Capital account convertibility

Also called: CAC, Full convertibility · Topic: Balance of Payments and Exchange Rates · NCERT: Beyond NCERT

Meaning

Capital account convertibility (CAC) is the freedom to convert domestic financial assets into foreign financial assets, and back again, at market-determined exchange rates. For example, you could sell Indian shares and buy US bonds without any limit.

It matters because it decides how freely money for investment and loans can enter or leave India. Free movement brings in foreign capital. It also lets that money leave quickly in a crisis, which makes the rupee fall and drains forex reserves.

Explanation

How it works

• Currency convertibility means you can exchange the rupee for foreign currency at the rate the market sets. It has two levels:
• Current account convertibility covers trade in goods and services, travel, education and remittances (money sent home by Indians working abroad).

• Capital account convertibility goes further. It covers assets and loans that cross the border, such as shares, bonds, property, deposits and foreign borrowing.

• Full CAC means no limits, taxes or approval rules on these asset flows, in either direction.

• Partial CAC means some capital flows are free and others are limited. Countries usually open up step by step.
• Example of a capital account transaction:
• An Indian person uses the Liberalised Remittance Scheme (LRS) to buy shares abroad. This is a capital outflow.
• A foreign fund buys Indian government bonds. This is a capital inflow.
• A trip abroad or paying fees at a foreign university is a current account transaction, not a capital one.

Capital controls: the tools of partial opening

• Capital controls are limits, taxes or approval rules on money that crosses the border. India uses calibrated controls (controls loosened a little at a time):
• ECB limits. ECBs (External Commercial Borrowings) are loans that Indian firms raise from abroad.
• FPI debt limits. These cap how much Foreign Portfolio Investors (foreign funds that buy Indian shares and bonds) can hold in Indian bonds.

• LRS limit. This caps how much a resident individual can send abroad in one financial year.

• When a control is relaxed, the capital account becomes more convertible. One example is the Fully Accessible Route (FAR) for government bonds.

Preconditions: the Tarapore Committees

• The Tarapore Committees (1997 and 2006) said full CAC should come only after India meets these preconditions:
• a low fiscal deficit (the government's borrowing to fill the gap between its spending and its income)
• low inflation
• low bank NPAs (non-performing assets, meaning loans that are not being repaid)

• adequate forex reserves (foreign currency, gold, SDRs and the IMF reserve position held by the RBI)

• Why these conditions? A weak economy with open capital flows is fragile:

• Investors lose confidence and pull money out quickly.
• The rupee falls sharply and reserves drain.
• Banks and firms with foreign loans find them costlier to repay.

Risks of full CAC

• Capital flight: under full CAC, money can leave the country very fast in a crisis.
• Sudden stop: foreign money suddenly stops coming in.
• Lesson from the 1997 East Asian crisis: fast outflows of money pushed down currencies and drained reserves in countries with open capital accounts.
• IMF "institutional view" (2012): the IMF now accepts capital-flow management measures in some conditions, for example during a sudden surge of foreign money. This supports India's step-by-step approach.

In India

• India has only partial CAC. Its capital account opens a little at a time.
• The order of opening was deliberate:
• Current account convertibility came in August 1994, when India accepted IMF Article VIII. Under Article VIII, a country promises not to restrict payments for current international transactions [1].

• The capital account is being opened slowly, keeping the Tarapore preconditions in mind.

• The law: FEMA 1999 (Foreign Exchange Management Act) replaced FERA 1973 and came into force in June 2000 [1].

• FERA's aim was to control scarce forex. Breaking it was a criminal offence.

• FEMA's aim is to make external trade and payments easier. Breaking it is a civil offence, punished with penalties.

• The RBI manages foreign exchange under FEMA and sets the rules for ECBs, FPI limits and the LRS.

