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The Concept Of Convertible Currencies

Paper Type: Free Essay Subject: Economics
Wordcount: 4703 words Published: 11th May 2017

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Convertible currencies is defined as currency which can easily be bought, sold and converted without the need to obtain a central bank or government agency. Most major currencies are fully convertible, that is, they can be freely traded without restriction and without required authorization. The easy convertibility of the currency is a relatively recent development and is partly attributable to the growth of international markets and trade in the Forex markets in particular. Historically, moving away from the gold exchange standard once in common use has led to more and more convertible currencies available on the market. Since the value of the currency is fixed relative to each other, rather than measured against a real commodity like gold or silver, trade in currencies is ready to offer investors an opportunity for profit.

Fully convertible currency

The 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 fixed value or minimum value to be placed on the dollar in international trade. For this reason, U.S. dollars have been one of the major currencies traded on the Forex market.

Partially convertible currency

The Indian rupee is only partially due to convertible control of the Indian Central Bank on the international investment in and out of the country. While most domestic trade transactions are handled without special requirements, there are significant restrictions on international investment and special recognition is often necessary to rupees into other currencies. Given the strong financial position of India in the international community, there is discussion about allowing the Indian rupee free to float on the market to change from a partially to a fully convertible currency convertible one.

Nonconvertible currency

Almost all nations have a certain method of currency conversion, Cuba and North Korea are the exceptions. They neither participate in the international FOREX market nor state conversion of their currencies by individuals or companies. As a result, these currencies currency known as blocked, the North Korean won and the Cuban national pesos can not be accurately measured against other currencies and are only used for domestic purposes and debt. Nonconvertible currencies such an important obstacle to international trade for companies that live in these countries.

Convertibility is the quality of paper money substitutes which gives the holder the right to redeem them on demand in good money.

Convertibility – evolution of the concept

Historically, the bill followed a common or very similar pattern in Western countries. Originally issued in various decentralized and independent banks, it was gradually brought under state control and a monopoly right of the central banks. In the process, the fact that the bill only a substitute for the real commodity money (gold and silver) was gradually lost sight of. Under the gold standard, bank notes were paid in gold coins. Similarly, under the silver standard, notes were paid in silver coins, and as part of a bi-metallic standard, payable in gold or silver coins, the debtor (the bank).

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Under the gold exchange standard of issuing banks were obliged to exchange their currencies into gold. Due to the limited growth in the supply of gold reserves during a time of great inflation of the dollar supply, the United States ultimately the gold exchange standard, abandoned and so precious convertibility in 1974 under the current international monetary arrangements, all currencies’ inherent value derives Fiat, so there is no longer a case (gold or other tangible storage value) which can be exchanged notes on paper. A currency can be converted into one another in open markets and through dealers. Some countries pass laws restricting the legal exchange rates of their currencies, or which allows more than a certain amount to be exchanged. Thus, these countries are not fully convertible currencies. Some countries’ currencies, such as North Korea and won the national peso’s Cuba can not be converted.

Nations tried to the gold standard after the First World War to revive, but it collapsed completely in the Big Depression of the 1930s. Some economists said adherence to the gold standard had prevented monetary authorities expand the money supply fast enough to revive economic activity. In any case, representatives of most leading countries of the world met at Bretton Woods, New Hampshire, in 1944 a new international monetary system be created. Because the United States currently accounts for over half the world production capacity and held most of the gold of the world, the leaders decided to link to global currencies to the dollar, which in turn , they agreed to be converted into gold at $ 35 per ounce.

Under the Bretton Woods system were the central banks of countries other than the United States the task of maintaining fixed exchange rates between their currencies and the dollar. They did this by intervening in the currency markets. If a country’s currency was too high against the dollar, the central bank’s currency sales in exchange for U.S. dollars, increasing the value of the currency. Conversely, if the value of money from one country was low, the country would buy its own currency, thereby driving up the price.

