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Capital Account Convertibility
Convertible currencies are defined as currencies that are readily bought, sold, and converted without the need for permission from a central bank or government entity.
Most major currencies are fully convertible; that is, they can be traded freely without restriction and with no permission required. The easy convertibility of currency is a relatively recent development and is in part attributable to the growth of the international trading markets and the FOREX markets in particular. Historically, movement away from the gold exchange standard once in common usage has led to more and more convertible currencies becoming available on the market. Because the value of currencies is established in comparison to each other, rather than measured against a real commodity like gold or silver, the ready trade of currencies can offer investors an opportunity for profit.
Fully convertible currency
The U.S. dollar is an example of a fully convertible currency. There are no restrictions or limitations on the amount of dollars that can be traded on the international market, and the U.S. Government does not artificially impose a fixed value or minimum value on the dollar in international trade. For this reason, dollars are one of the major currencies traded in the FOREX market.
Partially convertible currency
The Indian rupee is only partially convertible due to the Indian Central Bank’s control over international investments flowing in and out of the country. While most domestic trade transactions are handled without any special requirements, there are still significant restrictions on international investing and special approval is often required in order to convert rupees into other currencies. Due to India’s strong financial position in the international community, there is discussion of allowing the Indian rupee to float freely on the market, altering it from a partially convertible currency to a fully convertible one.
Almost all nations allow for some method of currency conversion; Cuba and North Korea are the exceptions. They neither participate in the international FOREX market nor allow conversion of their currencies by individuals or companies. As a result, these currencies are known as blocked currencies; the North Korean won and the Cuban national peso cannot be accurately valued against other currencies and are only used for domestic purposes and debts. Such nonconvertible currencies present a major obstruction to international trade for companies who reside in these countries.
Convertibility is the quality of paper money substitutes which entitles the holder to redeem them on demand into money proper.
Capital Account Convertibility
Capital Account Convertibility is a monetary policy that centers around the ability to conduct transactions of local financial assets into foreign financial assets freely and at market determined exchange rates. It is sometimes referred to as Capital Asset Liberation.
It is basically a policy that allows the easy exchange of local currency (cash) for foreign currency at low rates. This is so local merchants can easily conduct transnational business without needing foreign currency exchanges to handle small transactions. Capital Account Convertibility is mostly a guideline to changes of ownership in foreign or domestic financial assets and liabilities. Tangentially, it covers and extends the framework of the creation and liquidation of claims on, or by the rest of the world, on local asset and currency markets.
Advantages of Capital Account Convertibility:
1. It encourages short term investments from foreigners
2. It makes it easier for a country’s citizens to invest in companies or properties abroad
Disadvantages of Capital Account Convertibility:
1. It makes it difficult for India’s producers as they now need to compete with international producers who may be subsidized by their home country’s currency which have a low rate of exchange. Example: China
2. It takes away investments from Indian companies
3. It makes the currency dependent on currency speculators who can cause immense damage within a short amount of time through flights of capital in periods of uncertainties.