As the current experience in Eastern Europe shows, sound macroeconomic policies are a crucial prerequisite
As the current experience in Eastern Europe shows, sound macroeconomic policies are a crucial prerequisite
With the rapialy unfolding developments in Eastern Europe, there have been resurgent calls for moves toward currency convertibility—essentially, the unrestricted use of a country’s currency for international transactions, allowing it to be freely exchanged for foreign currencies—as a part of the process of integration into the world market economy. The virtues of convertibility appear to be widely accepted: offering greater freedom of choice between foreign and domestic goods, services, and assets, when combined with the liberalization of those transactions; and enhancing efficiency through the elimination of price distortions. Less clear, however, is whether countries with previously highly protected economies equally accept the inevitable costs inherent in the wrenching adjustment entailed in moving toward greater currency convertibility. This has given rise to divergent views on the desirable pace toward convertibility. Some are opting for a gradual approach, while others, such as Poland and Yugoslavia, launched bold initiatives in early 1990.
To understand what is involved in the move to convertibility and why some countries opt for approaches that are faster than others, it is helpful to place the concept of convertibility in perspective. This article briefly recaps this background, highlighting the rules of the IMF on convertibility, before moving on to detail the necessary preconditions for the successful introduction and maintenance of convertibility. Finally, some observations concerning the convertibility of Eastern European currencies are presented, ones that pertain in varying degrees to policy dilemmas faced by economic decision makers in other regions. The main point that emerges is that if governments wish to avoid resorting to restrictions on the use of domestic currency for foreign transactions, then sound economic policies must be pursued.
The concept of convertibility
Convertibility—traditionally defined as the unrestricted exchange of paper money into gold at a predetermined rate—has long played a central role in international economic relations. Until 1914, the United Kingdom maintained full convertibility of sterling into gold at a fixed rate. But in 1925, and again, in 1947, it failed in its attempts to restore convertibility, not only to gold but also to the US dollar, because of high underlying rates of inflation and inappropriate supporting policies. It took until 1958 for the major Western European nations to re-establish currency convertibility—following the breakdown of the world financial system between the two world wars and the move from a gold standard to a modified gold/dollar standard—although the financial discipline imposed by the convertibility requirements at pre-established par values eventually proved unacceptable to certain major industrial countries. In 1973, the par value system, which had been adopted with the founding of the IMF at Bretton Woods in 1944, collapsed, and the era of floating rates was ushered in. In theory, this should have allowed most countries to move toward full convertibility, since there would be no need to impose restrictions to support a particular exchange rate.
In practice, a large number of governments were not willing to give total freedom to their currencies’ movements, preferring fixed exchange rates, or at least targets for the exchange value of their currencies. Many resorted to restrictions on trade and payments rather than monetary and fiscal discipline to support their exchange rate policies, correspondingly reducing the degree of convertibility of their currencies. As a result, even where tight government controls on currency convertibility existed, there was usually a parallel, and often illegal, market where currency could be exchanged at some price.
Currency convertibility is, in principle, a simple concept. It applies to the ability of residents and nonresidents to exchange domestic currency for foreign currency without limit. There are, however, many degrees of convertibility, with each denoting the extent to which governments impose limitations on the use of currency, which can take the form of prohibitions, taxes, special deposits, nominal ceilings (such as for travel allowances), or procedures for allocating foreign exchange. But even in cases where currencies are fully convertible, the practical scope depends not only on the extent of governmental limitations on foreign exchange and payments but also on restrictions applied to the underlying transactions, such as imports, services, or investing abroad. To free one without the other is to effectively limit the use of a given currency in a practical sense, by reducing the extent to which it can be used to carry out transactions and make purchases. Thus, convertibility—a financial concept—should be accompanied by liberalization of trade and other international transactions, implying that the benefits of full convertibility are derived from both “financial” and “commodity” convertibility.
The IMF—one of whose founding purposes was to seek a multilateral, nondiscriminatory system of payments and transfers for current international transactions, and to eliminate foreign exchange restrictions—accommodated the switch to floating exchange rates by incorporating them into the Second Amendment to its Articles of Agreement in 1978. This flexibility implied that there would no longer be any impediments, in principle, to the adoption of full convertibility of members’ currencies.
