Capital Account Convertibility

Capital account convertibility refers to a country's ability to swiftly convert its domestic financial assets to foreign financial assets and vice versa. The concept plays an integral role in trade, investments, and global market activities, and the integration of financial markets reflects on the country's economic policy and global engagement.

CAC defines the ease with which a country allows the conversion of its domestic currency to foreign currencies and vice versa. It depends on how the nation wants to approach it, either with a full convertibility level with an unrestricted capital movement or with a limited CAC that includes restrictions and other controls over the asset conversion. It is also known as capital asset liberation.

Capital account convertibility refers to the ease with which a country can participate in currency conversion and get its national currency converted into gold or another foreign currency through different global exchanges. CAC was first introduced by the Tarapore Committee of the Reserve Bank of India in 1997. It was established to seek fiscal and economic policies for third-world countries. Still, several problems linked to the CAC theory troubled its formalization but eventually helped India with the free flow of assets and quick liquidation of both domestic and foreign assets.

The CAC phenomenon reflects the financial regulations on the inflow and outflow of capital between nations. If a currency is not easily or fully convertible, it means it is tightly controlled by the underlying nation's central bank or official regulatory authority. In contrast, when a currency is highly convertible, it allows businesses, investors, and governments to seek new investments, trade opportunities, and business setups, seek diversification through foreign assets, generate employment, and pay for goods and services in a foreign currency.

It depends on the government which type of CAC model they opt for their currency. It can be partial currency convertibility with limitations and strict control over the flow of capital or complete currency convertibility with no curbs or limitations. Over the years, many developing countries have adopted partial or full CAC as per their need to participate in international markets. Every nation's economy is indirectly dependent on its currency convertibility level.

Below are two distinct examples to understand the concept better –

Example #1

Suppose there is a small developing nation with a weak financial market and limited participation in the global economy despite being rich in natural resources and domestic products. To stimulate economic growth, the government introduces full CAC, allowing unrestricted currency exchanges between the domestic currency and foreign currencies.

Initially, the move attracts foreign investment and trade as investors see an opportunity to exploit the country's untapped resources. Banks begin offering loans in foreign currencies, and gold trading becomes more extensive. Domestic companies gain access to foreign funding, leading to the establishment of new projects and businesses.

However, soon after, the country experiences challenges. The sudden influx of short-term speculative investments leads to economic volatility, as investors withdraw funds at the first signs of instability. The currency depreciates sharply, and the banking system struggles to handle the capital outflows, putting pressure on the domestic economy. Without proper financial market reforms and safeguards, the initial gains from capital account liberalization are overshadowed by these risks.

Example #2

In February 2023, the European Union continued to push India to liberalize its capital account restrictions and move towards free currency account convertibility during the third round of India-EU FTA negotiations. Free currency convertibility implies that there would be no restrictions on the amount of rupees that can be converted into foreign currency, allowing Indians to purchase foreign assets without barriers. Likewise, foreign entities would face no restrictions on bringing foreign currency to acquire assets in India.

However, experts expressed mixed views on this proposal. Some, like Anuradha R.V. of Clarus Law Associates, believe India must cautiously approach capital account convertibility due to its potential risks, as seen in past banking and currency crises. Others, like Rajesh H. Gandhi of Deloitte, note that while India already allows partial convertibility, full liberalization could pose significant challenges. Despite these concerns, proponents of partial convertibility suggest that it could help further integrate India into the global economy, provided proper safeguards are in place.

The advantages of capital account convertibility are –

• With a good CAC, individuals, investors, and businesses enjoy better access to international financial markets, making transactions smoother and significantly increasing the availability of funds for a wider range of investments.
• CAC promotes international trade, attracts foreign investments, substantially reduces the cost of capital, and encourages competition.
• Banks and financial institutions can now issue loans in foreign currency denominations more easily. CAC permits the trading of gold and other precious metals.
• If a country has full CAC, it will allow domestic companies to facilitate external commercial borrowing with increased access to funds and reduced levels of bureaucracy.
• With an unrestricted CAC, investors can purchase and hold foreign assets and equity, which eventually helps them diversify and mitigate market risks.
• The participation of companies, entities, and other financial institutions is increasing in the global markets.

The disadvantages of capital account convertibility are –

• CAC increases the risk of financial instability and capital flight.
• Improper CAC management can induce currency depreciation.
• If a country needs to regulate CAC appropriately, it can significantly impact its trade and capital flows.
• For some countries, it becomes challenging to impose control on financial activities in global markets once CAC is initiated, which may lead to different illicit and illegal financial activities.
• Excessive participation of foreign investors and companies can disrupt the domestic financial markets.