Capital Account Convertibility (CAC), Benefits, Examples

Capital Account Convertibility refers to ease & freedom with which a country allows conversion of its domestic financial assets into foreign assets & viceversa. Read about CAC, its benefits & examples

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Capital Account Convertibility

In today’s interconnected global economy, the flow of capital across borders plays a crucial role in shaping financial landscapes and influencing economic growth. One key concept at the heart of this phenomenon is capital account convertibility. Capital account convertibility refers to the ease and freedom with which a country allows the conversion of its domestic financial assets into foreign assets and vice versa.

It represents a pivotal aspect of a nation’s economic policy and international engagement, impacting trade, investment, and financial market integration. This article delves into the significance of capital account convertibility, its implications for economies, and the factors that shape its implementation in different countries.

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What is Capital Account Convertibility?

Capital account convertibility pertains to the degree of ease and freedom in converting a country’s currency into foreign currencies and vice versa, particularly in relation to capital account transactions. It involves the ability to exchange domestic financial assets for foreign financial assets based on prevailing market exchange rates. Full capital account convertibility implies the unrestricted movement of capital.

In the case of India, the government opted for limited capital account convertibility due to an unfavourable current account situation, marked by a significant current account deficit. The objective was to ensure the availability of foreign exchange at a reasonable cost for essential imports of goods and commodities.

India adopted a cautious approach to granting full capital account convertibility for the rupee, taking into account the lessons learned from the Mexican crisis and the subsequent East Asian crisis. The experience of partial capital account convertibility during specific circumstances validated this strategy.

While complete capital account convertibility can attract capital inflows, it also carries the risk of capital outflows during adverse conditions. Such outflows can lead to increased exchange rate volatility and potentially result in a crisis, similar to what transpired during the East Asian crisis.

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Capital Account Convertibility in India

In India, the concept of capital account convertibility (CAC) has been an ongoing focus of attention and policy considerations. The Tarapore Committee, established with the aim of charting a roadmap for CAC, introduced a three-year plan that concluded in 1999-2000. However, it recognized that the timeline could be adjusted based on the achievement of certain pre-conditions, such as fiscal consolidation, strengthening of the financial system, and maintaining a low inflation rate. Unfortunately, apart from the latter, the remaining pre-conditions have not been fully met.

The progress of India’s capital account convertibility depends on meeting the Tarapore Committee’s preconditions, which encompass factors like fiscal consolidation, controlling inflation, minimizing non-performing assets, maintaining a low current account deficit, and bolstering financial markets. The degree to which these preconditions are fulfilled will determine the extent of capital account convertibility in the country.

To facilitate the move towards capital account convertibility, India has implemented various measures. While it still retains partial capital account convertibility (40:60), significant reforms have been undertaken, resulting in a level of convertibility that meets specific foreign exchange requirements. Some steps include granting Indian corporations full convertibility up to $500 million for investments in international enterprises, allowing prepayment of external commercial borrowings (ECBs) through an automated route for debts exceeding $500 million, and permitting individuals to invest up to $250,000 annually in foreign assets, shares, and securities.

Furthermore, certain relaxations have been introduced, such as unlimited imports of gold, although this mechanism operates as a form of convertibility through the current account route rather than comprehensive capital account convertibility accessible to everyone.

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Capital Account Convertibility vs Current Account Convertibility

The following table gives a comprehensive analysis of Capital Account Convertibility vs Current Account Convertibility:

	Capital Account Convertibility	Current Account Convertibility
Definition	The ease and freedom to convert domestic financial assets into foreign financial assets and vice versa.	The freedom to conduct international trade in goods and services and settle cross-border payments.
Focus	Deals with capital flows and investments across borders.	Deals with trade flows and transactions in goods and services.
Components	Includes foreign direct investment (FDI), portfolio investment, loans, remittances, and repatriation of funds.	Comprises merchandise trade (exports and imports), services trade (e.g., tourism, transportation, and financial services), and unilateral transfers (e.g., foreign aid and remittances).
Purpose	Promotes financial market integration, attracts foreign investment, and encourages capital flows into and out of the country.	Facilitates international trade, ensures smooth cross-border transactions, and supports balance of payments stability.
Impact on Economy	Can lead to increased economic growth and access to global capital markets, but also exposes the economy to risks like capital flight and financial instability.	Affects a country’s trade balance, competitiveness, and overall economic stability. A deficit or surplus in the current account can impact exchange rates and reserves.
Convertibility Level	Can range from limited (with restrictions and controls on capital flows) to full convertibility (unrestricted movement of capital).	Typically allows for higher degrees of convertibility, with fewer restrictions on current account transactions. Certain restrictions may still exist for specific goods or services.

