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.

Why is Deflation Undesirable?

In developing, growing nations such as India, The Central Bank is usually preoccupied with controlling inflation. It doesn’t usually encounter the problem of deflation. Developed nations like Japan on the other hand, have been grappling with deflation for a while. Persistent deflation is undesirable, destructive even. Let’s see why.

1. Deflation causes people to delay Consumption spending because they expect prices to fall further. Why buy now, when the dollars you hold today will become more valuable in the future and allow you to buy more goods? Since the public delays spending, consumption spend falls, which leads to reduced sales at businesses. This leads to production cuts and worker lay-offs (output and employment fall). When this happens, demand gets even more depressed. 

2. What makes the situation worse is that people avoid Borrowing as well. Let’s explain with an example involving two scenarios. 1) A business borrows Rs. 100 for one year when prices are rising (+2%), at a nominal interest rate of 5% (real interest rate of 3% + inflation of 2%). 2) The same business borrows Rs. 100 when prices are falling (-2%), at a nominal interest rate of 1% (real interest rate of 3% + inflation of -2%). 

In the first case, output that the business sold for Rs. 100 when it took the loan, is sold for Rs. 102 a year later, when it is time to repay the loan (we assume that market price for the business’s end product also rises by 2% in line with the general price level). So what’s left to be paid is = Rs. 3 = Rs. 105 -102.

In the second case, output that the business sold for Rs. 100 when it took the loan, is sold for Rs 98 a year later, when it's time for repayment (we assume 2% price fall for the business’s products as well). So what’s left to be paid is once again = Rs 3 = Rs 101 - 98.

But repaying Rs 3 is much harder when prices have fallen, vs. when prices have risen. When prices fall, what the business sold for Rs 3 when it look the loan (a year earlier), can now be sold only for Rs. 2.94 (deflation of 2%). When prices rise, what the business sold for Rs 3 when it accepted the loan, can now be sold for Rs. 3.06 (inflation of 2%). The “real” burden of the debt is much higher when prices fall. 

As a result, people are loath to borrowing money when deflation is rampant. They fear they won’t be able to repay. 

3. Unwillingness to borrow means Investment spending falls. In a deflationary environment, lowering interest rates is often ineffective in boosting investment spend. 

We’ve already seen how people avoid borrowing when prices are falling. Since borrowing is the predominant method of financing investment, this leads to a drop in investment spend (reinforcing the drop in consumption spending). Usually when investment spend is anemic, the government lowers interest rates to give investment spending a boost. In a deflationary environment however, interest rates can become ineffective in boosting investment demand. 

Let me explain. The nominal interest rate (rate at which borrowers lend) is the sum of two rates, 1) the “real interest rate” - the reward for bearing the risk of lending, and 2) inflation. When there is deflation, nominal interest rates tend to be low. For instance, if the real interest rate is = 3% and inflation is -2%, the nominal interest rate is just 1%. 

The public may already be wary of borrowing even at this low rate of 1% because of the reason explained above. What happens if the nominal interest rate is lowered to 0%? Investment may still not rise. The public’s fear of the increased “real” burden of their debt in an economy where output and prices are falling may continue to hold them back from borrowing even at a 0% interest rate!

(Note: the nominal interest rate cannot fall below 0% because if it does, lenders will not lend anymore. They’d rather just sit on their capital and preserve its nominal value). 

4. The drop in Consumption and Investment spending coupled with the ineffectiveness of interest rates cuts in raising Investment demand, can lead to the dreaded “Deflationary Trap”. 

Deflation causes Consumption and Investment spending to fall. Lower interest rates are unable to boost investment spend. Lower spending leads to cuts in output and worker layoffs/unemployment. This leads to further decreases in demand and spending. This causes prices to fall further.

What I have described above is the dreaded “deflationary spiral” or “deflationary trap” where deflation begets deflation. It become hard to escape this vicious cycle and economies can get trapped here for a long time. Japan for example has been battling deflation since the mid-1990s. 

5. Persistent deflation can be more dangerous than inflation. Inflation can be tackled with interest rate hikes etc., but once deflation sets in, it can be hard for the economy to escape. As we’ve explained above, the interest rate mechanism often fails to work.

Why does Money Supply Need to Grow at all?

So I recently did a post on the Quantity Theory of Money (QTM) titled What is the Quantity Theory of Money and When does it Hold?. QTM continues to be a rather controversial subject in economic theory. Asking seemingly naïve, even stupid questions is critical for a deep understanding of QTM. Only unconstrained thinking and unabashed questioning can allow one to fully appreciate the controversy that QTM almost always evokes. 

In this post I will ask and answer a seemingly naïve, yet fundamentally important question - Why does the supply of money need to grow at all? What if the supply of money were to remain constant? 

