Final Current Account

8/8/2019 Final Current Account

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Report on

Current Account

Submitted by :

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Table of Content:

Current Account Transactions : ........................................................................... 2

Prohibition on drawal of Foreign Exchange : .................................................... 4

Prior approval of the Government of India : ..................................................... 4

Prior approval of the Reserve Bank: ................................................................. 5

Exchange facilities for Transactions : .................................................................. 7

Remittances for other Current Account Transactions : ........................................ 7

Components of Current Account Trade ................................................................ 8

visibles a primer ................................................................................................ 8

Recent trends in the external sector : ................................................................. 8

Balance of Payments: ........................................................................................ 13Merchandise Trade ............................................................................................ 14

Invisibles : .......................................................................................................... 17

Importance of Invisibles : ................................................................................... 18

Current Account Balance ............................................................................... 19

Rupee Convertibility : ....................................................................................... 20

Current Account Convertibility ....................................................................... 21

Partial Rupee Convertibility: .......................................................................... 22

Evolution of Indias Current Account : ............................................................... 26

Current Account Transactions :

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Current Account Transactions as defined in Section 2 (j) of FEMA, means a transaction

other than a capital account transaction and without prejudice to the generality of the other

provisions shall include:

payments due in connection with foreign trade, other account current business,

services and short term banking and credit facilities in tire ordinary course ofbusiness;

payments due as interest on loans and as net income from the investments; remittances for living expenses of parents, spouse and children residing abroad; expenses in connection with foreign travel, education and medical care of parents,

spouse and children.

Provisions to Section 5 of FEMA empowers the Central Government in public interest andin consultation with the Reserve Bank to impose such reasonable restrictions for currentaccount transactions in exercise of the powers conferred and in consultation with theReserve Bank the Central Government issued Foreign Exchange Management (Current

Account Transactions) Rules 2000 on 3rd May, 2000 in this regard.

In terms of provisions of Section 5 of FEMA, any person may sell or draw foreignexchange to or from an authorized dealer if such sale or withdrawal is a current accounttransaction.

The proviso to Section 5 empowers Government of India, in public interest and inconsultation with the Reserve Bank to impose reasonable restrictions on certain currentaccount transactions.

In terms of the rules 3, drawal of exchange for the following transactions is prohibited.

Travel to Nepal or Bhutan Transactions with a person resident in Nepal or Bhutan (unless specifically

exempted by Reserve Bank by general or special order). Remittance out of lottery winnings Remittance of income from racing/riding etc. or any other hobby. Remittance for purchase of lottery tickets, banned/proscribed magazines, football

pools, sweepstakes, etc. Payment of commission on exports made towards equity investment in Joint

Ventures/Wholly Owned Subsidiaries abroad of Indian companies. Remittance of dividend by any company to which the requirement of dividend

balancing is applicable. Payment of commission on exports under Rupee State Credit Route. Payment

related to Call Back Services of telephones. Remittance of interest income on funds held in Non-Resident Special Rupee

(NRSR) Account scheme.

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Prohibition on drawal of Foreign Exchange :

Rule 3 of Foreign Exchange Management (Current Account Transactions) Rules, 2000provides that the drawal of foreign exchange by a person is prohibited for the followingpurposes, namely:

transactions specified in Schedule III of the notification; travel to Nepal and/or Bhutan; a transactions to the person resident in Nepal/or Bhutan.

The prohibition on the transaction with a person resident in Nepal or Bhutan may beexempted by the Reserve Bank of lndia subject to such terms and conditions as it mayconsidered necessary to stipulate by general or special order.

The transactions which are specified in Schedule P and thereby absolutely prohibited are:

remittance out of lottery winnings; remittance of income from racing/riding etc. or any other hobby; remittance for purchase of lottery tickets, banned/prescribed magazines, football

pools, sweepstakes payment of commission on exports made towards equity investment in joint

ventures/wholly owned subsidiaries abroad of Indian companies; remittance of dividend by any company to which the requirement of dividend

balancing is applicable

payment of commission on exports under Rupee State Credit Route; . paymentrelated to Call Back Services of telephone;

remittance of interest income on funds held in Non-Resident Special Rupee SchemeAccount;

Prior approval of the Government of India :

Provides that no person shall draw foreign exchange for the transaction included in .Table-A without prior approval of the Government of India.

