Currency convertibility has always been a fundamental notion in international economic relations. Yet, since the abandonment of the Bretton Woods par value regime, a remarkable degree of silence has until recently surrounded the subject. Possibly this silence is related to the advent and prevalence of flexible exchange rate arrangements that followed the Bretton Woods order. The reason could be that, in theory, flexible exchange rates would make exchange and other restrictions unnecessary or redundant; and, therefore, under such exchange rate arrangements currencies would be convertible by definition, so to speak. But as is often the case, what can be expected in principle does not always materialize in practice; exchange, payments, and other international restrictions have continued to prevail in the period of flexible exchange rates and, therefore, questions of currency convertibility have remained open.

Recently, though, the silence has been broken and numerous writings on the subject of convertibility have begun to appear. Two different sets of factors account for the renewed interest. One has been the widespread process of reform currently under way in the ex-collectivist economies of central and eastern Europe, as well as of the former Soviet Union, that began in the late 1980s. The other has been the process of domestic financial sector deregulation and capital market liberalization that either de jure or de facto has been carried out during the last decade in the industrial world at large and in many developing countries.

From the standpoint of the societies in transition from central planning to a market-based system of economic organization, the issue of currency convertibility has become important in that it constitutes a key component of their reform efforts. In this context, it has been pointed out that the concept of convertibility transcends the boundaries of a narrow monetary question and that it embodies central elements of the strategy to transform economic regimes radically and comprehensively.

Developments in domestic financial markets in industrial economies and in many developing countries and the consequent globalization of international capital markets, in turn, have also stimulated interest in currency convertibility issues. The interest here has focused on the degree, rather than the concept, of convertibility. In this regard, the issues brought to the fore have been those concerning currency convertibility for capital account transactions, more commonly referred to as capital account convertibility.¹

This paper discusses the concept of convertibility in its various modalities and degrees. Convertibility, like other related economic concepts, such as liquidity and restrictiveness, is not always amenable to precise definitions and, therefore, it is worth stating explicitly what it entails, its scope, which is not invariant in time or in economic usage.

Concept of Convertibility

Traditionally, that is, until early in this century, convertibility generally referred to the right to unrestrictedly convert a currency into gold at a given rate of exchange. This right was an essential component in the functioning of the gold standard that prevailed at the end of the nineteenth and the beginning of the twentieth centuries. In this sense, no currency is convertible today. At present, gold no longer plays a significant monetary role and therefore convertibility into it is no longer a relevant concept. Instead, convertibility now refers to the right to convert freely a national currency at the going exchange rate into any other currency. Clearly, the going exchange rate can be either fixed or flexible, in principle, and convertibility is a concept that would apply to a currency under either regime. Yet, as hinted in the introduction, the strength of the concept of convertibility is not invariant with regard to the existing exchange system.

To the extent that flexibility in exchange rates replaces the need for restrictions on exchange transactions, it is clear that such flexibility and currency convertibility go hand in hand. Deviations between the two concepts arise whenever a flexible exchange rate coexists with exchange restrictions, as is often the case in practice. In theory, though, flexible exchange rates render such restrictions (and international reserves) unnecessary, or in any event less necessary than otherwise. Convertibility in this context is a corollary of exchange rate flexibility. A soft concept of convertibility, therefore, would be embodied in the ability to engage in unrestricted exchange of currencies at market-determined exchange rates.

Most discussions of convertibility, however, do not envisage such an unconstrained notion. In fact, the general understanding of convertibility is rather the right to engage in unrestricted exchange of currencies at a given exchange rate. This is a hard concept of convertibility and the one associated with fixed exchange regimes. To the extent, though, that exchange restrictions accompany fixed exchange rate systems, the scope of convertibility is thereby limited.

So far, the discussion has been conducted on the basis that convertibility is a financial, a currency, concept. And it has been argued that the concept depends on the nature of the exchange regime, both in terms of the exchange rate system and of the presence or absence of exchange restrictions. But even when exchange restrictions do not exist, convertibility in a fundamental sense is very much affected by restrictions other than those on exchange transactions. This is particularly true with controls on the underlying transactions, such as those on imports of goods and services and of capital exports. That is to say, a currency that is convertible at a given exchange rate (the hard concept discussed above), because there are no exchange restrictions, can be made practically inconvertible through trade and capital controls. These interconnections between financial and real transactions are the basis for the distinction between real or commodity convertibility (prevailing when there are no exchange and trade controls) and financial convertibility (requiring only absence of exchange controls).