IMPORTANT: This question is wonderfully answered here on the Philosophical Economics blog - a must read for all Economics aficionados. I’m doing the same explanation here in my own words.... 

Lets use the example of an Economy where Money Supply is Fixed and Output doesn’t Grow 

Let’s assume India is a closed, simple economy. The money supply in India is fixed at Rs 500. 100 units of output are produced; the price of each unit of output is Rs 5; total output or GDP = Rs 500. The entire GDP (Rs 500) gets distributed as income and is spend on buying the output produced. This is your basic circular flow of income where output = income = expenditure. 

Remember from my QTM post: MV=PY. In our fictional economy, M = 500, P = 5, Y = 100, and the velocity of money (V) is =1. We assume that “V’ remains constant. 

If nothing changes (output, demand/tastes, no supply shocks etc.) and everything goes on like this, the Indian economy will remain in this steady state for perpetuity. There will no need for money supply to change. 

But Output needs to grow to keep up with a growing Population

That being said, it’s highly unrealistic to assume that India’s output won’t grow over time. A growing population will demand output growth, and technology advances along with increased resources (labour, capital etc.) will make this growth possible. 

What happens when Output needs to expand, but Money Supply remains fixed? 

So the right question to ask is how will output grow if money supply is fixed? Let’s use the example to answer this. 

Suppose India now has the technology and resources to produce 200 units of output. If unit price were to remain the same, total output would be worth Rs 1,000. But the money supply is fixed at Rs. 500. There is no way output worth Rs 1,000 can be produced if there isn’t enough money in the economy to pay those involved in producing it.

MV ≠ PY

500 x 1 ≠ 5 x 200 

Remember, the velocity of money (V) in our fictional economy is fixed at 1. What can India do in such a situation? 

There are only two Options. 1) Grow Output and accept Deflation or 2) Keep Output constant and accept Economic Stagnation. 

There are really only two options for India:

1)  Grow output and accept deflation 

India can go ahead and produce 200 units of output. However, since money supply is fixed at Rs 500, the price of each unit will have to fall to Rs. 2.5.

MV = PY

500 x 1 = 2.5 x 200 

India will have to accept deflation if it has to grow it’s output without increasing money supply. 

2) Keep output constant and accept economic stagnation

The other option is to continue to produce the same output (100 units), even though the economy has the capacity to produce more. In this case, prices will remain constant (there will be no deflation), but there will be no economic growth either. The economy will stagnate, unable to meet the growing demands of its population. 

MV = PY

500 x 1 = 5 x 100 (no deflation, no output growth)

Both Options are Undesirable. Economic Stagnation is an obvious “bad”, but what’s so bad about Deflation? Read my post Why is Deflation Undesirable? for the answer.

What is the Quantity Theory of Money and When does it Hold?

The Quantity Theory of Money (QTM) says that Money supply (M) has a direct, proportional relationship with the price level (P) in the economy. Per QTM, changes in the value of money (i.e. Price level) are determined mainly by changes in the Money supply. When money supply is abundant, the value of money or its purchasing power drops i.e. prices rise, and when money is in scarce supply, the value of money or its purchasing power increases i. e. prices fall. Sounds intuitive, doesn’t it? It’s just like any other commodity. 

What precisely does the Quantity Theory of Money state?

While that (above) is the intuitive message of QTM, let’s put down what the QTM precisely states.

The Quantity identity on which QTM is based is:

MV = PY 

Where M = money supply, v = the income velocity of money, P = price level and Y = real GDP. 

The income velocity of money measures the average number of times in a given period that each dollar is spent on currently produced goods and services.

Now, the Quantity identity is quite intuitive. It says that the amount of money in the economy x the number of times it changes hands = the nominal value of the output produced in the economy. 

Based on this identity, Quantity theory asserts that a given change in Money supply (% ΔM) induces an equal change in inflation (% ΔP). This claim is based on 2 assumptions:

1. The income velocity of money (v) is constant. 

2. Money growth has no impact on real GDP (Y), at least in the long run. So, Y is constant as well. 

If these two assumptions are believed to be true (MV = PY, where V and Y are fixed), it’s pretty obviously that % ΔM = % ΔP. 

So whether QTM holds or not, depends on how well these assumptions reflect economic reality. 

Is Velocity of Money constant? 

This has been a controversial subject in economic theory. Classical economists/ proponents of the Quantity theory believed that “v” was constant. Keynes and others subsequently refuted this assumption. Various (post WW2) studies have since shown that velocity (“v”) is infact not constant. It is now generally accepted the velocity function is a relatively stable one, determined by a number of factors, key among which are enumerated below. 

Velocity varies directly with Real Income/Output (Y) 

Studies have shown that when real output/income increases, the demand for money increases as well. Since the money supply is the same, in order to meet the increased demand for money, the public circulates each dollar more rapidly (i.e. “v” increases). So, an increase in “Y”, leads to an increase in “v”. Similarly, a fall in “Y” causes “v” to drop as well. 

