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Note on Capital Account Convertibility

By: CA. Sudha G. Bhushan

6/23/2011 www.taxpertpro.com

Taxpert professionals Private Limited | sudhag999@gmail.com www.taxpertpro.com

Convertible currencies are defined as currencies that are readily bought, sold, and

converted without the need for permission from a central bank or government entity. Most

major currencies are fully convertible; that is, they can be traded freely without restriction

and with no permission required. The easy convertibility of currency is a relatively recent

development and is in part attributable to the growth of the international trading markets

and the FOREX markets in particular. Historically, movement away from the gold exchange

standard once in common usage has led to more and more convertible currencies becoming

available on the market. Because the value of currencies is established in comparison to

each other, rather than measured against a rea commodity like gold or silver, the ready

trade of currencies can offer investors an opportunity for profit. In case of two convertible

currencies, Forward Exchange Rates reflect interest rate differentials between these two

currencies. Thus, we can say that the Forward Exchange Rate for the higher interest rate

currency would depreciate so as to neutralize the interest rate difference. However,

sometimes there can be opportunities when forward rates do not fully neutralize interest

rate differentials. In such situations forward exchange rates quickly adjust to eliminate the

possibility of risk-less profits.

Fully convertible currency

The U.S.dollar is an example of a fully convertible currency. There are no restrictions or

limitations on the amount of dollars that can be traded on the international market, and the

U.S. Government does not artificially impose a fixed value or minimum value on the dollar

in international trade. For this reason, dollars are one of the major currencies traded in the

FOREX market.

Partially convertible currency

The Indian rupee is only partially convertible due to the Indian Central Bank’s control over

international investments flowing in and out of the country. Foreign exchange transactions

are broadly classified into two types: current account transactions and capital account

transactions. Transactions on the current account are fully convertible and foreign exchange

was made freely available for such transactions. But capital account transactions are not

fully convertible. The rationale behind this is clear, that India wants to conserve precious

foreign exchange and protect the rupee from volatile fluctuations.

Capital account convertibility is likely to bring depth and large volumes in long-term INR

currency swap markets. Thus for a better market determination of INR exchange rates, the

INR should be convertible.

For more insight in Fuller convertibility of Rupee follow the link:

http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/72252.pdf