Convertibility- Current and Capital Account
Convertibility, which may seem as a complex economical jargon, but has a fairly simple concept. It is the freedom of converting a foreign currency to a domestic currency or vice-versa at market determined exchange rate. Currency can be exchanged for various purposes such as for imports, exports, remittances, investments etc. This convertibility is categorised into two parts depending upon whether the transaction took place under current account or capital account. It can also be said that the distinction between two forms of convertibility is on the basis of the impact on assets and liabilities of an economy. These two divisions are-
Current Account Convertibility– It is the freedom to convert a domestic currency to any foreign currency or vice-versa to accomplish trade in imports or exports or the invisibles. Transactions in this account do not impact assets and liabilities of an economy.
Capital Account Convertibility- It is the freedom to convert a domestic currency to a foreign currency or vice-versa on capital account transactions of an economy. Transactions in this account impact assets and liabilities of an economy. A formal and workable definition of CAC was provided by a committee headed by S.S. Tarapore in 1997 to evaluate the feasibility of full capital account convertibility which says, “CAC refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. It is associated with changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by, the rest of the world.” Thus , CAC enables the firms and residents to freely buy overseas assets such as equity or bonds (in the form of FPIs with certain conditions), property ( in the form of FDI), seeking external credits, foreign deposits etc.
However, the extent of ease with which a domestic currency can be converted to a foreign currency or vice-versa depends on whether the economy follows a full convertibility or partial convertibility. In a fully convertible economy, there is no restriction on the conversion of currencies whatsoever. But, an economy which follows a partial convertibility, there exists restriction to this conversion owing to the risks associated with it. The Asian Financial Crisis in 1997 is a classical example of how full convertibility on capital account, without exercising prudence, can even plunge roaring economies to the abyss of economical crisis.
When it comes to India, except for four current account transactions, Indian rupee is fully convertible under current account, however, India follows a partial capital account convertibility. Indian government upon making rupee fully convertible under current account envisaged for full convertibility on capital account. Therefore, in 1997, RBI constituted a committee under S.S. Tarapore to look for the suitability of full Capital Account Convertibility considering various facets of Indian economy. The committee, in this direction, recommended some crucial preconditions to be fulfilled before implementing full convertibility on capital account. Inherent to these recommendations were the need for fiscal consolidation. Though, government has taken numerous steps towards full capital convertibility,e.g., FDIs in most sectors have been allowed under automatic route, recently cap on FDI in insurance sector has been raised from 49% to 74%, ECB no longer require RBI’s or GOI’s approval, though, up to a certain extent, limit of investment in foreign markets has been raised to $2.5 lakhs per financial years etc. But, yet India has to go far way to achieve full convertibility on capital account. The reason behind exercising enormous caution is because of the volatility that comes with full capital account convertibility. Sudden capital flight in the wake of any panic may lead to increase in Current Account Deficit owing to higher foreign-domestic currency conversion rate and thus higher import bills, e.g., in March 2020, FIIs pulled out more than $14 billion dollars out of the Indian capital market which was considered as one of the reason behind plummeting dollar-rupee exchange rate. Moreover, full capital account convertibility also makes an economy prone to Contagion effect, i.e., if a particular economy is gripped in a financial crisis, there is a heightened possibility of transmission of that crisis to the Indian economy. No cap on external debts may also prove to be disastrous as it poses exchange rate risk while repayment. In India the lion’s share of external debt is that of external commercial borrowings followed by NRI deposits. In a situation of full capital account convertibility there will be higher tendency to borrow more from the external market ( cheap credits because of low interest rate) and in the worst case scenario if the growth of the economy plunges it may trigger a systemic economic crisis. However, the reason behind ruminating on the capital account convertibility is due to its intricate link with the buzz of today’s techno-economic world- the cryptocurrency.
Cryptocurrency is nothing but a digital currency. In other words it is the digital representation of a value only available and accessible in electronic form. The word “crypto” is derived from the various encryption techniques which are employed to secure the network which is a distributed ledger based on blockchain technology. It differs from the paper currency ( fiat currency ) with two aspects-
1) Its not backed by any authority i.e., it is decentralized and
2) its anonymous or pseudonymous nature of operation.
These two features, though, may look lucrative in the world of deepening privacy conscience, however, they also pose a challenge to the existing economic models adopted and furthered by different economies in general and India in particular. As people went on binge for cryptocurrency as an alternative investment option, various countries have started to recognize it in different legal forms, such as assets or capital or even as a legal tender. El Salvador is the first country which has given it the status of a legal tender i.e., it has accepted bitcoin as a formal currency apart from dollar. With this expedited growth in popularity, it becomes necessary to understand its underlying impact on Indian economy as Indian retail investors in India too are not falling back to invest in this newest and perhaps the biggest financial innovation of our times.