Velocity directly related to market Interest Rates

The alternative use of the money that the public holds is investment. The interest rate on these alternative investments (bank deposits, bonds etc.) is the “opportunity cost” of holding money i.e. the reward that one has to forgo in order to hold money. When market interest rates rise, the opportunity cost of holding money rises. As a result, the public becomes loathe to holding more money and instead, tends to circulate the money it holds more rapidly, leading to an increase in velocity. 

Velocity increases with the availability of close Money Substitutes 

The greater the availability of close money substitutes (we are using the M1 definition of money here; M1 = currency + demand deposits) i.e. liquid assets that can be quickly and easily converted into cash at low cost, the greater is the velocity of money. Why? Because when you know that you can easily access cash through money substitutes, you’ll tend to hold a smaller amount of money to fulfill your daily needs. You’ll circulate this money more rapidly (velocity rises), rather than holding a larger amount of money that doesn’t change hands much, but makes you feel more secure and prepared for financial emergencies. 

Velocity rises with growing financial innovation and enhanced reach of financial institutions

ATMs and other types of financial innovation along with the growing reach of financial institutions, continues to allow customers to hold a lower amount of money for their day-to-day needs i.e. enable higher velocity of money. This factor and the availability of close money substitutes are intimately related. 

Bottom-line: Though not constant, the velocity function is a relatively stable one determined by a number of independent variables (key among which are listed above), which makes it relatively predictable as well. That being said, the velocity of money continues to remain a controversial subject in economic theory. I’m sure I’ll do more posts to address some of the controversies/complexities surrounding this seemingly innocuous variable. 

Is Output (Y) constant?

This is essentially the Classical vs. Keynesian assumption vis-a-vis “full employment” encapsulated into a single question. Classicals believe that the economy tends to operate at the full employment (full capacity) level barring some small periods of adjustment. If this is the case, then when money supply expands, all it does is raise the price level, since output is already at full capacity. 

Keynesians however have asserted (and there is enough real-world evidence to back this up) that economies can and do operate below full-employment for long periods of time. As a result, monetary expansions/contractions can and do lead to changes in output, at least over the short term. 

When does the Quantity Theory hold?

So, we know that MV = PY. Now we also know that “v” and “Y” are not constant. How then can % ΔM be = % ΔP? Does the Quantity theory hold at all?

The Quantity theory does hold over the long term, since in the long run, the economy does tend to operate at the full-employment level (Y), and the velocity of money (v) though not constant, is relatively stable and predictable. Over a shorter time horizon however, the proportional relationship between % ΔM and % ΔP is hard to observe. 

For example, analysis shows that money growth and inflation are indeed highly correlated in the very long run. Over a 15-20 year period, a correlation of 0.6 - 0.8 has been observed between money growth and inflation. However, over a 2-8 year time period (horizon of a business cycle), the correlation never exceeded 0.4. (Source: St. Louis Federal Reserve). 

Watch out for more QTM related posts.

So you think a drop in Inflation will increase your Real Wage?

Since we’ve talked about how real wage is determined, I’m doing this short post to bust a common misconception.

It appears common sensical to believe that if inflation falls, the purchasing power of your wage i.e. your “real wage” will increase. So inflation seems to be the enemy. If inflation were lower, you’d be richer in real terms.

Not true. Let me explain.

Some basics first:

Real wage signifies the purchasing power of our nominal wage (w) or the amount of goods and services we can buy with our nominal wage. It is calculated as w/P where “P” is an appropriate wage deflator such as CPI inflation. CPI (Consumer Price Index) inflation for July 2016 was 6.46% (latest data). 

Now, remember from my post Market Structure: Classical Vs. Keynesian Assumption, that in a perfectly competitive market, the firm’s demand curve for labour is: 

w = P0 * MPL              (1)

Where w = nominal wage, P0 = price of the output, and MPL = Marginal Product of labour. 

Recall that the Marginal Product of labour (MPL) = the units of output produced by employing an additional unit of labour, keeping everything else constant. 

Rearranging (1), we get

w/P0 = MPL

This means that real wage (w/P0) is = the Marginal Product of labour. 

Now....

if there is inflation in the economy i.e. prices rise, then P0 will rise. But the MPL will still remain the same. This means that “w” will have to rise as well.

Lets assume the opposite i.e. prices fall. When prices fall --> P0 falls --> since MPL remains the constant, “w” falls as well. 

So here’s the thing......

Wages tend to move along with inflation, so that purchasing power remains the same (= the marginal product of labour). If inflation continues to drop, wage rise will tend to slow down as well. 

So even though inflation appears to be the enemy, it is not. Real wages can rise only if the productivity of labour (Marginal Product) rises. Else they remain stagnant.