In a world where goods, services, and financial markets have become increasingly integrated, it is argued that current account convertibility has become an anachronism.¹ Yet, current account convertibility remains at the center of the mandate of the International Monetary Fund and constitutes for many countries an important policy objective, which is often seen as an intermediate step toward the attainment of full convertibility. A key unresolved issue is whether countries with inconvertible currencies should move directly to full convertibility or go through a transitional period of current account convertibility. While the focus of this paper will be primarily on current account convertibility, it will attempt to shed some light on the considerations involved in the move to full convertibility.

The paper will, first, provide some background on the concept and gradations of convertibility. Second, it will outline the benefits and costs involved in the introduction of convertibility, as well as the conditions that need to be met and sustained to introduce and maintain convertibility. Third, it will place the issue of convertibility in the wider framework of the speed of adjustment and the appropriate sequencing of reform policies. Against that framework, it will attempt, fourth, to analyze the relative merits of different approaches to achieving current account convertibility. It concludes by highlighting how transitioning through current account convertibility to achieve full convertibility can be viewed as consistent with both theoretical welfare and pragmatic considerations.

Gradations of Convertibility

The founding fathers of the International Monetary Fund gave high priority, in Article I(ii) of the IMF’s Articles of Agreement, to the establishment of current account convertibility as a means of facilitating “the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income. …” As such, a key mandate of the Fund was

[t]o 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(iv); italics added).

Capital account convertibility was viewed as being important only in so far as its absence hindered current account transactions, as evidenced by the provision in the Articles of Agreement that

[m]embers may exercise such controls as are necessary to regulate international capital movements, but no member may exercise these controls in a manner which will restrict payments for current transactions or which will unduly delay transfers of funds in settlement of commitments … (Article VI, Section 3, IMF, 1993; italics added).

From an economic point of view, currency convertibility can be defined as the ability (1) to exchange one currency for another, at a given or market-determined rate, and (2) to use the acquired currency for foreign transactions. There are wide gradations of convertibility. At one extreme, total convertibility involves the unrestricted exchange of the currency of a country into any other currency without limitation on its use 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. At the other end, total inconvertibility denotes the complete inability 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 or restrictions 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 (Table 1).²

The Fund’s concept of convertibility, as provided for under Article VIII, Sections 2, 3, and 4, lies in between these two extremes. It involves the abolition of exchange restrictions on current account transactions, namely, trade and invisibles. It does not, however, extend to restrictions on trade and invisibles that could, in themselves, limit the usability of the currency for some current account transactions or capital transactions. It also does not provide for internal convertibility, defined as the ability of residents to hold and convert the domestic currency into other currencies within the country.³

The official establishment of current account convertibility, involving acceptance of the obligations of Article VIII, Sections 2, 3, and 4, has proceeded at a relatively slow pace since the establishment of the Fund (see Appendix). In 1946, only four countries accepted those obligations. It was not until the early 1960s that most of the industrial countries had done so. In the following years, several countries accepted the obligations, although at an average rate of somewhat less than three countries a year. There was a pickup in 1993, with 8 additional countries accepting, bringing the total to 82 countries (Chart 1). However, weighing the countries by their importance in world trade in 1990, the most important progress was made in the early 1960s, followed by the period 1986–93 (Chart 2). It was only in the late 1960s and early 1970s that the major industrial countries had gone beyond the requirements of Article VIII, moving for the most part to full convertibility.

Benefits, Risks, and Conditions

The Fund’s Articles of Agreement are clear on the systemic benefits from current account convertibility, notably in terms of the promotion of world trade, allocative efficiency, growth, and employment.⁴ From a country’s point of view, the move to current account convertibility carries numerous benefits. Establishing current account convertibility helps to reduce distortions associated with foreign exchange rationing. It contributes to a rise in productivity by opening the internal market to increased competition, improves the access to production inputs and capital equipment; and helps import foreign technology. As internal prices become more aligned with world prices, current account convertibility also helps in fostering allocative efficiency and in moving to areas of production in line with the country’s comparative advantage. All these factors also contribute to improving the incentive structure and thereby stimulating investment, employment creation, and growth. Apart from the resulting positive incidence on real per capita income of current account convertibility, consumer welfare is further improved as a wider range of consumption items becomes available. Further benefits, however, can be achieved with the move to full convertibility, particularly as the flow of capital can help to attract foreign investment. This, in turn, can accelerate the introduction of improved technology and more efficient production methods, while the knowledge of foreign investors of market opportunities abroad can foster export growth.⁵

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There can, of course, also be negative transitional effects associated with the establishment of current account convertibility, as the expansion of foreign competition could prompt the restructuring of domestic production and lead to temporary output losses. However, these losses have to be viewed as a necessary cost of restructuring the economy and moving it to a higher growth path. Furthermore, the move to full convertibility could result in capital outflows if the macroeconomic policies were perceived to be inconsistent with a sustainable stable domestic financial environment or if there were uncertainties regarding the economic or political prospects of the country. It may be argued, however, that, under such circumstances, the incentives for capital outflows are so high that capital restrictions will be bypassed through parallel market activities or the overinvoicing of imports.⁶

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Number of Member Countries That Have Accepted the Obligations of Article VIII, Sections 2, 3, and 4 of the Articles of Agreement

(Cumulative. 1946 through 1993)

Source: International Monetary Fund.

