BackDe-jargoned: Capital account convertibility
It means freedom to convert currency, both in terms of outflows and inflows, for capital transactions
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International movement of capital is not always free. Controls are used by the state to insulate the economy from erratic flow of capital, which can lead to financial instability.
In India, for example, there are restrictions on movement of foreign capital and the rupee is not fully convertible on capital account. Capital account convertibility (CAC) means freedom to convert currency, both in terms of outflows and inflows, for capital transactions. Whether India should allow full convertibility on capital account is being discussed for some time now. “My hope is that we will get to full capital account convertibility in a short number of years," said Raghuram Rajan, governor of the Reserve Bank of India (RBI) on 10 April, as reported by PTI.
A BRIEF HISTORY
In the budget speech of 1997-98, the then finance minister P. Chidambaram argued in favour of laying out a roadmap for capital account convertibility. “I also believe that the time has come for preparatory work towards capital account convertibility. This is a cherished goal…. For the present, I am asking RBI to appoint a group of experts to lay out the road map towards capital account convertibility, prescribe the economic parameters which have to be achieved at each milestone and work out a detailed time table for achieving the goal," said Chidambaram. Consequently, in 1997, RBI constituted an expert committee.
In absence of a formal definition of CAC, the committee recommended a working definition for its report as: “CAC refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. It is associated with changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by, the rest of the world. CAC can be, and is, coexistent with restrictions other than on external payments. It also does not preclude the imposition of monetary/fiscal measures relating to foreign exchange transactions which are of a prudential nature."
In 2006, the then Prime Minister, Manmohan Singh, in a speech at RBI, had talked about revisiting the subject. A committee was again constituted by the central bank to suggest a roadmap for fuller capital account convertibility.
THE PRESENT SITUATION
Capital flows have been liberalized over the years but moving to full CAC requires better macroeconomic management, among other things. For example, the 1997 committee on CAC recommended bringing down the fiscal deficit to 3.5% of the gross domestic product and inflation between 3% and 5% (average for three years) by 1999-2000. These conditions are not easily attainable, as both fiscal deficit and inflation have been on the higher side even in recent years. Without adequate safeguards, full CAC can pose a risk to financial stability, especially in the current global environment.
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