II Concepts of Convertibility and Stages of Monetary Integration
- Saleh Nsouli, John McLenaghan, and Klaus-Walter Riechel
- Published Date:
- August 1982
This chapter considers concepts of convertibility and the meaning of convertibility under different exchange arrangements. It also reviews the benefits and costs of various stages of monetary integration.
Meaning of Convertibility
Currency convertibility can be defined as the ability to exchange one currency for another at a given conversion rate and in terms of the usability of a currency for foreign transactions. Various degrees of convertibility can be identified, ranging from the extremes of total cnvertibility to total inconvertibility. Total convertibility refers to the unrestricted exchange of the currency of a country into all other currencies without limitation on the usability of the currency for any foreign transaction. This would be achieved if the country had no exchange controls or restrictions vis-à-vis the rest of the world, as well as no quantitative or financial barriers to external transactions. By contrast, total inconvertibility refers to the complete inability, de facto and de jure, to exchange the currency of a country into any other currency or to use it for any foreign transaction. This would be the situation in a country that had instituted exchange controls and restrictions and/or quantitative or financial barriers that completely cut off all external transactions. Along this spectrum, the degree of convertibility of a currency can be identified by the effectiveness of exchange controls and restrictions and of quantitative or financial barriers to external transactions.
A currency may therefore have different degrees of convertibility vis-à-vis other currencies, depending on the ease with which it can be converted and the extent to which it can be used for foreign transactions. In practice differing degrees of exchangeability and usability of currencies define a currency’s degree of convertibility. In this context and for the purposes of this study, “limited convertibility” refers to the unrestricted exchange and use of the currencies of countries within a region, as would be the case if all exchange controls and exchange restrictions within the region were eliminated.6
Under the Second Amendment of the Fund’s Articles of Agreement, which became effective April 1, 1978, the concepts of “a convertible currency” and “currency convertible in fact” disappeared.7 Nevertheless, “it remains a purpose of the Fund that members should undertake to perform the obligations of convertibility under Article VIII, among which the obligations relating to market convertibility are of leading importance.”8
In the context of Article VIII, Section 4(a), the convertibility of foreign-held balances is determined by the condition that:
Each member shall buy balances of its currency held by another member if the latter, in requesting the purchase, represents:
that the balances to be bought have been recently acquired as a result of current transactions, or
that their conversion is needed for making payments for current transactions.
The buying member shall have the option to pay either in special drawing rights, subject to Article XIX, Section 4, or in the currency of the member making the request.
There are a number of conditions under which this obligation does not apply. In terms of Article VIII, Section 4(b), they do not apply when:
the convertibility of the balances has been restricted consistently with Section 2 of this Article or Article VI, Section 3;
the balances have accumulated as a result of transactions effected before the removal by a member of restrictions maintained or imposed under Article XIV, Section 2;
the balances have been acquired contrary to the exchange regulations of the member which is asked to buy them;
the currency of the member requesting the purchase has been declared scarce under Article VII, Section 3(a); or
the member requested to make the purchase is for any reason not entitled to buy currencies of other members from the Fund for its own currency.
The Commentary in the Proposed Second Amendment to the Articles of Agreement: A Report by the Executive Directors to the Board of Governors (IMF, Washington, March 1976) points out that these provisions would not be operative in a period of market convertibility.
The requirements for satisfying the conditions of Article VIII, Section 4, differ in at least three respects from the requirements for total convertibility. First, under Article VIII a currency is not necessarily exchangeable for the currency of any other country. What is involved is a commitment on the part of each Fund member to buy any balances of its own currency acquired by another member, subject to various provisions, in special drawing rights (SDRs) or in the currency of the country requesting payment. Second, the amounts presented for conversion are limited to those acquired through current transactions. Amounts acquired through capital transactions are not covered under Article VIII, nor will any controls on capital transactions result in a violation of the convertibility of foreign-held balances in the sense defined by the Fund. Third, since Article VIII refers only to exchange restrictions, it follows that quantitative or financial barriers, such as tariffs or surcharges, export taxes, levies on transfers, export or import quotas, do not violate the convertibility of foreign-held balances according to Article VIII.9
The Second Amendment introduced the concept of a “freely usable currency.” This is defined in Article XXX(/): “A freely usable currency means a member’s currency that the Fund determines (i) is, in fact, widely used to make payments for international transactions, and (ii) is widely traded in the principal exchange markets.” This definition applies, of course, to the operations of the Fund.10 From an economic point of view, a “freely usable currency,” as defined, may be regarded as involving a type of convertibility that relates closely to the importance of the currency in international transactions.
