An important factor which influences the Balance of Payments of an economy is the exchange rate of its currency vis-a-vis other major currencies. Therefore influencing the exchange rate movement is one of the instruments available for correcting the imbalances in the current account.
Exchange Rate is the rate at which domestic currency can be exchanged for foreign currency. Fixed Exchange Rate or Official Exchange rate is the rate at which government agrees to exchange.
Floating Exchange Rate is the exchange rate determined in the Foreign Exchange Market by the free interplay of demand and supply forces. Real Effective Exchange Rate (REER) is an important explanatory factor of export growth.
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It is the exchange rate arrived at after adjusting the nominal exchange ratio by the relative price changes within the country and in that particular foreign country. Nominal Effective Exchange Ratio (NEER) of rupee is a weighted average of exchange rates vis-a-vis the currencies of major trading partners. The weightings are assigned based on the direction of India’s export during 1992-97.
In India before 1991 there was an administered exchange rate, and the exchange rate was also overvalued. The currency was devalued in July 1991 and simultaneously, the EXIM scrip scheme was introduced under which certain imports were permitted only against export entitlement. In 1992-93 Budget a dual exchange rate called Liberalised Exchange Rate Mechanism System (LERMS) was introduced.
Under this system 40% of the foreign exchange earnings were to be surrendered at official exchange rate and the remaining 60% was to be converted at market determined rate. The 1993-94 Budget introduced full convertibility of rupee on trade account and the dual exchange rate was dispensed.
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Which under this all export and import of goods and all receipts whether on current or capital account of balance of payments (but not all payments) were 100% convertible?
Convertibility refers to the freedom of the holder of a currency to freely convert it into any other foreign currency. No country grants full convertibility but restricts it for certain purposes and excludes certain other purposes. For example, the trade account convertibility is largely restricted to exports and imports though certain associated aspects are also permitted under it like remittances (what Indians living abroad sent to their friends and relatives in India) etc.
The 1994-95 Budgets introduced Current Account Convertibility which covered all payments in connection with foreign trade including services, payments due to interest on loans and net income from other investments, moderate remittances for family living expenses, education, tourism, life and general insurance etc. This process continued and now there is almost full convertibility on current account.