Capital Account Convertibility (CAC) means the freedom to convert Rupees to foreign currencies and back for capital transactions i.e. purchase and sale of assets. In other words CAC gives the sanction to convert local financial assets into foreign financial assets at market determined exchange rates and vice versa without the permission of the Central Bank (RBI), thus leading to free exchange of currency at lower rates and an unrestricted mobility of capital.
Thus in the current stream of events, where globalization has become the buzzword and financial liberalization has become synonymous with 'developed economies', the key issue that is to be considered, is whether India is ready to plunge towards CAC. Over the years since 1991, a large number of financial reforms have taken place and a lot of relaxation has been made on controls by RBI in case of Capital Accounts also, but still permission is required for large purchases of capital goods and for External Commercial Borrowings. Suppose one wants to import plant and machinery or invest abroad and needs a large amount of foreign exchange say $10 million, the importer will first have to obtain the permission of RBI. If approved this becomes a "capital account transaction".
CAC is widely regarded as one of the hall marks of a developed economy. It is also seen as a major comfort factor for overseas investors since anytime the local currency can be converted into foreign currency and the money can be repatriated out of India. India presently has Current Account Convertibility, which means that foreign exchange can be easily accessed for import and export of goods and services without restrictions and partial CAC in terms of FDI, portfolio investment etc.
Once a country eases capital controls, typically there is a surge of capital flows, both long term in projects as well as short term in investments. This gives boost to the economy and also rejuvenates the stock markets.CAC is also stated to bring with it greater discipline on the part of the government in terms of reducing excess borrowings and rendering fiscal discipline.
The downside of CAC is the prospect of speculative outflows at short notices which may affect the economy very seriously. Only vibrant economies, having done structural and financial reforms, following sound macro economic policies and considerable amount of foreign exchange reserves should go for CAC. Mexico's currency crisis and the East Asian crisis are examples of the ill effects of CAC.
Significantly India and China are the two most growing countries who still do not have CAC. When questioned on this recently, both the RBI governor and his deputy expressed their views that it is an inescapable choice and India has to go for it in a short number of years to integrate fully with the global economy.