The way cryptocurrency works provides, apart from other facilities, unhindered ease of investment in it and thereby trading it anywhere across the globe. This can be done through various decentralized crypto exchanges, some of which are OTC platforms ( how OTC cryto exchanges functions facilitating utmost anonymity is a subject matter of separate discussion) , that cropped up all around the globe. Since apprehension exists regarding cryptocurrency’s facilitation in money laundering, so most of these exchanges implement AML measures and other KYC norms to allay the fears of money laundering and other malicious activities. Still, trading with exchanges, especially which are setup abroad, runs the risk of ravaging the very the initiative of data localisation in India. Prosaic occurrences of cyber attacks, virtualisation of platforms, all posit substantial threat to massive data pilferage. Thence, the commitment or assurances of “impregnable security” is nothing more than a charade. Since, cryptocurrency is decentralized, so it remains beyond the ambit of authorities to regulate its transaction or operation. So, in the situation of any discrepancy , no concrete grievance redressal is available at the disposal of the investor. However, the purpose of this discussion is focussed on cryptocurrencies’ ability to transform partial convertibility to full convertibility. The cryptocurrencies, as mentioned above, can be bought from or can be traded on various crypto exchanges around the globe which provide various identification norms to be followed. However, there exists numerous exchanges ( especially OTC exchanges which facilitate OTC trading) that prioritize anonymity over any other factors and work with seeming opacity. These exchanges function in such jurisdictions which do not mandate strict adherence to KYC or any like norms and thus a particular cryptocurrency can be bought and traded seamlessly without the scope of identity disclosure. Because of these exchanges’ easy and less documentation, limited collateral requirements, they provide an edge over the formal channels of transferring money may it be for remittances, investments, sourcing credits etc. Coupled with VPN services, trading buying investment can be done without keeping any trace for watchdogs to sniff for. Now, imagining a situation where remittances from an entity A from abroad is to be sent to another entity B in India. A can either send through the established banking channels or can opt to use the cryptocurrency exchanges’ various services to accomplish the task. A can transfer his money to the wallet of the exchange , use this money to buy crypto then transfer it to the crypto wallet of the receiver i.e., B. Storing money in the exchange’s wallet dissevers the transaction from the bank. This way any amount can be transferred. In the same way, if any entity opts for foreign lending, it can do so bypassing established channels and regulations using VPN services to mask its IP then transferring its money to wallets then buying requisite crypto and finally lending it to the recipient. Alternatively, if any entity holds some cryptocurrency then it can directly channelise its assets to the borrower through OTC exchanges which provide the loan amount to the borrower but holds some collateral which also is a cryptocurrency. In this process, if the borrower fails to repay the credit amount then the lending entity or the exchange can sell the collateral at the prevailing market price or better and recoup its losses. VPN, OTC crypto-exchange or other crypto-platforms ( either operating from jurisdictions which provides concealment of identity as a perk or which do not have any KYC mandates) allows unrestricted flow of capital from and to an economy. Recent instances of capital flight using Bitcoin has occurred in China. The country’s citizens have an annual limit of $50,000 to purchase foreign currency. A report by Chainalysis, a crypto forensics firm, found that more than $50 billion moved from China-based bitcoin wallets to other countries in 2020, which means, Chinese citizens may have converted the local currency to Bitcoin and transferred it across borders to elude government regulation. Even, it has become possible to invest in stocks of other nations beyond the permissible limit through these OTC exchanges. It is becoming evident now that the reason behind innovation of cryptocurrency back in 2008 is being gradually inching towards achieving its aim of deregulated economic system.
The utilisation and accessibility to these facilities which, otherwise, were restricted on account of risks associated with it along with legal barriers, have now made it possible to circumvent the capital controls and thus bring about capital convertibility. Irrepressible and unfettered foreign investment inflows and outflows, rampant borrowings and trading not only pushes economy towards full convertibility but also tends to create a parallel economic system. The Contagion effect, which resulted in spread of 2008 Lehman’s crisis all across the globe was because of unfathomed capital convertibility, but could not maim the economy of India. This was due to the fact that India was pursuing a policy of partial convertibility. Now, due to crypto-led new economic adjustment, the financial system will be exposed to an abrupt clime of full capital convertibility. Moreover, crypto being more of a speculative asset poses a serious threat to the wealth of an investor in its way of facilitation of lending and borrowing. Two of such effects have been discussed below-
1) Carry trade- Say an investor deposits its crypto in a crypto savings account of an exchange offering high rate of interest ( more than banks). The exchange finds a prospective borrower of the crypto and then sells this deposited crypto to extend credit to the borrower. As discussed above, in this process the exchange gets some crypto as collateral to be sold if the borrower fails to repay the loan. The interest during the whole tenure of the credit will be paid to the lender who, in the beginning, deposited the crypto. Now, if the debtor is unable to pay the debt ( because these exchanges do not employ any method for analysing borrower’s creditworthiness, so the credit gets disbursed to anyone without evaluating credibility) and at the same time if the value of the crypto falls or crashes or the particular cryptocurrency gets stolen ( crypto exchanges have been an easy target for hackers recent examples proves this vulnerability), the value of the collateral will fall and the investor is sure to lose money. This will set off a wide scale “digital mortgage crisis”. Moreover, if, say, banks follow expansionary or contractionary monetary policy by manipulating the money supply in the economy, then it is a part of broader macroeconomic strategy designed for the whole economic system considering various parameters of the economy to regulate inflation, employment, spur sector specific growth, consumer spending etc. Voracious rise in crypto-investments, irrespective of the need of the economy, debauches this tested and established financial arrangement.