The Bretton Woods system lasted until 1971. By that time, inflation in the United States and a growing U.S. trade deficit were undermining the value of the dollar. Americans urged Germany and Japan, both of which had favorable payments balances, to appreciate their currencies. But these countries were reluctant to take this step, since the increase in the value of their currencies would increase prices for their goods and their exports hurt. Finally, the United States abandoned the fixed value of the dollar and allowed it to “float” – ie, fluctuate against other currencies. The dollar dropped immediately. World leaders have sought the Bretton Woods system with the so-called Smithsonian Agreement in 1971 to revive, but the attempt failed. In 1973, the United States and other countries agreed to exchange rates to float.

Economists call the resulting system a “managed float regime, which means that although the rates for most currencies float, the central banks still intervene to prevent sharp changes. As in 1971, countries with large trade surpluses often sell their own currencies in an attempt to prevent them from appreciating (and thereby hurt exports). Similarly, countries with large deficits often buy their own currency depreciation, making the domestic price increases occur. But there are limits to what can be achieved through intervention, particularly for countries with large trade deficits. Ultimately, a country that is acting in support of its currency may deplete its international reserves, making it unable to continue supported the currency and may leave it to its international obligations.

Fixed and floating exchange rates

Exchange rate systems are classified according to the flexibility that the monetary authorities show the direction of fluctuations in exchange and traditionally broken into two categories, namely:

• systems with a fixed exchange rate

• systems with a flexible exchange rate.

In the former system of the exchange rate is usually a political decision, in the second, prices are determined by market forces, in line with supply and demand. These systems are often referred to as fixed Peg (sometimes described as “hard peg”) and floating systems. But as usual, between these two extremes there is also an intermediate range of different systems with a limited degree of flexibility, commonly referred to as “soft pegs”.

Fixed exchange rate

A country decides the value of its currency to link currency of another country, gold (or another commodity), or a basket of currencies.

A fixed rate is generally used for the value of a currency stabilization, relative to the currency is linked to. This makes the trade and investment between the two countries easier and more predictable and is especially useful for small economies where foreign trade constitute a significant proportion of their GDP.

It can also be used as a means to control inflation. However, if the reference value rises and falls, so does the currency associated with it. Moreover, according to the Mundell-Fleming model with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy to ensure macroeconomic stability.

Determine the value of national currency against that of a low inflation country is one approach for central banks to price stability objectives. The advantage of a target for the exchange rate is the brightness, making it readily understood by the public. In practice, it requires the central bank to limit money creation to levels comparable to those of the country whose currency is linked. If credible maintained an exchange rate target, the inflation down to the level in the anchor country. Experiences with fixed exchange rates, however, indicate a number of drawbacks. A country that its exchange rate policy from the control of domestic monetary policy fixes.

A fixed exchange rate is one that is set by a government, usually through a central bank. A currency is linked to other currencies at a specified rate. For example, the Chinese yuan to be established on the dollar, which means that the rate is kept within a range, depending on the dollar. Some countries make their currencies to the Japanese yen or the euro. In other cases, a fixed currency pegged to a basket of currencies.

The main criticism of a fixed exchange rate is that flexible exchange rates to automatically serve the balance of trade. When a trade deficit occurs, there will be an increased demand for the foreign (or domestic) currency which will push up the price of foreign currency in terms of domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, it is automatically re-balancing does not occur.

The belief that the fixed exchange rate entails stability is only partially true, since the tendency to speculative currency attacks target fixed exchange rate regimes, and in fact, the stability of the economic system is managed primarily through capital controls. A fixed exchange rate should be seen as an instrument of control in the capital.

Thus, China has allowed free exchange for current account transactions since 01.12.1996. Of more than 40 categories of capital account, about 20 of them are convertible. These convertible accounts are mainly related to FDI. Because the control of the capital, even the renminbi is not under the managed floating exchange rate, but free to float, so it is somewhat redundant for foreigners to buy renminbi.

Floating exchange rate

A floating currency is one that is more influenced by the market. Supply and demand determines the price. For example, if more people want to buy euros, dollars and to sell, the value of the euro rises in response, while the value of the dollar – against the euro in forex trading is.

