The capital account, takes into account cross-border flow of funds that are associated with financial or other assets in the trading countries. For example, the direct and portfolio investments made by foreign investors, in India, are captured by the capital account balance of the BOP. The capital account also encompasses foreign investments of Indian companies, foreign aid and bank deposits of Non-resident Indians (NRI).
Capital account convertibility implies the right to transact in financial and other assets with foreign countries without restriction. For example, if a currency is convertible on the capital account, the residents of the domestic currency may freely convert it into other (convertible) currencies to purchase and maintain bank accounts abroad. Similarly, residents of other countries should also be able to freely convert their currencies into the domestic currency to purchase domestic capital and money market instruments. In other words, capital account convertibility is associated with the vision of free capital mobility.
Convertibility as an issue, and subsequently as a goal, was a priority in the agenda of the member countries of the International Monetary Fund (IMF) which was born out of the Bretton Woods Agreement. During the Bretton Woods period, "the term convertibility [was] used in two different contexts: convertibility into gold and convertibility into other currencies. Only the United States maintained gold convertibility during Bretton woods. Convertibility into other currencies for current account transaction purposes was a main goal of Bretton Woods and was reached, to a large extent, early on in the system; however, the agreements to the IMF allowed more flexibility with regard to the imposition of exchange controls on capital account transactions. The flexibility was partly a result of a prevailing feeling that short-run speculative capital flows could be potentially destabilising and governments should have the freedom to resist.
Owing to other reasons, developing countries have historically not had convertible currencies. Typically, their currencies have been partially convertible on the current account and the capital of the BOP, the rationale for the choice being embedded in the macroeconomic realities and the policy perspectives of the countries concerned. In India, the rupee was made convertible on the current account in August 1994. However, the currency as yet has limited convertibility on the capital account. The biggest test faced by the then Indian Finance Minister P. Chidambaram during the annual budget of 2006 was, whether to make the rupee fully convertible before the government's term expired in 2009. With the Indian central bank holding $140 billion as reserves in 2006, more than double the $59 billion level in 2002, it was the time the Finanance Minister should have acted on his own advice and announced a timeframe for residents to take money out freely and invest overseas. Most international investors could then buy and sell Indian assets at will. This will help companies which are not permitted to directly invest in Indian Stocks to move money in and out of India with the help of offshore derivative securities. But this is again a government economic policy which is closely related to the Budget of the country. The first of its trial to make the Rupee convertible on the capital account came in the year 1997 under the panel chaired by S. S. Tarapore, former deputy governor of RBI. The plan was to make the Rupee convertible on the capital account within 3 years. The report was perfectly crafted, but the timing was inappropriate with the beginning of Asian currency crisis. Since the Asian crisis even the IMF has taken a formal stance on this issue of “financial globalization”. CAC (Capital Account Convertibility) for Indian Economy refers to the abolition of all limitations with respect to the movement of capital from India...