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Currency convertibility is not a policy instrument per se, but rather a reflection of a policy outcome where a country has achieved balance between the demand and supply for foreign exchange vis-à-vis its currency. As such, currency convertibility can be simply achieved by allowing the exchange rate to float and removing all exchange restrictions. However, if domestic financial policies were too expansionary, continuous pressure on the exchange rate would result, leading to an inflationary cycle involving depreciation-inflation-depreciation, a cycle that would disrupt investment incentives and growth. Furthermore, the lack of an adequate level of foreign exchange reserves would limit the ability of the monetary authorities to smooth fluctuations in the exchange rates arising from seasonal or transient factors, with the resulting instability of the currency (in the absence of stabilizing arbitrageurs) undermining confidence in the currency.⁷ Finally, if the regulatory environment was such that prices, production, and trade decisions were centrally controlled, the benefits of the introduction of convertibility would not be passed on to the economy.

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Members That Have Accepted the Obligations of Article VIII, Sections 2, 3, 4 of the Articles of Agreement

(In billions of U.S. dollars in 1990 trade; cumulative. 1946 through 1993)

Source: International Monetary Fund.

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Because of these considerations, the economic literature has generally focused on the preconditions that need to be satisfied to successfully introduce convertibility.⁸ The presumption is that these are prior conditions. In fact, however, they are conditions that need to be satisfied prior to or concurrently with the introduction of convertibility and are needed to sustain it. Thus, it is more appropriate to refer to the conditions that are necessary for the successful introduction and maintenance of convertibility. There are four conditions that, though interdependent, can be analytically isolated.

First, internal financial balance needs to be established by adopting sound fiscal and monetary policies that equilibrate aggregate demand with available resources. Otherwise, excessive inflationary pressures would undermine the competitiveness of the economy and lead to a deterioration in the balance of payments situation, given the exchange rate.

Second, external financial balance must be achieved. To this end, the exchange rate has to be set or allowed to float to a level that would equilibrate the demand for and supply of foreign exchange without exchange restrictions, taking into account the demand-management policies. In principle, the achievement of external financial balance is a necessary and sufficient condition for convertibility. Thus, if the exchange rate is allowed to float, the demand for and supply of foreign exchange will be equalized. However, if domestic financial policies remain excessively expansionary, inflationary pressures will build up, resulting in a continuous depreciation of the currency. In such an unstable environment, investment and growth would suffer. To prevent that, external and internal financial balance must be achieved simultaneously.

Third, an adequate level of reserves must be maintained to allow the country (1) to absorb domestic or exogenous shocks, without reintroducing restrictions, while domestic policies or the exchange rate, or both, are adjusted, and (2) to finance transient or seasonal fluctuations in net exchange receipts so as to avoid large temporary swings in the exchange rate. In general, the level of reserves needed will depend on the exchange rate policy of the authorities. A higher level of reserves will be needed if the authorities place a high priority on exchange rate stability over time. Otherwise, movements in the exchange rate could be used to fully absorb transient or more permanent shocks to the economy. Thus, an adequate level of reserves, while not absolutely essential, can provide a buffer against temporary shocks, and serve as a cushion that would allow some margin for introducing policy adjustments to tackle more permanent shocks.

Fourth, the incentives system must be liberalized to allow the positive effect of convertibility on resource allocation to be transmitted to the economy. It is, therefore, to be seen as a condition not for currency convertibility but for deriving the allocative efficiency that would result from currency convertibility. It would require the elimination of trade controls, tariff barriers, internal marketing controls, price controls, interest rate ceilings, regulatory monopolies, labor market restrictions, and other administrative hindrances to the functioning of the market system.

Issues in Speed and Sequencing

The speed with which convertibility is introduced and the sequencing of its introduction are critical to ensure that it generates beneficial effects for the economy. From the discussion above, it is clear that the successful adoption of convertibility involves a comprehensive set of both macroeconomic and structural reforms to achieve financial balance and allocative efficiency. It is, therefore, synonymous with successful adjustment, culminating in a viable balance of payments position.

The views on the appropriate speed of adjustment are divided. Some analysts argue that a fast adjustment, involving the immediate move to convertibility, can generate greater benefits than a gradual approach, where convertibility is phased in pari passu with the progress made on the adjustment and reform fronts. Others argue that the benefits of a gradual approach are greater. In my view, the distinction between the two approaches is somewhat overdrawn. In practice, the speed of adjustment, and the concomitant introduction of convertibility, will depend on the specific circumstances of each country. In a purely theoretical model, however, the problem can be defined as that of finding the optimal adjustment trajectory that will maximize the intertemporal welfare function, with an appropriate social discount rate, subject to various financial and structural constraints.

