Convertibility is the quality that allows money or other financial instruments to be converted into

other liquid stores of value. Convertibility is an important factor in international trade, where
instruments valued in different currencies must be exchanged.
[1]

Definition of 'Currency Convertibility'
The ease with which a country's currency can be converted into gold or another
currency. Convertibility is extremely important for international commerce. When a
currency in inconvertible, it poses a risk and barrier to trade with foreigners who have no
need for the domestic currency.

Investopedia explains 'Currency Convertibility'
Government restrictions can often result in a currency with a low convertibility. For
example, a government with low reserves of hard foreign currency often restrict
currency convertibility because the government would not be in a position to intervene in
the foreign exchange market (i.e. revalue, devalue) to support their own currency if and
when necessary.

Read more: http://www.investopedia.com/terms/c/convertibility.asp#ixzz2GA7JHQf7
Currency trading
Freely convertible currencies have immediate value on the foreign exchange market, and few
restrictions on the manner and amount that can be traded for another currency. Free
convertibility is a major feature of a hard currency.
[citation needed]

Some countries pass laws restricting the legal exchange rates of their currencies, or requiring
permits to exchange more than a certain amount. Some currencies, such as the North Korean
won, the Transnistrian ruble and the Cuban national peso, are officially nonconvertible and
can only be exchanged on the black market. If an official exchange rate is set, its value on the
black market is often lower.
[2]

Convertibility controls may be introduced as part of an overall monetary policy. For example,
restrictions on the Argentine peso were introduced during an economic crisis in the 1990s,
and scrapped in 2002 during a subsequent crisis.
[3]

[edit] Commodity money

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(May 2010)
See also: Commodity money
Convertibility first became an issue of significance during the time banknotes began to
replace commodity money in the money supply. Under the gold and silver standards, notes
were redeemable for coin at face value, though often failing banks and governments would
overextend their reserves.
Historically, the banknote has followed a common or very similar pattern in the western
nations. Originally decentralized and issued from various independent banks, it was gradually
brought under state control and became a monopoly privilege of the central banks. In the
process, the fact that the banknote was merely a substitute for the real commodity money
(gold and silver) was gradually lost sight of.
Under the gold exchange standard, for example the Bretton Woods Institutions, banks of
issue were obliged to redeem their currencies in gold bullion, or in United States Dollars-
which in turn were redeemable in gold bullion at an official rate of $35/troy ounce. Due to
limited growth in the supply of gold reserves, during a time of great inflation of the dollar
supply, the United States eventually abandoned the gold exchange standard and thus bullion
convertibility in 1974.
Under the contemporary international currency regimes, all currencies' inherent value derives
from fiat, thus there is no longer any thing (gold or other tangible store of value) for which
paper notes can be redeemed.
Currency convertibility
Convertibility of a currency determines the ability of an individual, corporate or government
to convert its local currency to another currency or vice versa with or without central
bank/government intervention. Based on the above restrictions or free and readily
conversion features currencies are classified as:
Fully Convertible - When there are no restrictions or limitations on the amount of
currency that can be traded on the international market, and the government does
not artificially impose a fixed value or minimum value on the currency in international
trade. The US dollar is an example of a fully convertible currency and for this reason,
US dollars are one of the major currencies traded in the FOREX market.

Partially Convertible - Central Banks control over international investments flowing
in and out of the country, while most domestic trade transactions are handled without
any special requirements, there are significant restrictions on international investing
and special approval is often required in order to convert into other currencies. Indian
Rupee is an example for partially convertible currency.

Nonconvertible - Neither participate in the international FOREX market nor allow
conversion of these currencies by individuals or companies. As a result, these
currencies are known as blocked currencies. e.g.: North Korean Won and the Cuban
national Peso
Currencies history
Early currency

Currency evolved from two basic innovations, both of which had occurred by 2000 BC.
Originally money was a form of receipt, representing grain stored in temple granaries in
Sumer in ancient Mesopotamia, then Ancient Egypt.