Degrees of Convertibility

Apart from the various definitions of convertibility just discussed, there are a number of other meanings given to the term that, rather than reflect additional variations of the concept itself, represent differences in degree. These degrees are derived from various perspectives from which the question of convertibility of a currency can be examined. The most common angles have been (a) the holders of the currency balances; (b) the purposes for which convertibility is sought; and (c) the geographical scope of convertibility.

From the standpoint of the holders of currency balances, distinctions have been made between external convertibility and internal convertibility. External convertibility typically refers to extending to foreign holders of currency the right to convert their balances into foreign exchange. This form of restricted convertibility becomes relevant in settings where promotion of foreign capital inflows is a relevant consideration. More generally, external convertibility will provide incentives for foreigners to engage in economic transactions in the countries that provide this freedom to their currency. Internal convertibility, in turn, typically relates to the right given to domestic (resident) holders of currency to convert their balances into foreign exchange. This modality of restricted convertibility, although it is not inconsistent with the promotion of foreign investment, focuses more on other aspects of an economy’s performance. Apart from providing incentives to residents to hold domestic cash balances, internal convertibility exposes domestic economic policies to external competition. As such, it poses risks to the policymaker, but it also contributes to making domestic policies internationally competitive. These two forms of restricted convertibility are also often referred to as nonresident versus resident convertibility.

From the standpoint of the purposes for which convertibility is sought, the criterion to define its scope is the nature of the transaction for which the foreign exchange is required. The traditional distinction here is between current account convertibility and capital account convertibility. Current account convertibility is the most common concept and is defined as the right to convert currency balances into foreign exchange for making payments for goods and services, or more generally, for payments related to current transactions. This is the degree of convertibility sought by the Bretton Woods par value regime. During its existence, participating countries undertook a commitment to establish for their currencies convertibility at a fixed exchange rate for payments in foreign exchange in respect of current international transactions and transfers. Capital account convertibility refers to the unrestricted right of currency holders to convert their balances into foreign exchange for payments in respect of capital transactions and transfers. This type of convertibility has been less widespread in practice than the one on current account. Nevertheless, recent liberalization of capital markets and financial sector deregulation trends have developed throughout the world economy and de jure or de facto capital account convertibility has become more common. In the particular context of the European Monetary System (EMS), virtually all its participants have lifted capital controls, thereby ensuring capital account convertibility for their currencies. In connection with the variety of incentives that each type of convertibility confers, it is clear that current account convertibility (like internal convertibility) stresses the competitiveness of an economy, while capital account convertibility (like external convertibility) emphasizes an economy’s ability to attract foreign capital. There are, of course, overlaps in the effects of each type of convertibility, but they do not invalidate the distinction.

From the standpoint of geographical scope, a distinction can be made between regional convertibility and global convertibility. Regional convertibility denotes the right to convert domestic currencies into the currencies of a given number of countries in a region. This was obtained, for example, when the participating countries of the European Payments Union (EPU) made their currencies reciprocally convertible but did not extend convertibility to the United States or other countries. More generally, even currencies with broader convertibility typically limit it, for practical purposes, to the main currencies in the system, that is, those in which international transactions are denominated. In the EMS, of course, participating currencies (until recently) exhibited hard convertibility among themselves and soft convertibility for outside currencies. Global convertibility, in turn, confers the right to currency holders to convert their balances into any foreign currency. As already noted, convertibility is only relevant or necessary in relation to the main international currencies. As with languages, ability to speak a few of the major ones does ensure capacity for universal communication.

