What is Capital Account Convertibility and How it Affects a Country

What is Capital Account Convertibility ?

Capital Account Convertibility means that the currency of a country can be converted into foreign exchange without any controls or restrictions.

In other words, Indians can convert their Rupees into Dollars or Euros and Vice Versa without any restrictions placed on them. The reason why it is called capital account convertibility is that the conversion of domestic currencies into foreign currencies is allowed in the capital account and not only the current account.

Capital account refers to expenditures and investments in hard assets, physical premises, and factories as well as investments in land and other capital-intensive items. Current account on the other hand, refers to investments that are short term in duration and hence, they fall under the current account head.

As we shall discuss later, there is a significant difference between capital and current accounts as they are different in the period of holding and the kind of investments made.

A precondition for many countries to get IMF (International Monetary Fund) or World Bank assistance is to make their currencies capital account convertible so that foreign investors have the exit option quickly and without hassles in times of economic crises.

Partially and Fully Convertible Currencies

Partially convertible currencies are those where the currency can be converted in the current account. This means that investors can invest in stock markets and bond markets of the target countries with an option to repatriate their holdings.

Further, ordinary citizens can convert their domestic currencies to dollars for expenses like going abroad for work, tourism, and education.

On the other hand, capital account convertibility or fully convertible currencies are those where just about anybody can convert the local currency for foreign currency without any questions or restrictions placed on such conversions.

The key aspect here is that many countries do not allow their currencies to be fully convertible if they do not hold significant foreign exchange reserves. This is also the reason why capital controls are imposed in times of economic crises to prevent a capital flight from these countries.

Many Asian countries have learnt from the bitter experience of the Asian financial crisis of 1997 and the Russian Default of 1998 where full convertibility lead to a stampede of foreign investors fleeing the countries in the aftermath of the economic crisis.

The other aspect here is that even in the European Union, capital controls are being planned to contain flight of capital to other countries as the Eurozone crisis deepens.

Impact on Countries

The previous sections discussed the difference between fully convertible and partially convertible currencies. The impact of convertibility on economies is felt in the way assets held in the domestic country can be repatriated with ease or partially.

For instance, in India where the currency is partially convertible, investors cannot liquidate their assets and leave the country without approval.

On the other hand, they can repatriate the money that they have invested in the stock market, as was the case in recent months.

The effect of this is that many foreign companies do not hold assets like buildings, premises, and other items that fall in the capital account. They also tie up with local companies because in times of crisis, they can exit the joint venture easily and get back their monies invested in the merged entity.

As for other countries in South East Asia that were fully convertible, the Asian financial crisis of 1997 was a wakeup call for them as investors fled the country and capital flight accelerated leading to a near collapse of the economies in the region with the exception of Singapore.

Concluding Remarks

Having considered the pros and cons of the issue, it must be said that emerging market economies must consider the kind of convertibility after taking into account the various factors that are internal to their functioning and must not make their currencies convertible because of external pressures.