This first stage of currency, where metals were used to represent stored value, and symbols
to represent commodities, formed the basis of trade in the Fertile Crescent for over 1500
years. However, the collapse of the Near Eastern trading system pointed to a flaw: in an era
where there was no place that was safe to store value, the value of a circulating medium
could only be as sound as the forces that defended that store. Trade could only reach as far
as the credibility of that military. By the late Bronze Age, however, a series of international
treaties had established safe passage for merchants around the Eastern Mediterranean,
spreading from Minoan Crete and Mycenae in the northwest to Elam and Bahrain in the
southeast. Although it is not known what functioned as a currency to facilitate these
exchanges, it is thought that ox-hide shaped ingots of copper, produced in Cyprus may have
functioned as a currency. It is thought that the increase in piracy and raiding associated with
the Bronze Age collapse, possibly produced by the Peoples of the Sea, brought this trading
system to an end. It was only with the recovery of Phoenician trade in the ninth and tenth
centuries BC that saw a return to prosperity, and the appearance of real coinage, possibly
first in Anatolia with Croesus of Lydia and subsequently with the Greeks and Persians. In
Africa many forms of value store have been used including beads, ingots, ivory, various
forms of weapons, livestock, the manilla currency, ochre and other earth oxides, and so on.
The manilla rings of West Africa were one of the currencies used from the 15th century
onwards to buy and sell slaves. African currency is still notable for its variety, and in many
places various forms of barter still apply.

Coinage

These factors led to the shift of the store of value being the metal itself: at first silver, then
both silver and gold. Metals were mined, weighed, and stamped into coins. This was to
assure the individual taking the coin that he was getting a certain known weight of precious
metal. Coins could be counterfeited, but they also created a new unit of account, which
helped lead to banking. Archimedes' principle provided the next link: coins could now be
easily tested for their fine weight of metal, and thus the value of a coin could be determined,
even if it had been shaved, debased or otherwise tampered with.

In most major economies using coinage, copper, silver and gold formed three tiers of coins.
Gold coins were used for large purchases, payment of the military and backing of state
activities. Silver coins were used for midsized transactions, and as a unit of account for
taxes, dues, contracts and fealty, while copper coins represented the coinage of common
transaction. This system had been used in ancient India since the time of the
Mahajanapadas. In Europe, this system worked through the medieval period because there
was virtually no new gold, silver or copper introduced through mining or conquest.[citation
needed] Thus the overall ratios of the three coinages remained roughly equivalent.

Paper money

In premodern China, the need for credit and for circulating a medium that was less of a
burden than exchanging thousands of copper coins led to the introduction of paper money,
commonly known today as banknotes. This economic phenomenon was a slow and gradual
process that took place from the late Tang Dynasty (618907) into the Song Dynasty
(9601279). It began as a means for merchants to exchange heavy coinage for receipts of
deposit issued as promissory notes from shops of wholesalers, notes that were valid for
temporary use in a small regional territory. In the 10th century, the Song Dynasty
government began circulating these notes amongst the traders in their monopolized salt
industry. The Song government granted several shops the sole right to issue banknotes, and
in the early 12th century the government finally took over these shops to produce state-
issued currency. Yet the banknotes issued were still regionally valid and temporary; it was
not until the mid 13th century that a standard and uniform government issue of paper money
was made into an acceptable nationwide currency. The already widespread methods of
woodblock printing and then Bi Sheng's movable type printing by the 11th century was the
impetus for the massive production of paper money in premodern China.

At around the same time in the medieval Islamic world, a vigorous monetary economy was
created during the 7th12th centuries on the basis of the expanding levels of circulation of a
stable high-value currency (the dinar). Innovations introduced by Muslim economists, traders
and merchants include the earliest uses of credit,[4] cheques, promissory notes,[5] savings
accounts, transactional accounts, loaning, trusts, exchange rates, the transfer of credit and
debt,[6] and banking institutions for loans and deposits.[6]

In Europe, paper money was first introduced in Sweden in 1661. Sweden was rich in copper,
thus, because of copper's low value, extraordinarily big coins (often weighing several
kilograms) had to be made.

The advantages of paper currency were numerous: it reduced transport of gold and silver,
and thus lowered the risks; it made loaning gold or silver at interest easier, since the specie
(gold or silver) never left the possession of the lender until someone else redeemed the
note; and it allowed for a division of currency into credit and specie backed forms. It enabled
the sale of stock in joint stock companies, and the redemption of those shares in paper.

