CAPITAL ACCOUNT CONVERTABILITY

Subject: Economics

Context: The RBI Governor recently said that India will continue to approach capital account convertibility as a process rather than an event.

Concept:

• Capital account convertibility refers to the ease and freedom in converting a country s currency into any other foreign currency (such as US dollar, pound sterling, Euro etc) and vice versa for the capital account transactions.
• It is the freedom to convert the local financial assets into foreign financial assets at the market determined exchange rates. Full capital account convertibility would ultimately lead to unrestricted movement of capital.
• Full capital account convertibility of Indian rupee was not introduced because the prevailing conditions were not in its favour as India was facing a large current account deficit.
• The government wanted to ensure the availability of foreign exchange at lower prices for the input of essential goods and commodities.
• India adopted a cautious approach in the full capital account convertibility of rupee in the view of the Mexican crisis.
• The subsequent East Asian crisis justified the approach of partial capital account convertibility. Earlier also partial capital account convertibility was allowed under certain conditions.
• Complete capital account convertibility can increase the inflow of capital in the country but if the conditions become unfavourable there is a great risk of the outflow of capital from the home country. This can lead to higher volatility in the exchange rates and can even create a crisis like situation as happened during the East Asian crisis.

Preconditions

• Macroeconomic stability in the domestic economy and sufficient degree of competitiveness of the domestic sector firms and companies.
• Trade oriented development strategy must be adopted before-hand along with sufficient incentives by the government for the growth of exports.
• The industrial policy of the country should be attractive for investments and the government should provide a favourable investment climate.
• There should be sufficient foreign exchange reserves and the current account position should also be comfortable.