Convertibility in the IMF

In the IMF, there are three essential aspects of the concept of convertibility that are traditionally stressed: the usability of a currency, its exchangeability, and its exchange value. These are the key standards for the measurement of the convertibility of a currency. From this standpoint, a currency would be deemed to be fully convertible if it can be used for all purposes without restrictions of a financial, or more precisely, a currency character; it can be exchanged for any other currency without limitations of a financial (or currency) nature; and it can be used or exchanged at a given rate of exchange, be it a par value, central rate, official rate, or some legal exchange rate.

Then, if these three standards are not satisfied, totally or in part, the currency in question will fall short of complete convertibility, that is, of a full direct or financial convertibility. Since each of the standards can be met to a varying extent, it is clear that convertibility will also exhibit diverse degrees. A currency may be partly usable, that is, usable for some purposes but not for others, or partly exchangeable and therefore, its standing on the convertibility axis cannot be described as either convertible or inconvertible.

An analogous relativity arises in connection with the third standard, that is, the currency exchange value, which was the basis for the distinction made earlier between hard and soft convertibility. On the assumption of unlimited usability and exchangeability, the robustness of the concept of convertibility will depend on the currency’s exchange value. In the extreme, that is, when this exchange value is determined by a freely fluctuating exchange rate, in a narrow sense, the currency will fulfill the three standards and therefore may be considered convertible. But this interpretation sets no boundary or constraint on the exchange value of the currency. In contrast, the other two standards exhibit well-defined bounds, at least conceptually. A currency can be used either without limits, that is, for all purposes, or not at all, that is, for no purpose, or more realistically, for only a few purposes; these two extremes confine the scope of relativity of convertibility on this scale. In turn, a currency can be exchanged either for all currencies without limit or for none; here again, this dimension of convertibility is bound by these two outer frontiers. But as far as exchange value is concerned, the scope of relativity is of a different nature: there is the possibility of defining convertibility on this scale as meaning that a currency is usable and exchangeable either at a given rate of exchange or at any rate of exchange. The former definition guarantees, so to speak, the currency’s exchange value, but the latter offers no such guarantee. Clearly, the usefulness of the concept of currency convertibility when its exchange value can oscillate without limits is very reduced, if it exists at all. Currencies can, of course, have varying degrees of convertibility in terms of the standard of their exchange value, which will depend on the particular exchange rate regime in place. The essential issue on this front revolves around where the exchange risk falls. Does the issuer of the currency or do its holders bear such risk? Hard convertibility allocates the risk to the issuer of the currency; soft convertibility passes it on to the holders of the currency balances.

The definition of convertibility in the Fund’s Articles of Agreement reflected the concern in the membership with restoring the free flows of international trade in goods and services that had been disrupted by World War II. This concern meant that the commitment in the area of convertibility that members undertook extended only to current transactions. This commitment is reflected in the Articles of Agreement as follows:

Subject to the provisions of Article VII, Section 3(b) and Article XIV, Section 2, no member shall, without the approval of the Fund, impose restrictions on the making of payments and transfers for current international transactions. (Article VIII, Section 2(a); italics added.)

The reference to Article VII, Section 3(b) concerns an authorization that the Fund can provide to members to limit the freedom of exchange operations in a currency that has been declared scarce. This scarcity clause was included in the Articles of Agreement to provide a constraint on unduly persistent balance of payments surpluses. As succinctly put in the Keynes Plan for an International Clearing Union,

… a country finding itself in a creditor position against the rest of the world as a whole should enter into an arrangement not to allow this credit balance so long as it chooses to hold it, to exercise a contractionist pressure against world economy… (Horsefield’s italics).²

The concern was with regard to symmetry, that is, with rules that would apply to both members with persistent deficits or surpluses in their balance of payments. But it also arose, in substance, with the need to avoid contractionist pressures on world trade, as made clear in the above quotation.

The second proviso, the reference to Article XIV, Section 2, refers to transitional arrangements that members are permitted to maintain until their balance of payments positions allow them to fulfill their convertibility commitment. The proviso states:

A member … may … maintain and adapt to changing circumstances the restrictions on payments and transfers for current international transactions that were in effect on the date on which it became a member. (Article XIV, Section 2)

A third proviso of importance in the context of the Fund’s concept of convertibility relates to the definition of the meaning and scope of payments for current international transactions, which include

• (1) all payments due in connection with foreign trade, other current business, including services, and normal short-term banking and credit facilities;

• (2) payments due as interest on loans and as net income from other investments;

• (3) payments of moderate amount for amortization of loans or for depreciation of direct investments; and

• (4) moderate remittances for family living expenses.