However, these advantages held within them disadvantages. First, since a note has no
intrinsic value, there was nothing to stop issuing authorities from printing more of it than they
had specie to back it with. Second, because it increased the money supply, it increased
inflationary pressures, a fact observed by David Hume in the 18th century. The result is that
paper money would often lead to an inflationary bubble, which could collapse if people
began demanding hard money, causing the demand for paper notes to fall to zero. The
printing of paper money was also associated with wars, and financing of wars, and therefore
regarded as part of maintaining a standing army. For these reasons, paper currency was
held in suspicion and hostility in Europe and America. It was also addictive, since the
speculative profits of trade and capital creation were quite large. Major nations established
mints to print money and mint coins, and branches of their treasury to collect taxes and hold
gold and silver stock.

At this time both silver and gold were considered legal tender, and accepted by governments
for taxes. However, the instability in the ratio between the two grew over the course of the
19th century, with the increase both in supply of these metals, particularly silver, and of
trade. This is called bimetallism and the attempt to create a bimetallic standard where both
gold and silver backed currency remained in circulation occupied the efforts of inflationists.
Governments at this point could use currency as an instrument of policy, printing paper
currency such as the United States Greenback, to pay for military expenditures. They could
also set the terms at which they would redeem notes for specie, by limiting the amount of
purchase, or the minimum amount that could be redeemed.

By 1900, most of the industrializing nations were on some form of gold standard, with paper
notes and silver coins constituting the circulating medium. Private banks and governments
across the world followed Gresham's Law: keeping gold and silver paid, but paying out in
notes. This did not happen all around the world at the same time, but occurred sporadically,
generally in times of war or financial crisis, beginning in the early part of the 20th century and
continuing across the world until the late 20th century, when the regime of floating fiat
currencies came into force. One of the last countries to break away from the gold standard
was the United States in 1971.

No country anywhere in the world today has an enforceable gold standard or silver standard
currency system.

Banknote era

A banknote (more commonly known as a bill in the United States and Canada) is a type of
currency, and commonly used as legal tender in many jurisdictions. With coins, banknotes
make up the cash form of all money. Mostly paper, Australia's Commonwealth Scientific and
Industrial Research Organisation developed the world's first polymer currency in the 1980s
that went into circulation on the nation's bicentenary in 1988. Now used in some 22 countries
(over 40 if counting commemorative issues), polymer currency dramatically improves the life
span of banknotes and prevents counterfeiting.

Sushanta Mallick
A former Research Fellow in International Economics, Royal Institute of International
Affairs, London.
Full profile
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Is India Ready for Full Currency Convertibility?