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Benefits of Capital Account Convertibility

Capital account convertibility, when implemented effectively and accompanied by sound regulations and oversight, can bring numerous benefits to an economy. Here is an analysis of the same.

Improved access to international financial markets

Capital account convertibility enables individuals, businesses, and financial institutions to access global financial markets more easily. This increased access allows for the availability of substantial funds and a broader range of investment opportunities.

Lower cost of capital

With capital account convertibility, the cost of capital can potentially decrease. As capital flows more freely, it encourages competition and attracts foreign investment, leading to greater availability of funds at more competitive interest rates.

Enhanced financial competitiveness

Capital account convertibility fosters financial competitiveness by providing Indian investors with the opportunity to purchase and hold foreign equities and assets. This diversification of investment portfolios helps mitigate risks and potentially offers higher returns.

Easier external commercial borrowing

Full capital account convertibility allows Indian corporations to obtain external commercial borrowing without requiring approval from regulatory bodies like the Reserve Bank of India (RBI) or the government. This facilitates the borrowing process, reduces bureaucracy, and promotes easier access to global funding sources.

Facilitation of foreign currency transactions

Under capital account convertibility, Indian residents are allowed to hold and transact in foreign currency-denominated deposits with Indian banks. This flexibility enables smoother cross-border transactions and provides individuals with more options for managing their international financial dealings.

Increased participation of financial institutions

With capital account convertibility, a larger number of financial institutions, including non-bank financial companies (NBFCs), gain access to the global financial market. This expansion of participation supports the growth and development of the financial sector and promotes broader market integration.

Global gold trading and loan issuance

Capital account convertibility permits the global trading of gold and allows banks and financial entities to issue loans denominated in foreign currencies. These provisions enable greater flexibility in gold transactions and enhance the availability of funding options for individuals and businesses.

Read about: Gold Monetisation Scheme

Capital Account Convertibility Examples

The following examples demonstrate various approaches and experiences with capital account convertibility, illustrating the different degrees of openness to cross-border capital flows and the accompanying risks and benefits.

Examples	Details
United Kingdom (UK)	The UK is known for its relatively high degree of capital account convertibility. It has a liberalized regime that allows for the free movement of capital across its borders. Individuals and businesses can invest in foreign assets, repatriate funds, and participate in international financial markets without significant restrictions.
Singapore	Singapore has implemented a gradual approach towards capital account convertibility. It has progressively liberalized its capital account over the years, allowing for greater flexibility in cross-border capital flows. The country has developed into a global financial hub, attracting foreign investments and fostering a vibrant financial sector.
Germany	Germany has a relatively open capital account, facilitating cross-border capital flows. It allows individuals and businesses to freely invest in foreign assets, repatriate funds, and engage in international financial activities. However, certain sectors, such as banking and financial services, are subject to regulatory oversight to ensure stability and mitigate risks.
Chile	Chile is an example of a country that has successfully transitioned to full capital account convertibility. It gradually relaxed capital controls and implemented reforms to liberalize its capital account. Today, it has a fully convertible capital account, allowing for unrestricted movement of capital in and out of the country.
Iceland	Iceland experienced the consequences of excessive capital account liberalization during the global financial crisis of 2008. The country had pursued a policy of liberalizing its capital account, resulting in significant capital inflows and an overheated economy. However, when the crisis hit, capital outflows led to a severe economic downturn. This example highlights the importance of careful management and regulation during the process of capital account convertibility.

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Capital Account Convertibility UPSC

Capital Account Convertibility is a crucial aspect of economic policies, and knowledge in this area allows candidates to comprehend the implications of capital flows, international trade, and financial market integration on the economy. Aspirants can learn such topics on UPSC Online Coaching platforms and test their knowledge by giving UPSC Mock Test, as it helps them develop a holistic understanding of concepts and enhances their ability to analyze and evaluate policy decisions in a global context.

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Capital Account Convertibility FAQs

What is the concept of capital account convertibility?

The concept of capital account convertibility refers to the ease and freedom with which a country's currency can be converted into foreign currencies and vice versa for capital transactions.

Does India has full capital account convertibility?

No, India does not have full capital account convertibility; it currently has partial capital account convertibility.

What is the difference between current account and capital account convertibility?

The difference between current account and capital account convertibility lies in the types of transactions involved: current account convertibility relates to trade in goods and services, while capital account convertibility involves the movement of financial assets.

What is capital account convertibility explain its advantages and disadvantages?

Advantages of capital account convertibility include improved access to international financial markets and lower cost of capital, while disadvantages can include the risk of capital flight and financial instability.

What are the essential conditions for capital account convertibility?

Essential conditions for capital account convertibility typically include fiscal consolidation, inflation control, strong financial systems, low non-performing assets, and a stable current account.