Currency Convertibility

Currency Convertibility
See also

Currency Convertibility is the ability of residents and nonresidents to exchange domestic currency for foreign currency and to use foreign currency in real or financial transactions. This implies the absence of restrictions on the making or receipt of payments for international transactions and on the exchange of local for foreign currency for those purposes. There are, however, may degrees of convertibility depending on the restrictions imposed by the government on the exchange of currency. A basic distinction can be made for these purposes between the current and capital account transactions.

For the Fund's purposes, current account convertibility refers to the absence of any restrictions on the making of payments and transfers for current international transactions (that is, all current account transactions and a few capital transactions). Full convertibility of a currency means that there are no payments (or receipts) restrictions either on the current or the capital account[1].

Current Account Convertibility

Establishing current account convertibility within an environment of liberal trade regulations can introduce a new degree of freedom into the economy, particularly in countries that have been characterized by central planning. In the absence of prohibitive quantitative restrictions on imports, current account convertibility can allow individuals a much greater choice of consumption items by simplifying and expanding the opportunity to purchase goods and services from abroad. This can lead to significant increases in consumption and consumer satisfaction in the short run, particularly where the output of domestic industries has in the past been unable to satisfy consumer demands. It may also promote domestic output by improving access to production inputs and modern technology.

Current account convertibility can help create such an environment, insofar as it exposes domestic producers to competition from abroad and helps introduce the relative prices for different goods prevailing on world markets. The strength of this competition depends not only on whether domestic currency is convertible for current account transaction but, more broadly, on the overall scope and nature of trade restrictions[2].

Degrees of Currency Convertibility and the Effect on Transactions

Table shows four entries on a convertibility scale[3]:

Degrees of Currency Convertibility
Total convertibility Article convertibility Limited convertibility Total inconvertibility
Trade no exchange or trade restrictions no exchange restrictions; possible trade restrictions possible exchange and trade restrictions comprehensive exchange and trade restrictions
Invisibles no exchange or invisibles restrictions no exchange restrictions; possible invisibles restrictions possible exchange restrictions; no invisibles restrictions comprehensive exchange and invisibles restrictions
Capital transactions no restrictions possible restrictions possible restrictions comprehensive restrictions
Convertible into all currencies yes no necessarily no no
Convertible into some defined set of currencies not applicable not applicable yes not applicable

Moves Toward Currency Convertibility

Moves toward greater currency convertibility have been associated with the adoption of more flexible, market-based exchange rates[4]:

  • First, as countries eliminated exchange restrictions on payments and transfers for current international transactions and liberalized capital movements, conditions were created for the development of domestic foreign exchange markets where exchange rates could be determined in a more flexible manner in response to supply and demand conditions.
  • Second, the elimination of exchange restrictions and in particular multiple exchange rates in itself often involved the adoption of market-determined exchange rates.
  • Third, many countries support their pegged exchange rates through administered constraints on the sale of export proceeds and have abandoned pegged exchange rates as they eliminate such constraints

Footnotes

  1. V. Galbis 1996, p.125
  2. J.E. Greene, P. Isard 2000, p.4-5
  3. J.B. McLenaghan, S.M. Nsouli, K. Riechel 2011, p.24
  4. R. B. Johnston, M. Swinburne 2010, p.38-39

References

Author: Ewa Szczyrbak