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CommentsView/Create comment on this paragraphIndia's political boldness in seeking peace with
Pakistan in their half-century twilight struggle for Kashmir may soon be matched by economic moves
equally as daring. Indeed, India is edging toward a truly bold reform: full international convertibility of
the rupee. How it goes about this will not only effect India's economic development, but provide object
lessons for China as it ponders convertibility in the years ahead.
CommentsView/Create comment on this paragraphSince 1991 India has been travelling on a path from
rupee devaluation to full convertibility, with the Reserve Bank of India (RBI) relaxing a range of foreign-
exchange controls. Resident Indians can now maintain a foreign-currency account and invest in shares
of foreign companies, while non-resident Indians can repatriate legacy/inheritance assets. Indian
companies listed abroad can buy property in foreign countries, and resident firms will be allowed to pre-
pay external commercial debt up to US$100 million. Limits on exporters' foreign-currency accounts will
be removed, and banks may invest in overseas money and debt markets.
CommentsView/Create comment on this paragraphIs India ready for full convertibility? The government
is still lagging on its domestic economic reforms. Structural reform and privatization have slowed,
eroding investors' confidence. But failure to address structural problems could expose the economy to
external shocks in the long term.
CommentsView/Create comment on this paragraphHence it would be premature for India to open up its
capital account immediately. Exchange rate stability is the key anchor when a country's reform process
is underway. There is, however, little evidence that capital account convertibility has a meaningful
impact on a country's growth rate.
CommentsView/Create comment on this paragraphWith capital-account convertibility, the rupee's
exchange rate will be determined more by capital flows than by inflation differentials, as India's inflation
rate remains broadly in line with the OECD average of around 3%. Because India is still running a trade
deficit, there could be some pressure on the rupee following any negative shock. Although monetary
growth is more than twice the rate of real GDP growth, the inflationary risk is probably low because
substantial excess capacity exists. Indeed, throughout the 1990s, despite rising output, deflation
occurred, which means that India's potential output is expanding.
CommentsView/Create comment on this paragraphThe moves towards full capital-account convertibility
have proceeded in step with impressive growth in India's foreign-currency reserves. Indeed, India's
external liquidity position has strengthened dramatically in the past decade. As a result of a current-
account surplus and an interest-rate differential of 3-4%, foreign reserves reached $70.3 billion by the
end of 2002--enough to cover almost 15 months of imports--up from only US$4 billion in 1990.
CommentsView/Create comment on this paragraphFollowing the 1991 balance of payments crisis, the
rupee's exchange rate was devalued around 20%. Exporters could exchange 30% of their earnings at
the market rate. This was subsequently replaced with a two-tier exchange-rate system making the
rupee partially convertible--60% of export earnings could be converted at the market exchange rate,
and the rest at the RBI's fixed rate (used by the government to finance essential imports like petroleum,
cooking oil, fertilizers, and life-saving drugs).
CommentsView/Create comment on this paragraphThe two-tier exchange-rate system acted as an
export tax, but it did not survive for long, giving way to a unified exchange rate on the trade account.
Full convertibility on the current account followed in August 1994. The policy debate then turned to
capital-account convertibility, with the IMF and the World Bank strongly in favor. In May 1997, the
Tarapore Committee on Capital Account Convertibility charted a three-stage liberalization process to be
completed by 1999-2000, with an accompanying emphasis on fiscal consolidation, a mandated inflation
target, and a strong financial system.
CommentsView/Create comment on this paragraphThen the East Asian currency crisis put further action
on hold and raised serious questions about when--and whether--to proceed. The sudden meltdown of
apparently healthy economies served as a stark reminder that strong external liquidity should not be the
driving force towards full convertibility. The downside risk of capital-account liberalization, after all, is
higher exchange-rate volatility, and even countries with sound liquidity positions could not prevent a run
on their reserves.
CommentsView/Create comment on this paragraphThe lesson for India is that, in the event of a
domestic or external shock, full convertibility could prove to be a costly, short-lived experiment. The
fundamental question is whether full convertibility will encourage higher net inflows or outflows of
capital.
CommentsView/Create comment on this paragraphThe downside risk of higher volatility for the rupee is
aggravated by some serious problems, including a deficit running at 6% of GDP and the strategic stand-
off with Pakistan. Short-term capital outflows--which might occur should either risk worsen--could create
greater output volatility. So it is vital for India to increase the inward flow of long-term capital,
regardless of whether the capital account is closed or open.
CommentsView/Create comment on this paragraphIn this context, it is noteworthy that China, with a
closed capital account, has foreign-exchange reserves of US$286 billion, four times the size of India's,
though China's economy is only double India's size. Nor is full convertibility the key to attracting higher
inflows of foreign direct investment (FDI). China attracted FDI inflows of US$52.7 billion in 2002--the
largest in the world.
CommentsView/Create comment on this paragraphIndia needs to attract higher FDI inflows to help soak
up the economy's excess capacity. This underscores the importance for India's financial stability of
successful management of the capital account (monitoring inflows and outflows) following any move
toward full convertibility. But, in the near term, full capital account convertibility is not in India's
interest.