Table 1 shows four entries on a convertibility scale. In principle, there could be an infinite number of gradations of convertibility. For illustrative purposes, the four entries shown in Table 1 indicate how the gradations of convertibility can be entered into the matrix.
|Trade||No exchange or trade restrictions||No exchange restrictions; possible trade restrictions||Possible exchange and trade restrictions 1||Comprehensive exchange and trade restrictions|
|Invisibles||No exchange or invisibles restrictions||No exchange restrictions; possible invisibles restrictions||Possible exchange restrictions; 1 no invisibles restrictions 1||Comprehensive exchange and invisibles restrictions|
|Capital transactions||No restrictions||Possible restrictions||Possible restrictions||Comprehensive restrictions|
|Convertible into all currencies||Yes||Not necessarily||No||No|
|Convertible into some defined set of currencies2||Not applicable||Not applicable||Yes||Not applicable|
Only vis-à-vis countries outside the region. No exchange restrictions would be applicable within the region.
The defined set of currencies would be the regional currencies.
Only vis-à-vis countries outside the region. No exchange restrictions would be applicable within the region.
The defined set of currencies would be the regional currencies.
Some concepts of convertibility are meaningful only under very special conditions. For example, the concept of limited convertibility, as defined above, refers to the unrestricted exchange and use of the currencies within a region. If the countries of an economic community maintain exchange restrictions of varying intensity (and thus have currencies with differing degrees of convertibility), the dismantling of all exchange restrictions on intracommunity transactions in order to establish limited convertibility would have important implications for the overall balance of payments positions of the individual countries.
Differing degrees of convertibility of currencies, as indicated by the restrictiveness of the exchange system, generally reflect differences in the magnitude of a country’s balance of payments problem. Payments deficits, if sustained over a period, normally result in an increasingly overvalued currency. When there is a move toward limited convertibility and all obstacles to exchange transactions within the region are removed, the community as a whole becomes effectively one market in terms of exchange transactions. In this situation, transactors will seek to move out of overvalued currencies into other regional currencies whose exchange rates reflect more accurately the underlying price relationships. Typically, the latter currencies are those of countries having the least severe exchange restrictions and thus the most pressure to keep prices in line with those in world markets. A dismantling of exchange restrictions within the region would therefore be accompanied by a move into the regional currencies that have the highest degree of convertibility. In other words, the highly convertible currencies act as a conduit for the external transactions of the community as a whole, with negative consequences for the balance of payments of countries with weak currencies.
To avoid such problems in establishing limited convertibility, the regional group of countries must adopt a uniform degree of convertibility vis-à-vis the rest of the world. Therefore, countries with highly restrictive exchange systems would be expected to achieve the same degree of liberalization as the least restrictive countries. This uniform degree of convertibility can be termed “full convertibility,” which would be assumed to lie somewhere between convertibility under Article VIII and total convertibility. Accordingly, when one (or more than one) country in the region eliminates exchange restrictions for transactions vis-à-vis all other countries, or is totally free of such restrictions, it will be necessary for all other countries of the region to completely dismantle their exchange restrictions.
Convertibility to any degree is compatible with any form of exchange arrangements, the latter being defined as the exchange rate system by which the value of the home currency is determined vis-à-vis foreign currencies. Various forms of exchange arrangements are open to each individual country: (1) a flexible arrangement involving a managed or independent float; (2) pegging to the SDR; (3) pegging to another basket of currencies; or (4) pegging to an individual currency. Article IV, Section 2(b), of the Fund’s Articles states:
Under an international monetary system of the kind prevailing on January 1, 1976, exchange arrangements may include (i) the maintenance by a member of a value for its currency in terms of the special drawing right or another denominator, other than gold, selected by the member, or (ii) cooperative arrangements by which members maintain the value of their currencies in relation to the value of the currency or currencies of other members, or (iii) other exchange arrangements of a member’s choice.