The provisions to this rule states that this rule shall not apply where the payment is madeout of funds held in Resident Foreign Currency (RFC) Account or Exchange EarnersForeign Currency (EEFC) Account of the remitter.

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TABLE-A

Purpose of Remittance Whose approval is required

Cultural Tours Ministry of Human Resources Developments(Department of Education and Culture) Ministry

of Finance, (Department of Economic Affairs)Advertisement abroad by any PSU/State AndCentral Government Department

Ministry of Finance, (Department of EconomicAffairs).

Remittance of freight of vessel charted by a PSU(Chartering Wing)

Ministry of Surface Transport

Payment of import by a Government Department(Chartering Wing) or a PSU on C.I.Fbasis (i.e.other thanF.O.B andF.A.Sbasis)

Ministry of Surface Transport

Multi-modal transport operators makingremittance to their agents abroad

Registration Certificate from the Director Generalof Shipping.

Remittance of hiring charges of transponders Ministry of Finance, (Department of EconomicAffairs)

Remittance of container detention chargesexceeding the rate prescribed by Director Generalof Shipping

Ministry of Surface Transport (Director Generalof Shipping)

Remittances under technical collaborationagreements where payment of royalty exceeds5%on local sales and 8% on exports and lump-sum payment exceeds US$ 2 million

Ministry of Industry and Commerce.

Remittance of prize money/ sponsorship of sportsactivity abroad by person other thanInternational/National/State level sports bodies, ifthe amount involved exceeds US $100000

Ministry of Human Resource Development(Department of Youth Affairs and Sports)

Payment for securing Insurance for health from acompany abroad

Ministry of Finance, (Insurance Division)

Remittance for membership of P & I Club Ministry of Finance, (Insurance Division)

Prior approval of the Reserve Bank:

There are certain transactions listed in below which cannot be undertaken without the priorapproval of the Reserve Bank, these provisions shall not apply where the payment is madeout of funds held in Resident Foreign Currency (RFC) Account or Exchange EarnersForeign Currency (EEFC) Account of the remitter.

The transactions for which prior approval of the Reserve Bank is needed are as follows:

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Remittance by artiste e.g. wrestler, dancer, entertainer etc. (This restriction is not applicableto artistes engaged by tourism related organizations in India like ITDC, State TourismDevelopment Corporations etc. during special festivals or those artistes engaged by hotelsin five star categories, provided the expenditure is met out of EEFC account) ;

Release of exchange exceeding US$ 5,000 or its equivalent in one calendar year, forone or more private visits to any country (except Nepal and Bhutan)

Gift, remittance exceeding US$ 5,000 per beneficiary per annum; Donation exceeding US$ 5,000 per annum per beneficiary ; Exchange Facilities exceeding US$ 5000 for persons going abroad for employment; Exchange Facilities for emigration exceeding US$ 5,000 or amount prescribed by

country of emigration; Remittance for maintenance of close relatives abroad exceeding US$ 5,000 per year

per recipient; Release of foreign exchange, exceeding US$ 25,000 to a person, irrespective of

period of stay, for business travel, or attending a Conference or specialized trainingor for maintenance expenses of a patient going abroad for medical treatment orcheck-up abroad, or for accompanying as attended to a patient going abroad formedical treatment/Check-up;

Release of exchange for meeting expenses for medical treatment abroad exceedingthe estimate from the doctor in India or hospital/doctor abroad;

Release of exchange for studies abroad exceeding the estimates from the institutionabroad or US$ 30,000, whichever is higher;

Commission to agents abroad for sale of resident flats/commercial plots in India,exceeding 5%of the inward remittance;

Short term credit to overseas offices of Indian companies; Remittance for advertisement on foreign television by a person whose export

earnings are less than Rs. 10 lakhs during each of the preceding two years; Remittances of royalty and payment of lump-sum fee under the technical.

collaboration agreement which has not been registered with Reserve Bank;

Remittance exceeding US$ 100,000 for architectural/consultancy services procuredfrom abroad;

Remittances for use and/or purchase of trade mark/franchises in India. Exchangefacilities for transactions.

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Exchange facilities for Transactions :

Exchange facilitate for transaction in schedule II to the rules may be permitted byauthorized dealers provided the applicant has secured the approval from the MinistryDepartment of Government of India indicated against the transactions.

In respect of transactions included in Schedule III where the remittance applied for exceedsthe limit, if any, indicated in the schedule or other transactions included in Schedule III forwhich no limit have been stipulated would require prior approval of Reserve Bank.

