Capital Account Convertibility – Advantages and Disadvantages


Capital account convertibility is freedom for converting rupees into foreign currency and back again for capital transactions. Conversion is done at market determined exchange rates. The CAC prompts free exchange of currency and unlimited capital mobility.

Advantages of CAC

1. Market forex rate is higher than officially fixed exchange rates so exporters can get more rupee against foreign exchange.

 2. Free or market determined exchange rate is more than previous officially fixed exchange rate . Imports become expensive and import substitution results in. This promotes economic self sufficiency

3. Remittance Incentives - Rupee convertibility also provides more incentives for sending forex remittances legally

4. Self Balancing Mechanism - When there is deficit BOP due to over valued exchange, currency convertibility leads to depreciation of currency and boosts exports through lowered prices. It also discourages imports leading to automatic correction of deficit BOP.

5. Competitive Specialisation - Currency convertibility causes market exchange rate to show purchasing power of currencies based on prices and costs of goods found in different nations; Where nations have competitive advantage, cost of goods are lower encouraging exports. Specialisation and international trade is carried out based on competitive advantage. Currency convertibility thereby integrates world economy through easy access to forex. It promotes trade and capital flows between nations.

Benefits for India

Capital account convertibility removes limitations on global flows on the capital account of India. Currencies can be converted into any other currency without the need for a transaction in case of CAC; freedom of movement from local to foreign currency and back strengthens the economy.CAC also promotes fund availability to supplement national resources. It promotes national economic growth. CAC also provides enhanced access to global financial markets. It reduces the capital cost. Indians also get incentive to hold and acquire foreign securities and/or assets. It also makes financial system globally competitive

Disadvantages of CAC

Cost push inflation may result of market determined exchange rates are higher than officially fixed exchange rates and prices of essential imports rise.

- If currency convertibility is not well managed, market exchange rate can cause domestic currency depreciation harming trade and capital flows in the nation

- Convertibility of currency makes it extremely volatile when currency depreciates due to speculative actions for example 1997-98 capital flight from South East Asian economies. 

- Currency depreciation makes capital inflows less likely 

Friday, 20th May 2016, 09:43:23 AM

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