A country is said to have attained full convertibility of its currency when residents and non-residents are allowed to convert the currency, at prevailing exchange rates, into foreign currencies and to use the latter freely for international transactions. However, it should be remembered that an open capital account does not necessarily mean unfettered capital account liberalisation, and in practice some capital controls and significant prudential regulations are consistent with capital account convertibility (CAC).

Even though capital account convertibility stimulated rapid growth in the 1990s, it was also revealed that the same mechanisms of convertibility could result in a massive withdrawal of capital, which eventually led to the East Asian meltdown in 1997, the Brazilian crisis in 1998-99, and the fall of the Argentine currency in 2001, among others.

After the crises, many economists argued that globalisation had gone too far and called for the return of capital controls. Even the IMF, which once advocated movement towards full convertibility, now cautions developing countries to move gradually. Although empirical investigation of the impact of capital account liberalisation on growth has produced mixed results, the mainstream view is that it can be beneficial when countries move in tandem with a strong macroeconomic policy framework, sound financial system and markets, facilitated by prudential regulatory and supervisory policies.

In Nepal, there has been a growing debate pertaining to the country’s move towards a CAC regime especially after the release of the Report of the Committee on Fuller Capital Account Convertibility by the RBI in 2006. The Committee had proposed that India shift to fuller CAC in five years under three phases: 2006-07 (phase I), 2007-08 and 2008-09 (phase II) and 2009-10 and 2010-11 (phase III).

Certain invaluable lessons can be drawn from the experiences of the emerging market economies, especially those of India. First capital account liberalisation should be viewed as a process and not an event and needs to be maintained in line with other reforms. Priority needs to be accorded to FDI in comparison to short-term flows. Furthermore, the speed and sequencing of liberalisation has to be responsive to domestic developments and political stability is indispensable for the success of reforms.In the process of gradual liberalisation of capital account, Nepal has already initiated a host of measures. However, although foreign investment in Nepal is permitted in almost all the sectors, the Nepali individuals/institutions are not permitted to invest abroad as per the “Ban on Nepali Investment in Foreign Countries Act 1965.” Another issue is the exchange rate as the Nepali rupee is pegged to the Indian currency. Experiences of many EMEs demonstrate that countries were forced off pegs after sudden reversals of capital flows under open capital accounts (for example, Mexico at the end of 1994, Thailand in July 1997, and Brazil in early 1999).

First of all, the Trade Policy of 1992 is obsolete in the globalisation context. Again, market and product concentrations of exports have led to volatile export growth. The third issue concerns the current account which has been experiencing continuous surplus for the last six years.

Based on the experiences of emerging market economies, some possible preconditions for fuller capital account convertibility can be enumerated: a) the move towards fuller CAC needs to be undertaken in measured steps commensurate with the strengthening of the financial system; b) the NPAs of the banking system should be lowered to below 5.0 percent; c) exchange rate management in the perspective of fuller CAC requires skillful and delicate operations; d) some external sector reform measures should be pursued to instil competitiveness ; e) a comprehensive database should be set up together with regular reporting of accurate information on capital transactions; f) being a least developed country, the current account position should be sustainable; g) official reserves should cover at least seven months of merchandise and service imports; h) the country has to craft a mechanism for achieving an inflation rate not too far out of alignment with inflation rate in India; i) for a small open economy like Nepal, the budget deficit of the government should be contained below 3 per cent of GDP.

Overall, it is crucial to approach capital account liberalisation as an integral part

of more comprehensive programs of economic reform, coordinated with appropriate macroeconomic and exchange rate policies, and including policies to strengthen financial markets and institutions. Priority should be accorded to the proper sequencing of the reforms and, more specifically, what supporting measures need to undertaken.

Pant is deputy director, Research Dept, Nepal Rastra Bank