IV When to Introduce Current Account Convertibility
- Joshua Greene, and Peter Isard
- Published Date:
- March 1991
The appropriate time to introduce current account convertibility will normally depend on the implementation of other measures in a country’s reform program. As indicated in this section, macroeconomic stability and appropriate microeconomic incentives are critical to the success of convertibility, which implies that certain conditions must be established before, or at the same time that, convertibility is introduced. Given the major benefits that convertibility can provide, countries should move as quickly as possible to establish the preconditions necessary for convertibility to succeed. Moreover, there is a strong case for rapidly moving most of the way to current account convertibility once these preconditions are established. Nevertheless, some countries may wish to introduce or maintain transitional arrangements, either to enhance their ability to stabilize the current account or the exchange rate, or to allow a phased intensification of import competition that places strong pressure on domestic enterprises to adjust while providing a reasonable but limited time in which to do so. In certain circumstances, such transitional arrangements can strengthen the transformation process, provided there is a credible system for limiting their duration.
Economists have traditionally identified certain preconditions that must prevail if currency convertibility is to be implemented successfully (for example, Jacobsson (1954) and Gilman (1990)). These preconditions have changed somewhat as the concept of convertibility and prevailing views on macroeconomics have evolved, and the basic requirements are now (1) an appropriate exchange rate; (2) an adequate level of international liquidity; (3) sound macroeconomic policies, including the elimination of any monetary overhang; and (4) an environment in which economic agents have both the incentives and the ability to respond to market prices, from which all major distortions should have been eliminated. The same preconditions apply to the elimination of trade restrictions generally.
As the discussion below will clarify, the first three of these conditions are seen as necessary to ensure that the introduction of current account convertibility does not generate macroeconomic instability, while the fourth condition is necessary to ensure that convertibility delivers the intended economic benefits. For countries undertaking the transformation from central planning to a market-oriented economic system, the third and fourth preconditions will require major institutional reforms. Whether to move to convertibility straightaway or in stages may thus depend on whether there is strong political support for a comprehensive and rapid approach to reform.
Appropriate Exchange Rate
The first precondition for the establishment of current account convertibility—an appropriate exchange rate—is easy to comprehend. Unless the exchange rate is broadly consistent with equilibrium in the balance of payments, introducing convertibility will generate large imbalances. These imbalances, in turn, will generally have destabilizing effects on the domestic economy, whether the authorities choose to let the external imbalances persist or decide to cool or stimulate the economy through domestic policy measures.
As indicated earlier, the exchange rate that conforms with balance of payments equilibrium in transforming economies is likely to change along with developments in the competitiveness of the country’s productive sector, including both export and import substitution industries. The real exchange rate needed if convertibility restrictions are removed early in the transformation process may well be more depreciated than the rate that is appropriate if these restrictions are removed at a later stage, when the country’s industries are more competitive and better able to respond to market forces. Accordingly, it may be useful to envision an exchange rate path that identifies levels of the real exchange rate consistent with current account sustainability at different points in the transformation process. The expectation would be that, other things being equal, there should be some appreciation in the equilibrium real exchange rate as the underlying competitiveness of the country’s productive sector improves.
In the short run, however, countries should aim for an exchange rate that will yield a sustainable current account balance in the light of whatever reforms are introduced. Too appreciated a rate can make it difficult for a country to attain current account balance, while an overly depreciated rate can bias production and investment decisions by making all imports appear very expensive for enterprises and households and by making exports appear too profitable for domestic producers and too inexpensive for nonresidents. The extent to which such decisions are biased would depend, of course, on the degree to which decision makers accurately anticipated movements in the real exchange rate over time.
Adequate International Liquidity
Even if its exchange rate is on a path broadly consistent with current account balance, a country must have an adequate level of international liquidity—comprising foreign exchange reserves, access to foreign financing, and, in some cases, holdings of foreign currency and foreign-currency-denominated assets by private residents—to withstand cyclical shortfalls in its balance of payments, such as those coming from an unexpected change in petroleum prices. Without adequate international liquidity, a country might be unable to maintain a stable macroeconomic environment for domestic producers and consumers, because of the difficulty of stabilizing both the exchange rate and interest rates in the face of adverse short-term disturbances to the volumes or prices of exports or imports. Moreover, adequate international liquidity is necessary for the credibility of a country’s overall adjustment effort. Without sufficient liquidity, the country might be perceived as vulnerable to unforeseen external developments, thereby encouraging speculative action against its currency. As described further in the Appendix, insufficient liquidity was a major reason why the industrial countries of Western Europe chose to create a central payments union as a transitional arrangement, and to move only gradually toward liberalizing trade and establishing convertibility between 1946 and the late 1950s, when fixed exchange rates and reliance on reserves were the norm.
