CAPITAL AND CURRENT ACCOUNT CONVERTIBILITY

ADVICE OF IMF FOR DEVELOPING NATIONS REGARDING CAC

Presented by
MITALI SAGAR
26 APRIL 2025
Currency Convertibility
The legal and economic freedom to convert a domestic currency
into foreign currency (and vice versa) for specific transactions.
Two Key Dimensions:

Current Capital
Account Account
Convertibility Convertibility

Two Types of Convertibility:

Partial Full
convertibility convertibility

Full convertibility on current account (since 1994)

Partial convertibility on capital account (selective FDI, FPI, ECBs allowed)
 Partial convertibility Full convertibility
Restrictions exist on certain No restrictions; free
flows (e.g., capital flows flow of currency for
controlled but trade flows both current and
open) capital transactions

Convertibility vs Exchange Rate

Freedom to convert currency for specific uses Price of one currency in terms of another

Convertibility affects currency demand & supply Exchange rate responds to those forces

Why Currency Convertibility Matters?

Enhances trade, investment, and competitiveness

Improves access to foreign technology, goods, and capital
Signals macroeconomic stability
 Current Account Convertibility
Freedom to convert currency for transactions in goods, services, income, and transfers.

Benefits

Encourages competitive market environment

Exposes domestic firms to international price signals
Increases efficiency by reducing domestic monopolies
Promotes innovation and quality improvements in domestic industry
Facilitates access to modern technology & inputs

Risks (Short Term):

Job losses due to import competition

Real income decline if domestic goods are uncompetitive
Political backlash if reforms cause visible pain
 Capital Account Convertibility
The ability to freely move capital across borders for investment, borrowing, and asset transfers.

Benefits

Attracts foreign direct and portfolio investment

Enables residents to diversify investments globally
Brings foreign management and technology
Can promote access to foreign markets

Risk/Warnings

Can invite capital flight in unstable economies

Increases exchange rate volatility
Can reduce domestic savings available for investment
Premature liberalization may lead to macroeconomic instability
IMF’s Advice to Developing Economies on Capital Account Convertibility

Gradual and Sequenced Liberalization

Ensure Macroeconomic Stability First

Strengthen Institutional and Legal Frameworks

Focus on Attracting Long-Term Capital

Avoid Full Convertibility Before the Economy is Ready

 Gradual and Sequenced Liberalization

Liberalize the current account to boost trade and expose firms to

competition. Ensure Macroeconomic Stability First

Liberalize capital flows selectively, starting with long-term and

productive flows like FDI.

Low and stable inflation

Delay short-term or volatile portfolio flows, which can cause
instability. Sustainable fiscal policy

Stable exchange rates

Avoid Full Convertibility Before the Economy is Ready
Stable government
Risks of early liberalization include

Capital flight (domestic savings moving abroad)

Debt buildup (if inflows are mostly borrowings)

Policy dilemma—what economists call the “impossible

trinity”:
Strengthen Institutional and Legal Frameworks

Reliable legal systems

Transparent investment codes
Efficient financial supervision
Strong infrastructure, including digital and
transportation systems

Focus on Attracting Long-Term Capital

IMF favors:
FDI and technology-oriented flows
(which bring management skills, market access, and
productivity)

It warns against:

Short-term speculative inflows

Tax subsidies to attract capital (as they are distortionary and
inequitable)
Why This Advice is Specifically for Developing Economies
Weak banking and
legal systems
cannot handle
complex capital
Premature openness flows
may cause public
dissatisfaction and
derail reform programs Political and economic
instability amplifies the
risks of open capital
accounts
Small shocks can
cause large
economic
disruptions
 Few Facts

Convertibility increases pressure on:

Exchange rate management

Foreign reserves
Interest rate policy

Most countries delay capital account convertibility until well after

establishing current account convertibility.”

Why?
“The risks of capital account convertibility—such as macroeconomic
volatility and capital flight—often outweigh the benefits in the early stages
of reform.”
 Few Facts

Impossible Trinity:
A country cannot have all three:

1. Fixed Exchange Rate

2. Free Capital Mobility
3. Independent Monetary Policy

Developing economies often sacrifice capital mobility to preserve policy control.

CASE STUDY
 INDIA
ARGENTINA

Gradual and Strategic Liberalization Premature Convertibility and Collapse

Pegged its currency to the U.S. dollar (1:1 parity)
Current account convertibility in 1994.
Maintains partial capital account convertibility.
Rapidly liberalized the capital account without building
institutional or fiscal discipline.
Avoided crises
Stable external sector capital flight.
Gradual integration into global capital markets Ran out of reserves, defaulted on debt in 2001.
Peg collapsed; severe social and economic crisis
followed

CHINA SOUTH KOREA

Controlled Convertibility with Global Integration Crisis, Recovery, and Smart Reforms
1997 Asian Financial Crisis, South Korea faced capital outflows
Liberalised its current account and currency collapse.

Maintains tight capital controls.

Strengthened banking supervision and transparency.
High FDI inflows with limited financial Introduced prudential regulations for capital inflows.
instability.

Became a resilient, high-income economy.

Maintains high capital mobility with robust monitoring.