Remittances for other Current Account Transactions :

Remittances for all other current transactions which are not specifically prohibited under the

rules or which are not included in Schedule II or III may be permitted by authorised dealerswithout any monetary/percentage ceilings subject to compliance with the provisions of Sub-section (5) of Section 10 of FEMA. Remittances for transactions included in Schedule IIImay be permitted by authorised dealers up to the ceilings prescribed therein.

For removal of doubts, it is clarified that -

The existing procedure to be followed by Indian companies for entering intocollaboration arrangements with overseas collaborators would continue.

There would be no restriction regarding receipt of advance payment or back to backletter of credit for merchanting trade transactions.

In terms of Foreign Exchange Management (Borrowing or Lending in ForeignExchange) Regulations, 2000 approval of Reserve Bank would be required forimporters availing of Suppliers Credit beyond 180 days and Buyers Creditirrespective of the period of credit.

Transactions relating to import of ship stores into bond for supply to Indian/foreignflag vessels, Indian Naval ships, and foreign diplomatic personnel will no more beregulated by Reserve Bank.

Remittance of surplus freight/passage collections by shipping/airline companies ortheir agents, remittances by break bulk agents, multimodal transport operators,remittance of freight pre-paid on inward consolidation of cargo, operating expenses

of Indian airline/shipping companies etc. may be permitted by authorised dealersafter verification of documentary evidence in support of the remittance.

The Reserve Bank will not prescribe the documentation which should be verified by theauthorised dealers while permitting remittances for various transactions, particularly ofcurrent account. In this connection attention of authorised dealers is drawn to Subsection (5)of Section 10 of FEMA which provides that an authorised person shall before undertaking

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any transaction in foreign exchange on behalf of any person require that person to makesuch a declaration and to give such information as will reasonably satisfy him that thetransaction will not involve and is not designed for the purpose of any contravention orevasion of the provisions of FEMA or of any rule, regulation, notification, direction ororder issued there under. Authorised dealers are advised to keep on record any

information/documentation on the basis of which the transaction was undertaken forverification by the Reserve Bank. The said clause further provides that where the saidperson (applicant) refuses to comply with any such requirement or makes unsatisfactorycompliance therewith, the authorised person shall refuse in writing to undertake thetransaction and shall if he has reason to believe that any contravention/ evasion iscontemplated by the person, report the matter to Reserve Bank.

Components of Current Account Trade

VISIBLE TRADE

INVISIBLE TRADE

VISIBLES APRIMER

The visible balance is that part of the balance of trade figures that refers to international tradein physical goods, but not trade in services; it thus contrasts with the invisible balance or

balance of trade on services. The balance of trade (or net exports, sometimes symbolized asNX) is the difference between the monetary value of exports and imports of output in aneconomy over a certain period. It is the relationship between a nation's imports and exports. Apositive or favourable balance of trade is known as a trade surplus if it consists of exportingmore than is imported; a negative or unfavourable balance is referred to as a trade deficit or,informally, a trade gap. Balance of trade is sometimes divided into a goods and a servicesbalance.

Most countries do not have a zero visible balance: they usually run a surplus or a deficit. Thiswill be offset by trade in services, other income transfers, investments and monetary flows,leading to an overall balance of payments. The visible balance is affected by changes in thevolumes of imports and exports, and also by changes in the terms of trade.

Recent trends in the external sector :

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1. In a globalised world, a congenial global economic environment and a sustainablebalance of payments position are critical for achieving the policy goal of stable growth. Theglobal recession in 2009 operated as a dampener on the prospects of a faster recovery.Besides the conventional channels of trade and capital flows for transmission of externalshocks to the domestic real economy, the uncertainty about global recovery continued to

affect business confidence and market sentiments, which indirectly affected domesticprivate consumption and investment demand. Indias high degree of resilience and capacityto manage a severe external shock was evident from the strength and pace of recovery inGDP growth during 2009-10.

2. In 2009, the global economy not only experienced a great contraction, but there wasalso significant uncertainty about the impact of the financial crisis in the advancedeconomies on the real economy. The successive and large revisions to the IMFs growthoutlook for 2009 indicate the extent of uncertainty that resulted from the subprime financialcrisis (Chart 1a). In the first quarter of 2010, stronger evidence of recovery in the globaleconomy started to emerge.

