Saturday, September 10, 2011

Capital account convertibility primer

Sir, few days back I read that “India Development Report” released recently mentions something about “A calibrated approach to Capital Account Convertibil­ity”. What is it?
Yes, yes sure. Please be patient. I will tell you all about it.In any city, you see that there are traffic lights to regulate the flow of traffic. City planners have designed them to prevent people to control themselves from over-driving and being reckless. Similarly, RBI is the planner of our country’s currency mechanism and they have installed a tool called “Capital Account Convertibility” (CAC) to prevent investors from being in an over-drive mode. Got it?
You are creating all the more con­fusion and curiosity in me. Please sir, can you be more specific?
Oh yes. Listen…Convertibility of a currency determines how easily capital can flow in or out of a country. A currency is fully convertible if it can be freely con­verted into currencies of other countries, and vice versa. If you walk into any bank and ask for dollars they would give it to you straight away in exchange for rupees – no questions asked!
Fuller convertibility implies that you are free to take money in or out of your country without any restrictions. Similarly, a foreigner is also free to take his money in or out of your country without any restrictions. This creates super linkage between your domestic currency and other currencies – No road­blocks! Also, your markets are also more sensitive to currency fluctuations. Quite obvious, isn’t it?
Oh wow! This means India has full capital account convertibility? And fuller convertibility leads to good business op­portunities. Good markets.
Stop.Stop.Stop. You are absolutely wrong! India does not have full capital account convertibility. In fact, it is more prudent for developing countries to have some control on capital. You should know that RBI was the first bank to propose CAC in 1997 in order to ensure Third world economies are able to trans­act with globalised market economies. But inflation, domestic markets, competition are all sensitive to capital inflows and outflows. India, too, is more vul­nerable to any sudden stops or reversal of capital inflows than countries with current account surplus­es as its foreign exchange reserves mostly comprise borrowed resources. We have a current account defi­cit of 3.4% up from 2.9% in the last fiscal. This is unsustainable. We do not have tight measures to restrict CAC as its just about enough to fund our deficit. But, in the longer run this is not going to be enough.
Ok ok. So, in India we have some restrictions in place. Like?
Today, CAC involves your transac­tions dealing with exports, imports, remit­tances, income, transfers,etc. However, reasonable restrictions in public interest are still imposed. For instance, a resident Indian can remit money only under the permissible limits. India currently encourages foreign direct investments in infrastructure and certain other sectors and foreign fund inflows into local stock markets. However, it has set a cap of $20 billion of foreign investments in corporate bonds and $10 billion in government bonds. I hope you are getting what I mean…
So, this means, our country, too, has been progressively moving towards great­er capital account convertibility. Thanks a lot, sir. I am now no longer ignorant about these Greek. All of these jargon makes a lot of sense now.


  1. capital account convertibility simply means conversion of one currency in to other foreign currency for smooth functioning of commercial activity and avoid delay in payment which is major challenges faced by developing countries. this kind of arrangement can help to domestic player and international groups or individual to have smooth and faster transaction in payment and receives.
    but country like India, it is impossible to have absolute capital account convertibility due to socio-economic-political difference.for instance India follows welfare state policy(directive principle of state policy)etc. have strong influnce on policies formation.

  2. Good one. Thanks a lot for the explanation. :)