Read more at http://www.project-syndicate.org/commentary/is-india-ready-for-full-currency-
convertibility-#7Rxm5JpGWjAsePsh.99
http://www.currency.org/convertibility.html


cac means .....
In India, the foreign exchange transactions (transactions in dollars, pounds, or any other currency)
are broadly classified into two accounts: current account transactions and capital account
transactions. If an Indian citizen needs foreign exchange of smaller amounts, say $3,000, for
travelling abroad or for educational purposes, she/he can obtain the same from a bank or a money-
changer. This is a "current account transaction". But, if someone wants to import plant and machinery
or invest abroad, and needs a large amount of foreign exchange, say $1 million, the importer will have
to first obtain the permission of the Reserve Bank of India (RBI). If approved, this becomes a "capital
account transaction". This means that any domestic or foreign investor has to seek the permission
from a regulatory authority, like the RBI, before carrying out any financial transactions or change of
ownership of assets that comes under the capital account. Of course there are a whole range of
financial transactions on the capital account that may be freed form such restrictions, asis the case in
India today. But this is still not the same as full capital account convertibility.

By "Capital Account Convertibility" (or CAC in short), we mean "the freedom to convert the local
financial assets into foreign financial assets and vice-versa at market determined rates of exchange. It
is associated with the changes of ownership in foreign/domestic financial assets and liabilities and
embodies the creation and liquidation of claims on, or by the rest of the world. " (Report of the
Committee on Capital Account Convertibility, RBI, 1997) Thus, in simpler terms, it means that
irrespective of whether one is a resident or non-resident of India one's assets and liabilities can be
freely (i.e. without permission of any regulatory authority) denominated (or cashed) in any currency
and easily interchanged between that currency and the Rupee.

Capital Account Liberalization and the IMF
Barry Eichengreen and Michael Mussa
Capital account liberalization may have substantial benefits, but recent experience
also underscores its risks. How should liberalization be sequenced and managed to
ensure that the benefits dominate?

