These transactions are broadly divided into two heads – current account and capital account. 
 

The current account covers exports and imports of goods and services, factor income such as interests received or paid, as well as dividends and unilateral transfers like remittances. 

The capital account records the net change in foreign assets and liabilities held by a country. The capital account tracks the movement of capital between two countries via investments and loans. This includes all kinds of investment assets like shares, debt, and property, or even corporate assets. 

What is Current account convertibility and Capital account convertibility?

Convertibility refers to the ability to convert domestic currency into foreign currencies and vice versa to make payments for balance of payments transactions. 
 

Current account convertibility is the ability or freedom to convert domestic currency for current account transactions. In other words, it means that anyone can convert any amount of foreign currency into domestic currency and domestic currency into foreign currency for trade and transfer purposes.
 

On the other hand, Capital account convertibility is the ability or freedom to convert domestic currency for capital account transactions. A fully convertible capital account, or internationalisation of the rupee, would mean there is no restriction on the amount of rupees one can convert into a foreign currency to buy an asset overseas. Similarly, there would be no restraints on overseas investors to bring in dollars or acquire assets in India.

The Tarapore Committee (2006), for instance, defined capital account convertibility as the “freedom to convert local financial assets into foreign financial assets and vice versa.”

The degree of convertibility of a country usually depends on the level of its economic development and degree of maturity of its financial markets. Therefore, advanced economies (AEs) are almost fully convertible while emerging market economies (EMEs) are convertible to different degrees.

India has full current account convertibility but a partially convertible capital account. This means the rupee can be freely converted into foreign currency and vice versa for current account transactions but is restricted for for capital account purposes. 

Over the years, steps have been taken to increase capital account convertibility such as the introduction of the Fully Accessible Route for foreign portfolio investors (FPI) in government securities.

For Indians looking to invest abroad, the cap on how much they can invest overseas every year has been raised gradually under the Liberalised Remittance Scheme (LRS) and now stands at $250,000 a person per year.

Currently, India has a partially convertible capital account policy. This is because an individual or high net-worth investor wanting to invest outside India can invest within an overall limit of $250,000 per financial year under the Liberalised Remittance Scheme for any permitted current or capital account transaction or a combination of both. This means, they can make investments to the tune of up to $500,000 in a calendar year.

The scheme, however, is not available to corporates, partnership firms, HUF, Trusts, etc.

Therefore, if India removes this limit on capital account transaction, it would have a fully convertible account, ideally raising outflow limits for HNIs.

A fully convertible capital account provides three key benefits. These are stock market returns, reduction in transaction cost due to free rupee convertibility, and improvement in savings and investments which effectively accelerates growth. 

Why is capital account convertibility important?

Free capital mobility will also lead to internationalization of rupee will lead to the broadening of the investor base for recipient country financial assets, improved liquidity in financial markets and positive pressures for market infrastructure and market practices. 
 

It will enable the access to a global savings pool and to different currencies, which can potentially reduce borrowing costs, facilitate better risk allocation and enhance global liquidity.

However there are risks too. The various currency and banking crises experienced over the last few decades have also highlighted the costs and risks of internationalization such as exposure to global shocks, credit and asset bubbles, exchange rate volatility associated with sudden exit of capital.

External sector liberalisation started in India with the economic liberalisation process that commenced in the early nineties – moving to a a floating exchange rate regime and freeing up current account transactions. The enactment of the Foreign Exchange Management Act, 1999 codified this arrangement with relatively free current account transactions (except for a negative list) and controlled capital account transactions.

Liberalisation in this context basically meant gradually freeing up capital account transactions. Over the last two decades, FDI has become more or less unrestricted except (i) for some sectoral caps and (ii) restrictions in a few socially sensitive (e.g., gambling) or volatile (e.g., real estate) or strategic (e.g., atomic energy) sectors.