The amount of international liquidity a country needs to support current account convertibility depends partly on the degree of exchange rate flexibility that it desires. Given the limited access of many developing countries to international credit markets, a number have been encouraged in recent years to accumulate foreign reserves amounting to at least three months of imports, c.i.f., although some countries (for example, Nigeria) that have adopted a floating rate system have successfully eliminated exchange and trade restrictions with a lower level of reserves. As this standard has applied to many countries with inconvertible currencies, arguably a larger amount of cover might be advised for countries when establishing a convertible currency. Poland, for example, which moved a long way toward establishing current account convertibility at the start of its present reform program in January 1990, had reserves and external lines of credit totaling at that time about $2.5 billion, equivalent to about 4.5 months of imports, c.i.f.
Sound Macroeconomic Policies
The third precondition for introducing current account convertibility—sound macroeconomic policies—involves policies that will, at a minimum, maintain a sustainable current account balance. What this entails will vary from country to country. However, fiscal and monetary policies must be strong enough to create an environment of general macroeconomic stability conducive to a successful reform program. When prospects for general macroeconomic stability, including in particular price stability, are clouded by doubts about the authorities’ willingness or ability to exercise firm macroeconomic control, external payments imbalances can lead to unsustainable speculative pressures. In this regard, the authorities should be cognizant of the key role that expectations can play (Calvo and Frenkel (1991)).
Countries moving from central planning to reliance on market forces must reform their monetary and fiscal policy institutions. In addition, they must introduce market mechanisms for transmitting excess demand or supply pressures to prices, wages, and interest rates, so that they can achieve macroeconomic stabilization through indirect means—such as open market operations—rather than relying on direct controls (Szapary and Wolf (1989) and Wolf (1990)).
Historical experience bears out the central role played by strong fiscal control in reform programs.12 Strong and credible fiscal discipline generally requires budgetary processes for controlling fiscal deficits, including ways to limit the automatic financing of loss-making enterprises and subsidized activities. In addition, as Blejer and others (1991) and McKinnon (1990a) have emphasized, the implicit tax systems of centrally planned economies must be replaced by explicit systems under which tax revenues expand elastically as public enterprises are divested or become managed under new incentives, and as the economy grows. At the same time, tax policies and fiscal expenditures must be conducive to encouraging the kind of investment needed to promote and maintain the competitiveness of domestic industry.
The importance of firm monetary control in stabilization efforts is also well documented. Strong monetary control in a market-oriented economy requires a central banking system able to stabilize the economy indirectly by adjusting interest rates or other policy instruments. Establishing such an institution is especially critical in economies that have had central planning, where controls over production and resource allocation and the absence of commercial banking activities may have obscured the importance of a strong monetary authority.
If monetary control is to be established, any “monetary overhang” must be eliminated to prevent the possibility of large increases in consumer spending (and imports) from the liquidation of outstanding monetary balances.13 Only then can monetary policy maintain a reasonable degree of stability in both the price level and the macro-economic environment. If restrictions on trade and currency convertibility are removed before the monetary overhang is eliminated, however, the opportunity to use domestic money balances to purchase imported goods will drain foreign exchange reserves and put strong pressure on exchange rates and interest rates.
Monetary overhangs can be eliminated through currency reform, price liberalization, or perhaps through the sale of state-owned assets (such as the housing stock). Excess liquidity can also be reduced by setting interest rates at positive real levels, although the latter may raise government expenditure if most interest-bearing instruments are claims against the government (Calvo and Frenkel (1991)).
