Capital account convertibility and how it affects you

What’s capital a/c convertibility
  • Freedom to convert local financial assets into foreign ones at market-determined exchange rates
  • Leads to free exchange of currency at lower rates and an unrestricted mobility of capital
  • Beneficial for a country because inflow of foreign investment increases
  • The flip side, though, is that it could destabilise an economy due to massive capital flows in and out of the country

India has been relentlessly moving on the path towards liberalization, opening up its markets and loosening its controls over many economic matters so as to integrate with the global economy.

Despite the opposition to globalization from some quarters, India has been quite watchful in its approach to embracing global economy. The issue of capital account convertibility is one such where the nation has tread very cautiously.

So what is capital account convertibility?

To put is simply, capital account convertibility (CAC) — or a floating exchange rate — means the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. This means that capital account convertibility allows anyone to freely move from local currency into foreign currency and back.

It refers to the removal of restraints on international flows on a country’s capital account, enabling full currency convertibility and opening of the financial system.

A capital account refers to capital transfers and acquisition or disposal of non-produced, non-financial assets, and is one of the two standard components of a nation’s balance of payments. The other being the current account, which refers to goods and services, income, and current transfers.

How are capital a/c convertibility and current a/c convertibility different?

Currency convertibility means “the freedom to convert one currency into other internationally accepted currencies, wherein the exporters and importers where allowed a free conversion of rupee.But still none was allowed to purchase any assets abroad.
Capital Account Convertibility means that rupee can now be freely convertible into any foreign currencies for acquisition of assets like shares, properties and assets abroad. Further, the banks can accept deposits in any currency.
so if a foreigner buys a building in India, and after 5 yrs its selling price rises so sells it at five times the cost he collected, now he has rupees in hand, can he easily convert these rupees into say ‘yen’ easily?
Considering that exchange rate is better in terms of INR-JPY, the foreigner would want to convert the currency into yen..and this can be done if complete capital a/c convertibility takes place..
Remittance to foreign countries from india is restricted by RBI. for import of machines you are remitting abroad means it is capital account convertibility. if you remit money to your son or relative living abroad means current account convertibility.
Capital account convertibility
It means the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange.It refers to the removal of restraints on international flows on a country’s capital account, enabling full currency convertibility and opening of the financial system. Capital account convertibility is considered to be one of the major features of a developed economy. It helps attract foreign investment.At the same time, capital account convertibility makes it easier for domestic companies to tap foreign markets. It is sometimes referred to as Capital Asset Liberation.
Current account convertibility
Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. In other words, it allows residents to make and receive trade-related payments — receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts, etc.

In nutshell, Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. In other words, it allows residents to make and receive trade-related payments — receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts, etc.

*The capital account is the net result of public and private international investments flowing in and out of a country. May also refer to an account showing the net worth of a business at a specific point in time.

Why capital account convertibility?

Capital account convertibility is considered to be one of the major features of a developed economy. It helps attract foreign investment. It offers foreign investors a lot of comfort as they can re-convert local currency into foreign currency anytime they want to and take their money away.

At the same time, capital account convertibility makes it easier for domestic companies to tap foreign markets. At the moment, India has current account convertibility. This means one can import and export goods or receive or make payments for services rendered. However, investments and borrowings are restricted.

But economists say that jumping into capital account convertibility game without considering the downside of the step could harm the economy. The East Asian economic crisis is cited as an example by those opposed to capital account convertibility.

Even the World Bank has said that embracing capital account convertibility without adequate preparation could be catastrophic. But India is now on firm ground given its strong financial sector reform and fiscal consolidation, and can now slowly but steadily move towards fuller capital account convertibility.

What are the PROs AND CONS of Capital Account Convertibility?

Argument in Favor

It facilitates foreign investments and borrowing. So competition is increased = more factories = more jobs = more product choices for consumers = good for economy.

Argument Against

a) Local producers have to compete with International giants. So they lose market and customers
b) What if foreigners buy lot of factories in India and suddenly they find that investing money in France is better than in India. So they immediately sell all those factories, get their Rupees converted into Euro and run away! That’ll lead to huge job loss and collapse in Indian economy
cons being the sudden flight of capital and thereby triggering in the recessionary trends and could even lead to depression..creating a similar situation of the mexican crisis.

Why full capital account convertibility of rupee is still a distant dream?

Capital account convertibility of the rupee is a distant dream because macro economic parameters have to be stable before it is implemented. The low current account deficit should be sustained and the fiscal deficit needs to be contained.

Once, Reserve Bank of India Governor Raghuram Rajan said, “My hope is we will get to full capital account convertibility in a short number of years.” But in words of Dwijendra Srivastava, chief investment officer (debt) at Sundaram Mutual Fund,“We are surely on that path but it will take a few more years. The rupee as a currency should be more frequently traded internationally.”

Ref :

  1. http://inhome.rediff.com/money/2006/sep/04faq.htm
  2. http://www.business-standard.com/article/economy-policy/full-capital-account-convertibility-of-rupee-still-a-distant-dream-115041500906_1.html
  3. http://www.ias.org.in/2011/07/what-is-difference-between-current.html
  4. http://www.ias.org.in/2011/07/discuss-pros-and-cons-of-capital.html

 

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