Convertibility Essay ⋆ Business Essay Examples ⋆ EssayEmpire

A currency is convertible when it can be exchanged freely for other currencies (or, in the past, gold). Restrictions on convertibility act as a barrier to international trade and capital flows; similarly, for convertibility to be meaningful, other barriers to trade must come down. Since the 1980s, convertibility has spread rapidly, as a large number of countries reduced or eliminated these barriers.

Since countries can impose several levels of currency controls, economists distinguish between different kinds of convertibility. The main distinctions are between current and capital account convertibility, and external and internal convertibility. Current account convertibility refers to the use of a currency for current account transactions, i.e., international payments for goods and services, interest and dividend payments, and remittances or gifts. Capital account convertibility means the absence of restrictions on international capital flows. External convertibility refers to transactions between residents of a country and nonresidents, while internal convertibility is the right of residents to hold assets denominated in foreign currency and to carry out transactions with them.

During the international gold standard, the major economies of the world maintained convertibility between their national currencies and gold at fixed ratios, and permitted international movements of gold with little interference. The U.S. dollar, for example, was defined as equivalent to 23.22 grains of gold. Issuers of these currencies were obligated to convert them to gold on demand at the defined rate (“par value”), and therefore the currencies were convertible to each other. The beginning of the period is not clearly defined, as various countries adopted the gold standard at different times (Great Britain in 1821, Germany in 1871, France and Switzerland in 1878, the United States in 1879, Japan in 1897).

Before that, these countries had followed either a silver or bimetallic standard, and in principle their currencies were convertible, but convertibility was frequently suspended during wars or financial crises. At the end of the 19th century, however, convertibility at the par value was considered to be a prime goal of monetary policy. The stability and confidence this provided helped the great expansion of international trade and investment during this period, sometimes regarded as the first age of globalization.

The outbreak of World War I in 1914 saw the belligerent countries impose strict trade and currency controls, and the gold standard and convertibility were suspended. During the inter-war period (1918– 39) attempts were made to restore convertibility, but economic instability, high unemployment, and competitive devaluations led to these attempts being less than successful. During World War II, international transactions again came under severe controls, and currencies became inconvertible.

At the end of World War II, the International Monetary Fund (IMF) was established to promote the smooth functioning of the international monetary system. One of its principal objectives was “to assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions which hamper the growth of world trade” (Article 1). Specifically, under Article 8 of the IMF charter, members were to remove restrictions on current account transactions (though such restrictions could be maintained on a temporary basis). Article 6, however, allowed members to regulate international capital movements, since they could be disruptive to the fragile macroeconomic stability of most economies in the immediate postwar period.

For many years, most industrial countries other than the United States and Canada maintained some “temporary” restrictions on current account transactions, particularly for nontrade items. Most developing and centrally planned countries had severe foreign exchange restrictions, and their currencies remained inconvertible.

With inconvertible currencies, international trade often took the form of barter or countertrade. Sometimes this was straightforward—for example, Pepsi Cola’s sale of soft drinks to the Soviet Union in the early 1970s in exchange for vodka. Frequently, it was more complex, like a three-way deal in the 1980s involving the export of cars from Germany to Romania, paid for in jeeps that were sold to Colombia, which paid for the jeeps in coffee and bananas, which were sold to a German supermarket. These transactions, of course, were more difficult to arrange than payment in cash, and inconvertibility was a major barrier to trade.

By the end of the 20th century, the situation had changed considerably, as the benefits of integrating national economies into the global economy became apparent to policy makers. Today, the 23 countries considered “industrial” in the IMF’s classification have no restrictions on the use of their currencies, which are fully convertible externally. Their residents also have almost complete freedom to hold accounts denominated in foreign currency, and therefore their currencies are internally convertible as well.

A majority of developing countries and former centrally planned countries have also accepted the obligations of Article 8, and dismantled currency restrictions on most current account transactions as part of comprehensive liberalization programs. Capital account convertibility has been given lower priority, and is more controversial. While the gains from free trade in goods and services are clear, free flows of capital are seen to have costs as well as benefits. The major benefits to developing countries are more resources and investment (since capital is expected to flow from developed to developing countries), leading to an increase in the standard of living. However there is a potential cost: As recognized in Article 6 of the IMF, macroeconomic stability can be endangered by large inflows of capital, since these would generate inflationary pressures. A second cost, illustrated in the Asian crisis of 1997, is that capital inflows can be reversed quickly, leading to severe dislocations in an economy, and by contagion, in other economies as well. Developing economies, therefore, are proceeding carefully in establishing convertibility in the capital account. Most also restrict residents’ ability to hold foreign currency accounts, because of concerns about dollarization, and thus do not have internal convertibility.

Bibliography:

Bhagwati, “The Capital Myth: The Difference Between Trade in Widgets and Dollars,” Foreign Affairs (1998);
Stanley Fischer, Should the IMF Pursue Capital-Account Convertibility? (International Finance Section, Department of Economics, Princeton University, 1998);
B. Johnston and Mark Swinburne, Exchange Rate Arrangements and Currency Convertibility: Developments and Issues (International Monetary Fund, 1999);
Braga de Macedo, B. Eichengreen, and J. Reis, Currency Convertibility: The Gold Standard and Beyond (Routledge, 1996);
International Monetary Fund, Currency Convertibility and the Fund: Review and Prognosis (IMF, 1996).

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