Membership and Funding: India is a founding member of the IMF. The IMF is a cooperative institution whose financial resources primarily come from the quotas subscribed by its member countries. The total initial fund at its inception was $8.8 billion.
• Quota System: Each member is assigned a quota, which broadly reflects its relative position in the world economy. The quota determines:
  • Subscription: The maximum amount of financial resources a member must contribute to the Fund.
  • Voting Power: The number of votes a member has in IMF decisions.
  • Access to Financing: The amount of financing a member can obtain from the IMF.
  • Historical and Current Quotas: At its inception, the USA had the largest quota at around 31%, while India’s was approximately 0.5%. Currently, following several quota reviews, the USA’s quota is around 17.44%, and India’s quota stands at 2.76%.
• Objectives:
  • To promote international monetary cooperation.
  • To facilitate the expansion and balanced growth of international trade.
  • To promote exchange rate stability and avoid competitive currency devaluations.
  • To assist in the establishment of a multilateral system of payments.
  • To provide resources to member countries experiencing balance-of-payments difficulties.
• Functions:
  1. Lending: The IMF provides temporary financial assistance to member countries facing BoP problems. These loans are conditional upon the implementation of economic reforms (Structural Adjustment Programs).
  2. Surveillance: The IMF monitors the economic and financial policies of its 190 member countries and the global economic system. It highlights possible risks to stability and advises on policy adjustments. This is primarily done through its flagship publications:
     • World Economic Outlook (WEO): Published twice a year, it provides analysis and forecasts of global economic developments and assesses risks.
     • Global Financial Stability Report (GFSR): Also published biannually, it assesses the stability of the global financial system and markets.
  3. Technical Assistance & Capacity Development: The IMF provides hands-on technical assistance and training to member countries, helping them to strengthen their capacity in areas such as fiscal policy, central banking, and economic data management.

Special Drawing Rights (SDR)

• Definition: The SDR is an international reserve asset created by the IMF in 1969 to supplement its member countries’ official reserves. It is not a currency in itself, nor is it a claim on the IMF. It is a potential claim on the freely usable currencies of IMF members.
• Valuation: The value of the SDR is based on a weighted basket of five major international currencies. The composition is reviewed every five years. The current weights are approximately:
  • US Dollar (USD): 41.73%
  • Euro (EUR): 30.93%
  • Chinese Renminbi (RMB): 10.92%
  • Japanese Yen (JPY): 8.33%
  • British Pound (GBP): 8.09%
  • The inclusion of the Chinese Renminbi in 2016 was a significant milestone, reflecting China’s growing role in the global economy.
• Inclusion Criteria: For a currency to be included in the SDR basket, it must meet two criteria:
  1. Export Criterion: The issuing country must be a major exporter.
  2. Freely Usable Criterion: The currency must be widely used to make payments for international transactions and widely traded in the principal exchange markets.
• Quota Formula: The formula for determining a member’s quota is a weighted average of four variables:
  • GDP (weight of 50%)
  • Openness (30%)
  • Economic Variability (15%)
  • International Reserves (5%)

Types of Financing by IMF

The IMF’s lending instruments are broadly divided into concessional and non-concessional facilities.

• A. Concessional Lending (at low or zero interest rates for Low-Income Countries - LICs):

  1. Extended Credit Facility (ECF): Provides medium- to long-term financial support for countries with protracted BoP problems.
  2. Stand-by Credit Facility (SCF): Addresses short-term or potential BoP needs.
  3. Rapid Credit Facility (RCF): Provides rapid financial assistance with limited conditionality to LICs facing an urgent BoP need (e.g., due to a natural disaster or commodity price shock).

• B. Non-Concessional Lending (at market-based interest rates):

  1. Stand-By Arrangement (SBA): The IMF’s workhorse lending instrument for addressing short-term BoP problems.
  2. Extended Fund Facility (EFF): Provides support for medium- and long-term BoP problems arising from structural impediments.
  3. Rapid Financing Instrument (RFI): Similar to the RCF but available to all member countries facing an urgent BoP need.
  4. Flexible Credit Line (FCL): For countries with very strong economic fundamentals and policy track records. It provides large, upfront access to IMF resources with no ongoing conditions, acting as a precautionary tool to boost market confidence.