3. Persistence of high growth in India and China largely moderated the depth of the globalrecession in 2009, even though these countries also experienced slowdown in growth inrelation to their high growth before the onset of global crisis (Chart 1c). World tradecontracted much harper than the contraction in GDP in 2009, and is projected to stage astronger recovery in 2010 Chart 1d). Reflecting the impact of weak global demandconditions as also the protectionist measures adopted by many countries, the decline inworld merchandise trade volume was as high as 11.8 per cent in 2009. According to WTO,world exports of commercial services also declined for the first time after 1983 by 13.0 percent during 2009. The impact of recession in the advanced economies was particularlystrong on the employment situation (Chart 1e).4. Reflecting the flight to safety response of global investors to the crisis, net capital flowsto the EMEs declined, with phases of sudden stops and revival, before exhibiting a rebound(Chart 1f). Unprecedented use of policy stimulus by countries around the world helped inaverting another Great Depression, but the fiscal conditions of the advanced economiesweakened significantly in that process (Chart 1g and h). In managing the financial crisis,the costs of financial excesses in the private sector shifted to the public sector, creating, inturn, the risk of potential sovereign debt crises.

5. Reflecting increased openness, the global recession and the contraction in world trade in2009 affected Indias exports of both goods and services. With global recovery, however,Indias exports have turned around since October 2009. Reflecting the revival in capitalinflows to EMEs, and driven by Indias recovery ahead of the global economy, India alsoexperienced resumption of capital flows in 2009-10. Stronger and durable recovery in theglobal economy could be necessary to improve the overall business confidence as well asexport prospects.

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Balance of Payments:

6. Indias balance of payments position improved during 2009-10, with turnaround inexports in the latter part of the year and resumption in capital flows, notwithstanding thehigher current account deficit that reflected stronger absorption of foreign capital. Key

external sector soundness parameters in the form of current account deficit, external debtand foreign exchange reserves remained comfortable and supported the overall policyenvironment to spur a faster recovery in growth. The balance of payments developmentsduring 2009-10 had contrasting ramifications for recovery in economic growth. The declinein exports The invisibles account reflects the combined effects of the transactions relating tointernational trade in services, income associated with non-resident assets and liabilities,labour and property and cross border transfers, mainly workers remittances of goods andservices in response to weak global demand had a dampening impact on overall GDP.However, a higher current account deficit led to stronger absorption of foreign capital. This,in turn, implied higher investment activities financed by foreign capital, which partlycontributed to the stronger recovery in growth. Major determinants of balance of payment

transactions, such as external demand, international oil and commodity prices, pattern ofcapital flows and the exchange rate changed significantly during the course of the year.With the turnaround in exports and revival in capital flows, external sector concernsreceded gradually.

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Merchandise Trade

7. Contraction in global trade volume was much sharper than the contraction in global GDPin 2009, and the impact on Indias merchandise exports was visible in terms of negativegrowth over12 successive months during October 2008 to September 2009. Indiasmerchandise exports witnessed a turnaround in October 2009. A durable recovery in worlddemand will be critical to sustain the strong positive export growth experienced duringNovember 2009 to June 2010, and then the monthly average growth of exports was 32.9 percent. Merchandise imports also contracted over eleven successive months; the recovery indomestic economic activity and resurgence in oil prices led to a rebound in Indias imports,since November 2009. As a result, imports witnessed a robust growth at a monthly averageof 47.9 per cent during December 2009 to June 2010 (Chart 2 a and b). The impact of theglobal crisis on export performance of various countries in 2009 was divergent. Countries

like Indonesia, India, China, Switzerland, Korea and the US recorded a relatively lowerdecline in exports than the world average (Chart 3).

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CHART 2


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8. Recognizing the pressure on export performance from adverse global developments, theGovernment of India had announced a number of incentive measures in the Union Budget2009-10 and Foreign Trade Policy (2009-14) to promote export growth. The Union Budgetfor 2009-10 announced measures such as extension of period of the Adjustment AssistanceScheme for badly it export sectors, extension of period for interest subvention of 2 per centon pre-shipment export credit, and extension of the period for income tax benefits to exportsector, etc. In the foreign Trade Policy (2009- 14), new products and new markets wereadded to the Focus Market Scheme (FMS) and Focus Product Scheme (FPS). MarketLinked Focus Product Scheme (MLFPS) was expanded by inclusion of various products.To facilitate technological up gradation of the export sector and thereby enhance

competitiveness of exports, Export Promotion Capital Goods (EPCG) scheme at zero dutywas introduced for various export sectors. Indias comparative advantage in specific exportitems was affected in the wake of the global crisis (For more details see Appendix 1).