The fundamental notion of convertibility fostered by the IMF is that countries should allow an unrestricted and nondiscriminatory right to residents to use domestic currency to effect payments and transfers for current international transactions. But it should be noted that the Fund’s concept of convertibility, as defined in its Articles of Agreement (Article VIII), is a limited one, related pragmatically to the economic circumstances of members. Fund members are obliged to maintain financial convertibility (the absence of government limitations on the making of payments and transfers), but not commodity convertibility. Moreover, the Fund’s concept applies only to current transactions (in a few instances, transactions of a capital nature are included, such as amortization of loans or depreciation of direct investments), and is limited mostly to relations with other Fund members. Deviations from the Fund’s convertibility objectives are permitted, although members are expected to remove restrictions as soon as circumstances permit.
Preconditions to convertibility
Over the years, many countries have found that the twin goals of relative exchange rate stability and convertibility cannot be achieved simultaneously in an inflationary environment or where inflation is repressed via price controls and rationing. More precisely, if a country’s price level rises faster than its trading partners—and abstracting from terms of trade, institutional, technological, and climatic changes—it cannot hope to maintain equilibrium in its balance of payments without either introducing ad hoc restrictions on imports or payments, or letting its currency depreciate; in other words, without abandoning either convertibility or the nominal stability of its currency. Clearly, within this trade-off (at least since the time of the Second Amendment), convertibility—accompanied by increasing trade liberalization—has been the more desirable objective. The goal of a stable system of exchange rates is to be achieved by the adoption of mutually consistent and appropriate macroeconomic policies.
In moving toward convertibility—while taking into account the size of the underlying macroeconomic imbalances and the degree of cost/price distortion in the economy—a country would need to establish certain preconditions if extreme fluctuations in its nominal exchange rate are to be avoided.
• Exchange rates must be realistic. Whatever type of exchange arrangement is put in place, the real exchange rate must be compatible with a sustainable balance of payments over the medium term—that is, relative prices must be roughly aligned. This will usually entail movement from an overvalued official exchange rate and a substantially more depreciated parallel market rate toward a unified, market-clearing nominal rate. This could involve, at least initially, floating the rate in an auction market through which an increasing proportion of external transactions (including those of the official sector) are channeled. The goal would be to narrow, and then eliminate, any difference with the parallel market rate. The maintenance of a realistic exchange rate (one that is perceived as being credible in terms of market expectations), is a sine qua non for the sustainable convertibility of a currency.
• Macroeconomic policies must be appropriate. At the same time, stable real exchange rates, whether in fixed or floating regimes, can only be maintained without recourse to restrictions when appropriate macroeconomic policies—essentially monetary and fiscal policies—are in place. Such policies would help restrain overall demand in line with a country’s productive and debt-servicing capacities. Internal financial stability, in the form of relatively low inflation, is essential to the success of convertibility. A major burden will fall on monetary policies, especially where there has been suppressed inflation and thus excess liquidity in the system. Steps could also be taken to absorb excess liquidity directly through the large-scale sale by the state of tangible assets (e.g., housing, businesses) and financial assets.
• Price controls should be eliminated. In countries where resource allocation has been distorted through the use of price controls, the use of a market-clearing price for foreign exchange will facilitate the determination of appropriate domestic market prices in the nontradable sectors. The longer the domestic price structure has been distorted, and the greater the degree of distortion, the greater the transitional costs of adjustment; conversely, the greater the benefits in the removal of distortions. The heated nature of the current debate on the appropriate degree of gradualism in adjustment programs being implemented by countries under these conditions—along with the emphasis on the need for a social safety net to cushion the adverse impact of adjustment on the poor—stem from these considerations.
• Adequate foreign exchange reserves are needed. Substantial foreign exchange reserves or external credit lines may be necessary to bolster market credibility in an initial period of adjustment, if convertibility is to be introduced while maintaining a particular nominal exchange rate, or within a specified range. Balance of payments support may also be needed in subsequent periods of external pressure. For members of the IMF, use of Fund resources could be temporarily made available for this purpose.
The removal or reduction of the above obstacles should permit a country’s authorities to move toward currency convertibility by eliminating various restrictions on payments and transfers—including the use of bilateral payments agreements, import deposits, and export subsidies. Moreover, liberalization of the underlying transactions, beginning with trade and services, should be pursued. Any remaining trade and payments restrictions in the transitional period should be included in “negative lists,” meaning that anything not explicitly restricted is permitted.
Partner countries should reciprocate these efforts by opening up their trade and payments systems, if they have not already done so. After all, the true efficiency gains from convertibility can only come about with the opening of an economy to international trade, services, and capital markets. It has to be recognized, however, that for countries with highly protected economies, these moves can involve considerable dislocation of firms and entire economic sectors, entailing high social costs, as economic agents will inevitably alter their spending and saving decisions when offered greater, and undistorted, freedom of choice. These costs, at least in the short run, will be higher, the more artificially insulated the country has been from the world economy.
