Capital Account Convertibility
Encyclopedia
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 and at market determined exchange rates. It is sometimes referred to as capital asset liberation or CAC.
In layman's terms, full capital account convertibility allows local currency to be exchange for foreign currency without any restriction on the amount. This is so local merchants can easily conduct transnational business without needing foreign currency
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
.
in 1997 by the Tarapore Committee, in an effort to find fiscal and economic policies that would enable developing Third World
countries transition to globalized market economies
. However, it had been practiced, although without formal thought or organization of policy or restriction, since the very early 90's. 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 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
s from the country, both domestic and foreign. It also exposed domestic creditors to overseas credit risks, fluctuations in fiscal policy, and manipulation.
As a result, there were severe disruptions that helped to contribute to the East Asian crisis of the mid 90's. In Malaysia, 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. This led to the Tarapore Committee meeting which formalized CAC as utilizing a mixture of free asset allocation
and stringent controls.
, the reasoning for capital account convertibility was so that foreign investors
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.
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
s, etc) was seen by many economists as directly responsible for stabilizing the idea of capital account liberalization.
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
that centers on the ability to conduct transactions of local financial assets into foreign financial assets freely and at market determined exchange rates. It is sometimes referred to as capital asset liberation or CAC.
In layman's terms, full capital account convertibility allows local currency to be exchange for foreign currency without any restriction on the amount. This is so local merchants can easily conduct transnational business without needing foreign currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
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
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
.
History
CAC was first coined as a theory by the Reserve Bank of IndiaReserve Bank of India
The Reserve Bank of India is the central banking institution of India and controls the monetary policy of the rupee as well as US$300.21 billion of currency reserves. The institution was established on 1 April 1935 during the British Raj in accordance with the provisions of the Reserve Bank of...
in 1997 by the Tarapore Committee, in an effort to find fiscal and economic policies that would enable developing Third World
Third World
The term Third World arose during the Cold War to define countries that remained non-aligned with either capitalism and NATO , or communism and the Soviet Union...
countries transition to globalized market economies
Market economy
A market economy is an economy in which the prices of goods and services are determined in a free price system. This is often contrasted with a state-directed or planned economy. Market economies can range from hypothetically pure laissez-faire variants to an assortment of real-world mixed...
. However, it had been practiced, although without formal thought or organization of policy or restriction, since the very early 90's. 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 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
Capital asset
The term capital asset has three unrelated technical definitions, and is also used in a variety of non-technical ways.*In financial economics, it refers to any asset used to make money, as opposed to assets used for personal enjoyment or consumption...
s from the country, both domestic and foreign. It also exposed domestic creditors to overseas credit risks, fluctuations in fiscal policy, and manipulation.
As a result, there were severe disruptions that helped to contribute to the East Asian crisis of the mid 90's. In Malaysia, 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. This led to the Tarapore Committee meeting which formalized CAC as utilizing a mixture of free asset allocation
Asset allocation
Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.-Description:...
and stringent controls.
Tenets
CAC has 5 basic statements designed as points of action:- All types of liquid capitalLiquid capitalLiquid Capital, or Fluid capital is a readily convertible asset, such as money or other bearer economic instruments, as opposed to a long term asset like real estate...
assets must be able to be exchanged freely, between any two nations in the world, with standardized exchange rateExchange rateIn finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
s. - 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 investorInstitutional investorInstitutional investors are organizations which pool large sums of money and invest those sums in securities, real property and other investment assets...
s should not use CAC to manipulate fiscal policy or exchange rates. - Excessive inflows and outflows should be buffered by national bankNational bankIn banking, the term national bank carries several meanings:* especially in developing countries, a bank owned by the state* an ordinary private bank which operates nationally...
s to provide collateral.
Application
In most traditional theories of international tradeInternational trade
International trade is the exchange of capital, goods, and services across international borders or territories. In most countries, such trade represents a significant share of gross domestic product...
, the reasoning for capital account convertibility was so that foreign investors
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
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.
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
Foreign direct investment
Foreign direct investment or foreign investment refers to the net inflows of investment to acquire a lasting management interest in an enterprise operating in an economy other than that of the investor.. It is the sum of equity capital,other long-term capital, and short-term capital as shown in...
aspect of CAC. The Tarapore Committee's recommendation of tying liquid assets
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
to static assets (i.e., investing in long term government bond
Government bond
A government bond is a bond issued by a national government denominated in the country's own currency. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or country...
s, etc) was seen by many economists as directly responsible for stabilizing the idea of capital account liberalization.