Capital account convertibility is a feature of a nation's
financial regime that centers on the ability to conduct transactions of local financial assets into foreign financial assets freely or at market determined exchange rates.
FAQ: Capital a/c convertibility and how it affects you
/ref> It is sometimes referred to as ''capital asset liberation'' or ''CAC''.
In layman's terms, full capital account convertibility allows local currency to be exchanged for foreign currency without any restriction on the amount. This is so local merchants can easily conduct transnational business without needing foreign currency
A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins.
A more general de ...
exchanges to handle small transactions. CAC is mostly a guideline to changes of ownership in foreign or domestic financial assets and liabilities. Tangentially, it covers and extends the framework of the creation and liquidation of claims on, or by the rest of the world, on local asset and currency markets
The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspe ...
.[Benu Schneider. Issues in Capital Account Convertibility in Developing Countries. Speech delivered to Overseas Development Institute, 2000.]
History
CAC was first coined as a theory by the Reserve Bank of India
The Reserve Bank of India, chiefly known as RBI, is India's central bank and regulatory body responsible for regulation of the Indian banking system. It is under the ownership of Ministry of Finance, Government of India. It is responsible f ...
in 1997 by the Tarapore Committee, in an effort to find fiscal and economic policies that would enable developing Third World
The term "Third World" arose during the Cold War to define countries that remained non-aligned with either NATO or the Warsaw Pact. The United States, Canada, Japan, South Korea, Western European nations and their allies represented the " First ...
countries transition to globalized market economies
A market economy is an economic system in which the decisions regarding investment, production and distribution to the consumers are guided by the price signals created by the forces of supply and demand, where all suppliers and consumers are ...
.[Vijay Joshi, Ian Malcolm, David Little. India's Economic Reforms, 1991–2001. Published 1996 Oxford University Press. ] However, it had been practiced, although without formal thought or organization of policy or restriction, since the very early 1990s. Article VIII of the IMF’s Articles of Agreement is agreed by most economists to have been the basis for CAC, although it notably failed to anticipate problems with the concept in regard to outflows of currency.
However, before the formalization of CAC, there were problems with the theory. Free flow
Open road tolling (ORT), also called all-electronic tolling, cashless tolling, or free-flow tolling, is the collection of tolls on toll roads without the use of toll booths. An electronic toll collection system is usually used instead. The m ...
of assets was required to work in both directions. Although CAC freely enabled investment in the country, it also enabled quick liquidation and removal of capital asset
A capital asset is defined as property of any kind held by an assessee, whether connected with their business or profession or not connected with their business or profession. It includes all kinds of property, movable or immovable, tangible or i ...
s from the country, both domestic and foreign. It also exposed domestic creditors to overseas credit risks, fluctuations in fiscal policy, and manipulation.[Zoubida Allaoua. India: sustaining rapid economic growth. Published 1997 World Bank Publications. ]
As a result, there were severe disruptions that helped to contribute to the East Asian crisis of the mid 1990s. In Malaysia
Malaysia ( ; ) is a country in Southeast Asia. The federation, federal constitutional monarchy consists of States and federal territories of Malaysia, thirteen states and three federal territories, separated by the South China Sea into two r ...
, for example, there were heavy losses in overseas investments of at least one bank, in the magnitude of hundreds of millions of dollars. These were not realized and identified until a reform system strengthened regulatory and accounting controls.[Prema-Chandra Athukorala. Crisis and Recovery in Malaysia: The Role of Capital Controls. Published 2003 Edward Elgar Publishing. Pg 44 ] This led to the Tarapore Committee meeting which formalized CAC as utilizing a mixture of free asset allocation
Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investment t ...
and stringent controls.[Zoubida Allaoua. India: sustaining rapid economic growth. Published 1997 World Bank Publications. ]
Tenets
CAC has 5 basic statements designed as points of action:[L. Bethell. The West and the Third World: Trade, Colonialism, Dependence and Development. Published 1999 Blackwell Publishing. ]
* All types of liquid assets
In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the ...
must be able to be exchanged freely, between any two nations in the world, with standardized exchange rates.
* The amounts must be a significant amount (in excess of $500,000).
* Capital inflows should be invested in semi-liquid assets, to prevent churning and excessive outflow.
* Institutional investors should not use CAC to manipulate fiscal policy or exchange rates.
* Excessive inflows and outflows should be buffered by national bank
In banking, the term national bank carries several meanings:
* a bank owned by the state
* an ordinary private bank which operates nationally (as opposed to regionally or locally or even internationally)
* in the United States, an ordinary p ...
s to provide collateral.
Application
In most traditional theories of international trade
International trade is the exchange of capital, goods, and services across international borders or territories because there is a need or want of goods or services. (see: World economy)
In most countries, such trade represents a significant ...
, the reasoning for capital account convertibility was so that foreign investors
Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort.
In finance, the purpose of investing is ...
could invest without barriers. Prior to its implementation, foreign investment was hindered by uneven exchange rates due to corrupt officials, local businessmen had no convenient way to handle large cash transactions, and national banks were disassociated from fiscal exchange policy and incurred high costs in supplying hard-currency loans for those few local companies that wished to do business abroad.
Due to the low exchange rates and lower costs associated with Third World nations, this was expected to spur domestic capital, which would lead to welfare gains, and in turn lead to higher GDP growth. The tradeoff for such growth was seen as a lack of sustainable internal GNP growth and a decrease in domestic capital investments.[Vijay Joshi. India: macroeconomics and political economy, 1964–1991. World Bank Publications ]
When CAC is used with the proper restraints, this is exactly what happens. The entire outsourcing movement with jobs and factories going overseas is a direct result of the foreign investment aspect of CAC. The Tarapore Committee's recommendation of tying liquid assets to static assets (i.e., investing in long term government bond
A government bond or sovereign bond is a form of bond issued by a government to support public spending. It generally includes a commitment to pay periodic interest, called coupon payments'','' and to repay the face value on the maturity dat ...
s, etc.) was seen by many economists as directly responsible for stabilizing the idea of capital account liberalization.
Controversy
Despite changes in wording over the years, and additional safeguards, there is still criticism of CAC by some economists. American economists, in particular, find the restriction on inflows to Third World countries being invested in improvements as negative, since they would rather see such transactions put to direct use in growing capital.[Zoubida Allaoua. India: sustaining rapid economic growth. Published 1997 World Bank Publications. ][Benu Schneider. Issues in Capital Account Convertibility in Developing Countries. Speech delivered to Overseas Development Institute, 2000.]
References
{{Reflist
Economic liberalization
Fiscal policy