Full Capital Account Convertibility: an overview of determinants and impact analysis

Introduction to Full Capital Accountability

In this blog post, I’ll touch upon one of the much debated but quite fuzzy topics discussed by economic experts – that of Full Capital Account Convertibility (FCAC) and its desirability. Especially, introduction of FCAC in India has been debated many a time with prolonged pro-con analysis.

The term Full Capital Account Convertibility itself is quite complex. At least, complex enough to leave non-economists wondering and pondering over what it means – or whether it is worth probing into.

Questions I have frequently encountered are: What is a Capital Account and how can it be “Convertible”? And, converted to what?

It is true – the concept of Full Capital Account Convertibility runs very deep, and has numerous interconnected threads to make it meaningful. In this blog post, my effort is channelized towards giving an overall understanding of what Full Capital Account Convertibility means, what determines FCAC, what are its impacts, and how a wrongly-chosen FCAC policy can have disastrous consequences for an economy.

Keeping simplicity in mind, I have divided the content into 4 parts: Introduction to FCAC, Factors that determine FCAC, a Case Study citing the negative consequences of a FCAC policy, and finally, Conclusions regarding FCAC adoption by an economy. This is the first part of the 4-part series.

Full Capital Account Convertibility explained

Full Capital Account Convertibility (FCAC) implies that residents in a country can freelyexchangedomestic currency/financial assets against foreign currency/financial assets,without any restrictions. For example, if India had FCAC in place, as an Indian we could freely buy US Dollars by selling Rupee, for any reason, without any restrictions. But restrictions do exist.

A foreign currency transaction can be of two types: CurrentAccount and Capital Account. While the former denotes transactions for normal tradeand some specified non-trade purposes (e.g. medical treatment, education expensesabroad), capital account transactions are only for investment purposes.

Restricted Capital Account Convertibility (CAC) implies existence of capital control. This section discusses a few aspectsof capital control.

Capital controls can be imposed on:

• Direction of Capital flows (Capital Inflows or Outflows)
• Type of capital Flows (FDI/FPI/Portfolio Debt or Equity)
• Maturity of capital flows (Short-term/Medium-term/Long-term Capital)
• Sectorial destination of capital flows (Capital in Financial/Real estate/Infrastructure etc.)

In essence, capital controls include restrictions pertaining to:

• Repatriation or surrender of proceeds from exports, invisibles and currenttransfers.
• Purchase and sale of capital- or money-market instruments.
• Derivatives or other instruments.
• Outward or inward FDI or real estate transactions.
• Liquidation (sell-Off) of direct investments.

Above instances of capital control can be categorized into three broad forms:

• Quantitative:
  • In this form, capital control is imposed in measurable quantitative formats, rangingfrom complete prohibition (100% control) to some liberalization, subject to limits andceilings. If Capital Control exists, it can never be 0%, since that would mean Zero Control.
• Price-based:
  • This form of control seeks to introduce “Disincentives” to discourage some categories ofcapital flows and/or incentives to encourage another category of capital flows. Tobin Tax is an example. It is a “Currency Transaction Tax (CTT)” on spot conversions of one currency into another.
• Regulatory:
  • This form on control is exercised by the country’s Regulatory authorities who can decide on the control measure to be put in place, in order to discourage free and bulk buying and selling of currencies, in an attempt to mitigate the shocks generated by random fluctuations of the quantities, and thus the prices, of currencies.