Current and Capital Account Convertibility
Current and Capital Account Convertibility are key concepts in international economics and foreign exchange markets, particularly in the context of balance of payments.
Current account convertibility refers to the freedom of converting local financial assets into foreign financial assets and vice versa at market-determined rates of exchange for income-related transactions (e.g., exports and imports, remittances).
Capital account convertibility refers to the freedom of conversion of local financial assets into foreign financial assets and vice versa at market-determined rates of exchange for capital transactions (e.g., investments).
A growing number of countries have embraced full or partial convertibility of their currencies.
Key Takeaways – Current and Capital Account Convertibility
- Current and capital account convertibility are important concepts in international economics and impact the balance of payments.
- Current account convertibility allows for the free conversion of currency for income-related transactions, promoting international trade and economic globalization.
- Capital account convertibility enables the free conversion of currency for investment purposes, attracting foreign investors but also exposing a country to risks such as capital flight and financial instability.
- We explain what FX traders can learn from these concepts.
Current Account Convertibility
Historically, many countries have adopted current account convertibility.
The International Monetary Fund’s (IMF) Article VIII encourages countries to make their currencies convertible for current account transactions.
In this regard, more than 180 countries have accepted the obligations of Article VIII, according to IMF data.
This implies that a vast majority of the world’s nations support the idea of current account convertibility.
In principle, current account convertibility makes it easier for individuals and businesses to engage in international trade by eliminating restrictions on the import and export of goods, services, and certain financial transactions.
This policy stance can lead to more open, competitive economies and is a key driver of economic globalization.
Capital Account Convertibility
In contrast, capital account convertibility – the ability to freely convert currency for investment purposes – is less widespread.
Many emerging economies maintained some degree of capital controls.
The Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) from the IMF indicated that approximately 60 countries, primarily developing and emerging economies, had multiple currency practices or certain types of capital controls.
This is because complete capital account liberalization can carry significant risks, such as potential for capital flight, financial crises, and macroeconomic instability.
For example, the Asian financial crisis in 1997 underscored these risks when a rapid outflow of foreign capital led to severe economic downturns in several Asian economies.
The Indian Case: A Gradual Shift Towards Convertibility
India serves as a prime example of a country making a gradual shift towards convertibility.
In 1994, India achieved full current account convertibility, a significant milestone after years of economic reforms initiated in 1991.
This transition resulted in a marked increase in India’s international trade, with its export-to-GDP ratio rising from approximately 7% in 1991 to over 20% today, according to World Bank data.
However, India’s progress toward full capital account convertibility has been more cautious.
The Tarapore Committee, set up by the Reserve Bank of India (RBI) in 2006 to lay down a roadmap for capital account convertibility, recommended a gradual and sequenced move towards full convertibility, underscoring the potential risks involved.
Lessons for Currency Traders
Current and capital account convertibility are important factors currency traders need to understand and monitor, especially with regard to EM FX.
Both forms of convertibility can significantly influence the supply and demand for a currency and therefore its exchange rate.
Impact of Current Account Convertibility
Full current account convertibility generally implies that a country’s currency can be freely exchanged to conduct trade in goods and services.
For currency traders, this can translate into increased liquidity and lower transaction costs, as restrictions on buying and selling the currency are limited.
The greater ease of transactions can lead to higher volatility, providing opportunities for currency traders to profit from exchange rate fluctuations.
Impact of Capital Account Convertibility
Capital account convertibility, on the other hand, can significantly impact capital flows and foreign investment.
Countries with fully convertible capital accounts attract more foreign investors as it allows easier repatriation of profits.
This can increase demand for the currency, potentially strengthening its value.
However, it can also make a currency more vulnerable to “hot money” flows – speculative capital that moves rapidly in and out of markets to take advantage of short-term price fluctuations.
Risks and Opportunities
As seen during the Asian financial crisis in 1997 and the global financial crisis in 2008, countries with fully open capital accounts can experience swift and sizeable capital outflows, leading to sharp currency depreciations.
This level of volatility can present both risks and opportunities for currency traders.
While the potential for large gains exists, the risk of substantial losses is equally present.
Therefore, currency traders must monitor a host of macroeconomic indicators, policy announcements, and global financial news to stay ahead of market movements.
Country Specific Considerations
Specific country considerations can also play a role in currency trading.
For instance, a country like India, which has full current account convertibility but partial capital account convertibility, presents a different risk-return profile for currency traders compared to a country with full convertibility on both accounts.
Traders must understand these nuances and their implications on currency value and volatility.
FAQs – Current and Capital Account Convertibility
What is current account convertibility?
Current account convertibility refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market-determined rates of exchange.
It is mainly associated with transactions of an income nature, such as import/export of goods and services, and cross-border remittances by individuals.
In simple terms, it means that goods and services can be traded freely and there aren’t restrictions on the conversion of currency for these transactions.
Under the rules of the International Monetary Fund, which most countries are a member of, countries are expected to allow full current account convertibility, which means that controls on transfers such as those for payments for imports or exports of goods and services, or remittances for living expenses, should be minimal or non-existent.
What is capital account convertibility?
Capital account convertibility also refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market-determined rates of exchange.
It is associated with capital transactions, namely those involving investments and loans. This implies that capital account convertibility allows money to move freely from one country to another for investment and borrowing.
Under this kind of convertibility, residents can purchase foreign assets and foreign residents can purchase domestic assets without any restriction.
Such an environment allows the flow of capital across countries and therefore, encourages an efficient allocation of international capital.
However, capital account convertibility can also make a country vulnerable to financial crises, as it exposes the country’s financial system to rapid cross-border movements of capital.
This is why many developing countries maintain controls on capital account transactions, while at the same time allowing full current account convertibility.
Are there risks to current account convertibility?
Risks to Current Account Convertibility:
- Exposure to Exchange Rate Risk: Current account convertibility implies that a country allows its currency to be exchanged for foreign currencies without restriction. If a country’s currency depreciates significantly, it could lead to a surge in the cost of imports and a potential balance of payments crisis.
- Trade Imbalances: Current account convertibility can lead to trade imbalances if a country is consistently importing more than it exports. Over time, this can lead to a significant trade deficit, which can put downward pressure on the country’s currency and potentially lead to a financial crisis.
- Harms Domestic Industry: If a country opens its borders to foreign goods and services without any restrictions, it may harm domestic industries which might not be able to compete with cheaper or superior quality imports.
Are there risks to capital account convertibility?
Risks to Capital Account Convertibility:
- Risk of Hot Money Flows: Capital account convertibility can lead to “hot money” flows where large amounts of capital are quickly moved in and out of the country. This can cause exchange rate volatility and potential instability in the country’s financial system.
- Financial Crises: If capital is allowed to flow freely, a sudden withdrawal of foreign investment could lead to a financial crisis, as was the case in several East Asian countries in the late 1990s. These countries had fully convertible capital accounts and when investors suddenly withdrew their capital, it led to what is now known as the “Asian Financial Crisis.”
- Loss of Monetary Policy Autonomy: Capital account convertibility can lead to a loss of control over monetary policy. This is because large inflows and outflows of capital can impact the country’s money supply, and therefore, limit the effectiveness of monetary policy. We discuss this more in our article about the trilemma problem.
The debate on current and capital account convertibility is, at its core, a balancing act between the benefits of openness and the potential risks of volatility and economic crises.
Economies need to consider their specific circumstances, levels of economic development, institutional quality, and financial market depth while deciding their approach to currency convertibility.
It’s a dynamic process that requires constant monitoring and adjustments in response to domestic and global economic conditions.