In the first article we explained what Full Capital Account Convertibility is. This section will explain some of the determinant factors of FCAC.
This section begins with the well-known Trilemma of Impossible Trinity, which says it is impossible to achieve the following three goals simultaneously: Exchange Rate Stability, Capital Market Integration and Monetary Autonomy. Any pair of goals is achievable by adopting a suitable payments regime abandoning the third. In particular,
Choice of appropriate X-Rate is critical in justifying long-run viability and desirability of CAC. Instead of adopting a rigidly fixed X-Rate, many countries have a “Managed Float”system where, even though the domestic currency is de-jure fully flexible and is “determined” by market demand and supply, the central bank intervenes at the right time to lessen any undesirable impacts of an appreciation or depreciation of domestic currency (primarily through Forex buying and selling) so that the deviation doesn’t extend beyond a certain band. This system is opted with the intention of keeping the X-rate within a targeted range.
Another wisely adopted system is the Pegged X-Rate system where the country in question “Pegs” its domestic “Soft Currency” to another “Hard Currency” (such as US Dollar). The value of domestic currency fluctuates according to the direction of change in the value of the Hard Currency. However, a time-tested fallout of a pegged system is that, if the domestic currency is kept deliberately overvalued for a prolonged period, the long-run export-competitiveness gets adversely affected whereas imports become cheaper, so current account deficit starts to widen. After a threshold level such an economy becomes unviable.
Since full CAC would result in increased forex flows in and out of the country, choice of X-rate becomes an important factor.
Trade openness is indirectly linked to capital account convertibility. The exports/GDP ratio and the Imports/GDP ratio together determine the CAD/GDP ratio. A widening CAD is sustainable if and only if matched by sufficient forex reserves or capital inflows, or both. Capital control affects CAD financing and sustainability.
Adequacy of forex reserves is an important consideration for capital account liberalization. With respect to managed-float economies, a passive way in which reserve accumulation occurs is as consequence of the exchange rate policy - when the central bank intervenes in forex market and buys forex. This is done when huge forex surplus is there in the system due to capital inflows. When forex supply exceeds forex demand, domestic currency appreciates. The appreciated domestic currency increases the forex value of the exportable, thus adversely affecting export-competitiveness. So the central bank buys forex in order to prevent this. However, there are costs associated with holding huge forex reserves. Increasing the forex reserves beyond a point is problematic for the central banks, since it increases liability. However, accumulation of excessive reserves can lead to a negative BOP problem.
That’s for this week, I hope you found that informative, if you any comments or doubts please comment below.
To get the next article to your inbox, subscribe using the top bar. See you in your Inbox.
Global Association of Risk Professionals, Inc. (GARP®) does not endorse, promote, review or warrant the accuracy of the products or services offered by EduPristine for FRM® related information, nor does it endorse any pass rates claimed by the provider. Further, GARP® is not responsible for any fees or costs paid by the user to EduPristine nor is GARP® responsible for any fees or costs of any person or entity providing any services to EduPristine Study Program. FRM®, GARP® and Global Association of Risk Professionals®, are trademarks owned by the Global Association of Risk Professionals, Inc
CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by EduPristine. CFA Institute, CFA®, Claritas® and Chartered Financial Analyst® are trademarks owned by CFA Institute.
Utmost care has been taken to ensure that there is no copyright violation or infringement in any of our content. Still, in case you feel that there is any copyright violation of any kind please send a mail to email@example.com and we will rectify it.
2015 © Edupristine. ALL Rights Reserved.