The growth of international financial transactions and international capital flows is
one of the most far-reaching economic developments of the late twentieth century
and one that is likely to extend into the early twenty-first century. Net flows to
developing countries tripled, from roughly $50 billion a year in 198789 to more
than $150 billion in 199597, before declining in the wake of the Asian crisis.
Gross flows to developing countries and more generally have grown even more
dramatically, rising by 1,200 percent between 198488 and 198994. An
increasing number of IMF member countries have removed restrictions on capital
account transactions in an effort to take advantage of the opportunities afforded by
this remarkable rise in international financial flows.
But these developments, as the official community has acknowledged, raise
important questions about the role of the IMF in financial liberalization. In
September 1996, the Interim Committee (the committee of finance ministers and
central bank governors that reviews IMF activities) requested the IMF Executive
Board to analyze trends in international capital markets and examine possible
changes to the IMF's Articles of Agreement so that the organization could better
address the issues raised by the growth of international capital flows. In April
1997, the Interim Committee agreed that there would be benefits from amending
the Articles to enable the IMF to promote the orderly liberalization of capital
movements. It reiterated this position in a statement issued at the Annual Meetings
of the World Bank and the IMF in Hong Kong SAR the following September.
This idea that the IMF should actively promote the liberalization of capital flows
has not gone unchallenged. In the wake of the Asian crisis, which has seen sharp
reversals of capital flows for a number of countries, officials and academics alike
have questioned how desirable capital account liberalization is and whether it is
advisable to vest the IMF with responsibility for promoting the orderly
liberalization of capital flows.
Growth of capital flows
Powerful forces have driven the rapid growth of international capital flows.
Prominent among these are
the removal of statutory restrictions on capital account transactions, which is a
concomitant of economic liberalization and deregulation in both industrial and
developing countries;
macroeconomic stabilization and policy reform in the developing world, which
have created a growing pool of commercial issuers of debt instruments;
the multilateralization of trade, which has encouraged international financial
transactions designed to hedge exposure to currency and commercial risk; and
the growth of derivative financial instrumentssuch as swaps, options, and
futureswhich has permitted international investors to assume some risks while
limiting their exposure to others.
Above all, technology has played a role. Revolutionary changes in information and
communications technologies have transformed the financial services industry
worldwide. Computer links enable investors to access information on asset prices
at minimal cost on a real-time basis, while increased computer power enables them
rapidly to calculate correlations among asset prices and between asset prices and
other variables. Improvements in communications technologies enable investors to
follow developments affecting foreign countries and companies much more
efficiently. At the same time, new technologies make it increasingly difficult for
governments to control either inward or outward international capital flows when
they wish to do so. All this means that the liberalization of capital marketsand,
with it, likely increases in the volume and the volatility of international capital
flowsis an ongoing and, to some extent, irreversible process with far-reaching
implications for the policies that governments will find it feasible and desirable to
follow.
It is important to recognize that financial innovation and liberalization are
domestic, as well as international, phenomena. Not only have restrictions on
international financial transactions been relaxed, but regulations constraining the
operation of domestic financial markets have been removed as countries have
moved away from policies of financial repression. Domestic and international
financial liberalization have generally gone hand in hand. Both respond to many of
the same incentives and pressures.
Costs and benefits
Capital mobility has important benefits. In particular, it creates valuable
opportunities for portfolio diversification, risk sharing, and intertemporal trade. By
holding claims onthat is, lending toforeign countries, households and firms
can protect themselves against the effects of disturbances that impinge on the home
country alone. Companies can protect themselves against cost and productivity
shocks in their home countries by investing in branch plants in several countries.
Capital mobility can thereby enable investors to achieve higher risk-adjusted rates
of return. In turn, higher rates of return can encourage increases in saving and
investment that deliver faster rates of growth.
At the same time, however, in a significant number of countries, financial
liberalization, both domestic and international, appears to have been associated
with costly financial crises. This association may be somewhat deceptive, given
that financial crises are complex events with multiple causes and have occurred in
less liberalized as well as more liberalized financial systems. Still, there have been
enough cases where financial liberalization, including capital account
liberalization, has played a significant role in crises to raise serious questions about
whether and under what conditions such liberalizationparticularly capital
account liberalizationwill be beneficial rather than harmful.
At the theoretical level, the controversy over the benefits of financial liberalization
reflects diverging views on whether liberal financial markets bring about an
efficient allocation of resources or are so distorted that the benefits they yield to
direct participants too often are detrimental to the general welfare. Although a
large "efficient markets" literature argues the first hypothesis, others insist that
asymmetric informationa situation in which one party to a transaction has less
information than the otherpervades financial markets, and that this greatly
undermines their efficiency as mechanisms for allocating resources. There is,
moreover, good reason to think that asymmetric information is particularly
prevalent internationally, because geography and cultural distance complicate the
acquisition of information. While the revolution in information and
communications technologiesby reducing economic distancehas a profound
effect in stimulating international financial transactions, it also leaves international
marketswhere information asymmetries are attenuated but not eliminated
particularly prone to the sharp investor reactions, unpredictable market
movements, and financial crises that can occur when information is incomplete and
financial markets behave erratically.
Role of policy
These developments make it critical to accompany financial liberalization with
appropriate policies to limit excess volatility and related problems and to contain
their potentially damaging effects. As has long been recognized, sound
macroeconomic policies are essential for maintaining financial stability. A
liberalized financial system is more demanding in this respect than a repressed
system in which large financial imbalances may be suppressed for long periods.
Recent experience, however, highlights the fact that macroeconomic stability,
while necessary, is not sufficient for financial stability, which also requires sound
financial sector policies.
The first line of defense against financial risk must be sound risk management by
market participants themselves. Banks and nonbank financial intermediaries must
manage their balance-sheet risks prudently. Corporate borrowers must recognize
and manage risks appropriately, which requires a strong system of corporate
governance. Any tendency to take on excessive risk can be contained through
market discipline facilitated by the adoption of best-practice accounting, auditing,
and disclosure standards. An appropriate environment can be created by adopting
policies that mandate proper accounting, auditing, and reporting rules and by
taking care not to form a culture of implicit guarantees, so that lenders will face
significant capital losses if they fail to assess credit risk prudently.
When risk-management techniques are not well developed, auditing and
accounting practices leave much to be desired, and other distortions interfere with
the ability of banks and others to manage risk, prudential regulation has an
especially important role. The argument for prudential regulation is reinforced
when central banks and governments backstop financial markets and provide a
financial safety net that can encourage banks and other market participants to take
on excessive risk. A century and more of experience points to the need, in most