Incentives and Ability to Respond to Market Prices
The fourth precondition for introducing current account convertibility—that economic agents have both strong incentives and the ability to respond to market prices, which in turn should be free of major distortions—presents a major challenge for economies in which well-functioning market price mechanisms have not yet been established. Under central planning, prices often bear no relationship to production costs or relative consumer values. Therefore, price reform, which aims to ensure that prices correctly indicate relative scarcity values and the marginal returns from alternative economic activities, is an essential part of the transformation process. In this context, there is broad agreement that the prices prevailing on world markets provide the best general indication of relative scarcity values for tradable goods and services, which in turn will affect the appropriate prices for nontradables.14
As noted earlier, the benefits from establishing current account convertibility—once major trade restrictions and other cost/price distortions have been removed and market price mechanisms are functioning come from exposing domestic producers to import competition and from creating an environment in which domestic production, investment, and consumption decisions are guided by the relative prices that prevail on world markets. Import competition forces domestic producers to be efficient and reduces the market power of domestic monopolists and oligopolists. By basing their decisions on relative world prices, moreover, domestic investors will allocate resources to areas consistent with the country’s comparative advantage in the world economy.
Unless domestic producers and households have both the incentives and the ability to increase supply and reduce demand in response to increases in prices, market price mechanisms will not function appropriately, nor will eliminating exchange and trade restrictions make production and investment more efficient. The reform of enterprise incentives is thus a critical step along the road to establishing current account convertibility. So is the introduction of laws or other measures to clarify property rights, to legitimize the kinds of activities with which economic agents can respond to market prices, and to designate which individuals have decision-making responsibilities within state-owned enterprises.
Privatization may also be important for strengthening both the incentives and, by eliminating entrenched bureaucracies, the ability of production units to respond to market prices (Borensztein and Kumar (1991) and Lipton and Sachs (1990b)). Where privatization takes time, however, other measures must be given priority in the short run.
In general, market price mechanisms do not function appropriately when producers are not subject to “the discipline of the bottom line” (Fischer and Gelb (1990)). In centrally planned economies, the bulk of production has taken place in enterprises operating with “soft budget constraints” (Kornai (1979)), under which financial losses have been routinely covered or disguised by subsidies, tax concessions, or automatic credits from the state. Producers at such enterprises have thus lacked incentives to respond appropriately to price signals. At the macroeconomic level, soft budget constraints have frequently led to fiscal budget deficits and inflation. Accordingly, the hardening of budget constraints is a particularly important step that should precede or accompany the establishment of current account convertibility.15 Privatization, of course, can be one way to harden budget constraints, by eliminating the automatic access of firms to budgetary subsidies.
Should Convertibility Be Established Quickly?
Whether a country can move successfully to current account convertibility early in the reform process depends largely on how fast it can establish the preconditions just described. This, in turn, may depend not only on the speed with which resources can be reallocated across sectors to reflect the new environment but also on whether there is ample popular support for rapid and comprehensive reform. The latter condition may hinge on the extent of the country’s initial macroeconomic instability and distortions.
Poland provides one example of the rapid approach to convertibility. Under conditions of hyperinflation and widespread popular discontent with the macroeconomic situation, and following a change in government in late 1989, Poland embarked on its bold program of economic reform and structural change on January 1, 1990. Simultaneously, the exchange rate was depreciated to a level considerably below that in the parallel market during mid-December 1989; stringent fiscal and monetary policies were imposed; prices were liberalized and interest rates raised; and major changes in enterprise management and financing were begun, including a sharp reduction in credit provision and government subsidies for loss-making firms. As part of the reforms, the zloty was made convertible for virtually all merchandise trade transactions (although convertibility restrictions were retained for a number of service transactions), most quantitative import restrictions were removed, and the tariff system was rationalized. These measures followed steps the authorities took in March 1989 to establish internal convertibility for households by making it legal for them to hold foreign assets and to purchase foreign exchange from dealers (the so-called kantor market).
Yugoslavia illustrates a somewhat different approach in that it introduced convertibility after easing trade restrictions and accumulating significant external reserves under a succession of prior adjustment programs. Since the early 1980s, Yugoslavia has been implementing economic adjustment programs with IMF support—first under stand-by arrangements, then under the enhanced surveillance procedure from mid-1986 to mid-1988, and subsequently again under stand-by arrangements. Although a large balance of payments deficit occurred in 1987, Yugoslavia’s external performance improved substantially in 1988 after the initiation of a new stand-by arrangement, which significantly improved external reserves and allowed the lifting of most quantitative import restrictions by 1989. Resulting hyperinflation led to a new and comprehensive stabilization program late in 1989 that involved a fixed exchange rate, stringent macroeconomic policies, and a temporary freeze on wages and certain prices. As part of the program, the dinar was made fully convertible, as of January 1, 1990, for both current and capital account transactions by resident individuals, and in the case of enterprises, for current account transactions and debt-service payments. Thus, as in Poland, convertibility was introduced at the start of a new adjustment program. In this case, however, the development of a strong reserve and balance of payments position and the lifting of import restrictions preceded convertibility and facilitated its introduction.