In the modern world, the majority of floating currencies in the world. Central banks often take on the markets to try to influence exchange rates, but such interventions are becoming less effective and less important as the markets are larger and less naive. These currencies include the most actively traded currencies: the U.S. dollar, euro, Japanese yen, pound sterling, Swiss franc and Australian dollar.

The Canadian dollar was the closest to the ideal floating currency as the Canadian central bank has not interfered with his price, as they officially stopped doing so in 1998,. The dollar is a close second with very few changes in its foreign reserves, however, Japan and the United Kingdom to pursue a greater degree. From 1946 until the early 1970s, was the Bretton Woods system of fixed exchange standard, but in 1971, the U.S. government’s gold standard, so the dollar is no longer a fixed currency, and most currencies of the world, followed suit.

It is not possible for a developing country to maintain the stability of the exchange rate of its currency in the foreign exchange. There are two options open to them-

1. Let the exchange rate may fluctuate in the open market according to market conditions, or

2. An equilibrium rate can be established to set and attempts should be made to maintain it as far as possible.

If there is a fundamental change in circumstances, should the rate be amended accordingly. The exchange rate of the first alternative is known as fluctuating exchange rate and under the second alternative is called flexible exchange rate. In modern economic conditions, the flexible exchange rate system is more suitable because it does not impede foreign trade.

Global Scenario

Global Trends in exchange rate regimes

1991 1999 2002

Number Percentage Number Percentage Number of countries countries countries Percentage

Hard Peg 25 45 15.72% 24.32% 49 25.93%

Intermediate 1998 61.64% 1963 34.05% 1958 30.69%

Free Float 36 22.64% 77 41.62% 82 43.39%

Totals 159 185 189 100.00% 100.00% 100.00%

There are economists who think that in most cases, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to external shocks and economic impact of mute, and the possibility of appropriating a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and security. This may not necessarily be true, considering the results of the countries that attempt to keep prices of their currency “strong” or “high” compared with others such as the UK or the Southeast Asian countries for Asian currency crisis.

The debate of making a choice between fixed and floating exchange rate regimes set by the Mundell-Fleming put model, which suggests that an economy can not simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose from two control, and leave one third to market.

In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies more technically known as a managed float. A central bank can, for example, allow a currency price to float freely between an upper and lower, a price “ceiling” and “floor”. Management by the central bank may take the form of buying or selling large lots for price support or resistance, or, in the case of some national currencies to offer to take, there may be legal penalties for trading outside these limits.

Free floating exchange rate currency market volatility rises. There are economists who think that this can cause serious problems, particularly in emerging economies. These economies have a financial sector with one or more of the following conditions:

• high liability dollarization

• the financial weakness

• strong balance sheet effects

When liabilities in foreign currencies while assets are in local currency, unexpected depreciation of the exchange rate deterioration of bank and corporate balance sheets and threaten the stability of the domestic financial system.

For this reason developing countries appear to face greater fear of floating because they are much smaller variations of the nominal exchange rate, but face bigger shocks and interest rate and reserve movements. This is the result of frequent free floating exchange rate countries in response to movements in monetary policy and / or intervention in the foreign exchange.

Current and capital account transactions

Current Account Transactions

Volume 2 (j) defines a current account transaction as a transaction and without prejudice to the generality of the foregoing such transaction includes-

1. Payments due in connection with foreign trade, other current business, services and short-term banking and credit facilities in the ordinary course of business,

2. Payments due as interest on loans and as net income from investments

3. Transfers on the cost of living of the parents, spouse and children living abroad, and

April. Costs associated with foreign travel, education and medical care of parents, spouses and children.

Any person may sell or draw foreign exchange to or from authorized person if such sale or withdrawal is a current account transactions. A reasonable restrictions on current account transactions may be imposed by the central government in the Public Interest, in consultation with RBI.

Capital movements

Section 2 (e) of the Foreign Exchange Management Act, 1999 defines a Capital Transaction as a transaction account that the assets or liabilities, including contingent liabilities change, residents outside India in India or the assets and liabilities in India, and includes acts referred to in sub-section (3) of Section 6.