countries, for central banks to provide lender-of-last-resort services to prevent
illiquid financial markets from seizing up in periods of general distress. This
backstopping function, though essential, is also a source of moral hazard. The
appropriate response for national authorities is rigorous prudential supervision and
regulation combined with careful design of the lender-of-last-resort facility to limit
the scope and incentives for financial market participants to take on excessive risk.
More generally, pursuing policies to develop a financial system that relies less
heavily on banks and other intermediaries and involves more direct risk bearing by
ultimate investors can help to reduce the risks of costly crises and moral hazard.
Policies toward the capital account
The most serious problems with international capital movements occur when
capital flows out of a country suddenly, precipitating a crisis. While sudden capital
outflows can affect all forms of capitaldebt, portfolio equity, and even direct and
real estate investmentthe macroeconomic consequences are particularly serious
when they involve debt, especially sovereign debt and banking and financial
system debt. Recent experience suggests, moreover, that short-term debt can pose
special problems for maintaining financial stability.
Like other risks, those posed by holdings of short-term debt are best controlled at
the source. The sovereign can and should control its own borrowing. Banks and
nonbank borrowers can and should avoid excessive dependence on short-term,
foreign-currency-denominated debt. Banks should develop in-house models with
which to manage risk, and the national authorities can refer to these when
calculating risk weights for capital requirements (as recommended by the 1996
Market Risk Amendment to the Basle Capital Accord). But where risk-
management techniques are underdeveloped or significant financial market
distortions exist, there is an argument for additional prudential measures to identify
and discourage excessive short-term, especially foreign-currency-denominated,
borrowing that could jeopardize systemic stability.
Prudential regulations to contain the risks associated with capital flows have been
designed and implemented in several ways. Many countries have addressed the
risk to the stability of the banking system mainly by limiting banks' open net
foreign currency positions (a net open position is the difference between unhedged
foreign currency assets and liabilities, typically expressed as a percentage of the
bank's capital base), while other countries (such as Chile and Colombia) have
sought to discourage excessive foreign exposures of domestic corporations and
banks by taxing essentially all short-term capital inflows. Some countries
differentiate reserve requirements for banks according to both the residency and
currency of denomination of deposits, while others differentiate according to
currency of denomination but not residency.
There need not be a conflict between these policies and the objective of capital
account liberalization, defined as freedom from prohibitions on transactions in the
capital and financial accounts of the balance of payments. Indeed, the analogy with
current account convertibility is direct. Article VIII of the IMF's Articles of
Agreement, which defines current account convertibility as freedom from
restrictions on the making of payments and transfers for current international
transactions and makes this an explicit objective of IMF policy, does not proscribe
the imposition of such price-based restrictions as import tariffs and taxes on
underlying transactions. Correspondingly, capital account convertibility means the
removal of foreign exchange and other controls, but not necessarily all tax-like
instruments imposed on the underlying transactions, which need not be viewed as
incompatible with the desirable goal of capital account liberalization.
Exchange rate flexibility can also help to discourage excessive reliance on short-
term foreign borrowing. There have recently been a number of episodes in which
an exchange rate peg has been seen by both lenders and borrowers as a link in a
chain of implicit guarantees. In these circumstances, the high nominal interest rates
characteristic of emerging markets can lead to very large short-term capital
inflows. The exchange risk associated with greater nominal exchange rate
flexibility can play a useful, if limited, role in moderating the volume of these
short-term flows. It can encourage banks and firms to hedge their short-term
foreign exposures, which insulates them from the destabilizing effects of
unexpectedly large exchange rate movements. Greater exchange rate flexibility is
no panacea, however; if introduced suddenly, without advance planning, and in a
setting where banks and corporations have heavy debts denominated in foreign
currency, its effects can be destabilizing. But if the authorities take advantage of a
period of capital inflows to introduce greater flexibility, so that the exchange rate
begins its more flexible life by strengthening, the beneficial effects are likely to
dominate.
Sequencing
The most important point to recognize in the sequencing of capital market
liberalization is the danger of precipitously removing restrictions on capital
account transactions before major problems in the domestic financial system have
been addressed. Among the problems under this heading are
inadequate accounting, auditing, and disclosure practices in the financial and corporate
sectors that weaken market discipline;
implicit government guarantees that encourage excessive, unsustainable capital inflows;
and
inadequate prudential supervision and regulation of domestic financial institutions and
markets, which open the way for corruption, connected lending, and gambling for redemption
(namely, the pursuit of high-return but low-probability investments by institutions with low
or negative net worth).
Countries in which these problems are severe but that suddenly and fully open the capital
account run the risk of incurring a serious crisis. This implies that countries should liberalize
the capital account gradually, at the same time as they make progress in eliminating these
distortions.
In addition, liberalization that is limited to inflows to and through the banking system can
pose considerable risks, even for a well-prepared and well-regulated system, if these flows
are substantial. Liberalization of capital inflows should thus proceed on as broad a front as
possible, beginning with direct investment inflows in order to avoid overloading channels
more vulnerable to sudden reversals.
While foreign direct investment sometimes raises concerns about foreign ownership and
control, there is considerable evidence that economic benefits, including the transfer of
technology and efficient business practices, are associated with such investment. Volatility in
flows of direct investment does not appear to generate the same acute problems of financial
crises as do sharp reversals of debt flows. For this reason, liberalization of inward direct
investment should generally be an attractive component of a broader program of
liberalization. Such liberalization need not occur all at once; for countries that face the
prospect of large surges of inward investment, a gradual approach may be advisable. It
generally makes little difference if foreign investment is limited in some selected sectors of
the economy. The financial sector, however, is an important exception. Opening domestic
financial markets to participation by foreign (or multinational) financial institutions is an
integral element of full capital market liberalization. There can be important benefits,
especially for smaller countries, from the diversification of risks that is made pos-sible when
banks can operate across national boundaries.
Conclusion
Capital account liberalization and financial liberalization more generally are inevitable for
countries that wish to take advantage of the substantial benefits from participating in the open
world economic system in today's age of modern information and communications
technologies. As recent events have again demonstrated, however, financial liberalization
also has its dangers. As liberalized systems afford opportunities for individuals, enterprises,
and financial institutions to undertake greater and sometimes imprudent risks, they create the
potential for systemic disturbances. There is no way to completely suppress these dangers
other than through draconian financial repression, which is more damaging. But they can be
limited considerably: sound macroeconomic policies to contain aggregate financial
imbalances and to ameliorate the effects of financial disturbances can be combined with
sound prudential policies designed to ensure proper private incentives for risk management,
especially in the financial sector. With these safeguards, orderly and properly sequenced
capital account liberalization and the broader financial liberalization of which it is part are not
only inevitable but clearly beneficial.
http://www.imf.org/external/pubs/ft/fandd/1998/12/eichen.htm