The Polish and Yugoslav experiences have demonstrated the reinforcing nature of comprehensive reforms. In particular, stabilizing prices and introducing strong incentives for enterprises to become more responsive to market prices helped create the preconditions for current account convertibility. Because strong stabilization measures followed by a period of austerity appeared necessary to end hyperinflation in both countries, it can be argued that these countries risked little in simultaneously moving most of the way toward establishing current account convertibility. Indeed, their decision to do so may have strengthened the incentives to maintain sound macroeconomic policies and move rapidly in implementing institutional changes and other structural reforms.
As a rule, a country is unlikely to succeed in implementing a strong and comprehensive reform program without broad popular support. Success in eliciting and sustaining such support depends not only on the degree of discontent with the initial economic situation but also on the extent and duration of the hardship resulting from the reform program. The latter, in turn, will depend on the country’s ability to implement, quickly and effectively, key structural reforms aimed at reorganizing production enterprises and the banking sector and creating the infrastructure needed to generate private direct investment flows and financial intermediation.16 Although many of these changes take time to implement, they are essential for any economic transformation program that aims to improve productivity and lay the foundation for higher output and living standards.
In deciding whether to introduce current account convertibility quickly, countries should consider not only how rapidly they can establish the economic preconditions, but also how quickly they can implement supporting institutional changes and other structural reforms. Ideally, the move to convertibility should wait until the preconditions have been firmly established and national authorities are confident that the remaining reforms will succeed. Nevertheless, countries in which initial macroeconomic instability and popular discontent are high may feel compelled to move more rapidly toward introducing the main elements of current account convertibility, even with some risk of harming particular sectors and thereby decreasing popular support for the reform program.
In countries where extensive economic controls have led to superficial macroeconomic stability, the prospect of heavy dislocation costs may limit popular support for large-scale and rapid structural reforms. This may be particularly true in countries that start the reform process with modest levels of inflation but serious distortions arising from widespread price controls and soft budget constraints on enterprises. Although there are strong arguments for introducing convertibility as quickly as possible, the necessary preconditions may take some time to establish in countries that lack broad support for implementing strong adjustment and comprehensive reforms.
Even after the preconditions have been established, countries unaccustomed to a liberal external environment may be reluctant to remove all restrictions on current account transactions, fearing that without constraints on the total volume of imports, convertibility will lead to large current account imbalances or major swings in exchange rates, or cause large declines in output and employment. In the past, such concerns have led many countries to move toward current account convertibility in stages. The next section examines various transitional arrangements that can allay these concerns while enabling countries to move a long way initially toward providing the key benefits of convertibility.
No matter how long a country takes to establish complete current account convertibility—that is, to eliminate all exchange restrictions on current account transactions—there is widespread agreement that it should adopt a unified exchange rate for current account transactions and certain types of trade policy reforms as soon as possible. The harmful effects arising from multiple currency practices are widely recognized (IMF (1985)); indeed, member countries of the IMF are obliged to adopt a unified exchange rate under its Articles of Agreement. Multiple exchange rate systems discriminate among different exporters and importers, which can be harmful to other countries as well as to residents. They can also involve heavy administrative costs and generally provide strong incentives for evasion. Prolonged reliance on such systems can distort the allocation of resources and retard the adoption of appropriate balance of payments adjustment measures.
With regard to trade policy reforms, two elements seem to matter most. As summarized by the World Bank (1987, p. 9):
The first is the move from quantitative restrictions to tariffs. This links domestic prices to foreign prices. The second is the reduction of the variation in rates of protection alongside reductions in its overall level.17
History provides few examples of countries that have eliminated all exchange restrictions on current account transactions in a single stroke. As noted in the Appendix, the moves to current account convertibility in postwar Europe and in the newly industrializing Asian economies occurred in stages. Moreover, although the steps taken by Czechoslovakia, Poland, and Yugoslavia over the past several years have gone a long way toward establishing current account convertibility, they have stopped short of removing all exchange restrictions on current transactions.