2) In a situation when the investor explores the process of “ leveraging “, it furthers the risk on the entire banking institutions, and for a country like India where banks already are under the burden of astounding NPAs, the situation may turn crippling. For example, a bank or a NBFC lends loan to an individual or to any entity. The individual invests the credit amount in crypto trading or to an exchange with a hope that the rising value of cryptocurrency will generate enough income to earn profit as well as to repay the debt. Apprehensive of the price of cryptocurrencies, if for some reason the value of crypto falls, the borrower will fail to return the amount creating additional stress on the bank. Needless to mention that while dealing in cryptocurrencies, there exist the counterparty risk as there exists no regulation or law, atleast in India, associated with cryptocurrencies.
One can surmise regarding the effect of crypto led convertibility on the dollar-rupee relation. It is not difficult to comprehend that more the dependency on decentralized cryptocurrencies increase less will be the dependence on dollars. De-dollarisation happens with the rise of global acceptability of cryptocurrencies. China and Russia are forerunners in this direction and European Union ,too, is motivated to wriggle off its dollar dependency. This is however a far-flung situation which is subject to governmental regulation on allowing cryptocurrencies in the substantial part of Balance of Payment. When it comes to India, the way cryptocurrency is manifested today, the likely short term effect on the economy of India may be in the form of appreciation of the rupee value against the dollar. FIIs influx may rise, initially, with the opening up of the huge market. In the same way, indication of any panic or instability may lead to efflux of capital as well. This may end up making rupee-dollar exchange rate highly volatile. This may also result, in the short run, decreasing import bill along with declining export competitiveness, cheap imports and expensive exports and thus have a bearing on the whole “ Aatmanirbharta” concept of growth and development of the economy. Since, cryptocurrencies remain beyond govt. regulation, it will give a hard time to the policymakers to stabilise this volatility and come up with a stable macroeconomic policy. Though government doesn’t have any law regulating cryptocurrency in India, but, increasing trend of acceptance of cryptocurrencies demands appropriate law to immunize the economy against any unwanted impact. A mistimed and fortuitous leap to full convertibility (crypto led) is sure to crash land with the casualty being the whole economy given the recommendations of the S.S. Tarapore committee are yet to be fulfilled.
However, on the flip side, the push towards fuller capital convertibility by the policy makers can be comfortably realised with the help of cryptocurrency. But the fruits of the convertibility via crypto can be realised only when its functioning remains within the sphere of governmental regulation and not on the mercy of the decentralized speculative asset, atleast till the economy adapts with the new regime. In this direction, to keep up well with the evolving technology and to tap the rising customer base of cryptocurrency, RBI planned to come up with its own cryptocurrency which it perceives will be a great driver towards deeper financial inclusion. It is to be seen how well the governmental crypto performs against other non-state cryptocurrencies which was only able to garner stupendous support of the people because of decentralization and anonymity or atleast pseudonymity as its inherent feature. RBI, with its centralised digital currency, will also have to be Argus-eyed about any signs of contracting “Dutch disease” as happened with Venezuela, and brace up for it .Here, it is worth mentioning that the reason behind inventing cryptocurrencies, with decentralized public ledger system employing technology immune to manipulation with the feature of anonymity, was to develop a currency system which is not controlled or regulated by conventional financial intermediaries, which was viewed as precarious in the eyes of the developers of cryptocurrencies given numerous instances of frauds and economic crisis faced by the various economies at different points of time. But, the history of cryptocurrency is equally blemished with instances of frauds, scams, cyber thefts and mismanagement. Africrypt-a cryptocurrency investment firm, founders of which fleed rendering $3.6 billion worth of bitcoins to disappear, iCE3- an exchange that announced abrupt shutdown due to discrepancies in the accounts, Mt. Gox- shut down its operation after losing a whooping $450 million worth of bitcoins due to cyber attack, Thodex- Turkey’s cryptocurrency exchange the owner of which ran away with $2 billion, etc provides enough material to satisfactorily conclude that cryptocurrencies too provide no better alternative to the present system and is equally or rather acutely susceptible to breaches. Thus, it raises a serious question regarding the need and utility of the cryptocurrency in the contemporary times, whether to accept it as any other investment asset or to render it debauch and replace the traditional economic system or to view it as a corrosive hazard to the order of the world economy?