Unit 2: Convertibility of rupee

Convertibility of Rupee

Convertibility of rupee refers to the freedom to exchange Indian currency (INR) for foreign currencies without restrictions at market-determined exchange rates.

Types of Convertibility

Current Account Convertibility (CAC)

It allows free conversion of rupee into foreign currency for day-to-day transactions such as:

• Import/export of goods & services
• Remittances
• Interest & dividend payments
• Travel & education abroad

Implemented in India: In 1994, India accepted Article VIII of the IMF and made the rupee fully convertible on current account.

Capital Account Convertibility (KAC)

It allows conversion of rupee into foreign currency (and vice versa) for capital transactions like:

• Investment in foreign assets or shares
• Borrowing from or lending to foreign entities
• Acquisition of property abroad

Status in India: India has partial convertibility on capital account.

• Corporates and NRIs have more freedom than individuals.
• Complete convertibility is not yet allowed due to risk of capital flight and financial instability.

Key Committees on Convertibility

• India has full convertibility on current account but partial on capital account.
• Full capital account convertibility requires strong financial institutions, low inflation, and stable fiscal policies.

Purchasing Power Parity (PPP)

PPP theory states that exchange rates between two countries should adjust so that identical goods cost the same in both countries when priced in a common currency.

Types of PPP

Formula (Relative PPP)

Example: Inflation in India = 6%, Inflation in USA = 2%

→ The rupee is expected to depreciate by 4% (6% - 2%) against USD.

Assumptions: Free trade, no transportation costs, no tariffs.

Criticism: Not valid in the short run due to trade barriers, different goods/services, and speculative flows.

International Fisher Effect (IFE)

IFE states that the difference in nominal interest rates between two countries will lead to a proportional change in exchange rates in the future.

Key Idea: A country with a higher interest rate will see its currency depreciate, and a country with a lower interest rate will see its currency appreciate.

Formula

Example: India’s interest rate = 8%, USA’s interest rate = 4% → The rupee is expected to depreciate by 4% against USD.

Relation to Fisher Effect

• Fisher Effect relates interest rate = inflation + real rate of return.
• IFE applies Fisher Effect internationally to predict exchange rate movement.

Assumptions: Capital mobility, no transaction costs, and perfect arbitrage.

Criticism: Not always accurate due to market speculation, risk factors, and government controls.

Summary Table

Interest Rate Parity (IRP)

Interest Rate Parity (IRP) theory states that the difference in interest rates between two countries is equal to the difference between the forward exchange rate and the spot exchange rate.

Key Concept: There is no arbitrage opportunity in the foreign exchange market when IRP holds.

Formula (Covered IRP)

Types of IRP:

Example: Interest rate in India = 6% , Interest rate in USA = 4%  → Forward premium on USD over INR = 2%

Assumptions: Free capital mobility, no transaction costs, risk-free arbitrage.

Implication: Investors earn the same return whether they invest domestically or abroad (after adjusting for exchange rate changes).

Administration of Foreign Exchange in India

• Governing Law: Foreign Exchange Management Act (FEMA), 1999, Regulates foreign exchange transactions in India.
• Regulatory Body: Reserve Bank of India (RBI) – Administers FEMA and issues licenses.

Authorized Persons under FEMA

Authorized Persons are entities or individuals authorized by the RBI to deal in foreign exchange.

Types of Authorized Persons

Authorized Dealers (AD) 

Authorized Money Changers (AMCs)

• Include Full-Fledged Money Changers (FFMCs).
• Deal only in currency exchange, not in capital account transactions.
• Used by tourists, travelers, and small remittance purposes.

Conclusion

• IRP ensures no arbitrage in forex markets due to interest rate differences.
• RBI regulates foreign exchange transactions in India through FEMA.
• Authorized Persons like ADs and AMCs facilitate legal forex operations.

Foreign Currency Accounts in Foreign Transactions

These accounts are maintained by banks to facilitate international trade and foreign exchange transactions.

Nostro Account

Meaning: "Nostro" means "Our account with you".

A Nostro Account is an account that a domestic bank holds in a foreign bank, in foreign currency. Example: SBI India maintains a USD account with Citibank USA. → For SBI, this is a Nostro Account.

Vostro Account

Meaning: "Vostro" means "Your account with us".

A Vostro Account is an account that a foreign bank holds in a domestic bank, in domestic currency. Example: Citibank USA maintains a rupee account with SBI India. → For SBI, this is a Vostro Account.

Loro Account

Meaning: "Loro" means "Their account with you".

A Loro Account is a way for a bank to refer to another bank’s Nostro account held with a third bank. Example: SBI India refers to PNB’s USD account with Citibank USA. → For SBI, it’s a Loro Account.

Comparison Table

Purpose of These Accounts

• Facilitate international trade.
• Enable settlement of foreign exchange transactions.
• Help banks maintain liquidity in foreign currencies.

Conclusion

• Nostro = Our account in foreign bank.
• Vostro = Foreign bank’s account with us.
• Loro = Their account with you (used for reference only).