Not all forms of exchange rate systems would be available to countries upon their entry into a monetary union, which is generally identified by two characteristics that are expected to be of a permanent nature: (1) the currencies of all member countries should be fully convertible within the union; and (2) a fixed exchange rate should be established between the currencies of the member countries, or one currency should be issued for all union members.
Table 2 shows the degree of compatibility between exchange arrangements for individual countries and the possible exchange arrangements under a monetary union. The monetary union may choose any of the four exchange arrangements listed above, since the union would be considered as one country by the rest of the world. These four arrangements are shown as options 3, 4, 5, and 6 in the compatibility matrix. Options 1 and 4 are closely linked since, if all currencies peg to the SDR, there would automatically be a fixed relationship between their currencies. Similarly, options 2 and 6 are virtually identical, with some qualification. No allowance is made for differences that may arise as a result of the setting of margins around a peg. For example, if countries within the monetary union pegged their currencies to the SDR within a margin of, say, +2 per cent for each currency, the system would differ from one in which currencies within the union were pegged to one another with no margins and were allowed simultaneously to fluctuate by 2 per cent around the SDR. Also, if a fixed exchange rate is established among currencies of members as a result of individual decisions to peg to the SDR or to a common currency, there would be no assurance of permanence in the cross rates between those currencies.
|Exchange Arrangements in a|
|Floating||Peg to a|
|Peg to a currency basket||0||0||0||0|
|Common currency peg||0||0||0||2|
|Peg currencies to one another at predetermined rates||3||5||4||6|
Zero means no compatibility.
Zero means no compatibility.
Preconditions for Convertibility and Gradations of Monetary Cooperation
The process of monetary integration can be viewed as the movement from a situation where each country or subset of countries within a region has its own separate currency and exchange arrangement, with differing degrees of convertibility, to one where all countries within a region share a common currency and, consequently, a unified exchange arrangement. The move toward monetary integration should be a gradual one in order to ensure that the costs of such a move are minimized while the benefits are maximized. As noted above, the establishment of limited convertibility would cause balance of payments problems unless full convertibility is established for all the currencies in the region vis-à-vis the rest of the world. Accordingly, the preconditions for monetary integration need to be carefully set forth. They relate essentially to measures needed to achieve full convertibility vis-à-vis the rest of the world for the currencies of the countries that are expected to enter into a monetary union. Since differences in the degree of convertibility or inconvertibility of currencies in the region generally reflect differences in the external positions of those countries, policies of adjustment would have to be adopted by each country to restore balance of payments equilibrium. For the most part, in the preconditions phase there would be little need for harmonization of current policies as the balance of payments problems of each country would be different.
The policy instruments to be used for adjustment are the traditional ones of demand and supply management, tailored to the specific situation in each country and having a specific time horizon. The imbalance in the external sector can be addressed by appropriate exchange rate changes, accompanied by measures to restrain the growth in demand while stimulating the growth in supply. Monetary, fiscal, incomes, and investment policies can be brought to bear upon aggregate demand and supply, in accordance with the institutional arrangements and the economic and social priorities of the country, in order to achieve a reasonable degree of external balance.
Depending on the extent of imbalance in the external sector, adjustment may be both sizable and prolonged and the measures to be taken over a particular period may require a major effort. During the program period the country would seek to liberalize its exchange system progressively so that, upon the complete dismantling of restrictions, it would achieve full currency convertibility, both de jure and de facto.
With the establishment of full convertibility, countries in the region could commence the process of monetary integration in stages, which can be viewed as gradations of monetary cooperation. Three phases of integration can be specified, in which the participating countries first could enter into a convertibility agreement, to be followed by the establishment of a partial monetary union and then by the institution of a full monetary union. Under a convertibility agreement, each country would be allowed to continue its own exchange arrangement, as long as it agreed to exchange without restrictions the currency of any other country in the region at rates to be determined by the cross rates between that currency and the rate prevailing between each currency and that of the reference (or intervention) currency. For purposes of discussion in the next section, it is assumed that countries in the region would not select a uniform exchange arrangement under such a convertibility agreement. In the second phase, a partial monetary union would come into being when, in addition to the convertibility agreement, irrevocably fixed exchange rates are established between the currencies of the members of the community. In such a union, a unified exchange rate arrangement for the community as a whole must be selected, but each country would maintain its own currency and its separate monetary authority. The final phase would involve a full monetary union in which individual currencies within the region were abolished and replaced by a single currency issued by one central monetary authority.