9. Despite the demand induced moderation in export growth resulting from the globalrecession, Indias exports performed relatively better as its rank among leading exporters

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improved from 27th in 2008 to 22nd in 2009, with the share in world exports at 1.2 percent. India ranked 15th among leading importers in 2009, with a share of 1.9 per cent,which also represents an improvement over 16th position in 2008. Since Indias GDPgrowth remained ahead of most countries, its import growth accordingly would have beenrelatively higher, leading to the higher rank among importers.

10. The disaggregated commodity and direction of trade data reveal that Indias trade in allmajor commodity groups and with major trading partners registered a decline/decelerationduring 2009-10 (Chart 4a to d). However, exports of primary products and petroleumproducts registered a positive growth in 2009-10. Also, exports of gems and jewellery haveturned around since Q3 of 2009-10. Similarly, imports of crude oil started rising with theincrease in its price.

11. Overall, Indias exports and imports contracted by 3.6 per cent and 5.6 per cent,respectively, during 2009-10 as against a growth of 13.7 per cent in exports and 20.8 percent in imports last year. As the decline in imports was steeper than the decline in exports,

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the overall trade deficit was lower during the year. On balance of payments basis, the tradedeficit as a percentage of GDP reduced from 9.8 per cent in 2008-09 to 8.9 per cent in2009-10.

Invisibles :

12. Invisibles receipts and payments had witnessed deceleration in growth in 2008-09 inrelation to the robust growth performance in the precrisis period. During 2009-10, invisiblereceipts declined further by 1.4 per cent mainly on account of decline in business, financialand communication services and investment income receipts. In contrast, invisiblepayments increased significantly by 11.8 per cent due to increase in payments underinvestment income, financial and business services. As a result, invisibles surplus declinedby 12.2 per cent to US$ 78.9 billion during 2009-10 from US$ 89.9 billion in the previous

year (Chart 5a)

13. Private transfer receipts, an important and resilient component of invisibles receipts,Increased by 14.9 per cent to US$ 53.9 billion during 2009-10 from US$ 46.9 billion in theprevious year (Chart 5b). A Survey conducted by the Reserve Bank in November 2009suggested an insignificant impact of the global crisis on remittance inflows to India. The

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CHART 5


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responses from different cities though varied, ranging from significant impact (such asKochi) to no decline (such as Ahmedabad).

14. Net services exports of India declined by 31.1 per cent during 2009-10 as against anincrease of 27.7 per cent during last year, mainly due to significant decline in services

receipts coupled with an increase in services payments. Growth in services receipts turnednegative for the first time after 1992-93, reflecting subdued global private demand anddecline in merchandise trade. The decline in net services was spread over transportation andmiscellaneous services such as business, financial and communication services. Softwareservices exports, which had declined during the first half recovered during the second half,resulting in a growth of 7.4 per cent during 2009-10. Non-software miscellaneous servicesreceipts, mainly on account of significant decline in communication, financial and businessservices, declined sharply to US$ 19.0 billion in 2009-10 from US$ 31.4 billion in 2008-09.Investment income receipts also declined to US$ 12.1 billion in 2009-10 from US$ 13.5billion in 2008-09 on account of low interest rate environment in international markets.

Importance of Invisibles :

In recent years, India's balance of payments (BoP) developments in the current accounthave been characterised by two elements viz., (a) persistence of higher trade deficits, and(b) buoyant invisible surpluses. The persistent and growing invisible surpluses haveprovided cushion to higher trade deficits and minimised the risks to external paymentsposition.

Net invisibles (invisibles receipts minus invisibles payments) stood at US$ 78.9 billionduring 2009-10 as compared with US$ 89.9 billion during 2008-09. At this level, theinvisibles surplus financed 67.3 per cent of the trade deficit (as against 75.8 per cent during2008-09).