As discussed earlier, the reluctance to eliminate all restrictions on current account transactions is based on the belief that convertibility poses serious risks for macroeconomic stability and the supply side of the economy. Thus, in seeking transitional arrangements to mitigate these risks, countries typically focus on one or more of the following objectives: retaining mechanisms for controlling the current account balance; stabilizing the exchange rate and thus providing a nominal anchor; and limiting the negative impact of import competition on output and employment in the short run.
Two kinds of transitional arrangement have been proposed for meeting these objectives while still going far to provide the key benefits that current account convertibility is intended to deliver: namely, competitive discipline and appropriate relative price signals. One type of arrangement relies to a limited extent on exchange restrictions. The other permits complete current account convertibility but involves import protection in the form of tariff barriers.18 Both present the danger that, in the absence of a preannounced timetable and a credible process for eliminating the restrictions over time, the transitional arrangements may become permanent and severely weaken or undermine economic transformation and growth over the long run.
The first kind of transitional arrangement provides much of the free access to foreign exchange that would arise under unrestricted convertibility, while enabling the authorities to maintain control over the total volume of resources available for imports. Such a system can be designed to accord with the institutional structures and preferences of individual countries. For example, open markets can be established for either foreign exchange, general import licenses, or foreign exchange certificates with which import licenses can be obtained automatically. These systems can be financed by foreign exchange surrender requirements for exporters, with the total resources for imports limited to available export earnings over the relevant time period, less amounts set aside for anticipated service payments and any desired increase in external reserves. Although, in the past, some versions of these systems (for example, exchange certificates) have been used to restrict transactions, they can be specifically designed, as a transitional measure toward current account convertibility, to involve low administrative and transaction costs, particularly compared with systems based on an administrative allocation of foreign exchange. Moreover, although such systems can lead to multiple currency practices in the form of parallel markets, the Fund has accepted such multiple currency practices as transitional arrangements in some cases, such as the 1990-91 stand-by arrangement with Poland.
This type of transitional arrangement, which can involve either fixed or floating exchange rates.19 provides a unified and transparent exchange rate for those exporters and importers included in the system. This rate—which the authorities can stabilize if they wish—reflects the market-clearing price of foreign exchange, import licenses, or foreign exchange certificates. Because virtually all external transactions are channeled through a market monitored by the authorities, this type of arrangement provides a mechanism for limiting imports financed by foreign-currency debt and for maintaining close control over the current account balance. As discussed in the Appendix, such arrangements were introduced by Taiwan Province of China in the late 1950s and by Korea in the mid-1960s. The exchange rate system now operating in Poland provides another example of this type of arrangement.20
A second kind of transitional arrangement that may be of interest uses a set of temporary import tariffs to regulate the current account deficit during the early period of convertibility (McKinnon (1990b)). Under this approach, countries would immediately introduce current account convertibility, unify the exchange rate for current account transactions, and remove all quantitative trade restrictions while establishing a set of temporary tariffs on goods to limit the short-term rise in imports. The tariff rates would initially be set high, to protect domestic firms from foreign competition during the period needed to restructure and undertake new investment. These rates would then decrease at a preannounced pace and would eventually be replaced by a fairly low and uniform customs duty, thereby signaling that domestic firms have only a limited time to become competitive. Such a system was used in Chile to establish current account convertibility during the 1970s (Edwards and Edwards (1987)).
On the one hand, the use of temporary import tariffs offers certain benefits. Current account restrictions precluded under Article VIII of the IMF’s Articles of Agreement would be eliminated immediately, and less government regulation of international transactions would be needed than under a system that established formal limits on the volume of imports. On the other hand, the use of high import tariffs would inhibit the introduction of more competition to domestic industries (although this may be part of the rationale for tariffs in the short run). In addition, any use of differential tariffs would preclude the full adjustment of domestic relative prices to those prevailing in world markets, thereby distorting domestic production and investment decisions.
