VI Internal Convertibility

Joshua Greene, and Peter Isard
Published Date:
March 1991
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The previous sections have focused on convertibility for current and capital account transactions. This section turns briefly to the issue of internal convertibility—here defined as the legal right of residents to acquire and maintain domestic holdings of certain assets (for example, currency and bank deposits) denominated in foreign currencies.21 Residents of countries with inconvertible currencies have traditionally favored the right to hold foreign currency as a hedge against domestic inflation. Freedom to hold and intermediate foreign exchange internally, however, is not tantamount to permission to make payments or hold assets abroad. In many of the transforming economies, holdings of foreign currency have also been encouraged because they have provided access to special state stores offering goods for sale only in so-called hard currencies.

Countries may, of course, limit the extent to which internal convertibility is permitted. In Poland, for example, households are essentially unrestricted in their ability to obtain foreign exchange and in the range of foreign-currency-denominated assets they may hold domestically, while enterprises must surrender fully all export proceeds.

Countries can permit internal convertibility while maintaining extensive controls on current account transactions. To be effective, however, such controls may have to take the form of restrictive tariffs or quantitative limits on trade, because with internal convertibility, residents will have the foreign exchange needed to make payments for imported goods and services. Moreover, internal convertibility may make it very difficult to maintain effective restrictions on capital outflows, which can be much harder to detect than outflows through the current account.

Historically, countries have sometimes chosen to maintain restrictions on internal convertibility after establishing convertibility for current account transactions. In general, the intent has been to limit the scope for capital outflows or to limit flows of official gold or foreign exchange holdings into the portfolios of private domestic residents.

The motivation for introducing internal convertibility differs from that for establishing current account convertibility. One reason is to induce residents to sell or deposit their existing cash holdings of foreign currency, thereby channeling foreign exchange resources into the banking system. A second reason is to integrate black markets into the formal economy, thereby lowering transaction costs and encouraging greater uniformity in exchange rates.22 These potential benefits must be weighed against the potential costs, however. In the absence of sound macroeconomic policies and attractive prospects, internal convertibility can lead to large-scale substitution out of domestic currency into foreign currency, which, in turn, can deplete official foreign exchange holdings.23 In addition, large resident holdings of foreign exchange deposits can complicate monetary policymaking.

The preconditions for introducing internal convertibility are the same as the first three preconditions for current account convertibility, namely, (1) an appropriate exchange rate, (2) adequate international liquidity, and (3) sound macroeconomic policies, including the elimination of any monetary overhang. Sound macroeconomic policies— policies that yield price stability and competitive returns on domestic currency holdings—are needed to make it attractive to hold assets denominated in domestic currency and thus discourage large-scale currency substitution. To limit speculative pressures and to insulate the domestic economy from smaller waves of currency substitution, a realistic exchange rate and adequate international liquidity are also needed.

Although the definition is common in parts of Eastern Europe today, the term also has other connotations, as noted in Section II.

In addition, legalizing transactions that previously occurred in black markets frees resources that would otherwise be used for enforcement by the authorities and evasion by participants in the black markets.

This did not happen in Poland, partly because of the relatively high real interest rates paid on domestic assets during the first few months of the new program, which made these assets competitive with those denominated in foreign currency. Indeed, the share of foreign currency deposits in the money stock declined from 63 percent at the beginning of 1990 to 42 percent at the end of June 1990.

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