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Factors impacting FCAC implementation

July 18, 2014

In the first article we explained what Full Capital Account Convertibility is. This section will explain some of the determinant factors of FCAC.

II. Direct and Indirect Factors Impacting FCAC Decision

II.A. CAC and Exchange Rate Regime

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,

  • Exchange stability and capital market integration can be covered by adopting a fixed X-rate regime, but by giving up monetary authority. Thus the authorities lose the power of changing the domestic interest rate independently of foreign interest rate.
  • Monetary autonomy can be combined with Capital market integration by giving up Exchange stability. Authorities can freely choose the domestic interest rate but must accept the market-dictated (floating) exchange rate.
  • Exchange stability can be combined with Monetary Autonomy by giving up Capital Market integration – in presence of capital controls, the interest rate/exchange-rate link breaks.

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.

II.B. Trade Openness and CAC

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.

II.C. Foreign Exchange Reserves Adequacy

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.

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