If tariffs are used as a stabilizing measure, they would tend to keep the exchange rate more appreciated in the short run. This would provide less stimulus to exports but would also prevent the emergence of an overdepreciated exchange rate, with its associated problems. There is the risk, however, that domestic enterprises, once under the protection of high tariff barriers, might resist the implementation of scheduled reductions in tariff rates. Furthermore, establishing even temporary import barriers in countries where they did not previously exist could violate the rules of the General Agreement on Tariffs and Trade (GATT), although the GATT might be willing to grant an exception in view of the special circumstances surrounding these tariffs.
Auctioning foreign exchange or foreign exchange certificates may avoid some of the adverse consequences of using import tariff barriers as a transitional arrangement, by facilitating the introduction of relative world prices and by allowing a greater depreciation of the exchange rate. However, in addition to being more likely to encourage variability in exchange rates or in international reserves, this approach imposes more administrative restrictions on the allocation of foreign exchange and prevents countries from moving immediately to Article VIII status.
Whatever set of transitional arrangements they adopt, countries should be aware of their limits. Such arrangements cannot stabilize both the external current account and the exchange rate: any move to reduce imports will automatically encourage some appreciation in the exchange rate, while efforts to stabilize the exchange rate will encourage more imports than would be likely at a more depreciated rate. Moreover, efforts to stabilize the exchange rate through transitional arrangements will be unlikely to succeed if inappropriate macro-economic policies lead to a significant divergence between exchange rates on the official and parallel markets.
After analyzing the relevance of financial structure and policies to economic growth in Hong Kong, Korea, Singapore, and Taiwan Province of China, Fry (1985) concluded that the differences in financial structures and policies outweighed the similarities, but that two common characteristics stood out: the absence of pressure for monetary expansion to finance large and continuous fiscal deficits; and the fact that none of the four countries allowed its currency to appreciate in real terms solely as a result of inflationary monetary expansion. Sargent (1982), in his study of ending hyperinflation, also stressed the critical role of strong fiscal discipline in re-establishing macroeconomic stability.
Even though most transforming economies start from a position where shortages of goods have been pervasive, in some cases, such as Poland, the counterpart “monetary overhang” may have been substantially reduced through inflation.
The appropriate prices of nontradable goods and services should reflect the scarcity values that would emerge from competitive domestic markets for these commodities, including labor.
Since the hardening of budget constraints curtails credit availability from the state, measures to facilitate the emergence of private credit markets—including the introduction of accounting standards and auditing and disclosure procedures— can play an important role in reducing the strains on potentially profitable enterprises.
As noted earlier, the emergence of private direct investment and financial intermediation flows is likely to depend on many considerations. These include the laws defining bankruptcy provisions, the investment code, and property rights in general; the quality of the physical and electronic infrastructure, including the transportation system and the communications network; and the availability, transparency, and accuracy of information relevant to direct investment and credit extension decisions, which depend in turn on having reasonably well-developed accounting, auditing, and disclosure standards.
The Bank also mentions as a third element: “the direct promotion of exports to offset the bias resulting from import tariffs.” However, it adds the following note of caution: “Specific measures to promote exports risk acquiring a permanent status… and often lead to the postponement of more fundamental changes relating to the exchange rate. They may also contravene the General Agreement on Tariffs and Trade, create lobbies that will oppose their removal, and risk countervailing duty actions from importers.”
A third possible transitional arrangement for Eastern European countries would be to establish a payments union analogous to the type of institution created by the Western European countries in 1950; see the discussion in the Appendix. Kenen (1991) and Polak (1991) argue strongly against this approach. A fourth approach would be to subsidize domestic production temporarily, for example, through employment subsidies, as has been proposed in the case of the former German Democratic Republic (Akerlof and others (1991)).
Quirk and others (1987), who refer to such floating rate arrangements as “auction markets” (as distinguished in practice from “interbank markets”), discuss the experiences with these systems in developing countries.
In Poland, households are free to make foreign exchange transactions in private markets, but enterprises are required to obtain foreign exchange in an official market and to surrender foreign exchange receipts to the monetary authorities. Moreover, official foreign exchange is not provided freely for capital account transactions, reflecting “concern on the part of the … [authorities] regarding the defensibility of a fixed parity, given the uncertainty surrounding the launching of the stabilization program” (Lipton and Sachs (1990a), p. 113). Although such a system involves multiple currency practices, the authorities’ intention to prevent the divergence between the parallel rate and the official rate from becoming significant made it a system that the Fund was prepared to approve as a transitional arrangement.