A Convertibility Agreement
In order to assess the benefits and costs associated with a convertibility agreement, it is assumed that the preconditions for full convertibility have been satisfied and that the external position of the countries is in approximate balance, permitting them to eliminate all exchange and other restrictions on external transactions without undue pressures on their foreign exchange reserves. Each country would maintain its own exchange arrangement.
One important benefit from a convertibility agreement is the long-run potential for expansion of trade. In the short and medium term, trade is determined primarily by the production structure and by infrastructural facilities. However, the move toward full convertibility of currencies would encourage traders to look across regional boundaries for new trading opportunities, thereby leading to the development of more diversified production structures for meeting regional demand and to the improvement of infrastructural regional facilities. Over time, intraregional trade should increase both relatively and in absolute terms.
Full convertibility under a convertibility agreement would also have a beneficial effect on investment within the region because of the overall improvement in resource allocation. When assured of the convertibility of currencies in the region, investors would seek investment opportunities with the highest return in various countries and, by doing so, contribute to more efficient resource utilization. To the extent that they perceive the region as a whole as a potential market (only possible if the currencies are convertible), investors would direct their investments into projects designed to meet the demands of the region. Furthermore, the improved allocation of resources should result not only from the movement of capital but also from the setting of the exchange rate at or near its equilibrium level in order to achieve convertibility. As a result, investment decisions would be based on the appropriate price indicators. The improvement in resource allocation, together with the accelerated investment within the region, would thus lead to an acceleration in the growth rate of the region.
Another probable beneficial effect of full convertibility is a reduced need for foreign exchange reserves. If full convertibility requires a country to maintain an exchange rate consistent with external balance, the need for surplus reserves to support a disequilbrium exchange rate would be eliminated.11
The costs of full convertibility arise mainly from the constraints on the conduct of economic policy. The flexibility of the exchange rate as a policy instrument is greatly reduced because the rate must be determined in light of current market conditions. For developing countries undergoing rapid structural changes, it may be inappropriate to do this. In this respect, a distinction can be drawn between short-run and long-run equilibrium exchange rates. Although the short-run rate equilibrates the current account position of the country, a currency depreciation that may be required for this purpose could interfere with the investment efforts of the country and might contribute to pressures on prices. On the other hand, the long-run equilibrium rate would provide some stability until the completion of the investment effort, at which time the short-run exchange rate and the long-run exchange rate would coincide. This does not imply that full convertibility runs counter to the growth objectives of member countries. Rather, it is necessary to indicate the need to establish an exchange rate which, through the investment programs and the probable generation of a surplus on the capital account, will work to improve the current account position of the country over the long term.
A convertibility agreement implies that participating countries have a long-term commitment not to reintroduce exchange restrictions for intracommunity transactions. As a result, they are obliged to adopt monetary and fiscal policies that are consistent with a sustainable degree of external balance. Thus, in turn, certain constraints are imposed on the use of monetary and fiscal policy instruments by individual countries.
A Partial Monetary Union
A partial monetary union constitutes a further phase of monetary integration in which members of the union set fixed exchange rates between their currencies. Even though the exchange rates are declared to be fixed or irrevocable, a certain element of uncertainty remains because, as long as countries issue their own separate currencies, it is possible that a country may at some time separate from the union or change its exchange rate. Thus, a “fixed rate” in this context can be taken to mean that it would be changed only under exceptional circumstances.
The benefits of entering into a partial monetary union relate largely to the lessening of the exchange rate risk inherent in a convertibility agreement. Individuals would carry out their transactions, knowing that the exchange rates of the currencies of the union members have been declared as fixed and are not expected to change over time. The reduced risk would be a positive factor for trade, both within the region and with the rest of the world, contributing to increased capital flows and to improved allocations of resources.