• The Fund may, after consultation with the members concerned, determine whether certain specific transactions are to be considered current transactions or capital transactions. (Article XXX)

Some of these categories are viewed, from an economic standpoint, as capital transactions. To a large extent, though, their inclusion reflected concern with encouraging sound development in current account transactions. These transactions typically require normality in the use and repayment of short-term banking and credit facilities and payments of regular loan amortization as well as allowance for depreciation of direct investment.

Clearly, the most important limitation on the scope of the concept of convertibility in the Fund is the power that members retain to restrict capital transactions. The only constraint on this power relates to the proviso that members may not exercise controls on capital movements

… in a manner which will restrict payments for current transactions or which will unduly delay transfers of funds in settlement of commitments, except as provided in Article VII, Section 3(b) and in Article XIV, Section 2. (Article VI, Section 3)

Thus, capital control procedures cannot apply to the transactions defined as current for purposes of the Articles of Agreement, and they cannot be used to indirectly restrict current payments or delay current transfers. Apart from these caveats, members are free to control capital movements, both inflows and outflows, and this freedom is acknowledged in the purposes of the Fund, which include

(iv) 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 I; italics added)

The stress in the Articles of Agreement on current account convertibility reflects the view that adjustment of external imbalances by the use of controls on capital movements was appropriate. It is clear then that although freedom to engage in current transactions was seen as contributing to economic welfare, the same could not be said of freedom of capital flows, and to quote again the Keynes’s Plan, “it is widely held that control of capital movements, both inward and outward, should be a permanent feature of the post-war system.”³ This view reflected the state of affairs in the world economy at the time of the drafting of the Articles of Agreement. But it is less clear that the reasons behind this view hold in present circumstances.⁴

The obligation to maintain current account convertibility in the sense described above is subject to two main qualifications (other than the one related to the currency scarcity clause described above). The first qualification is that the Fund is authorized under certain circumstances to approve restrictions imposed by members for balance of payments reasons. Such approval may be granted by the Fund only when it is clear that the restrictions are necessary to cope with the balance of payments problems and that their use will be temporary. The second qualification is that the convertibility commitment applies only to transactions among member countries.

Apart from this formal definition of convertibility as contained in the Articles of Agreement, there is the concept of de facto convertibility. This concept refers to the status of the currency of those countries that maintain no restrictions on payments and transfers for current international transactions but have not formally accepted the obligations of Article VIII, Section 2, 3, and 4. In general, the Fund has recognized various forms of convertibility that can be grouped under the general label of de facto convertibility, all of which share the common characteristic that the currencies in question have a high degree of convertibility in practice. This is clearly implicit in the use of the term freely usable currency in the Articles of Agreement, which is used for operations with the Fund and is defined as follows:

(f) 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. (Article XXX)

Then, there is the concept of external convertibility, which refers to the provision of freedom for nonresidents to convert current earnings in a currency by exchanging them into foreign currencies. This type of convertibility, which is the one attained by western European countries in the late 1950s, also provided that the conversion would be at official (fixed) exchange rates; it was, then, a hard convertibility concept. The concept, though, is narrower than that of convertibility under Article VIII, Section 2, and also than de facto convertibility because it did not extend an equivalent degree of freedom to residents.

Requirements for Convertibility

There are a number of prerequisites that have been traditionally identified as necessary for an effective establishment of currency convertibility. These are an appropriate exchange rate level; an adequate stock of international reserves; balanced macroeconomic management; and an effective market environment. The latter prerequisite is one that applies mainly to those economies in the process of moving from central planning to a market-based system.

The notion that the exchange rate should be at a realistic level when a currency is to be made convertible is straightforward. If the exchange rate is not consistent with external balance, pressures will build on the economy and soon they will bear on the exchange rate itself, thus threatening the sustainability of the convertibility commitment, if this is of the hard modality. The requirement is less binding, of course, under convertibility in the soft version, as the pressures that would develop from an inappropriate level of the exchange rate would be eased by fluctuations in the exchange rate.