Despite a lower trade deficit, decline in invisibles surplus led to higher current accountdeficit at US$ 38.4 billion (US$ 28.7 billion in 2008-09)

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Given the importance of invisibles, the developments in these areas are published by theReserve Bank of India (RBI) in two stages viz., (i) standard presentation with broad headson a quarterly basis to meet the IMF's Special Data Dissemination Standards (SDDS) in theRBI's website and subsequently in monthly Bulletin of the RBI, and (ii) detailedpresentation with break-up of broad heads in an annual article titled 'Invisibles in India'sBalance of Payments' in the RBI's monthly Bulletin.

Current Account Balance

15. On balance of payments basis, trade deficit decreased marginally to US$ 117.3 billion(8.9 per cent of GDP) during 2009-10 from US$ 118.7 billion (9.8 per cent of GDP) in2008-09 (Chart 6). Lower net invisibles during 2009-10 financed about 67.3 per cent of

trade deficit as compared with 75.8 per cent in the previous year. Despite lower tradedeficit, the decline in invisibles surplus led to a higher current account deficit of 2.9 per centof GDP during 2009-10 as compared with 2.4 per cent of GDP a year ago.

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Rupee Convertibility :

Rupee convertibility means the system where any amount of rupee can converted into anyother currency without any question asked about the purpose for which the foreignexchange is to be used. Currency convertibility means the freedom to convert one currencyinto other internationally accepted currencies. Currency convertibility implies the absenceof exchange controls or restrictions on foreign exchange transactions.

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Convertibility is a two-step process- current account and capital account.

Convertibility for current international transactions

Convertibility for international capital movements

Current Account Convertibility

Current account convertibility refers to freedom in respect of Payments and transfers forcurrent international transactions. If Indians are allowed to buy only foreign goods andservices but restrictions remain on the purchase of assets abroad, it is only current accountconvertibility. As of now, convertibility of the rupee into foreign currencies is almostwholly free for current account i.e. in case of transactions such as trade, travel and tourism,education abroad etc.

Current account convertibility is popularly defined as the freedom to buy or sell foreignexchange for :-

a. The international transactions consisting of payments due in connection withforeign trade, other current businesses including services and normal short-termbanking and credit facilitiesb. Payments due as interest on loans and as net income from other investmentsc. Payment of moderate amounts of amortisation of loans for depreciation ofdirect investmentsd. Moderate remittances for family living expenses

e. Authorised Dealers may also provide exchange facilities to their customerswithout prior approval of the RBI beyond specified indicative limits, provided,they are satisfied about the bonafides of the application such as, business travel, participation in overseas conferences/seminars, studies/ study tours abroad,medical treatment/check-up and specialised apprenticeship training.

Steps towards Rupee Convertibility:

The process of opening up the Indian economy has proceeded in steady steps :i. The exchange rate regime was allowed to be determined by market forces as against

the fixed exchange rate linked to a basket of currencies.

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ii. This was followed by the convertibility of the Indian rupee for current accounttransactions with India accepting the obligations under Article VIII of the IMF inAugust 1994.

iii. Capital account convertibility has since then proceeded at a steady pacebecause RBI views capital account convertibility as a process rather than as an

event. At present Indian entities are allowed to invest /acquire assets outside India ora foreign entity remit funds for investment with specified cap on such investmentsand for specific purpose.

iv. Distinct improvement in the external sector has enabled a progressive liberalisationof the exchange and payments regime in India. Reflecting the changed approach toforeign exchange restrictions, the restrictive Foreign Exchange Regulation Act(FERA), 1973 has been replaced by the Foreign Exchange Management Act, 1999.

Partial Rupee Convertibility:

The government introduced a system ofPartial Rupee Convertibility (PCR) on February29, 1992 as part of the Fiscal Budget for 1992-93. PCR was designed to provide a powerfulboost to export and to achieve as efficient import substitution by reducing bureaucraticcontrols, which contribute to delays and inefficiency. Government liberalized the flow offoreign exchange to include items like amount of foreign currency that can be procured forpurpose like travel abroad, studying abroad, engaging the service of foreign consultants etc.

For most countries deregulation of foreign trade transactions must precede deregulation ofinternational capital account flows. For an economy in transition from a controlled to amarket based one, international capital movements can be highly destabilizing anddisruptive. It is essential that capital flows be regulated under a separate controlled regimeduring the initial movement towards convertibility.

The PCR system was introduced to combine the advantage of relatively suitable managedfloat and the BOP- balancing property of a freely floating rate. This involves creation oftwo exchange rate channels:

a. A market channel in which the exchange rate is determined by market forcesof supply and demand of foreign exchange where access if free for alltransactions (other than those specified as not free).

b. An official channel where the exchange rate continues to be determined byRBI on the base of the value of rupee in relation to the basket of currenciesand fixed, but access to the market is restricted.