Meanwhile in Eastern Europe
Inconvertibility is hardly limited to Eastern Europe, or even to centrally planned or socialized economies, in general, as many countries have overvalued exchange rates, administered prices, distorted resource allocation, and extensive restrictions on trade and payments. While all six Eastern European countries that either are Fund members (Hungary, Poland, Romania, and Yugoslavia) or applied for membership in 1990 (Bulgaria and Czechoslovakia) maintain bilateral payments arrangements with other Fund members and with nonmembers as of the end of 1989, there are another 39 Fund members who also maintained such arrangements among themselves.
In essence, therefore, the convertibility issue faced by the countries of Eastern Europe is similar to that confronting other Fund members, and the preconditions for establishing convertibility discussed earlier apply to all countries. Indeed, these conditions constitute the core of much of the Fund’s policy advice to members within the context of annual consultations or Fund-supported programs. The details need to be examined on a case-by-case basis, depending upon the initial degree of convertibility, the state of economic development, structural and market features, confidence factors (such as the public’s faith in the government’s ability to pursue the necessary policies), and the extent to which appropriate economic policies have been carried out in the past.
For countries wishing to profit from participation in the world economy, inconvertibility is no longer an option. Modern communications, the ease of travel, the size and sophistication of international capital markets, and the importance of trade for even formerly autarkic economies mean that countries have relatively limited margins for insulating themselves from the discipline of the market. And it should be stressed that attempts to do so also exact enormous economic costs because draconian restrictions are required. Moreover, partial convertibility, except as a transitional mechanism, will not work. Restrictions will be evaded and parallel markets will emerge. Not surprisingly, therefore, more and more countries are dismantling restrictions, introducing market-determined exchange rates, and adopting appropriate macroeconomic policies, often in the context of Fund-supported programs.
When considering calls for convertibility of Eastern European countries, it is important to keep in mind that they are starting from diverse economic situations in terms of the degrees of central planning, use of the price mechanism, and privatization. Moreover, in many ways, events have overtaken the initial cautious calls for gradualism. For example, the likelihood of organizing economic relations through the Council for Mutual Economic Assistance, or other regional arrangements, diminishes as country after country—Hungary, the Soviet Union, and Yugoslavia—announces its intention to move to convertible currency settlement in 1991. While Poland and Yugoslavia have already established foreign exchange markets, the other Eastern European countries have started to nudge their currencies closer to market-clearing levels. In addition, other critical steps are being taken: Hungary allows enterprises to trade excess transferable ruble proceeds among themselves; Czechoslovakia and the Soviet Union have held foreign currency auctions; and in Hungary, Poland and Yugoslavia, foreign currency deposits are freely held and constitute a significant portion of the total money supply.
Since the beginning of 1990, Poland and Yugoslavia have undertaken bold experiments, which will also set examples for other countries in Eastern Europe and elsewhere. The first step has been the introduction of “resident” convertibility for their currencies at fixed exchange rates, the appropriateness of which will be kept under review. (This means that residents can freely convert domestic currency at a given exchange rate and use those funds to spend abroad on most current transactions, but nonresidents—for the moment—cannot do so.) In both countries, the necessary preconditions had been met: realistic exchange rates had been introduced, supported by appropriate policies. Over time, the structures of domestic prices and resource allocation, assisted by legal reform and privatization, should align themselves, but perseverance in the face of significant transitional costs will be required. An alternative sequence involving completion of structural reforms, as a precondition for the move to opening up the economy, also entails costs.
In the sequencing of reform measures, a rapid move to convertibility can play an especially important role in Eastern European countries, all of which have been characterized by highly monopolized sectors of the economy. Introducing convertibility would facilitate foreign trade, so that foreign competition could substitute to some extent for the initial lack of a competitive domestic market structure. It would also eliminate the need for regulation and bureaucracy, which could facilitate the inflow of foreign private capital and send a signal to the international community that a serious commitment to trade liberalization and reform was in place. In addition, convertibility—when combined with anchoring the exchange rate to a reserve currency—would enable governments to increase the credibility of their commitment to fight inflation. This allows them to take advantage of the established credibility of a foreign central bank, possibly alleviating the degree of severity of the monetary shock needed to establish their own credibility.