The importance of having an adequate stock of international reserves to establish and maintain currency convertibility is also easy to understand. The availability of reserves is essential to cope with shortfalls and other shocks that, on a recurrent basis, always affect balance of payments and economies in general. The need for international reserves is most acute for establishing and maintaining hard convertibility. As the convertibility requirement softens, the need for reserves diminishes. In the extreme, soft convertibility interpreted as convertibility with a freely floating exchange rate would necessitate no reserves whatsoever.

The third requirement, sound macroeconomic management, is of the utmost importance for all concepts and degrees of convertibility. In substance, credible and appropriate macroeconomic policy is a sine qua non for the effectiveness of convertibility. This entails appropriate fiscal and monetary management, the importance of which cannot be over-stressed in the context of full convertibility, that is, convertibility that extends to capital transactions. But it is also clearly relevant for soft convertibility concepts, if stability is to be provided to exchange rate developments.

The fourth requirement, the existence of an effective market environment, a setting where market forces are allowed to play a role, also has relevance for economies where the market is the principle of economic organization. The sense in which this requirement is important is in the need for flexibility in product and factor markets so that the domestic cost-price structure can adjust to changes in real or other factors. Such flexibility is of particular importance in the context of hard convertibility, where wage-price flexibility will be essential to underpin the given fixed exchange rate.

Concluding Remarks

Currency convertibility, in practice, is a relative concept bound by an outside definition to which few, if any, currencies adhere, that is, the freedom to convert a currency into foreign exchange for any and all purposes at a given rate of exchange. In terms of the ability to conduct international transactions, much progress has been made in terms of current and capital account liberalization. In that respect, convertibility of currencies has been established de jure or de facto to a large extent in many countries. But in essence, it is soft convertibility that prevails, as exchange rate arrangements have moved toward flexibility. Until recently, hard convertibility was characteristic of the currencies in the exchange rate mechanism (ERM) of the European Monetary System, which maintained a virtually fixed link among participating countries. But their convertibility softened when a decision was taken to broaden the margin for most currency fluctuations within the ERM from 2.25 percent to 15 percent.

In essence, convertibility of currencies, as liquidity of money, is amenable to many gradations, and in fact, has gone through many of those gradations in the last half century. Most currencies at the outset of the Bretton Woods period were inconvertible, since international transactions were tightly controlled. Indeed, one of the central purposes of the International Monetary Fund was precisely to liberalize the exchange systems of member countries and ensure that a reasonable measure of convertibility was attached to their currencies. Much progress has been made in the international economy at large in lifting exchange restrictions and establishing current account convertibility for many currencies.

This progress helped to strengthen the integration of national economies into the world system and thereby tightened the constraints of interdependence. Difficulty or unwillingness to live with the constraints led, inter alia, to the abandonment of the Bretton Woods par value regime in favor of a system of flexible exchange rate arrangements. Hard convertibility was consequently also abandoned, and countries entered into a period of soft convertibility of their currencies, the degree of which varied depending on the presence and magnitude of exchange restrictions.

The period since the demise of the Bretton Woods system saw also an enormous growth in the scale of capital movements. These capital flows affected currency convertibility in a variety of ways. To the extent that the emergence of capital flows allowed for the financing of current account imbalances, they lessened the degree of exchange rate adjustments that would have been necessary in their absence. Thus, they contributed to a measure of hardening of currency convertibility. Capital flows also were instrumental, together with a trend in governmental policy circles in favor of market prices, in bringing about a de jure or de facto lowering of capital controls. Thus, they also broadened the degree of convertibility by moving currencies toward capital account convertibility. In this respect, reality has surpassed the aims of the code of conduct embedded in the Articles of Agreement, which still contemplate the use of capital controls as an available policy option.

In sum, currency convertibility, in its hard modality, is equivalent to domestic price stability as a government aim. The latter will ensure the government’s willingness and ability to maintain the internal value of money. The former amounts to the similar principle in the international domain: the government’s willingness and ability to maintain the external value of money.