Capital Account Convertibility is a feature of a nation's financial regime 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 or CAC.

In layman's terms, it is basically a policy that allows the easy exchange of local currency
(cash) for foreign currency at low rates. citation needed This is so local merchants can easily
conduct transnational business without needing foreign currency exchanges to handle
small transactions. citation needed CAC 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.

Contents
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• History
• Tenets
• Application
• Controversy

• References

History
CAC was first coined as a theory by the Reserve Bank of India in 997 by the Tarapore
Committee, in an effort to find fiscal and economic policies that would enable developing
Third World countries transition to globalized market economies. However, it had been
practiced, although without formal thought or organization of policy or restriction, since
the very early 90's. Article VIII of the IMF’s Articles of Agreement is agreed by most
economists to have been the basis for CAC, although it notably failed to anticipate
problems with the concept in regard to outflows of currency.

However, before the formalization of CAC, there were problems with the theory. Free
flow of assets was required to work in both directions. Although CAC freely enabled
investment in the country, it also enabled quick liquidation and removal of capital assets
from the country, both domestic and foreign. It also exposed domestic creditors to
overseas credit risks, fluctuations in fiscal policy, and manipulation.

As a result, there were severe disruptions that helped to contribute to the East Asian crisis
of the mid 90's. In Malaysia, for example, there were heavy losses in overseas
investments of at least one bank, in the magnitude of hundreds of millions of dollars.
These were not realized and identified until a reform system strengthened regulatory and
accounting controls. This led to the Tarapore Committee meeting which formalized
CAC as utilizing a mixture of free asset allocation and stringent controls.

Tenets
CAC has basic statements designed as points of action:

• All types of liquid capital assets must be able to be exchanged freely, between any
two nations, with standardized exchange rates.
• The amounts must be a significant amount (in excess of $ 00,000).
• Capital inflows should be invested in semi-liquid assets, to prevent churning and
excessive outflow.
• Institutional investors should not use CAC to manipulate fiscal policy or
exchange rates.
• Excessive inflows and outflows should be buffered by national banks to provide
collateral.

Application
In most traditional theories of international trade, the reasoning for capital account
convertibility was so that foreign investors could invest without barriers. Prior to its
implementation, foreign investment was hindered by uneven exchange rates due to
corrupt officials, local businessmen had no convenient way to handle large cash
transactions, and national banks were disassociated from fiscal exchange policy and
incurred high costs in supplying hard-currency loans for those few local companies that
wished to do business abroad.

Due to the low exchange rates and lower costs associated with Third World nations, this
was expected to spur domestic capital, which would lead to welfare gains, and in turn
lead to higher GDP growth. The tradeoff for such growth was seen as a lack of
sustainable internal GNP growth and a decrease in domestic capital investments. 7

When CAC is used with the proper restraints, this is exactly what happens. The entire
outsourcing movement with jobs and factories going oversees is a direct result of the
foreign investment aspect of CAC. The Tarapore Committee's recommendation of tying
liquid assets to static assets (i.e., investing in long term government bonds, etc) was seen
by many economists as directly responsible for stabilizing the idea of capital account
liberalization.

Controversy
Despite changes in wording over the years, and additional safeguards, there is still
criticism of CAC by some economists. American economists, in particular, find the
restriction on inflows to Third World countries being invested in improvements as
negative, since they would rather see such transactions put to direct use in growing
capital.