In response to capital movements are prohibited by Foreign Exchange Management (Permissible capital movements) Regulations, 2000 –

Transactions are not allowed in the FEMA – capital movements are not allowed in the FEMA Act, rules or regulations. In other words, all capital account transactions are prohibited unless specifically permitted. The current account transactions, the position is exactly the opposite, ie all current transactions are permitted unless explicitly prohibited.

Investments in certain sectors – Foreign investment in India in any company, firm or self-interest involved or planning to go into the next operator is completely prohibited:

• Chit Fund

• Nidhi Company

• Agricultural or plantation activities

• Real Estate Company or the construction of farms

• Trading in transferable development rights (certificates issued in respect of land acquired for public purposes, either by the central government or the State Government in respect of surrender of land by the owner without monetary consideration. The TDR is transferable in part or whole .

In practice, the distinction between current and capital movements are unclear. There are transactions that straddle the current and capital account. To illustrate, the payments for imports are a current account item, but where they are on credit, a capital liability arises and the increase in trade payments, trade finance would balloon and the resulting vulnerability should be carefully monitored during the transition to FCAC. In contrast, extension of credit to the export amounts to capital flight.

Towards residents, capital restrictions are clearly more stringent than for non-residents. In addition, resident companies are faced with a relatively liberal regime than resident individuals. Until recently, people living face a virtual ban on capital flight but a little easing undertaken in recent times.

Part 4 of FEMA provides that no person resident in India acquire, hold, own, possess or carry any foreign currency, foreign security or immovable property situated outside the Netherlands, except as provided by law .

Under Article 6 (4), a person resident can hold its own, transfer or invest in foreign currency, foreign security or immovable property situated outside India, if such currency, security or property was acquired, held or owned He is that person was resident outside India or inherited from one person who was living out of India.

Besides various remittances provide a resident individual can upto 200.000 USD per year contract for permitted capital and current account transactions under the Liberalised Remittance Scheme. Initially USD 25,000 to its introduction in 2003, which was increased by $ 50,000 to $ 100,000 on 20/12/2006 08/05/2007 then and now to $ 200,000.

There is justification for some liberalization of rules on residents investing abroad in order to diversify assets. The experience so far shows that there is no difficulty with the current order of the limits for these outflows. It would be desirable to a gradual liberalization of resident companies / business services, banks, non-banks and individuals to consider. The issue of liberalization of capital outflows for individuals is a powerful confidence building measure, but such openness must be calibrated and when fears of waves of outflows. The general experience is that if the capital account is liberalized for resident outflows, the net inflow does not decrease, provided the macroeconomic framework is stable.

Capital account convertibility

Capital account convertibility is a monetary policy focused on the possibility of transactions of local financial assets into foreign financial assets, freedom and market-determined exchange rates. It is sometimes referred to as Capital Asset liberation.

It’s actually a policy that makes it easy exchange of local currency (cash) for foreign currency at low prices. This is the local merchants can easily enter transnational companies without foreign currency for small transactions. Capital account convertibility is usually a guide changes of ownership in foreign or domestic financial assets and liabilities. Tangentially, it covers and extends the framework of the creation and liquidation of claims on or by the rest of the world, active in the local markets and currencies.

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It’s actually a policy that makes it easy exchange of local currency (cash) for foreign currency at low rates. This is the local merchants can easily implement transnational companies without foreign currency for small transactions. CAC is primarily a guide for changes of ownership in foreign or domestic financial assets and liabilities. Tangentially, it covers and extends the framework of the creation and liquidation of claims on or by the rest of the world, active in the local markets and currencies.

Capital account convertibility has five basic statements designed as points of action:

1. All types of liquid assets should be freely exchanged between two nations, with standardized rates.

2. The amounts to a substantial amount (more than $ 500,000 to be).

3. The influx of capital should be invested in semi-liquid assets churning and excessive outflow to occur.

April. Institutional investors should not use capital account convertibility fiscal policy or exchange rate manipulation.