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Prelims Pointers

• Currency convertibility means the freedom to convert domestic currency into foreign exchange at a market-determined rate.
• India adopted full convertibility on the Current Account in August 1994.
• India accepted the obligations of Article VIII of the IMF Articles of Agreement in 1994.
• India has partial convertibility on the Capital Account.
• Tarapore Committee I (1997) and Tarapore Committee II (2006) provided roadmaps for Capital Account Convertibility.
• Pre-conditions for full convertibility (Tarapore Committee): Fiscal deficit at 3.5% of GDP, inflation at 3-5%.
• International currencies include USD, Euro, GBP, JPY, and Chinese Renminbi.
• Bretton Woods Conference was held in 1944 in New Hampshire, USA.
• It is also known as the United Nations Monetary and Financial Conference.
• It led to the creation of the IBRD (World Bank) and the IMF.
• A proposal for an International Trade Organization (ITO) failed, leading to the GATT (1947).
• India is a founding member of the IMF and the World Bank.
• India’s current quota in the IMF is approximately 2.76%.
• The USA has the highest quota in the IMF at around 17.44%.
• IMF publishes two major reports: World Economic Outlook (WEO) and Global Financial Stability Report (GFSR).
• Special Drawing Rights (SDR) is an international reserve asset created by the IMF in 1969.
• The value of the SDR is based on a basket of five currencies: USD, Euro, Renminbi, Yen, and Pound Sterling.
• The Chinese Renminbi was added to the SDR basket in 2016.
• The SDR basket is reviewed every five years.
• The largest component of India’s external debt is Commercial Borrowings.
• The largest currency component of India’s external debt is the US Dollar.

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Mains Insights

Capital Account Convertibility: The Debate on Pace and Sequencing

• Dilemma: The central policy debate for India is not whether to move towards fuller Capital Account Convertibility (CAC), but when and how. This involves a classic trade-off between the potential benefits of economic growth and the risks of financial instability.
• Arguments for a Gradual Approach (The Dominant View):
  1. Lessons from Crises: The East Asian Crisis (1997) and the Global Financial Crisis (2008) serve as stark reminders of the dangers of premature or poorly regulated capital account liberalisation. Countries with some capital controls were often better insulated from contagion.
  2. The ‘Impossible Trinity’: Also known as the Mundell-Fleming Trilemma, this economic principle states that a country cannot simultaneously have a fixed exchange rate, free capital movement, and an independent monetary policy. To maintain control over domestic interest rates (monetary policy autonomy) while allowing the rupee to float, India must retain some control over capital flows.
  3. Macroeconomic Pre-conditions: As highlighted by the Tarapore Committees, India is yet to consistently meet the pre-conditions of low fiscal deficit, contained inflation, and a robust financial sector (especially the banking system burdened with NPAs). A premature move to full CAC without these fundamentals in place could be disastrous.
• Arguments for a Faster Approach:
  1. Economic Ambitions: To become a $5 trillion economy and a global manufacturing hub, India needs massive capital inflows. Fuller CAC would signal policy stability and attract long-term investment.
  2. Internationalisation of the Rupee: Full CAC is a non-negotiable prerequisite for making the rupee a significant international currency, which would reduce India’s reliance on the US dollar and enhance its strategic autonomy.
• Conclusion: The optimal path is a calibrated, sequenced approach. This involves strengthening the domestic financial system, improving macroeconomic indicators, and gradually liberalising specific capital flows, rather than a “big bang” reform.

Internationalisation of Rupee: Strategic Imperative vs. Economic Risk

• Strategic Dimension (GS Paper II):
  • Reduced Dollar Dependence: A more internationalised rupee would allow India to insulate its economy from the volatility of the US dollar and the impact of US monetary policy. It would also reduce the transaction costs for Indian businesses.
  • Enhanced Global Stature: An international currency bestows significant ‘seigniorage’ benefits (profit made by a government by issuing currency) and enhances a country’s geopolitical influence. It aligns with India’s aspirations to be a leading power.
• Economic Challenges (GS Paper III):
  • Loss of Monetary Policy Autonomy: The RBI would have to consider the interests of global investors holding the rupee, potentially limiting its ability to set interest rates based purely on domestic conditions.
  • Increased Volatility: The rupee’s exchange rate would become more volatile as it would be subject to global capital flows and sentiments, which could harm Indian exporters and importers.
  • Need for Deeper Markets: India’s financial markets, particularly the corporate bond market, are not yet deep or liquid enough to handle the demands of being an international currency.

Bretton Woods Institutions: A Critique of Governance and Legitimacy

• Historical Imbalance: The IMF and World Bank were designed in 1944, reflecting the global power structure of that era. This has led to a persistent ‘democratic deficit’ where the voting power and leadership positions are skewed in favour of the US and European nations.
• Quota and Voice Reforms: Emerging economies, including India and China, have long argued that their quota and voting shares in the IMF do not reflect their increased weight in the global economy. While some reforms have taken place, they are seen as too slow and inadequate, leading to a crisis of legitimacy for the institutions.
• Conditionalities and Sovereignty (The ‘Washington Consensus’): IMF loans often come with stringent policy conditions (Structural Adjustment Programs), which typically involve fiscal austerity, privatisation, and trade liberalisation. Critics argue that these one-size-fits-all policies can harm social spending, exacerbate inequality, and infringe upon the economic sovereignty of borrowing nations.
• Rise of Alternatives: The dissatisfaction with the Bretton Woods institutions has directly contributed to the creation of new multilateral development banks like the New Development Bank (BRICS Bank) and the Asian Infrastructure Investment Bank (AIIB), where emerging economies have a greater say. This represents a significant shift in the landscape of global economic governance.