RBI introduced a system called the Liberalized Exchange Rate Management System(LERMS) effective from 1st March 1992.

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Till 1st March 1992 all foreign exchange remitted into India was implicitly handed over toRBI by Authorized Dealers (ADs) and then RBI made a Foreign exchange available forapproved purpose.

Under new system, the RBIs retention ratio has been reduced from 100% to 40% of all

foreign exchange remittances received with effect from 1.3.1992. The ADs apply theofficial exchange rate in calculating the value of rupees to be paid to the remitter for this40% and surrender the exchange to the RBI. The remaining 60% of the value of theremittance is purchased by AD at a market-determined exchange rate. AD s, retain this 60%portion for sale to other AD s, authorized broker or buyer of foreign exchange.

Transactions at official rate:

The government has notified that payment obligations for the import of the items specifiedbelow to the extent authorized by the Ministry of Finance can be made available at the

official exchange rate:i. Import for Government departments needs.ii. Crude Oil.iii. Diesel.iv. Kerosene.v. Fertilizer.vi. Import of Life-saving drugs and equipment.vii. In respect of imports under advance licenses and import for replenishment of rawmaterials for gem and jewellery exports.viii. All transactions relating to official grants and relating to the IMF.

All Otherpayment transactions for import of goods and services take place exclusively atthe market exchange rate.

Requisites for Current Account convertibility :1

Before moving to a full current account convertibility we had to fulfill other pre-requisites.

Government had to bring down fiscal deficit. Our current account deficit atthe worst of times has not been more than 2.5 to 3 percent of GDP. Foreignexchange reserves are more than adequate.

RBI was given full control of monetary policy. RBI was not under the rule ofFinance Ministry. In developed countries, the Central Bank has full autonomy. In

1 Currency convertibility and the transformation of centrally plannedeconomies by Joshua E. Greene, Peter I

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the US, the President cannot impeach the Central Bank Governor and theGovernor can be removed only if a fraud has been committed. Similarly Indiaalso planned for monetary authority, fully independent of the government.

Inflation rates have to be reined. (Preferable: 4 5%) . Our banking systemwas not fully in good shape especially with regard to non-performing assets.NPA management was done. Financial regulation is fairly good under RBI andSEBI. Sometimes they control too much, they should actually control less.

Adequate level of international liquidity is required. The banking sector openedup and the statutory liquidity ratio requirements were fixed at 25%. Therefore,most of the pre-conditions for current account convertibility are present in Indianeconomy.

Sound macroeconomic policies (no monetary overhang). Monetary Overhang

refers to the liquidity that quantity-constrained consumers may accumulate

in excess of the money they would accumulate if commodities were freely

available in the market.

Above conditions are important to ensure that current account convertibility does not

cause macroeconomic instability .

Environment where monetary agents have both ability and incentive torespond to market prices This condition is important so that current

account delivers the necessary benefits.

Currrent Account convertibility Pros and Cons

Pros :

1. Current account convertibility opens up the domestic economy to foreign capital.

Foreign capital augments investible resources of the home country and facilitatesfaster growth.

2. Cost of capital for domestic firms is lowered and access to global capital markets isenhanced. Just as there are gains from international trade in goods and services,there are gains from trade in financial assets. It allows residents to hold globally

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diversified portfolios improving their risk return trade off. It lowers the funding costfor resident borrowers.

Cons :

1. Large deficits show up on current account as debits and running up large currentaccount deficits will lose the confidence of foreign investors in meeting ourliabilities.In normal situations current account deficit should not exceed 1.5-2 % of GDP.Anything beyond that is not sustainable and quite dangerous also.

Example: In Thailand, the current account deficit for three years was nine percent of

GDP. If we have to keep current account under control then budget deficits shouldalso be under control.

2. They must raise more resources by way of taxation not by way of borrowing.Borrowing creates problems for the future as interest burden will increase.

3. Large deficits will also lead to depreciation of currency.

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Evolution of Indias Current Account :

India launched its market-oriented economic reforms in 1991. In India, post-1991 economic

reforms have been evolutionary and incremental in nature. India also launched its massive

economic reforms in 1991 under the pressure of economic crises. The twin crises were

reflected through an unmanageable balance of payments crisis and a socially intolerably

high rate of inflation that were building up in the 1980s and climaxed in 1990-91. This can

be seen from the data provided in Table1. The current account deficit as a percentage of

GDP peaked at a high of 3.1 percent (compared to an average level of 1.4 percent in the

early 1980s).

