Capital Account Convertibility (CAC) refers to the ability to convert domestic capital assets (investments and loans) to international capital assets and vice versa at a market-determined exchange rate. This means that anyone can convert local currency to foreign currency and back. In this article, we will look into the meaning of Capital account Convertibility which is important for the UPSC exam.

What does Capital Account Convertibility mean?

• For capital account transactions, capital account convertibility refers to the ease and freedom with which a country's currency can be converted into any other foreign currency (such as the US dollar, pound sterling, or Euro) and vice versa.
• It refers to the ability to convert domestic financial assets into foreign financial assets at market exchange rates. Full capital account convertibility would eventually result in unlimited capital movement.
• The Indian rupee was not given full capital account convertibility because the current account situation was not favorable, as India had a substantial current account deficit. The government intended to make sure that foreign exchange was available at a lesser cost for the import of vital products and commodities.
• Given the Mexican crisis, India took a cautious approach to rupee full capital account convertibility. The East Asian crisis that followed validated the partial capital account convertibility strategy. Partial capital account convertibility was previously permitted under certain situations.
• Complete capital account convertibility can promote capital inflows into the country, but there is a significant risk of capital outflows from the home country if conditions deteriorate. This can lead to increased exchange rate volatility and perhaps a crisis, similar to what occurred during the East Asian crisis.

Preconditions for full currency convertibility

• Domestic macroeconomic stability and a suitable level of competitiveness of domestic sector industries and companies.
• Beforehand, a trade-oriented development strategy must be implemented, as well as suitable government incentives for export growth.
• The country's industrial policy should be attractive to investors, and the government should create an investment-friendly environment.
• Foreign exchange reserves should be enough, and the current account balance should be favorable.

Roadmap of Capital Account Convertibility

• In India, the Tarapore committee established a three-year roadmap for CAC that ended in 1999-2000.
• It however noted that this timeline might be accelerated or delayed, depending on the accomplishment of the pre-conditions, which include fiscal consolidation, financial system strengthening, and a low rate of inflation. The other two preconditions, except the last, have not been achieved.
• The rate at which India meets the Tarapore Committee's preconditions for capital account convertibility, such as fiscal consolidation, inflation control, a low level of non-performing assets, a low current account deficit, and the strengthening of financial markets, will determine the country's capital account convertibility.
• Sound policies, a strong regulatory framework that promotes a strong and efficient financial sector, and excellent systems and processes for monitoring capital flow all increased the likelihood of such flows fostering long-term growth rather than disrupting and causing a crisis.

Current Status of CAC

• Following the recommendations of the S.S. Tarapore Committee on Capital Account Convertibility (1997), India has been moving toward full convertibility in this account, although with necessary safeguards.
• India is still a country with partial capital account convertibility (40:60), but within this general policy, enough reforms have been achieved, and it is now an economy with complete capital account convertibility to specific levels of foreign exchange requirements. To achieve capital account convertibility, the following measures have been taken.
  • In the automatic method, Indian corporations are given full convertibility up to $ 500 million in international enterprises (investment by Ltd. companies in foreign countries allowed).
  • If the debt exceeds $ 500 million, Indian corporations are authorized to prepay their external commercial borrowings (ECBs) via automated route.
  • Individuals are authorized to invest up to $ 2,50,000 per year in foreign assets, shares, and other securities.
  • Importing an unlimited amount of gold is permitted (this is equivalent to enabling full convertibility in the capital account via the current account route, but this is not practicable for everyone), which is currently prohibited.

Advantages of Capital account Convertibility

• Improved access to international financial markets makes substantial money more accessible.
• Lowering the cost of capital.
• The financial incentive for Indians to buy and hold foreign equities and assets.
• Greater financial competitiveness.
• Will assist Indian corporations in obtaining external commercial borrowing without the approval of the RBI or the government.
• Foreign currency-denominated deposits can be held and transacted by Indian residents with Indian banks.
• A certain number of financial institutions and, later, non-bank financial companies (NBFCs) have access to the global financial market.
• Gold may be traded globally and loans can be issued by banks and financial entities.

Disadvantages of Capital account Convertibility

• When market currency rates are greater than government fixed exchange rates, import prices rise and Cost-push inflation occurs.
• Improper CAC management can result in currency depreciation, which can disrupt trade and capital flows.
• According to studies, the benefits are fleeting, and international financial institutions are wary of CAC following the 2008 financial disaster.
• Speculative activity, like in the case of various South East Asian countries in 1997-98, might result in capital flight from the country.
• Once CAC is implemented, imposing control in a worldwide setting will become difficult.

Difference between Current and Capital Account Convertibility

Conclusion

The ability of a currency to easily convert with other national currencies for capital creation is referred to as capital account convertibility. It refers to the ability, freedom, or ease of converting rupees to other national currencies for capital development, foreign investment, international borrowing, FDI, FII, and other purposes in India.