Capital Account Convertibility Explained: An Insight into Financial Transitions



What is capital account convertibility?  (HPAS Mains Question Paper 2022 – GS 3, Q.3)

Capital Account Convertibility is a policy that allows residents of a country to convert their local currency into foreign currencies freely and vice versa for all capital account transactions. In other words, CAC allows for unrestricted and unconditional cross-border capital flows. Foreign direct investment, portfolio investment, external commercial borrowings, and other capital transactions are examples of capital account transactions.

Capital account convertibility promotes economic growth by encouraging foreign investment and capital inflows and allowing for greater financial integration with the global economy. It also gives investors more freedom to manage their assets and diversify their portfolios.

India’s path to capital account convertibility has been slow and methodical. India began to liberalise its economy and move towards a more market-oriented approach in 1991. Partial capital account convertibility was implemented in 1994, allowing foreign institutional investors to invest in the Indian stock market. Since then, additional steps towards full capital account convertibility have been taken.

However, capital account convertibility exposes a country to greater financial volatility and the risk of capital flight. This can be especially difficult for countries with weak or vulnerable economies. As a result, many countries take a gradual and cautious approach to capital account convertibility, imposing restrictions on the size and timing of capital flows, limiting foreign investment in specific sectors, and employing capital controls in times of crisis to prevent capital flight and currency depreciation.

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