5. Excessive inflow and outflow should be buffered by the national banks to provide collateral,.

The status of the capital account convertibility in India for various non-residents is as follows: for foreign companies and foreign institutions, there is a reasonable amount of convertibility, non-resident Indians (NRI) is roughly an equal amount of the convertibility but accompanied by severe procedural obstacles and regulatory nature. For non-residents other than NRIs, there is near zero convertibility. Movement to a Fuller Capital Account convertibility implies that all non-residents (companies and individuals) should be treated equally. This would mean the abolition of tax concessions granted to NRIs are currently on special arrangements for bank deposits NRIs, ie., Non-Resident External Rupee Account [NR (E) RA] and foreign currency non-resident (Banks) Scheme [ FCNR (B)]. Non-residents other than NRIs, should be allowed to FCNR (B) and NR (E) RA accounts without tax breaks to open, subject to Know Your Customer (KYC) and Financial Action Task Force (FATF) standards. In the case of the current arrangements for NRA different types of investments, other than deposits, there are a number of procedural obstacles and should be investigated by the government and the RBI.

A person resident in India is permitted to be kept open and maintain with an authorized dealer in India a foreign currency account known as Exchange Earner Foreign Currency (EEFC) Account subject to the terms and conditions of the Exchange Earner the foreign currency account scheme specified. Furthermore, all types of foreign exchange earners permitted maximum credit of 100 percent of their foreign exchange earnings, as defined in paragraph 1 (A) of the Schedule, to their EEFC account.

All categories of foreign currency earners can credit up to 100 percent of their foreign exchange earnings, as defined in paragraph 1 (A) of the Schedule, to their EEFC account. As such, in order for authorized dealers to allow

SEZ developers to open, hold and maintain EEFC account and credit to 100 percent of their foreign exchange earnings, as defined in paragraph 1 (A) of the schedule.

Any person resident in India,

i) is outside India (other than to Nepal and Bhutan) currency notes of Government of India and Reserve Bank of India notes up to a maximum of Rs.7, 500 (Rupees seven thousand five hundred only) per person, and

ii) who had arrived from India with a temporary visit to India to bring at the time of his return from a place outside India (other than Nepal and Bhutan) currency notes of Government of India and Reserve Bank of India notes up to a maximum of Rs.7, 500 (Rupees seven thousand five hundred only) per person.

Under Regulation 7 of the Foreign Exchange Management (Foreign Accounts by a person resident in India) Regulations, 2000,

(I) A citizen of a foreign state, living in India, an employee of a foreign company or a citizen of India employed by a foreign company outside India, in both cases on deputation to the office / branch / subsidiary / joint venture in India of such foreign company may open, hold and maintain a foreign currency account with a bank outside India and receive the entire salary to pay for his service to the office / branch / subsidiary / joint venture in India of a such foreign company, by credit to such account, provided that the income-tax under the Income Tax Act 1961, being paid on the entire salary as accrued in India.

(Ii) A citizen of a foreign State resident in India in employment with a company in India may open, hold and maintain a foreign currency account with a bank outside India and the competence of the entire receiving salary in India in Indian rupees to one such account, for services to such Indian company, provided that the income-tax under the Income Tax Act 1961 is paid on the total salary incurred in India.

It would be desirable to a gradual liberalization of resident companies / business services, banks, non-banks and individuals to consider. The issue of liberalization of capital outflows for individuals is a powerful confidence building measure, but such openness must be calibrated and when fears of waves of outflows. The general experience is that if the capital account liberalization for resident outflows, the net inflow does not decrease, provided the macroeconomic framework is stable.

As India gradually moves on the path to convertibility, the question of investment through a given country to obtain tax benefits would emerge as the investment through other channels to get discriminated against. Such discriminatory tax treaties are not consistent with an increasing liberalization of capital account as distortions inevitably occur, possibly raising the cost of capital to the host. With global integration of capital markets, tax policy should be harmonized. It would therefore be desirable that the government review of tax policy and tax treaties links.


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