What is Current Account Convertibility?

If I had a penny for each time I’ve heard the phrase “Capital Account Convertibility”! Bespectacled old men argue about it on TV all the time.

While I learnt about Capital Account Convertibility in college, I never quite understood the concept with clarity. It’s not that the concept is hard to understand; the complication is that it requires one to understand the basics of Exchange rates, the Balance of Payments and Current Account Convertibility in earnest first. 

In this post, I’m going to talk about Current Account Convertibility.

What is the Current Account?

I’ll talk about the Current Account and the Capital Account in detail in a future post on the Balance of Payments (BOP). For now, I’m just going to give a broad, basic description. The BOP is essentially an account that shows us all the monetary transactions between a country and the Rest of the World during a given time period (usually a year). It shows us how much money is going in and out of the country during this period. 

The BOP is divided into two parts - the Current Account, and the Capital Account. 

The Current Account shows us the inflow and outflow of funds from a country as a result of the export and import of goods and services, earnings/payments on investments (interest, dividends etc.), as well as unilateral transfers. Unilateral Transfers (a Transfer is a transaction where there is no quid pro quo i.e. a payment - monetary or otherwise - is made without the exchange of a good or service) on the Current Account mainly include workers’ remittances sent back home and certain kinds of foreign aid. 

The Capital Account shows the inflow/outflow of funds from a country as a result of the sale/purchase of physical and financial assets, the acquisition and payback of foreign loans/debts, as well as transfers of a “capital” nature. 

What is Currency Convertibility?

Full Currency Convertibility means that a currency, say the Rupee, can be exchanged for any other convertible currency, without any restriction, at market determined Exchange Rates. Notice there are two conditions here:

• At market determined exchange rates: If a currency’s value/ exchange rate (against other foreign currencies) is not allowed to be determined by the free forces of market demand and supply, it cannot be called a “convertible” currency. For e.g. if the RBI fixed the Rupee exchange rate vs. the US dollar at Rs. 65/USD and mandated that all forex transactions were to be conducted at this administered rate, the Rupee could not be called a “convertible currency”. 

• Without any restriction: This is the tricky part. What qualifies as a “restriction” in relation to currency convertibility? This question isn’t easily answered. It annoyed and frustrated me for longer than I care to admit, until I stumbled across a paper on the IMF site called “The International Monetary Fund and Current Account Convertibility”. God bless whoever wrote it. Here’s the link to this paper: Link

Trade Restriction vs. Exchange Restriction

Let’s first understand the difference between a Trade Restriction and an Exchange Restriction. In the pre-liberalisation days (pre-1991) in India, there were a plethora of restrictions such as selective granting of export/import licenses and quantitative restrictions on imports. These were Trade Restrictions since they prohibited/restricted certain transactions. An Exchange Restriction (which is what is relevant to currency convertibility) applies to payments/transfers for transactions, and not to the transactions themselves. For instance, if there are no trade restrictions on the import of a commodity, but the forex is made available only in certain cases, then this is an Exchange Restriction. 

Exchange Restrictions vs. Exchange Controls

Now, let’s understand the difference between Exchange Restrictions and Exchange Controls. 

Per the IMF’s articles, a verification procedure for the purchase of foreign currency by residents going abroad, is part of a country’s Exchange Controls, but is not a Restriction. If, however, the full amount requested for the payment or the purchase cannot be obtained because of a regulation imposing a ceiling, or because of an administrative decision denying the application, there is a restriction. Similarly, if the verification procedure imposes undue delays, there is a restriction. (Extract from paper titled “The International Monetary Fund and Current Account Convertibility”; link provided above).

It is these sort of "Exchange Restrictions" that should be eliminated for a currency to be convertible. 

Let’s explain with an Indian example:

India imposes a cumulative limit of US $250,000 (under the Liberalised Remittance Scheme or LRS) for the provision of forex to a resident (individual) for payments for certain current account transactions such as 1) education abroad, 2) medical treatment abroad, 3) emigration, 4) tourist/business travel abroad, 5) maintenance of close relatives abroad, and 6) gifts/donations sent abroad. If the individual remits any amount under the LRS (for any of the above transactions) in a financial year, his total remittance limit will be reduced from $250,000 by the amount remitted.

Since this restriction does impose limits on the availability of forex for these transactions, it is technically an “Exchange Restriction”. 

