Advantages and Disadvantages of Capital Account Convertibility

Capital account convertibility is a debatable topic because many people think that it is good for the economy while others think that it is detrimental to the economy. Under capital account convertibility regime a foreign national can convert the foreign currency into domestic currency and also he or she can freely buy and sell the assets like real estate, stocks, bonds and so on. As far as domestic national are concerned they can also convert domestic currency into foreign currency and buy and sell assets freely abroad. In order to understand this concept better let’s look at some of the advantages and disadvantages of capital account convertibility –

Advantages of Capital Account Convertibility

  1. The first and foremost advantage of capital account convertibility is that it helps the currency of the country because due to capital convertibility being implemented foreign investors feel free to invest in the country resulting in glut of foreign currency flowing into the country and due to foreign currency inflows the currency of the country appreciate against the foreign currencies. Hence as far currency is concerned capital account convertibility initially is a boon and indirectly helps the imports of the country getting cheaper because appreciation in currency results in imports of the country getting cheaper.
  2. Another advantage of capital account convertibility is that it helps in increasing the confidence of the foreign investors as they can freely buy and sell assets and also convert the domestic currency into foreign currency anytime they want which results in an improved outlook for the economy of the country by the foreign investors.
  3. As far as domestic companies and individuals are concerned they also benefit from capital convertibility because they also can invest in the foreign countries so if an individual wants to take advantage of opportunities in foreign country due to fall in price of stock or real estate or other asset classes in foreign countries then they can easily do it under capital convertibility regime and on the other side domestic companies can also borrow funds from foreign countries if the rate of interest is on the lower side. So for example the rate of interest on borrowings in developing nations like India is 10 percent to 14 percent whereas in developed countries like the USA it is between 3 to 5 percent, capital account convertibility results in companies taking advantage of this huge gap between the rate of interest between developing and developed nations.

Disadvantages of Capital Account Convertibility

  1. The biggest disadvantage of capital account convertibility is that it exposes the country to the volatility of global world markets hence if anything happens globally it will have repercussions in the domestic markets also even if the domestic economy has no or little relation to global events. For example in the year 2008 Lehman brothers crisis was related to United States of America but it affected all the financial markets and if country has adopted full capital account convertibility then it could lead to panic like situation because in case of global problem foreign investors would withdraw large sums of money leading to pressure on currency of the country and in worst cast scenario it can lead to complete collapse of the currency.
  2. Another disadvantage of it is that it may lead to inflation in the domestic economy because due to opening up of economy money flows into the economy and when excess money chases goods or assets it leads to inflation as supply of goods or assets in any country is limited, although moderate inflation is good for the economy excessive inflation leads to many other problems both for people as well as government of the country.
  3. Another limitation of capital account convertibility is that it can result in bubble like situation in asset classes, so for example in case of housing market if there is no capital account convertibility then only domestic investors who really require the house for living would buy hence the demand for housing will be real whereas if capital account convertibility is implemented then foreign investors would buy house as an investment looking to sell it for profit leading to artificial rise in price as demand is not real creating a bubble like situation and we all know that bubbles eventually burst and when they burst it affects many innocent investors.

As one can see from the above that capital account convertibility has both advantages and disadvantages and country looking for adopting capital account convertibility should carefully examine the pros and cons and then take the decision as this decision will have long-term implication on the economy of the country.

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