The practical translation of this maximization problem into a real-world adjustment program is virtually impossible. But three generalizations would seem plausible: (1) the higher the social discount rate, other things being equal, the lower the optimal speed of adjustment—as there will be a tendency to defer net costs; (2) the greater the financial constraints, the faster the speed of adjustment required—whether orderly or disorderly; and (3) the greater the structural constraints—in terms of infrastructure, institutional capacity, administrative capacity, and so forth—the slower the speed of adjustment.

From these, it follows that

• if a program were designed to achieve convertibility at a faster rate than provided by the social discount rate, other things being equal, social tensions would rise, leading to a disruption of the adjustment process;

• if a program were designed to achieve convertibility at a slower rate than implied by the financial constraints, other things being equal, the adjustment process would break down because of lack of resources;

• if a program were designed to achieve convertibility at a faster pace than given by the structural constraints, there would also be a breakdown of the process because of the problems that would be encountered in implementation; and

• if a program were designed to achieve convertibility at a slower speed than given by the optimization solution, it would follow tautologically that there would be welfare losses.

The above theoretical discussion of the pace at which convertibility can be achieved provides only a broad framework; it is of little use in practically determining the speed at which macroeconomic adjustment should take place or the manner in which reforms should be phased in. Nonetheless, there are a number of interrelated practical considerations that are essential in determining the time frame and phasing under an adjustment program leading to the introduction of convertibility.

Regarding the time frame, two practical considerations are critical:

Required financing. The external financing required for adjustment should be compatible with a return to a viable balance of payments position; that is, the resulting debt-service ratio should not undermine the external sector position.

Available financing. The overall speed of adjustment cannot be slower than that given by the availability of external financing, subject to the first consideration above.

As to the sequencing, the following considerations arise:

Macroeconomic policies. Given that the alignment of aggregate demand with available resources is critical for the establishment of convertibility, the adoption of sound fiscal, credit, and exchange rate policies needs to be given priority.

Compatibility. There would be a need to phase structural reforms in a manner compatible with the re-establishment of macroeconomic stability. Consider, for example, the rationalization of tariff structures, which would be essential to reinforce the positive effects of convertibility, but which would have immediate adverse effects on revenue and the deficit; the introduction of tax reforms, which would be essential to reduce financial imbalances, but which could take some time to be introduced; or the increased emphasis on credit to the private sector, which would be essential to finance investment associated with the improved incentive structure, but which could be incompatible with an acceptable rate of monetary expansion.

Complementarity. The complementarity of policies should determine the timing of actions. Consider a country with an overvalued exchange rate and price controls. An adjustment in the exchange rate will only have the desired absorption and expenditure-switching effects if domestic prices are concurrently deregulated (or adjusted) to reflect the exchange rate change. Similarly, the positive effects of liberalizing trade restrictions would be reaped only if domestic prices were deregulated. However, an ensuing sharp rise in prices can be limited only if restrained fiscal and monetary policies are put in place.

Lead time. Structural reforms should be phased in, taking into account the time for the requisite preparatory work, the implementation, and, where applicable, the gestation period. For example, if tax reforms are needed to improve the fiscal position so as to reduce excess demand pressures and introduce convertibility, the phasing would depend on the time required to prepare the studies, recruit or train the requisite personnel, prepare and adopt the legislation, put in place a functioning-institutional structure, and generate the requisite revenue.

Distribution effects. The phasing of reforms to achieve convertibility should take into account income distribution effects. Reforms that in the short run affect adversely and simultaneously large segments of the population or the most vocal and politically influential segment may lead to social tensions that would derail the reforms and lead to higher adjustment costs.

Differing Approaches

The above framework provides a basis for assessing the different speeds at which the introduction of convertibility can be approached. Three different approaches—which for illustration can be classified as the front-loaded, the preannouncement, and the by-product approaches—are examined.⁹

To analyze these approaches, consider a country with both internal and external financial disequilibria exemplified by a high budget deficit, a monetary overhang, an inadequate exchange rate, widespread exchange and trade restrictions, as well as price controls, and large parallel markets for goods and foreign exchange. What would be the implications of the three approaches for the country?

Full Convertibility

There is no question that in today’s world—where the financial markets are as important if not more important than the goods markets—current account convertibility can be viewed as an anachronism in the sense that it deprives the country of the full benefits of convertibility. However, historically, many countries have moved gradually to establish current account and, subsequently, capital account convertibility. In terms of the framework set out in this paper, the establishment of current account convertibility as a transitional step toward achieving full convertibility would seem consistent with the “revealed” optimal adjustment path that would maximize a country’s welfare function.

In practical terms, the debate for a move to full convertibility is based on two major arguments: (1) the conditions required for establishing current account convertibility are not substantively different from those required to achieve full convertibility; and (2) capital controls are, in any event, ineffective and can be circumvented. This position, however, overlooks what may be termed the confidence factor, namely, that even if the macroeconomic and structural conditions for full convertibility are met, a country with a track record of policy reversals needs to change market expectations by performing well over a certain period of time. The introduction of current account convertibility and its sustenance can increase the confidence in the currency, minimizing the potential for speculative capital flows once capital controls are lifted. Although it is possible that the confidence factor can be offset at the outset through the adoption of a high interest rate policy, such a move has to be assessed in terms of its implications for some of the country’s internal objectives.