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Foreign exchange market advantages and disadvantages

Foreign exchange market advantages and disadvantages

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Therefore, to achieve higher 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.

Meaning of Currency Convertibility:

Let us first explain what is exactly meant by currency convertibility. 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.

For example, convertibility of rupee means that those who have foreign exchange (e.g. US dollars, Pound Sterlings etc.) can get them converted into rupees and vice-versa at the market deter­mined rate of exchange. Under convertibility of a currency there are authorised dealers of foreign exchange which constitute foreign exchange market.

The exporters and others who receive US dol­lars, Pound Sterlings etc. can go to these dealers which are generally banks and get their dollars exchanged for rupees at the market determined rates of exchange. 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.

Current Account and Capital Account Convertibility of Currency:

A currency may be convertible on current account (that is, exports and imports of merchandise and invisibles) only. A currency may be convertible on both current and capital accounts. We have explained above the convertibility of a currency on current account only.

By capital account convertibility we mean that in respect of capital flows, that is, flows of portfolio capital, direct investment flows, flows of borrowed funds and dividends and interest pay­able on them, a currency is freely convertible into foreign exchange and vice-versa at market deter­mined exchange rate.

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. can get them freely converted into rupees without taking any permission from the government.

Likewise, the dividends, capital gains, interest received on purchased stock, equity etc. profits earned on direct investment get the rupees converted into US dollars, Pound Sterlings at market determined exchange rate between these currencies and repatriate them.

Since capital convertibility is risky and makes foreign exchange rate more volatile, is intro­duced only some time after the introduction of convertibility on current account when exchange rate of currency of a country is relatively stable, deficit in balance of payments is well under control and enough foreign exchange reserves are available with the Central Bank.

Convertibility of Indian Rupee:

In the seventies and eighties many countries switched over to the free convertibility of their currencies into foreign exchange. By 1990, 70 countries of the world had introduced currency con­vertibility on current account; another 10 countries joined them in 1991.

As a part of new economic reforms initiated in 1991 rupee was made partly convertible from March 1992 under the “Liberalised Exchange Rate Management scheme in which 60 per cent of all receipts on current account (i.e., merchandise exports and invisible receipts) could be converted freely into rupees at market determined exchange rate quoted by authorised dealers, while 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. Thus, partial convertibil­ity of rupee on current account meant a dual exchange rate system.

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.

However in case of capital account there is some restriction. In capital account portfolio investment, direct investment , external commercial borrowing and loan comes. There is a law which restricts borrower or investors to limit its borrowing/investment. Suppose I want to invest in an Indian Factory $500 Million but according to rule I can invest only $300 Million in that , If i invest more than under Foreign Exchange Management Act I will be booked .

Let look advantage and disadvantage -

Indian market will get more investment and borrowing in FDI or ECB. It will help Indian economy through Job creation and Inflation reduction . It will create new Infrastructure which enhance capital.

According to Tarapore Committee 1999- If Fiscal deficit is below 3.5%, NPA is below 5% and CRR is 3% than Full Capital Account convertibility can be a reality. But right now NPA is more than 6% and Fiscal deficit is at 4.1% so it is feasible right now.

Second point is inflation, It is not due to capital deficit syndrome . It is due to domestic problem which is mansoon, GST, complex governemnt procedure and bubbling NPA.

Disadvantage is indian economy will be susceptible to volatility in exchange rate.

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