cac means .....
In India, the foreign exchange transactions (transactions in dollars, pounds, or any other currency)
are broadly classified into two accounts: current account transactions and capital account
transactions. If an Indian citizen needs foreign exchange of smaller amounts, say $3,000, for
travelling abroad or for educational purposes, she/he can obtain the same from a bank or a money-
changer. This is a "current account transaction". But, if someone wants to import plant and machinery
or invest abroad, and needs a large amount of foreign exchange, say $1 million, the importer will have
to first obtain the permission of the Reserve Bank of India (RBI). If approved, this becomes a "capital
account transaction". This means that any domestic or foreign investor has to seek the permission
from a regulatory authority, like the RBI, before carrying out any financial transactions or change of
ownership of assets that comes under the capital account. Of course there are a whole range of
financial transactions on the capital account that may be freed form such restrictions, asis the case in
India today. But this is still not the same as full capital account convertibility.

By "Capital Account Convertibility" (or CAC in short), we mean "the freedom to convert the local
financial assets into foreign financial assets and vice-versa at market determined rates of exchange. It
is associated with the changes of ownership in foreign/domestic financial assets and liabilities and
embodies the creation and liquidation of claims on, or by the rest of the world. " (Report of the
Committee on Capital Account Convertibility, RBI, 1997) Thus, in simpler terms, it means that
irrespective of whether one is a resident or non-resident of India one's assets and liabilities can be
freely (i.e. without permission of any regulatory authority) denominated (or cashed) in any currency
and easily interchanged between that currency and the Rupee.