[Economy Q] Capital and Current Account Convertibility brief explanation

QUESTIONS

1. Current account & capital account : What does that mean?
2. Current & capital account convertibility.
3. Which account is permanent & which is reversible & why?
4. Full capital account convertibility : Pros and cons
5. On which account government needs to keep close eye?

I composed the post in MS Word, but this blog-spot is not preserving the text-format, charts and tables properly. So Elaborate answer is in the PDF : CLICK ME TO DOWNLOAD (700kb)

#1: WHAT IS CURRENT AND CAPITAL ACCOUNT?

• In an open economy, we buy stuff from abroad (Import), We sell stuff to abroad.(export)
• Similarly Indians invest abroad, foreigners invest in India.
• So lot of money incoming and outgoing.
• Current and Capital accounts are nothing but method of classifying that incoming and outgoing money.
As you know, Balance of Payment (bop) = Import – Export.
This BoP is calculated under two heads: Current Account and Capital Account.

*more in pdf*

#2. CURRENT AND CAPITAL ACCOUNT CONVERTIBILITY ?

• Convertibility = converting one currency into another. Like rupee to dollar, yen to pound…anything.
• Since money is incoming and outgoing. People will need to convert the money into different currencies based on their requirements.
• We classified the incoming and outgoing money into Current and Capital account.
• Similarly we classify the procedure involved in converting that money. In brief


*more in pdf*

#3. Which account is permanent & which is reversible & why?

• Current account =Money sent and received during import and export
• You sold something (exported) and received the money, so that money is yours forever (until you spend it on something else!) So Current account is permanent and irreversible.
• Capital account = Money sent and received during investment and borrowing.
• Suppose Japanese guy buys factory in India (capital account), sells it after 5 years and takes back the money. So Capital account inflow is NOT PERMANENT and hence reversible (because he took back the money he invested in India).

#4. FULL CAPITAL ACCOUNT CONVERTIBILITY PRO AND CONS

As we saw above, we don’t have full capital account convertibility in India.

ARGUMENT IN FAVOR OF FULL CAPITAL ACCOUNT CONVERTIBILITY

• It facilitates foreign investments and borrowing. So competition is increased = more factories = more jobs = more product choices for consumers = good for economy. :)

ARGUMENTS AGAINST OF FULL CAPITAL ACCOUNT CONVERTIBILITY

Local producers have to compete with International giants. So they lose market and customers :(

• (Counter-argument#1: Business is about survival of the fittest, so perform or perish, ain’t no need to get sentimental about Swadeshi. Why should consumer pay for ‘not-so-good’ quality yet expensive product from a local man, if a foreigner is offering better stuff at cheaper quality?)
• (Counter argument#2: If a few Indians lose the customers, many more Indians get jobs in those new factories started by foreigners.

What if foreigners buy lot of factories in India and suddenly they find that investing money in France is better than in India. So they immediately sell all those factories, get their Rupees converted into Euro and run away! That’ll lead to huge job loss and collapse in Indian economy!

• (Counter argument#1: It’s a two way street: if Foreigners can do that, Indians can also do it while investing abroad.
• (Counter argument#2: Sudden outflow of money happens only when governing institutions have weak foundations and policies. [For example, when Government is busy firefighting Sugar-Onion prices without any long-term vision, it makes cronies get involved in speculative business] If every country has sound economic policies, then it’ll be attractive to invest in every country. Then there will be no sudden outflow or inflow of money in any country and hence no-one will be misusing the full capital account convertibility.

#5.On which account government needs to keep close eye?

Sorry I don’t know that exact answer. Government needs to keep an eye on both accounts to make changes in trade policies, tax rates etc. But since Capital account inflows come with a risk (of sudden outflow collapsing the economy), so Government should keep a close eye on Capital account.