Currency Convertibility

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.

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.

Degrees of Currency Convertibility and the Effect on Transactions

Table shows four entries on a convertibility scale:

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:

• 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

Types of Currency Convertibility

• Full Convertibility: This is the highest level of currency convertibility and refers to the unrestricted ability to convert domestic currency into foreign currency and vice versa. This means that there are no restrictions on the movement of capital across borders and payment for goods and services can be made in either currency. For example, in the European Union, all member states have full convertibility of the Euro currency.
• Partial Convertibility: This refers to the situation where certain restrictions are imposed on the convertibility of a currency. This can include restrictions on the amount of currency that can be converted at any given time or restrictions on the types of transactions that can be made in foreign currency. For example, in India, the Rupee is only partially convertible, with residents of India only able to convert limited amounts of currency for certain types of transactions.
• Crawling Peg: This is a type of currency convertibility where the exchange rate between two currencies is adjusted periodically by a small amount. This allows the exchange rate to remain relatively stable while still allowing some flexibility in the conversion process. For example, the Chinese Yuan has a crawling peg with the US Dollar, with the exchange rate adjusted every few months in order to keep it relatively stable.

Advantages of Currency Convertibility

One of the key advantages of currency convertibility is its ability to facilitate international trade and investment. Here are some of the benefits of currency convertibility:

• Increased economic efficiency: Currency convertibility allows for improved pricing of goods and services as well as greater competition, resulting in more efficient allocation of resources and improved overall economic growth.
• Expansion of international trade and investment: Currency convertibility facilitates access to foreign markets and increases the flow of international capital, expanding the opportunities for businesses and investors.
• Improved liquidity: Currency convertibility allows for more efficient flows of capital and liquidity among countries, reducing the risk of financial volatility and crisis.
• Reduced risk of financial crisis: Countries with freely convertible currencies are less likely to experience sudden financial shocks, as investors have more confidence in their currencies.
• Increased foreign direct investment: Currency convertibility makes it easier for investors to make foreign investments, leading to increased foreign direct investment (FDI) into the country.

Limitations of Currency Convertibility

Currency convertibility has some limitations, which include:

• Capital Controls - Capital controls are restrictions imposed by a government on the movement of capital in and out of a country. These controls can include limits on foreign exchange transactions and restrictions on the purchase of foreign assets.
• Exchange Rate Policy - Exchange rate policy is the set of principles used by a government to determine the value of its currency relative to other currencies. Governments may use various tactics to devalue their currency, such as setting arbitrary exchange rates, imposing tariffs, or manipulating the money supply.
• Political Uncertainty - Political uncertainty can make it difficult for individuals and businesses to convert their domestic currency into foreign currency. This is because political instability can often lead to economic volatility, making it more difficult to accurately value a currency.
• Inflation - Inflation can also make it difficult to convert currency because the value of a currency is constantly changing. If a currency experiences high inflation, it may be difficult to determine the true value when exchanging it for foreign currency.

Other approaches related to Currency Convertibility

• Exchange Rate Regime: This is a policy that determines the exchange rate of a currency and the mechanism by which the exchange rate is adjusted. It can be either fixed or floating depending on the government’s policy. A floating exchange rate is determined by the forces of supply and demand in the market while a fixed exchange rate is determined by the government.
• Capital Controls: These are measures taken by a government to regulate the movement of capital flowing in and out of a country. These measures can include restrictions on transactions, such as minimum and maximum limits on the amount of foreign capital that can enter or exit a country.
• Currency Swap: This is an agreement between two parties to exchange two different currencies for a certain period of time at a predetermined exchange rate. This is often used to help countries manage their foreign exchange reserves and finance international trade.
• Monetary Policy: This is a policy set by the central bank of a country to manage the money supply, interest rates, and inflation. It is used to maintain the stability of the economy and to help achieve economic objectives such as price stability, full employment, and economic growth.

Each approach has its own advantages and disadvantages, and the best approach will depend on the country’s economic and political situation.

Footnotes

Currency Convertibility — recommended articles

Fixed exchange rate — Price stability — Open economy — Emerging market economy — Money emission — Capital flow — Global demand — Floating exchange rate system — Foreign exchange reserves

References

• Galbis V., (1996), Currency Convertibility and the Fund, International Monetary Fund, London.
• Greene J.E., Isard P., (2000), Currency Convertibility and the Transformation of Centrally Planned Economies, International Monetary Fund, Washington.
• Johnston R.B., Swinburne M., (2010), Exchange Rate Arrangements and Currency Convertibility, International Monetary Fund, Washington.
• McLenaghan J.B., Nsouli S.M., Riechel K., (2011), Currency Convertibility in the Economic Community, International Monetary Fund, Washington.

Author: Ewa Szczyrbak