That said, per the IMF, if such limits are only indicative i.e. banks are authorised to automatically approve forex for all transactions within these limits, and authorities approve all requests for forex beyond these limits upon establishing their bonafide character, and the public is made aware of this policy, then there is NO Restriction. (Extract from paper titled “The International Monetary Fund and Current Account Convertibility”; link provided above). 

This is indeed the case for 1) education abroad, 2) medical treatment abroad, and 3) emigration as per the Liberalised Remittance Scheme. If the resident individual can show the authorities bonafide paperwork proving that he requires forex beyond the $250,000 limit, he is granted the requested amount. Therefore, there is no Exchange Restriction in the case of these transactions in the Indian context. 

For 4) tourist/business travel abroad, 5) the maintenance of close relatives abroad, and 6) gifts/donations, the limit of USD 250,000 is imposed (as far as I know). So technically, this is an Exchange Restriction per IMF articles.

Since these are Current A/C transactions, does this mean that the Rupee is not convertible on the Current Account? The answer is no. I'll explain later in this post. 

Let’s put it all together now ---> Current Account + Currency Convertibility = Current Account Convertibility 

Now that I’ve explained what the Current Account is and what Currency Convertibility means, it’s easy to understand the concept of “Current Account Convertibility”. 

Current Account Convertibility means that the currency of a country can be exchanged for any other convertible currency, without any restriction (i.e. Exchange Restriction), at market determined Exchange Rates for Current Account transactions such as import/ export of goods & services, earnings/payments on investments (interests, dividends etc.) and unilateral transfers. 

Note: Current Account transactions include forex purchases for travel abroad for tourist, medical and educational purposes as well the purchase of forex for emigration and maintenance of close relatives abroad. In these transactions, residents are essentially purchasing foreign services (importing services) such as travel, education, medical treatment, emigration services etc. When residents remit foreign currency to maintain relatives, they’re again essentially paying for foreign goods and services that their relatives consume. All these transactions fall under the category of Current Account Transactions. 

The Indian Rupee is fully Convertible on the Current Account

Recent History

By 1991, India had a fixed exchange rate system (the Rupee exchange rate was not market determined). The Rupee was pegged to the value of a basket of currencies belonging to nations we did the majority of our trade with. Also, there were a plethora of Trade restrictions (high trade tariffs, very strict export/import licensing, etc.) as well as Exchange restrictions on Current Account transactions. Bottom-line, the Rupee was an Inconvertible currency on the Current Account as well as Capital Account. 

After the BOP crisis of 1991, the government (GOI) initiated reforms/liberalisation on the urging on the IMF. First, the Partial Convertibility of the Rupee was introduced on the Current Account, under which 60% of all receipts on the Current Account could be freely converted into Rupees at market-determined rates, while the remaining 40% were surrendered to the RBI at rates determined by the RBI. This was called the Dual Exchange Rate system. 

Finally, in 1993, full Current Account Convertibility was introduced whereby all foreign currency receipts could be converted into Rupees at market determined rates. 

The Situation Today

First, the Exchange Rate of the Rupee vs. other currencies is freely determined by the market. The RBI intervenes sometimes by buying or selling USD, but only to prevent excessive volatility in exchange rates.

Second, while procedures mandated by the RBI have to be followed, there are hardly any Exchange Restrictions on the Import/Export of goods and services. 

Third, while full Current Account Convertibility was introduced in India in 1993, technically (going by the book) there have always been a few Exchange Restrictions on certain types of the Current A/C transactions. These restriction however, are quite reasonable. 

For instance, there are limits on the amount of foreign exchange an individual can take out the country for tourist/business travel - this limit was $25,000 in 2006; under the LRS today, this limit is $250,000. Maintenance of relatives and gifts/donations are also subsumed under this $250,000 limit. 

I’d argue that for these transactions a limit of $250,000 is quite reasonable. It would cover the requirements of the vast majority of residents. Also, its important to remember that for a country like India, which does not have Capital Account Convertibility, allowing residents (individuals and institutions) to remit forex without any limits for travel, family maintenance and gifts, could create a loophole. Residents could use this loophole to remit inordinate amounts of forex that could be used for transactions of a capital nature. Even if this is avoided through verification procedures, it could still lead to large inflows of forex out of the country, which is undesirable (could cause the Rupee to depreciate). 

Bottom-line, India has full Current Account Convertibility. There are a minimal number of Exchange Restrictions on certain transactions, which are quite reasonable and don’t take away from the “complete” nature of convertibility on our Current Account.