Currency Convertibility: Advantage, Benefits and Preconditions for Capital Account Convertibility! For the rapid growth of world trade and capital flows between countries convertibility of a currency is desirable. Therefore, to achieve capital account convertibility meaning investopedia forex rate of economic growth and thereby to improve living standards through greater trade and capital flows, the need for convertibility of currencies of different nations has been greatly felt.
Under Bretton Woods system fixed exchange rate system was adopted by various countries. In order to maintain the exchange rate of their currencies in terms of dollar or gold various countries imposed several controls over the use of foreign exchange. This required some restrictions on the use of foreign exchange and its allocation among different uses, the currency of a nation was converted into foreign exchange on the basis of officially fixed exchange rate. When Bretton Woods system collapsed in 1971, the various countries switched over to the floating foreign exchange rate system. Under the floating or flexible exchange rate system, exchange rates between different national currencies are allowed to the determined through market demand for and supply of them. However, various countries still imposed restrictions on the free convertibility of their currencies in view of their difficult balance of payment situation. By convertibility of a currency we mean currency of a country can be freely converted into foreign exchange at market determined rate of exchange that is, exchange rate as determined by demand for and supply of a currency.
Under convertibility of a currency there are authorised dealers of foreign exchange which constitute foreign exchange market. Similarly, under currency convertibility, importers and other who require foreign exchange can go to these banks dealing in foreign exchange and get rupees converted into foreign exchange. A currency may be convertible on both current and capital accounts. We have explained above the convertibility of a currency on current account only. Thus, by convertibility of rupee on capital account means those who bring in foreign exchange for purchasing stocks, bonds in Indian stock markets or for direct investment in power projects, highways steel plants etc.
Likewise, the dividends, capital gains, interest received on purchased stock, equity etc. US dollars, Pound Sterlings at market determined exchange rate between these currencies and repatriate them. 10 countries joined them in 1991. 40 per cent of them was to be surrendered to Reserve Bank of India at the officially fixed exchange rate. These 40 per cent exchange receipts on current account was meant for meeting Government needs for foreign exchange and for financing imports of essential commodities.
This partial convertibility of rupee on current account was adopted so that essential imports could be made available at lower exchange rate to ensure that their prices do not rise much. Further, full convertibility of rupees at that stage was considered to be risky in view of large deficit in balance of payments on current account. As even after partial convertibility of rupee foreign exchange value of rupee remained stable, full convertibility on current account was announced in the budget for 1993-94. From March 1993, rupee was made convertible for all trade in merchandise. In March’ 1994, even indivisibles and remittances from abroad were allowed to be freely convertible into rupees at market determined exchange rate. However, on capital account rupee remained nonconvertible. An important advantage of currency convertibility is that it encourages exports by increasing their profitability.