• Liberalised Remittance Scheme (LRS): resident individuals can send money abroad for permitted current and capital transactions without RBI approval, using a simple self-declaration [2].
• It began on 4 February 2004 at US$25,000 [2].
• The limit is now US$250,000 per financial year, and it has applied since 26 May 2015 [2].

• Only individuals can use it. Companies, partnership firms, HUFs and trusts cannot, and a PAN is mandatory [2].

• Fully Accessible Route (FAR): in effect from 1 April 2020 [3].

• Non-residents can invest in specified G-secs (government securities) with no FPI investment limit [3].
• All new 5-, 10- and 30-year G-sec issues from 2020-21 were made eligible [3].

• FAR was the first step towards Indian bonds entering global bond indices [3].

• The reserve buffer: total forex reserves were US$625.9 bn on 10 January 2025 [4]. NCERT gives about US$646 bn for 2023-24. In 1991 they were about US$6 bn. Large reserves make gradual opening safer.

Don't confuse with

• Current account convertibility: it covers trade, services and remittances. India has had it in full since August 1994 (IMF Article VIII) [1]. CAC covers assets and loans, and India has it only partially.
• Full convertibility vs partial convertibility: "full convertibility" usually means full CAC as well as current account convertibility. India has full current account convertibility but partial capital account convertibility.
• Floating exchange rate: this is about how the rate is set (by the market). CAC is about what you are allowed to exchange. India has had a market-determined rate since March 1993, under a managed float (the market sets the rate, and the RBI steps in only to smooth sharp swings). Its capital account is still only partly open.
• Tarapore Committee vs Rangarajan Committee: the Tarapore Committees (1997, 2006) dealt with capital account convertibility. The Rangarajan High Level Committee (1993) dealt with the Balance of Payments.

Prelims Hooks

• CAC is the freedom to convert domestic financial assets into foreign financial assets and back at market rates. India has it only partially.
• Tarapore Committee (1997 and 2006) = CAC. Its preconditions were a low fiscal deficit, low inflation, low bank NPAs and adequate forex reserves.
• Current account convertibility came in August 1994, when India accepted IMF Article VIII [1]. (Trap: it was not Article XIV, and not 1991.)
• LRS: individuals can send money abroad for both current and capital transactions, up to US$250,000 per financial year [2]. It began in 2004 at US$25,000, and companies, firms, HUFs and trusts cannot use it [2].
• Fully Accessible Route (FAR) (from 1 April 2020): no FPI limit on specified G-secs [3]. It was a step towards joining global bond indices [3].
• FEMA 1999 (in force June 2000) replaced FERA 1973. FEMA is civil; FERA was criminal [1].

Mains Points

• Why India sequenced convertibility:
• India opened the current account first (1994), because trade needs it.
• It is opening the capital account slowly, only as the Tarapore preconditions are met.

• This step-by-step approach protected India in the 1997 East Asian crisis and in 2008. Full CAC can bring capital flight and sudden stops. The IMF's 2012 institutional view also supports temporary capital-flow management measures.

• Benefits vs risks of opening further:

• LRS, FAR and bond-index inclusion bring in foreign capital, lower borrowing costs and give Indians more choice of where to invest.
• But they also tie India to global interest-rate cycles. Money can leave quickly when rates rise abroad.

• The lesson of 1991 is that a sustainable current account deficit, financed by stable flows such as FDI, is safer than depending on short-term, fickle money.

• The impossible trinity:

• A country cannot have all three at once: a free capital account, a stable exchange rate and an independent monetary policy.
• As India opens its capital account, the RBI must hold large reserves (over US$600 bn in 2025) [4] and carry out costly sterilisation (the RBI selling bonds to soak up the extra rupees it created when buying dollars).
• Keeping CAC partial gives India room to protect both rupee stability and monetary independence.

Related concepts

• Currency convertibility
• Current account convertibility
• Capital controls
• Liberalised Remittance Scheme

Read more

• India's 1991 BoP crisis and the road to a convertible rupee