How is Currency Convertibility Done?

The following article will guide you about how is currency convertibility done. Also learn about the IMF rules on convertibility.

In international transactions currencies of different countries are used. Some of the world’s currencies are accepted in all types of transactions throughout the world. These are called convertible currencies. Examples are US dollar, Swiss franc, French franc, British pound, Germany marc and so on. Other currencies are called inconvertible currencies because these are not accepted by all countries in all types of transactions.

The international status of a country’s currency depends on two things:

(i) The country’s balance of payments position and

(ii) The confidence of the rest of the world in the country’s currency (which depends largely on the stability of the currency in recent past).

Currency convertibility is of two types: on current account and on capital account. If a currency is convertible only on current account it is called a partly convertible currency. Such a currency is accepted for all current transactions such as exports of goods and services and unilateral payments and receipts. However, if a currency is convertible on capital account also it is called a fully convertible currency.

Such a currency can be used to repay the external debt. For example if rupee becomes a fully convertible currency India will be in a position to repay her external debt in rupees rather than in foreign exchange. Capital account convertibility is also likely to encour­age greater inflow of financial capital from the rest of the world and thus improve the country’s balance of payments position.

IMF Rules on Convertibility:

Just as the general acceptability of national currency eliminates the costs of barter within a single economy, the use of national currencies in interna­tional trade makes the world economy function more efficiently.

To pro­mote efficient multilateral trade, the IMF Articles of Agreement urged members to make their national currencies convertible as soon as possible. A convertible currency is one that may be freely exchanged for foreign currencies. The US and Canadian dollars became convertible in 1945.

This meant, for example, that a Canadian resident who acquired US dollars could use them to make purchases in the United States, could sell them in the foreign exchange market for Canadian dollars, or could sell them to the Bank of Canada, which then had the right to sell them to the Federal Reserve (at the fixed dollar/gold exchange rate) in return for gold. General inconverti­bility would make international trade extremely difficult.

A French citizen might be unwilling to sell goods to a German in return for inconvertible DM because these DM would then be usable only subject to restrictions imposed by the German government. With no market in inconvertible francs, the Germans would be unable to obtain French currency to pay for the French goods. The only way of trading would therefore be through barter, the direct exchange of goods for goods.

The IMF articles called for convertibility on current account transactions only Countries were explicitly allowed to restrict capital account transac­tions provided they permitted the free use of their currencies for transac­tions entering the current account.

The experience of 1918-39 had led policymakers to view private capital movements as a factor leading to economic instability, and they feared that speculative movements of “hot money” across national borders might sabotage their goal of free trade based on fixed exchange rates.

By insisting on convertibility for current account transactions only, the IMF hoped to facilitate free trade while avoiding the possibility that private capital flows might tighten the external constraints faced by policymakers.

Most countries in Europe did not restore convertibility until the end of 1958, with Japan following in 1964. Germany also allowed substantial capital account convertibility, although this was not required by the IMF articles Prior to that date, a European Payments Union had functioned as a clearing house for inconvertible European currencies, performing some of the functions of a foreign exchange market and thus facilitating intra-European trade. Britain had made an early ‘dash for convertibility in 1947 but had retreated in the face of large foreign reserve losses.

The early convertibility of the U.S. dollar, together with its special posi­tion in the Bretton Woods System, made it the post-war world’s key cur­rency Because dollars were freely convertible, much international trade was done through dollars and importers and exporters held dollar balances for transactions. In effect, the dollar became an international money — a uni­versal medium of exchange, unit of account and store of value.

Also con­tributing to the dollar’s dominance was the strength of the American economy relative to the devastated economies of Europe and Japan: Dollars were attractive because they could be used to purchase badly needed goods and services that only the United States was in a position to supply. Central banks naturally found it advantageous to hold their international reserves in the form of interest-bearing dollar assets.

Convertibility of the Rupee:

The Indian rupee was made a partly convertible currency in the wake of the liberalisation policy announced in July 1991. Rupee has been linked to a basket of currencies and a new exchange rate system has been introduced since then called liberalised exchange rate mechanism system (LEMS). Now rupee is floating in the international market and its external value is deter­mined by the free play of market forces. But rupee is yet to be made a fully convertible currency.

Regarding the effect of full currency convertibility on balance of pay­ments there is difference of opinion among economists and policymakers.

Despite evidence of the inherent risks of free capital flows, most LDCs are moving in the opposite direction — towards restraints on capital flows The articles of agreement of 1944 at Bretton Woods, did not embrace the capital account convertibility as a goal, but only “avoidance of restrictions on payments for current transactions”.

But tire IMF, at its annual meeting in Hong Kong in September 1998 virtually endorsed the eventual move towards capital account convertibility which means that nationals and foreigners could take capital in and out freely, in any volume, at any time.

Proponents of capital mobility often compared it to trade in goods and services, and mutual gains from trade, refuting the theory of comparative advantage. But unrestricted capital mobility, unlike protectionism has costs often greater than gains. Asian crisis is an example.

The Asian crisis was created primarily by excessive short-term borrow­ing by Asian banks as the capital controls were loosened in the Asian countries.

But many claim that this downside to capital mobility can be ameliorated:

(1) Either by ignoring the IMF, and letting the market forces settle the problem; or

(2) By enhancing the power of the IMF to be a lender of last resort.

However, there is a correspondence between free trade in goods and services and free capital mobility. So interfering with either will create efficiency losses.

Short-term borrowing over free capital mobility will be, and has been a source of considerable economic difficulty. Mexico, in 1994, the Asian economies of Thailand, Indonesia and South Korea — all were heavily burdened with short-term debt.

When a foreign currency crisis hits, countries raises interest rates, as the IMF has required of Indonesia. lit turn, it creates a credit crunch, and the firms with any large debt are required to sell their assets in a “fire sale” as in the case of Thailand and South Korea.

Hence, any economic efficiency resulting from free capital mobility must be set against these losses if a wise decision is to be made.

Even if one believes free capital mobility is beneficial, a distinction must be made between free portfolio capital mobility and foreign direct invest­ment. Perhaps, without the freedom of portfolio capital mobility, direct foreign investment might be less attractive. But there is no evidence to substantiate it. Any loss from it would be small compared to a “pro-foreign investment strategy”.

None of the solutions currently proposed can eliminate the instability generated from capital mobility.

The case for free capital mobility in India is centred round the idea of free trade — the liberalisation of trade in goods and financial services. This is likely to be achieved only if rupee is made a fully convertible currency.

The advocates of free convertibility argue that the “ideal world is one of free capital flows”.

Critics put forward the traditional free trade arguments to promote the free capital mobility:

The movement in goods and services and capital internationally is no different from their inter-regional movements within a country. If move­ments of capital between Los Angeles and Dallas benefit the parties con­cerned, the same argument can be advanced in favour of movements of goods and services and capital across national borders.

It is felt that the liberalisation will not succeed without strong institu­tional framework: “through improved accounting and disclosure rules”. What is needed is the strengthening of institutional framework of markets rather than stopping the flow of capital.

In the context of quota one may advocate a sequential and incremental movement towards full convertibility.