On the other hand, in comparison with a convertibility agreement, a partial monetary union necessarily entails less flexibility in the application of economic policies. Since exchange rates are fixed, it is not possible for member countries to adopt divergent financial policies, because such divergence would be reflected in pressures in their external positions. If an external imbalance arises in a participating country through a divergence in policies or exogenous factors, the burden of adjustment falls more heavily on internal demand and supply management policies because the opportunity to apply the exchange rate instrument has been forgone.
Another important cost of entering into a partial monetary union relates to regional development problems. These have two facets: (1) the least developed countries in the group could be forced to follow austere financial policies that may adversely affect investment and economic growth; and (2) there could be a tendency for capital to flow to countries that are at a higher stage of development—those characterized by a more advanced infrastructure and the presence of industries that provide external economies for any new industries. In such circumstances, the region might experience accelerated growth in the more developed countries and stagnation, or perhaps a slowdown in economic growth, in the others.
The need for member countries to maintain foreign exchange reserves could be greater in a partial monetary union than under a convertibility agreement. Under a convertibility agreement, a country with a balance of payments disequilibrium can use the exchange rate as an instrument of adjustment. By contrast, the member countries of a partial monetary union acting individually cannot freely use the exchange rate to complement other policy measures aimed at external adjustment. Thus, adjustment might have to be effected over a longer period and could require greater reserves.
Another important factor in the establishment of a partial monetary union is the choice of a unified exchange arrangement. Whichever arrangement is chosen, there will be different costs and benefits for each country within the region. Overall, most countries would benefit from a reduction in the impact of internal and external shocks on any one country, as the effects of any shock would tend to be spread across the participating countries. However, the adoption of a floating rate for the union as a whole might increase the exchange risk of trade for countries that were previously pegged to the currency of a major country and were carrying out a substantial part of their external transactions with that country. On the other hand, for some countries the adoption of a peg to the currency of a major trading country might open up new trading opportunities. Without considering the specific circumstances of each country, it is not possible to determine the exchange arrangement that would be most appropriate for the union as a whole. In such a choice, a conflict might arise between the overall welfare of the monetary union and the welfare of individual countries.
A Full Monetary Union
A full monetary union entails the issuance of a single currency for all participating countries. All exchange rate risks within the union are totally eliminated and, consequently, intraregional trade and intraregional capital flows would be facilitated even more than they would be under a partial monetary union. Likewise, resource allocation would be more efficient and economic growth would be enhanced. In addition, no single member country would need to hold foreign exchange reserves for the financing of intraregional transactions. Accordingly, there might be less need for exchange reserves than there would be under a partial union.12 Of course, individual countries would have some disadvantages in a full monetary union. First, the member countries would lose autonomy in the conduct of their monetary policies. Second, a country’s option of issuing currency for financing fiscal deficits would be constrained by the policies of the central monetary authority. Third, the problem of divergent growth rates of countries entering the union at different levels of economic development would be aggravated even more than in a parital monetary union or under a convertibility agreement. Fourth, there would be institutional costs in the setting up of a regional monetary authority.
As in the case of a partial monetary union, it would be necessary to choose an exchange rate system for the union as a whole. As noted earlier, the costs and benefits to the various countries would differ considerably and, for each individual country, would not necessarily be the same as the net benefit accruing to the union as a whole.
These countries could, however, continue to maintain some restrictions on transactions for trade or invisibles, or capital flows, so that, although the currencies of the region were fully exchangeable, they would be usable only for a defined range of transactions.
See Joseph Gold, Use, Conversion, and Exchange of Currency Under the Second Amendment of the Fund’s Articles, IMF Pamphlet Series, No. 23 (Washington, 1978), p. 2.
See Joseph Gold, “Convertible Currency Clauses Under Present International Monetary Arrangements,” Journal of International Law and Economics, Vol. 13 (February 1979), p. 252.
See Joseph Gold, Use, Conversion, and Exchange of Currency (cited in footnote 7), pp. 4–7 and 26-31.
This is not to suggest that currencies not so identified by the Fund would not be usable in practice.
Some offset to the reduction may occur because of a rise in the volume of transactions.
A saving in the use of reserves for settling intraregional balances could also occur if an appropriate and efficient regional clearing mechanism operates under a convertibility agreement or a partial monetary union.