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Through reform, India overcame its worst economic crisis in the remarkably short period of

two years. Macro-economic stabilization reforms (along with structural economic reforms)

were launched in June 1991. Through prudent macro-economic stabilization policies

including devolution of the rupee and other structural economic reforms the balance of

payments crisis was clearly over by the end of March 1994. Foreign exchange reserves had

risen to the more than adequate level of US$15.07 billion and the current account deficit as

a percentage of GDP was nearly eliminated.

Macro-economic stability has endured in the ten years of economic reforms to 2003.

Foreign-exchange reserves peaked at US$70 billion at the end of March 2003 (and touchedUS$80 billion in June 2003).31 The current account recorded a surplusequivalent to 0.3

percent of GDPin 2001-02.

India, has presented an interesting pattern in terms of the evolution of financial structure.

The Indian financial system was actually quite well developed even before the

Independence and unrestricted until the 1960s when the government started to use controls

for the purpose of directing credit towards development programs. Until

introducing the economic reforms in 1985, Indian financial system was tightly restricted

with controls on exchange rate and interest rates and high restrictions on international

capital inflows and outflows. Following the balance of payments crisis in 1991, a

stabilization program was initiated with the help of the International Monetary Fund (IMF)

and the government began to gradually relax the restrictions on inward capital flows and on

currency convertibility for current account transactions.

Exchange rate policy has gone through a series of transitional regimes since 1991, leading

to a total transformation at the end of three years. The reforms began with a devaluation of

about 24% in July 1991 in a situation in which extensive trade restrictions were still in

place. The devaluation was accompanied by an abolition of export subsidies to help the

fiscal position, and an offsetting increase in export incentives in the form of special

incentive licenses (Eximscrips) given to exporters which could be used to import items

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which were otherwise restricted. These licenses were freely tradeable and commanded a

premium in the market depending upon the excess demand for restricted imports. The

system was modified in March 1992 by the introduction of an explicit dual exchange rate

system simultaneously with the dismantling of licensing restrictions on import of raw

materials, other inputs into production and capital goods. These items were made freely

importable against foreign exchange obtained from the market at a market determined

floating exchange rate. Imports of certain critical item's such as petroleum, essential drugs,

fertilizer and defence related imports were paid for by foreign exchange made available at

the fixed official rate, and the demand for foreign exchange at the official rate to pay for

these imports was met by requiring exporters to surrender 40% of their export earnings at

the official rate. The remaining 60% of export earnings was available to finance all other

imports, all other current transactions and debt service payments, at the market rate. This

dual exchange rate system was again a shortlived transitional arrangement to a unified

floating rate which was announced in March 1993. By 1993-94, the rupee was made

convertible on the current account with market-determined rates. After a year's experience

with the unified rate the Government, in March 1994, announced further liberalisation of

payment restrictions on current transactions and stated its intention of moving to current

account convertibility. . In 1994, India moved to full convertibility on current account

transactions and formally accepted the obligations under

Article VIII of the IMF.

Capital controls however remain in place.

Thus in the short space of two and a half years the trade and payments system has moved

from a fixed and typically overvalued, exchange rate operating in a framework of

substantial trade restrictions and export subsidies, to a market determined exchange rate

within a framework of considerable liberalisation on the trade account and the elimination

of current restrictions. The transition is by no means complete, since consumer goods

remain subject to quantitative restriction and tariffs are still high, but the changes made thus

far are certainly substantial. The fact that they have been successfully managed has created

the confidence necessary for an easy transition through the remaining stages.

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In India, the volume of private flows more than doubled following the liberalization of

current account and continued to increase, except during the period of financial distress in

1995. Gradual opening of financial system and current account liberalization in 1993 led to

a surge of capital inflows. Portfolio flows began in 1993 and India continued to receive an

average of $2.5 bn portfolio investment each year till the Asian crisis. In 1998, the Indian

stock market experienced an outflow reaching $601 mn, but soon the inflows went back to

the $2-3 bn per year level until 2003. Beginning from 2003, portfolio flows to India soared

and reached to an average of $10 bn.

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Documents

Final Current Account